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The Private Foundation Alternative
Roger Silk | 08-30-01
As I discussed in my previous article, two types of clients seek to set up charitable remainder trusts. Those who are looking to maximize their income through the trusts' tax benefits will rarely gain a personal benefit by doing so. As Congress intended when it set the tax laws, only clients with a genuine philanthropic interest should consider a charitable remainder trust.
Before setting up such a trust, though, advisors should also consider whether clients with appreciated stock would be better served by establishing a private foundation.
Charitable Remainder Trusts vs. Private Foundations: An Example
For example, a donor who is considering putting $5 million in appreciated stock into a charitable remainder unit trust, for which he would get a $500,000 deduction, might consider instead simply putting $500,000 directly into a private foundation, selling the remaining $4.5 million, and reinvesting the proceeds.
Note that the private foundation alternative reduces taxable income by up to $1 million, even though only $500,000 is contributed to the foundation. This happens because not only does the contribution generate a tax deduction of $500,000, but it also removes the gain that is to be realized on the $500,000 from the donor's income.
Both a private foundation and a charitable remainder trust will produce the same up-front income tax deduction, and both will irrevocably set aside assets for charity. However, there are a number of important differences between the two options, and often, a private foundation will be the better alternative. Though the analysis uses a charitable remainder unit trust (CRUT), similar conclusions apply with a charitable remainder annuity trust.
| Charitable Remainder Trusts vs. Private Foundations |
|
|
|
| |
Contribute $5 million
to CRUT |
Contribute $500,000
to Private
Foundation,
Sell Remaining Assets |
| |
| Income Tax Deduction |
$500,000 |
$500,000 |
|
Liquidity
|
Limited to annual
cash flows |
Complete liquidity of
both personal and
foundation assets |
|
|
Risk of giving "more than intended" to charity
|
Risk of not living
to life expectancy
|
None
|
|
| Uncertainty of
tax treatment |
Minor, because IRS still unhappy with some
CRTs |
None |
|
|
| Potential
conflict of interest between trust beneficiaries |
Risk exists |
None |
|
| Subject to
private foundation rules |
Yes |
Yes |
|
| Potential to
benefit from deferral of income taxes |
Yes |
No |
|
|
Investment flexibility |
Limited by trust rules and by charitable
interest |
Majority of assets
are unrestricted |
|
Income Tax Deduction
Both a charitable remainder unit trust and a private foundation produce an income tax deduction of $500,000 in our example.
However, the trust requires the irrevocable commitment of 10 times as many assets as the private foundation to produce the same income tax deduction.
Liquidity
With the unit trust, the donor's liquidity is limited to the annual cash flows, which constitute the "retained unitrust" interest. The donor basically gives up liquidity by placing assets into the trust. Furthermore, during the term of the trust, the charity does not have access to the CRUT assets either. Only at the conclusion does the remainder amount become available for charity.
With the private foundation alternative, in contrast, all amounts are fully liquid. Moreover, donors retain outright ownership and control over the majority of their assets. The assets are theirs, free and clear, to do with whatever and however they wish.
Risk of Giving "More Than Intended" to Charity
With a charitable remainder unit trust, all the assets are placed in trust, and the remainder interest at the end of the trust term goes to charity. With a trust whose term is defined by a life (or lives), this raises the possibility that an early death could result in much more going to charity than was intended by the donor.
With a private foundation, this risk does not exist because the amount put into the foundation is known and fixed up front.
Uncertainty of Tax Treatment
Although the 1997 law changes have greatly reduced the uncertainty regarding the potential tax treatment of high-payout charitable remainder unit trusts, more recent IRS positions raise continuing doubts. Private foundations, in contrast, are not subject to any such uncertainty.
Potential for Conflict of Interest
Because a charitable remainder unit trust is a split-interest trust, the trustee owes a fiduciary duty not only to the donor, but also to the charitable remainder beneficiary. At times, the interests of the donor and the charity may come into conflict. This conflict of interest, combined with the trustee's fiduciary obligations, can cause a trustee to behave in a manner that is not to the donor's liking.
For a donor who believes that the CRUT is "his," this can be a nasty and unwelcome surprise--not only for the client but also for professional advisors who might be caught in the middle.
Private Foundation Rules
Both the charitable remainder trust and the private foundation are subject to the many rules governing private foundations. This means, among other things, that the trust donor is extremely limited in his ability to conduct transactions involving trust assets.
While the private foundation rules apply to both entities, with the charitable remainder unit trust strategy they apply to 10 times the amount of assets. Put another way, with the private foundation strategy, only 10% of the assets are affected by the private foundation rules, leaving the other 90% flexible.
