Charitable Planning Mistakes to Avoid
This article highlights specific areas of the charitable planning process where mistakes seem to recur based on the authors' combined experiences. As you read through the article, mistakes from the seasoned professional to the charitable planning novice are highlighted. By sharing these real-life situations, the authors hope to disperse knowledge, not from the painful school of hard knocks, but from the less painful old cliche, "learn from the mistakes of others."
Not Putting the Donor's Interests Ahead of All Others
As planners work together as a team to recommend a charitable plan for a client, it is imperative to always put the client's interests ahead of the charitable organization, attorney, CPA and agent. Sometimes a plan can seem so good, the planner does not want to throw water on the proposal by mentioning the possible disadvantages. Here's a case where the planners went a little too far.
In the case of Martin v. Ohio State University Foundation (Ohio App., 10th App. Distr., 2000), the donors of a "net income with makeup" charitable remainder unitrust (NIMCRUT) sued their life insurance agent, the life insurance company and the charitable organization that also acted as their NIMCRUT's trustee. An attorney and insurance agent proposed a plan to a couple that included the donation of $1.3 million of undeveloped farmland to a NIMCRUT. The donors would use income from the NIMCRUT to purchase a $1 million life insurance policy costing $40,000 per year for wealth replacement for the donors' children.
The donors received several proposals over a few months. Each proposal showed the NIMCRUT paying the donors' income immediately after the execution of the NIMCRUT. Because the donors' annual income prior to the transaction was only $24,000, the donors were counting on the trust income to pay insurance premiums.
The charitable organization's representative wrote a comment on the last proposal shown to the donors that a net income trust funded with non-income-producing land cannot make any income payments until after the land is sold. When the insurance agent saw the comment on the proposal, he deleted it before giving it to the donors.
Unfortunately, the land was not sold until 2 1/2 years later, and no income was paid to the donors during that time. In the meantime, the agent tried to loan the clients enough money to pay the insurance premiums. But in the end, the policy lapsed. The donors sued for fraud, negligent misrepresentation, breach of contract and breach of fiduciary duty on the ground that they had never been told the truth about income not being payable from the NIMCRUT until after the land was sold.
In Martin, the advisors failed to give the donors accurate and complete information as to how the charitable gift would work in their situation. The advisors intentionally deceived the clients for what appears to be their own financial gain. At all times and in all aspects of the planning process, the goal must be to provide advice that is in the clients' best interests. Clients deserve objective, comprehensive and accurate advice from their planners even if it prevents the gift from occurring.
Recommending a Charitable Gift Without a Full Understanding of the Donor's Financial Needs and Goals
Sometimes planners recommend a charitable gift as if it were a financial product. But a charitable gift is not a product; it must be analyzed as part of an integrated estate and charitable planning process. To illustrate, one planner wanted to set up a charitable remainder annuity trust (CRAT), funded with farmland, for an older client. The planner had a fixed annuity he wanted to sell to the trustee using the proceeds from the land. The planner was under the impression the trust was required to purchase a commercial annuity because it was a charitable remainder "annuity" trust. The planner was then advised that a well-balanced mutual fund may be a more suitable vehicle for the proceeds. Unfortunately, the planner responded that he wasn't licensed to sell mutual funds. Upon further learning that the annuity would produce "tier one" ordinary income at the client's marginal income tax bracket of 42 percent, the planner replied that the client would obtain a large income tax deduction and could afford to pay more in income taxes.
Sadly, in this situation, the product-selling planner wasn't mindful of the drawbacks of recommending a charitable remainder trust (CRT). The planner did not ascertain his client's charitable interests. Instead, he suggested the CRT as a means to avoid or even evade capital gains taxes when, in fact, the strategy would potentially increase his client's tax liability. The recommendations for this plan weren't in the client's best interests and could be considered malpractice.
Serving as Trustee
Another misstep can occur when an advisor serves as the trustee for a client's trust. Financial planners, brokers and insurance agents need to use caution when asked by their clients to serve as the trustee. The best answer to give a client is: "No, thank you." Serving as trustee can create a serious conflict of interest if the trustee benefits by the transaction, not to mention SEC problems if the agent or broker has a securities license.
Generally, nonlegal advisors are not well trained in the duties imposed on the trustee as a fiduciary. Moreover, these advisors are typically unfamiliar with the language used in trust documents, as well as the implications of a trust's provisions.
Even attorneys may be reluctant to serve as trustees because attorneys know all too well the complex duties involved when acting as a fiduciary and following the prudent investor rules. One trust officer, who found out the trustee's duties too late, served as the trustee of a testamentary CRAT. He asked how long he could wait to make payments to the income beneficiaries because the land held by the CRAT hadn't been sold and there were no other assets in the trust. Three years later, the income beneficiaries still hadn't received their first income payment from a trust that has no legal recourse but to distribute income or assets annually, regardless of whether those assets are liquid.
Donating Inappropriate Assets
Another difficulty arises when a charitable planner is not familiar with the consequences of making gifts using different types of assets. The tax rules covering charitable deductions for various assets can be complex, so the best way to prevent these mistakes is to know the rules for each type of asset. The table below lists assets that either should be given with caution or should not be given at all.
