Lessons From the Experts

Charitable planning can be one of the most satisfying areas in which an advisor can practice. When your clients' interests and charitable organizations' interests are in line, the results can be terrific. Charitable planning is a specialty, however, with technical rules and an abundance of potential pitfalls. The purpose of this article is to alert you to some of the pitfalls you may encounter, enabling you to do a better job for your clients. In our experience helping many clients fulfill their philanthropic objectives and in sharing experiences with other advisors, we have come across some common traps for the unwary.

Disengage Yourself From the Outcome

As human beings, advisors can sometimes lose sight of their biases. If you hold yourself out as a charitable planner, sit on charitable boards or have seen the positive results of charitable planning in other clients' situations, it pays to remember to approach each client with a fresh perspective and to stay objective. As advisors, your first duty is to your clients. This responsibility as advisors means helping them uncover their goals and priorities, including any charitable goals. The most successful approaches endeavor to educate clients about the costs, benefits, risks and rewards of charitable planning. Detailed explanations of the various planning vehicles, illustrations and schedules can all aid in conveying this information. It is important to discuss with your clients and agree upon assumptions, including rates of return, inflation and life expectancy. Using software that can predict the probability of what the client considers a successful outcome is helpful. The client can then make an informed decision.

Consult Other Experts

Charitable planning and implementation often cross many disciplines, including law, accounting, investments, insurance and strategic philanthropy. It is unlikely that there is even one advisor who possesses genuine expertise in all of these areas, so for those who don't have all these skills, there are teams. Teams can be formal business relationships or informal alliances. Taking a team approach to charitable planning could avert many of the errors discussed below.

Errors in Drafting

Trust companies, investment firms, charitable organizations, even the IRS, distribute form documents for charitable vehicles. While this may add value for a client or prospective donor, it is important that the client retain an attorney experienced in charitable planning to draft the document, rather than relying on a form to save expenses. Look out for these provisions in charitable remainder trust (CRT) forms:
  • Trustee Provisions

    While many form-CRT documents do not name the client to serve as trustee, generally there is nothing prohibiting the client from serving as trustee of a CRT. In fact, most clients want to maintain control. Thus, clients should be informed of this opportunity in evaluating trustee options.
  • Charitable Remainder Beneficiary

    Many forms do not permit the client to name more than one charitable remainder beneficiary or to change the charitable beneficiary during the client's life. The client's advisors should present these options.

    In addition, it is important for the client to decide whether he or she wants the flexibility to ever name a private foundation as the remainder beneficiary. This decision may affect the client's ability to take the income tax deduction generated by the gift to the CRT. As a general rule, clients may take deductions for gifts of appreciated property to public charitable organizations up to 30 percent of the client's adjusted gross income (AGI) in the year the gift is made. If the gift exceeds 30 percent of the client's AGI, the client may carry the deduction forward over five years. With gifts of marketable, appreciated securities to a private foundation, a client may deduct gifts up to 20 percent of AGI per year over six years. In the context of a CRT, if the trust prohibits a private foundation from ever being named remainder beneficiary, then contributions to the CRT will be subject to the higher 30 percent limitation.

    When a client is establishing a charitable remainder trust, the client's accountant should prepare income tax projections to determine whether and how quickly the client will use the income tax deduction. If the entire deduction at the private foundation percentage limitations can be easily used, there is no reason to restrict the remainder beneficiary to a public charitable organization. While many clients will never establish a private foundation, flexibility should be favored in irrevocable instruments unless there is a countervailing reason. On the other hand, if the client's ability to use the deduction may be compromised by the 20 percent limitation, it may be better to prohibit private foundations. If property other than marketable securities is to be contributed, the remainder beneficiary should be a public organization; otherwise the deduction will be limited to cost basis.
  • Early Distributions of Trust Principal

    If a client wants to make a large current gift, but is concerned about cash flow, accelerating the charitable remainder can be a good strategy. Many form documents do not permit early distributions to the remainder beneficiaries, so it must be custom-drafted. If a properly drafted provision is included, the client can accelerate all or a portion of the charitable remainder interest during the client's life.

