How Investment Decisions Affect Life Income Gifts 

By Eric Swerdlin

Anyone involved in the creation or planning of life income gifts knows that 2000 to 2003 were the most challenging years since the Tax Reform Act of 1969 (TEFRA '69) codified the rules regarding these gifts. During that time the coupling of a significant equity market pullback and the lowest fixed interest rates in 45 years created challenges for the maintenance of donor relations and establishment of new gift plans, and created discomfort for fiduciaries managing ongoing gifts. Also, the decoupling of investment returns (bond prices move in an inverse way to yields) highlighted and validated the Prudent Investor Act's mandate to diversify portfolios. Furthermore, these events highlighted the need for full disclosure when gift planners meet with donors to discuss gift arrangements.

During the fourth quarter of 1969, when TEFRA '69 was signed into law, the average constant maturity 10-year Treasury note yielded up to 7.51 percent. With a 7.5 percent interest rate environment as a backdrop during these three years, the mandatory 5 percent annual payout from charitable remainder trusts seemed wholly reasonable.

As of the writing of this article (2003), the 10-year Treasury note hovered around 4 percent. Also, widespread usage of personal computers did not become commonplace until the mid-1980s, by which time interest rates had peaked in the mid-teens: Advisors could now, using the first versions of software designed to illustrate the economic result of creating a charitable remainder trust, forecast ending remainder values and annual payout amounts from charitable remainder trusts.

New Software. These software programs typically asked the advisor to plug in assumed rates of return, both growth and income, and then performed a linear extrapolation. Unfortunately, if the assumed return was higher than the payout rate for a unitrust, the graphs would show ever increasing levels of payout and remainder values. Having a bull market for most of the late ’80s and all of the 1990s led many advisers to feel comfortable with these illustrations.

More recently a new model has emerged—one that uses the probability theory to illustrate the potential likelihood of attaining certain results for both the income beneficiary and the remainderman. This new software-modeling tool does a much better job of preparing the donor for potential economic results.

Full Disclosure. Another change in gift presentation has been a move to increased disclosure about the attributes of the various gift vehicles. When discussing potential gift arrangements, time must be spent discussing the best-case and worst-case scenarios of a gift plan. A good starting point is to discuss variable payout versus fixed payment life income gift vehicles. It has long been axiomatic that trusts created by relatively young donors should be unitrusts, with a varying payout, and trusts expected to be of a relatively shorter duration should be annuity trusts, paying a fixed payout.

But is this necessarily so? In reality, much more emphasis must be paid to the donor's risk tolerance, with a particular focus on the donor’s ability to weather downturns in annual cash flow in the context of their overall financial planning.

Just as in any diversified portfolio, there are investments that are fixed payments (fixed income) and those with variable returns (equities), and there is no reason that a life income gift cannot be part of an individual's fixed-income portfolio. A fundamental difference between a charitable remainder annuity trust and a charitable remainder unitrust is that in an annuity trust investment risk is almost entirely borne by the remainderman. The notable exception to this is the risk to the income beneficiary of exhausting the entire principal and having the payments cease. With a unitrust, the investment risk is borne more evenly by both income beneficiary and the charitable remainderman.

The need for full disclosure about the variability of payout can be seen clearly through the historical performance of pooled income funds. In the early 1980s, with interest rates in double digits, pooled income funds became an extremely popular life income gift vehicle. After all, donors were told they could receive double-digit returns and still get a tax deduction.

Finally, a critical component in providing stewardship and protecting oneself is to maintain a file that documents the amount of disclosure furnished to the donor. A file showing the efforts made by the gift planner to inform the donor of the best case/worst case scenarios and the different attributes of the gift vehicles can go a long way with forgetful donors and litigious relatives.


Charitable Remainder Trusts
Fiduciaries of split-interest gifts must manage these assets with an eye toward tax awareness, including the fact that the annual income distribution of all charitable remainder trusts is taxed under a four-tier tax system.

A Four-Tier Tax System

  • Tier 1: Ordinary income (taxable bond interest and stock dividends)
  • Tier 2: Capital gains (distributed short-term gains first and then long-term gains)
  • Tier 3: Other income (e.g., tax-free)
  • Tier 4: Return of principal

Distributions are deemed to have occurred in a "worst in/first out" manner. Therefore, asset management decisions on CRTs can have an enormous impact on the long-term tax treatment for the income beneficiaries.

It is a myth that the donor avoids payment of capital gains taxes when creating a CRT. To be accurate, the donor avoids payment of capital gains taxes on the transfer to the trust, and the CRT, a tax-exempt entity, then is able to sell and reinvest the assets without paying a tax.

But the annual payment to the income beneficiary is subject to tax under the four-tier system. One should try to manage the trust to distribute much of the ongoing income as long-term gain, both pre-contribution and post-contribution.


Income-Exception Charitable Remainder Unitrusts
Fiduciaries of income-exception trusts such as net income charitable remainder unitrusts (NICRUT) and net income with makeup charitable remainder unitrusts (NIMCRUT) may wish to invest a portion of the trust assets in relatively higher yielding securities like convertible bonds (funds) and publicly traded real estate investment trusts (REITs) along with traditional fixed income securities.

Be aware, there have been changes in how some states structure their Principal and Income Acts. In many states, long-term gain attributable to post-contribution appreciation can now be declared "distributable income" if the trust language refers either to this process or to state law. These changes, rooted in a belief in total return investing, have led to some creative gift structures.