Potential to Benefit From Tax Deferral
This is the one area in which the charitable remainder unit trust strategy enjoys a clear advantage. The trust generates deferral of income taxes, and the private foundation does not. Like all deferral strategies, the one using a charitable remainder trust works better over longer time periods. Although not part of this analysis, it appears that, among deferral strategies in general (e.g. deferred comp, qualified retirement plans, etc.), charitable remainder unit trusts take longer to reach breakeven.
Investment Flexibility
Investment flexibility is restricted for assets placed within a charitable remainder trust. There are two primary reasons for this.
First, the trustee is subject to the normal prudent man rules (or whatever other standard may prevail in the relevant jurisdiction). These rules tend to be fairly restrictive.
Second, as noted above, the existence of two classes of beneficiaries creates the potential for conflicts of interest between the classes. The prudent trustee will therefore tend to adopt a conventional investment approach whose primary guiding light is to deflect criticism.
Charitable remainder trust assets are also subject to the (much less restrictive) private foundation investment rules. Of course, the assets in the private foundation are also subject to the investment rules. But with the private foundation strategy, these rules apply to only 10% of the assets, versus all of the assets with the trust strategy.
Deferral Benefits Must Be Decisive to Sway the Decision to a CRUT Strategy
As the table above and the preceding discussion show, the only benefit of a charitable remainder trust over a private foundation is the potential to benefit from deferral of income taxes on the appreciation of the property placed into the trust.
The question then becomes under what circumstances does the value of the deferral outweigh the other considerations. The break-even point occurs when the accumulated cash flows from the charitable remainder trust, distributed to the donor and reinvested, are greater than the amount the donor would have accumulated by selling the appreciated stock and reinvesting the net proceeds.
Whether the trust makes sense or not depends primarily upon the basis ratio (the ratio of the cost basis in the stock to its market value). The lower the basis ratio, the more valuable deferral, and the higher the basis ratio, the less valuable the deferral. For basis ratios greater than about 45% (i.e., when the basis of the stock in question is more than 45% of the current market value), the deferral of tax on the gain will never make up for the fact that the donor is getting only cash flows and has no access to the principal.
For basis ratios below 45%, if donors can wait long enough, they can eventually realize more value from the charitable remainder trust alternative than from the private foundation alternative. But this waiting period can be extremely long.
Using a base-case assumption of 8% returns over the long run, a 20% effective tax rate, and a life charitable remainder unit trust, here are number of years to break even.
| Years to Break Even |
|
|
|
|
|
|
Basis as percentage of market value |
| Age |
10% |
20% |
30% |
40% |
|
|
| 35 |
32 |
34 |
36 |
43 |
| 45 |
25 |
28 |
31 |
Never |
| 55 |
18 |
21 |
Never |
Never |
| 65 |
12 |
14 |
Never |
Never |
| 75 |
6 |
7 |
Never |
Never |
| 85 |
4 |
5 |
Never |
Never |
|
A careful review of this table shows several prominent patterns.
First, the younger the donor, the longer the break-even period. Second, the time to break even is always fairly close to the life expectancy for a given age. For example, while the life expectancy for a 35-year-old might be 42 years, that 35-year-old will have to wait 34 years to break even if the basis ratio is 20%, and 43 years if it's 40%.
For older ages, notably above 65, the break-even periods are much shorter. However, the corresponding annual payment rates are also very high. As noted, given recent IRS attitudes, there appears to be some reason for caution with respect to high rate charitable remainder trusts.
Even if the client uses a charitable remainder trust, it's often advisable to name a private foundation as the remainderman. Although this technique is often overlooked, it's probably the best way to maintain flexibility as to the ultimate recipients of the charitable interest.
Too often, donors set up a charitable remainder trust, name a public charity as the remainderman, and then, long before the trust term is completed, regret their choice of remainderman. Naming the donor's own private foundation as the remainderman eliminates this particular source of dissatisfaction.
Charitable remainder trusts are a useful way to minimize taxes for the charitably minded. However, this analysis has shown that in many cases, much, or even all, of the net financial benefits available from the use of trusts can be achieved by funding a private foundation and selling appreciated assets.
In many cases, the private foundation strategy is simply the financially superior one. And even in those cases in which, given enough time, the trust deferral will ultimately yield greater financial benefits, the private foundation alternative leaves the donor with far greater flexibility, liquidity, control over assets, and access to assets, while setting aside an equal amount for charity.
Thus, it would appear that in many cases where charitable remainder trusts are now used, private foundations, if considered, would provide a superior alternative.
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