    Consider the following example: Joe sets up a 6 percent standard charitable remainder unitrust, to which he contributes $1 million. This trust would pay Joe $60,000 in year one. Assuming the trust principal also earns $60,000 in year one, the trust would pay him the same $60,000 in year two. If Joe decides in year two that he would like to make a $20,000 outright charitable gift, he could satisfy the gift with $20,000 of his other assets. But if Joe doesn't want to part with $20,000 of his other assets, he could accelerate a $20,000 portion of the remainder interest in his CRT. If he did so, the trust principal at the end of year two would be $980,000 and Joe's year-three payment would be $58,800. In this case, Joe is only out of pocket $1,200 in year two. In addition, as a result of his gift in year two, Joe would receive an income tax deduction equal to the present value of his income interest in the $20,000. The decreased principal will also diminish his payments in future years.

    If the opportunity to make a charitable gift in this manner arises, take care that the transaction is conducted in such a manner as to avoid self-dealing, as discussed below.

Investing and Administrative Errors

In addition to skilled drafting, careful investment and administration of charitable trusts are essential. Charitable trusts, like all split-interest trusts, require a sound investment policy that balances the interests of the life and remainder interests. The Prudent Investor Rule charges the trustee to consider each investment in the context of the whole portfolio and does not eliminate per se any particular investment. In addition, complex tax rules apply to charitable trust investments and cannot be overlooked. Here are some of the most common issues we have come across in our practices:

  • An Ad Hoc Investment Approach

    In many instances, a client may serve as trustee of a charitable trust. While this may be technically possible and even desirable in many cases, it is important that the client be cognizant of the fiduciary duties of trustee. As trustee, the client cannot favor the life beneficiary over the remainder beneficiary, and vice versa. In the case of a split-interest charitable remainder trust, the state attorney general may intervene on behalf of the charitable beneficiary to prevent the beneficiary's interests from being compromised.

    Thus, while a client may want and be able to serve as trustee of his or her charitable trust, it is generally advisable for the client to hire investment advisors experienced in investing charitable trusts. Such an investment advisor will typically develop an asset allocation and investment policy statement for the trust that addresses these issues and prohibits improper investments. It is equally important for the investment advisor to consult with the other members of the client's advisory team.
  • Lack of Diversification

    Most states impose a duty to diversify on trustees. Where the client is serving as trustee, he or she may have a difficult time diversifying. Where the charitable entity is funded with stock from the client's business or with real estate that the client has owned for a long time, diversification may be particularly difficult. The difficulty can stem from internal causes (e.g., emotional attachment) or external causes (e.g., stock trading restrictions or market conditions). In these cases, it is even more important that the client work with advisors experienced in such areas to develop a disciplined diversification plan as part of the investment policy and asset allocation.
  • Unrelated Business Taxable Income (UBTI)

    An example of an improper investment is one that generates unrelated business taxable income (UBTI). UBTI is most commonly created by debt-financed income. The most common examples of UBTI are assets purchased on margin; publicly traded limited partnerships, which pass through debt-financed income; rental real estate property acquired with debt; and alternative investments, such as hedge funds.

    The consequences of generating UBTI can be severe. If a CRT has UBTI, in prior years in would have been taxed on all its income for that year, but now is subject to a 100 percent penalty tax. UBTI in a charitable lead trust (CLT) can severely limit the trust's ability to deduct the income interest paid to a charitable organization.
  • Self-Dealing

    An excise tax is imposed on each act of "self-dealing" in which a charitable trust or foundation engages. Self-dealing is typically a transaction between the charitable entity and a "disqualified person." The term "disqualified person" includes a substantial contributor to the entity; a foundation manager, including an officer, director or trustee of the entity; and family members of a contributor or foundation manager. An excise tax of 10 percent is charged to the disqualified person and an additional 5 percent excise tax is levied on the foundation manager who knowingly participates in an act of self-dealing.

    The most common forms of self-dealing are transactions between the client and the charitable entity that he or she established, such as sales, loans, payment of unreasonable compensation and use of trust property for the client's benefit. One less obvious potential act of self-dealing is the satisfaction of a charitable pledge. Even if a pledge is not legally binding, there is the possibility that the satisfaction of such a pledge with charitable trust or foundation assets could be construed as self-dealing.

Be a Better Planner

With care, you can use charitable planning to help your clients meet their financial and philanthropic goals. You should understand the costs and benefits of charitable planning to properly educate clients about these techniques, and also be aware of the potential pitfalls to avoid in implementation. Working in teams of advisors from different disciplines with charitable experience is probably one of the best ways to serve clients competently in this area.

Please call Laurie Dietrich at 507-933-6043, or e-mail us at dietrich@gustavus.edu, for more information.