Thursday April 25, 2024
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3.10.10 Investments of Unitrust Corpus
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Investments of Unitrust Corpus
Introduction: One of the major decision points when creating a charitable remainder trust (CRT) is developing an investment strategy.
Permissible Investments: The laws governing trust investments are state specific, but more than 40 states and the District of Columbia follow the Uniform Prudent Investor Act (UPIA).
Advisor Roles: Attorneys and CPAs normally are not Registered Investment Advisors (RIA) because they are excluded from registering as an RIA if they do not sell products.
Donor Goals: Most donors have three goals.
Investment Strategy: The investment strategy will be directly related to the trustee selection.
Portfolio Allocations: The investment strategy team will need to determine the percentage of the portfolio allocated to stocks and the percentage allocated to bonds.
Costs and Net Returns: The costs of managing a trust vary greatly, depending upon the selection of trustee and the investment manager.
Importance of Cost Reduction: It is essential to review costs.
Conclusion: Economic analysis is an art and not a science.
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Introduction
One of the major decision points when creating a charitable remainder trust (CRT) is developing an investment strategy. Under the four-tier accounting rules, the type of income paid out of the trust is determined by the trust investments.
Permissible Investments
The laws governing trust investments are state specific, but more than 40 states and the District of Columbia follow the Uniform Prudent Investor Act (UPIA).
The UPIA states that a trustee must invest using the prudent investor standard. In other words, the trustee must exercise reasonable care, skill and caution when investing trust assets. The trustee should consider the overall risk and return before making investment decisions. Although no particular type of investment is prohibited, diversification is considered essential.
Therefore, the trustee typically should invest in a diversified portfolio consisting of stocks and bonds. Alternatively, other less typical investments may be used as long as the trustee fulfills his or her fiduciary duty and meets the prudent investor standard.
Although the Tax Code does not address whether a CRT may hold an insurance policy, such an investment has been approved in Revenue Rulings and PLRs (the latter of which cannot be used as precedent). Specifically, Rev. Rul. 84-179 discusses the permissibility of a CRT owning a life insurance policy. In addition, PLRs 7928014 and 8745013 discuss the same issue. PLR 7928014 permitted an insurance policy as a unitrust investment. Since the taxpayer retained no rights except the right to change charity, the payments were deductible. PLR 8745013 also permitted an insurance policy as a unitrust investment and discusses the possibility of jeopardizing the charitable remainder. Lastly, although it does not focus on the issue, PLR 200017051 mentions a unitrust holding an insurance policy.
Advisor Roles
Attorneys and CPAs normally are not Registered Investment Advisors (RIA) because they are excluded from registering as an RIA if they do not sell products. As a result, they are not authorized to make specific investment recommendations. Nevertheless, a donor's attorney, CPA and gift planner are often objective third parties who can provide invaluable assistance in discussing both fiduciary responsibilities and general trust investment strategies.
Donor Goals
Most donors have three goals. First, they want a favorable trust return. Second, they hope that the return will be favorable enough so that the trust can grow. Finally, they would like most of the trust payouts to be taxed at a lower rate than their ordinary income rate.
These goals often are not the subject of extensive discussion. However, the typical unitrust donor has carefully built up his or her estate. Having painstakingly accumulated these resources, the typical donor tends to be fairly averse to risk. Thus, the advisor faces the classic challenge. Higher returns and favorable tax rates require investing in equities, but equities can fluctuate in value.
Investment Strategy
The investment strategy will be directly related to the trustee selection. If a corporate trustee is selected, then the investment strategy will necessarily be consistent with the policies of that trustee. With many charities, once again the investment strategy is going to be largely determined by the investment committee for that charity. For the donor who desires greater investment flexibility or options, a private trustee may prove to be an appropriate solution.
Portfolio Allocations
The investment strategy team will need to determine the percentage of the portfolio allocated to stocks and the percentage allocated to bonds. A "conservative" portfolio may consist of 50% stocks and 50% bonds. The standard trust portfolio typically holds 60% stocks and 40% bonds. During the 1990s, many institutions with endowments transitioned to a 70% stocks and 30% bonds portfolio.
| Potential Portfolio Returns |
| Portfolio | 50% St. - 50% B. | 60% St. - 40% B. | 70% St. - 30% B. |
| Returns | 4.0% 2.25% | 4.8% 1.8% | 5.6% 1.35% |
| Total Return | 6.25% | 6.6% | 6.95% |
Costs and Net Returns
The costs of managing a trust vary greatly, depending upon the selection of trustee and the investment manager. Trustee costs may range from zero to 1.2% or 120 basis points (100 basis points equals 1%).
