By John M. Goralka, J.D., LL.M.
Are you a Lottery Winner, Selling Appreciated Assets, or Have High income? If so, then you should better understand The Split Interest Income Trust.
The combined marginal tax rate for California residents can now exceed 50%. Taxes on capital gains can take 1/3 or more of the sale proceeds. Every dollar of tax savings that is invested can produce a lifetime return on investments for the family.
Many, but certainly not all, tax planning structures involve charitable structures. This article focuses on an often-missed planning opportunity. The Split Interest Income Trust provides for the creation of a charitable trust that provides an income tax deduction. When funded, income to you for life (or you may also include your children for their living) with the remainder to your designated charity upon the death of the last-named beneficiary.
In a real-world example, a father, age 49, with three (3) kids ages 28, 24 and 11, made a $7 million contribution to a Split Interest Intergenerational (includes the kids) Income Trust. He received an income tax deduction of $2,171, 200 and safe annual income for his entire life of $420,000 (projected at 6%) and lifetime income for each of his kids. The father is able to maintain investment control through his own investment advisor and could invest in real estate.
The result is very similar to a Charitable Remainder Trust (“CRT”). However, the income tax deduction for the Split Interest Income Trust is calculated differently than the CRT. The income tax deduction is generally substantially larger for the Split Interest Income Trust.
For example, a $1,500,000 contribution contributed to a Split Interest Income Trust provides a charitable income tax deduction of $983,325 income for his life. This provides yearly tax savings of $324,497 and for his wife’s lifetime of $90,000. The cumulative value of that income after 20 years is $1,040,705. If that was related to the sale of real property or an appreciation, an additional tax savings of $247,500 is possible through bypassing a portion of the capital gain.
On the other hand, the same $1,500,000 contribution to a Charitable Remainder Unitrust (“CRUT”) would generate a charitable deduction of only $150,000. A CRUT is a charitable trust where a portion of the income is distributed to the family. The amount paid to the family differs each year based on the investment return. The amount remaining at the end of the Term of life is paid to the designated charity.
A similar contribution to a Charitable Remainder Annuity Trust (“CRAT”) would generate an income tax deduction of $329, 347.41. A CRAT pays a specified amount to the family for a stated term or life. The remainder is paid to the designated charity.
The deduction for the CRAT of $329,347.42 is larger than the $150,000 available for the CRUT. However, both are substantially smaller than the $983,325 charitable contribution available for a comparable Split Interest Income Trust.
This seemingly too good to be true alternative is a form of pooled income fund (“PIF”). Both the PIF and the CRT have been in existence and used since 1969. PIFs are governed under Internal RevenueCode, Section 642 (c)(5). CRTs are governed under IRC, Section 664. Both PIFs and CRTs generally providefor a donor or the donor’s family to receive economic benefits for a term or lifetime with a remainder interest being distributed to a charitable organization recognized under IRC Section 501 (c)(3). However, the PIF and the CRT have substantial differences.
The CRT is available in a wide variety of forms, each with unique characteristics. These forms include but are not limited to the Charitable Remainder Annuity Trust, the Charitable Remainder Unitrust, the Net Income CRT, the Net Income with makeup CRT, and the Flip Crut. The holder of the remainder interest must be a charity, preferably a public charity. All CRTs are tax exempt trusts. This means that a low basis asset may be contributed for a charitable contribution deductive equal to the assets fair market value. That asset can be sold by the CRT tax free. This enhances the benefit of the charitable contribution which can be used to offset tax on other assets sold or other income.
The CRT must utilize a minimum payout of at least 5% annually. The CRT planners must make an actuarial calculation embedded in the trust that creates a remainder investment for charity equal to 10% of the original contribution.
PIFs, while providing a similar result are very different. There is only one form of PIF which is not a tax exempt trust. However, a PIF can receive and sell low basis assets without recognition of a capital gain. There is no minimum payout and no 10% remainder test as required for a CRT. While a PIF does require pooling, this requirement can be satisfied by a gift from a husband and a wife enabling a pool for a single family. There is no minimum age for a PIIF income beneficiary. An Intergenerational or even Multigenerational PIF can be treated for three (3) or four (4) generations. That is not possible with a CRT.
As indicated above, a PIF generally provides a significantly larger charitable income tax deduction. This makes a PIF a planning consideration to offset high income tax events such as business sales, ROTH conversions or even lottery winners.
Careful consideration should be given to both the CRT and the PIF. However, if multigenerational planning is needed, only the PIF will work. For younger donors, including married couples age 45 or younger, a lifetime CRT may not satisfy the IRS requirements.