For instance, one planner suggested a client donate artwork valued at $3 million to a CRUT with a 10 percent income payment. After the CRUT was established, the client continued to display the artwork in his home. The planner mistakenly thought the charitable organization would advance the 10 percent income payment to the trust each year. The planner did not know the artwork could not be kept on display at the client's home because of the self-dealing rules. To make matters worse, the charitable deduction was not based on the artwork's fair market value (although the planner told the donor his deduction would be based on fair market value). Instead, the deduction for tangible personal property with no "related use" is based on the donor's lower cost basis.
Another planner was working with a client whose assets consisted of $75,000 of mutual funds and a $350,000 IRA. The planner didn't realize the entire IRA would be subject to income taxes and possible penalty taxes if the client donated it to a charitable organization in exchange for a charitable gift annuity. Adding to the misunderstanding was the offending charitable organization's IRA donation "proposal" which failed to adequately disclose the tax disadvantages of using an IRA for a lifetime charitable gift.
Handle With Care
These assets need extra-special handling:
- Encumbered real estate
- Closely held C corporation stock
- Tangible personal property, including artwork
- Restricted (Rule 144) stock
- Stock with a tender offer in place
- Sole proprietorships, partnerships and ongoing businesses
- S corporation stock
These assets should generally be avoided in charitable gift planning:
- Property with an existing sales agreement
- Installment notes
- Stock options (both ISO and nonqualified stock options)
- Lifetime transfers of IRAs and qualified plan dollars
- Lifetime transfers of commercial deferred annuities
- Lifetime transfers of savings bonds
Reinvesting CRT Assets Improperly
Often a charitable trust is established by a planner with the expectation that the donor, who generally serves as trustee, will use the planner to reinvest the proceeds of the gifted asset once it's sold. While there is nothing wrong with this, advisors need to be educated on the complexities of the prudent investor rules, charitable trust accounting, tax deductions and other rules in order to fully comprehend the consequences of their recommendations.
An example of improperly invested CRT assets occurred when a planner recommended that his middle-aged donor establish a CRAT. Inside the CRAT, the donor-trustee bought a "life-only" single premium immediate annuity to "guarantee" the annuity payments to the income beneficiary. The flaw in this transaction is that the charitable organization's remainder interest would be empty when the trust ends, because a single premium immediate annuity for "life only" will end upon the death of the client with no principal balance leftover. This recommendation could make the trust subject to the state's attorney general for imprudent investment oversight and all its advisors potentially liable to the charitable organization.
To compound an already unpleasant situation, when the planner was advised about the flaw, he argued that the trustee's purchase was valid because the trust "passed the 10 percent test." The planner didn't understand the difference between the 10 percent test and the subsequent problems when investing CRT assets improperly.
Improper investing occurred with a stockbroker who invested his client's CRT funds in several partnerships (creating unrelated business taxable income) in the CRT's first year. In prior years this choice created a taxable CRT that didn't avoid capital gains tax when the appreciated asset was sold with no income tax deduction to offset the reinvestment error. Now it generates a 100 percent penalty tax.
Other mishaps have occurred when the trustees were given access to a charge card on a money market account held inside a CRT. When trustees have charge cards on CRT assets, the outcome can be self-dealing and debt-financed problems similar to trading on margin accounts and charging the CRT interest on the loan when the trades do not materialize as expected.
If a planner recommends ("sells") a CRT as a way to take assets under management or sell wealth replacement, it isn't unethical but may be shortsighted. It can result in unhappy clients who find themselves stuck with an irrevocable plan that doesn't meet their needs. Planners who recommend charitable gifts must be knowledgeable of the law and pull in an expert team to implement a plan in the donor's best interests.
The four-tiered system of accounting in a CRT can seem complex. Often planners may not fully comprehend all the issues involved, and this leads to mistakes. For instance, one attorney counseled her client to fund a CRT with farmland. The attorney recommended that the trustee purchase tax-free municipal bonds after the land was sold to obtain tax-free income from the CRT. What the professional didn't realize, however, is how the capital gain income from the sale of the real estate is higher on the four-tier accounting system than any new tax-free income generated by the municipal bonds. Understandably, the client was quite unhappy when the income wasn't "tax-free."
This article demonstrates the pitfalls that planners want to avoid as they help clients with charitable plans. Take this as an opportunity to learn from the mistakes of others and avoid them in your practice.
Clients need complete disclosure of the advantages and disadvantages of the plan being proposed. Well-informed clients tend to be appreciative of the extra effort and it's an important factor in client satisfaction. Take the extra time and make sure your clients' charitable plans are proposed with your clients' best interests first.
Vaughn Henry's consultancy, Henry and Associates, specializes in gift and estate planning services, wealth conservation, and domestic and international financial services. Henry, who resides in Springfield, Ill., also owns www.gift-estate.com, a frequently updated wealth planning resource website.
Johni Hays, J.D.
Johni Hays is the senior gift planning consultant for The Stelter Company. She is also the co-author of the book "The Tools and Techniques of Charitable Giving," published by The National Underwriter Company. She can be reached at JohniH@stelter.com. Reprinted with permission. Copyright 2002 Vaughn W. Henry and Johni Hays.
Please call Lori L. Hoby at (866) 204-8102, or e-mail us at firstname.lastname@example.org, for more information.