Pooled Income Funds
In all cases, pooled income funds must be invested in accordance with the trust's governing document. That said, when given latitude in the document, investment managers can diversify using securities that are paying a reasonable income stream and offer the possibility of growth of asset values. Trust managers can look at convertible bonds and REITs as appropriate assets to include in a well-diversified pooled income fund.

In most cases, net short-term gain in a pooled fund is taxable to the fund itself. Investment managers must carefully choose appropriate assets for a pooled income fund. Donors generally do not create this gift with the intention that investment management would produce a taxable event that depletes part of the fund. With regard to taxation of the fund itself, if a charitable organization receives any income from the fund, taxes can be levied for excess business holdings and result in jeopardizing investments.

Tax-exempt securities (e.g., municipal bonds) should never be donated to a pooled income fund. That action would "poison the well" and the fund would be disqualified. For that matter, the governing document of the fund must contain prohibitions against accepting or investing in tax-exempt securities.


Charitable Gift Annuities
Except for their charitable component, charitable gift annuities are so similar to commercial annuities that they are subject to regulation by state insurance commissioners. Most states have either offered exemptions (full or conditional) to charitable organizations issuing gift annuities or are silent on the matter, while the remaining states have restrictions, reserve requirements and required annual statement filings. The reserves, which typically can be 70 percent to 80 percent of the original face value of the original gifts can have percentage limitations associated with various asset classes.

Thirteen states as of 2003 had regulations pertaining to the investment of the reserve portion of their gift annuity assets; another six or more are considering implementing regulations.


Charitable Lead Trusts
Charitable lead trusts (CLTs) are almost the inverse of CRTs. A CLT, which can be established during life or at death, pays an income stream to a qualified charitable organization for a fixed period of years, the duration of a life (or lives), or a combination of the two, after which time the trust principal reverts to the donor (reversionary grantor trust) or other individuals (nonreversionary, nongrantor trust). A CLT can be structured as a charitable lead annuity trust or as a charitable lead unitrust.

The planning goals of the donor will determine which variety of lead trust is appropriate. With grantor trusts, the donor is considered the owner of the account and all tax liabilities incurred by the trust flow through to the donor. The primary use of a grantor lead trust rather than a reversionary grantor lead trust is to accelerate and maximize the charitable income tax deduction, often to offset a large realized gain, in a particular year. Because all income and gains received by the trust are taxed to the donor (even though the cash flow goes to the charity), a common investment (and funding) vehicle for reversionary grantor trusts is tax-exempt bonds.

The most commonly used lead trusts, however, are nonreversionary, nongrantor trusts. A nongrantor lead trust is taxed as a complex trust, does not pass tax liabilities through to the donor, and is used to discount the value of the assets and diminish transfer (gift or estate) tax imposed through the conveyance of these assets to another party.

Part of the investment decision-making process must take into account recent case law that addresses the need to diversify the portfolios of nonreversionary, nongrantor trusts. This, coupled with the mandate to manage with an eye toward tax results, can add to the levels of complexity of managing nongrantor trusts.

This can be particularly true when managing an inter vivos trust, where the assets receive no step up in cost basis.

In this situation, the manager must weigh the tax cost of selling a contributed appreciated asset versus the risk of having a concentrated portfolio.

Strategically, a nonreversionary, non-grantor trust is used to discount the present value of a gift to an heir over a period of years. That value is largely determined by the trust’s payout rate. While investment returns cannot be accurately predicted, the discount factor used to calculate the deduction and present value of the CLT (as well as CRTs) is defined in Section 7520 of the Internal Revenue Code.

This factor, which is 120 percent of the midterm applicable federal rate rounded to the nearest 2⁄10 of one percent, has had a great impact on the efficacy and desirability of lead (or remainder) trusts. This is particularly true of annuity trusts, which, unlike unitrusts, have a fixed payment that does not vary with market values.

The low interest rate environment in 2011, relative to that of the prior 50 years, affords some of the most fertile discount opportunities for CLTs seen since TEFRA '69. Periods of low interest rates are splendid for lead trust donors, where the goal is to minimize the calculated future value of a taxable gift.

The planning opportunities are particularly appealing if the investments inside the trust produce total returns greater than the sum of the payout rate and the inflation rate.


Sleeping Better in Volatile Markets
Life income gifts normally last a long time and afford donors (and their heirs) a long time to become dissatisfied with some aspect of the gift or the plan. As always, providing proper disclosure, with the documentation to back it up, is in the best interest of the donor, the advisor and the sponsoring organization.

For more information, please contact Steve Brier at (866) 204-8102 or sbrier@willamette.edu.

Eric Swerdlin
Eric Swerdlin is president of Swerdlin Philanthropic Management Services, LLC, in Morristown, New Jersey. Previously, Eric founded and was CEO of Swerdlin White Huber, Inc, (SWH) a firm dedicated to investment management, administration and program support for planned giving programs at nonprofit organizations throughout the country. In 1999 SWH was sold to a large northeastern bank.

An accomplished speaker and author, Eric has spoken at numerous planned giving councils, the NCPG Annual Conference and the ACGA Conference.

He has written articles for, among others, the Journal of Taxation, the Journal of Gift Planning, and Planned Giving Today.

Eric has appeared on CNN, Fox News Network and Bloomberg Television discussing planned giving. In addition, Eric has been quoted on topics relating to charitable giving in The Wall Street Journal, The Chronicle of Philanthropy, Forbes, and many other print publications.

He can be reached at (973) 644-4756 or at erics@swerdlin.com.