Similarly, the investment management fees could be significant. The cost for investment management ranges from 18 basis points for a large S&P 500 Index fund to 100 basis points for many large mutual funds, to 200 basis points for some international funds.
| Option | ||||
| | Trustee Fee | Inv. Fee | Total |
| Option I | Trustee Private or Charity | 20 Basis Points | 30 Basis Points | 50 Basis Points |
| Option II | Private with Advisor | 25 Basis Points | 75 Basis Points | 100 Basis Points |
| Option III | Corporate | 100 Basis Points | 60 Basis Points | 160 Basis Points |
If the trust holds a portfolio of 70% stock and 30% bonds and earns 6.95%, then the net return of the trust will be that amount less the fees. For Option I, the net return is 6.95% minus 0.5%, or 6.45%. Option II produces a net of 5.95% and Option III produces a net of 5.35%.
These fees are not unusual. Some trust accounts have fees in excess of 200 basis points and some financial planning firms have proposed "wrap accounts" with fees of 300 basis points.
Importance of Cost Reduction
It is essential to review costs. Charities, private trustees and corporate trustees must all carefully review their cost structure. With lower return rates, it is essential to minimize cost burdens.
There are valid reasons for all three trustee choices. Many charities serve effectively as trustee with very low costs. A private trustee enables the donor to have control over the managing process and may operate less expensively. For large trusts, the costs of a corporate trustee are more moderate in proportion to trust size. In addition, the objective nature of the corporate trustee may be essential for large estates where there are relatives.
Conclusion
Economic analysis is an art and not a science. Yet basic economic literacy and assumptions are very helpful in assisting donors or clients with charitable remainder trusts. Donors will be much better able to understand the inevitable changes in the markets if they have participated to some degree in the design of the trust investment strategy.
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Case Studies on Investments of Unitrust Corpus
Funding a Charitable Remainder Trust with a Commercial Annuity:
Judy Ross, age 55, recently attended a presentation by one of her favorite charities. In this presentation, she learned that she could transfer appreciated assets to a charitable remainder trust. By doing so, she could bypass capital gain, receive a charitable deduction and also receive an income stream for life. But Judy did not need any additional income at the present time. Thus, she was very interested when the presenter spoke about a net income with makeup charitable remainder trust. This type of charitable remainder trust would allow Judy to contribute the assets, receive an income tax deduction now, but delay the income payments from the trust for 10 years until her planned retirement date.
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Private Letter Rulings
PLR
200423029 CRTs May Pool Assets in Newly Created LLC for Investment Purposes:
The Humperdink family has ten charitable remainder trusts (CRTs). The Humperdink Family Foundation (Foundation) serves as trustee of each of the CRTs and wants to form a limited liability company (LLC) to coordinate the investments of all the CRTs. Formation of an LLC will allow the CRTs to diversify their portfolios, pool assets to obtain economies of scale, and obtain access to investments with higher minimums. Foundation requests rulings that formation of the LLC, contribution of CRT assets to the LLC and use of the LLC to manage the CRTs assets will not constitute self-dealing.
PLR
200704036 Trusts Holding Units of Charity's Endowments Will Not Result In UBTI:
C is a tax-exempt 501(c)(3) organization classified as an educational organization under Sec. 509(a)(1) of the Code. C served as the trustee of a number of charitable remainder trusts (CRTs). C received concerns from trust donors and beneficiaries that the CRTs were not generating as much of a return on investments as C's endowment fund.
PLR
200806019 Endowment Shares Not UBTI:
Charity (M), a 501(c)(3) tax-exempt organization, is both trustee and remainder beneficiary of several charitable remainder trusts (CRTs). M proposes to issue a contractual right to each of the trusts for a proportionate share of M's endowment fund where trusts would receive payments on the shares held by it equal to the payout rate set by M.
PLR
200816034 Endowment Shares Do Not Generate UBTI:
R is an educational organization as described under Sec. 509(a)(1) and is the trustee and remainder beneficiary of a number of charitable remainder trusts (Trusts).
PLR
200826026 Redemption of Endowment Shares Produces Capital Gain in CRT:
Trust is a qualified charitable remainder unitrust within the meaning of IRC Sec. 664. University is the remainder beneficiary of Trust and serves as its trustee. As part of its activities, University maintains a highly diversified endowment pool.
PLR
200904025 No UBTI to Trust From Endowment:
College is the trustee and sole remainder beneficiary of a charitable remainder unitrust (CRUT). College proposes to issue shares of College's endowment to CRUT through a contractual obligation.
PLR
200913065 Shares of Endowment - No UBTI:
M, a tax-exempt educational organization, maintains a diversified endowment. M also serves, at no cost, as the trustee of a number of charitable remainder trusts.
PLR
201218015 Endowment Units Payouts Not UBTI:
ORG is tax-exempt under Sec. 501(c)(3) and classified as an educational organization under Secs. 509(a)(1) and 170(b)(1)(A)(ii). ORG is the trustee of six trusts.
PLR
201223021 Endowment Shares Not UBTI:
M is a tax-exempt educational organization under Secs. 501(c)(3) and 509(a)(1). M is the remainder beneficiary and trustee of a number of charitable remainder trusts (CRTs).
PLR
7928014 Insurance in a Unitrust:
Taxpayer desired to fund a two-life unitrust with an insurance policy and deduct the remainder value of insurance premium payments. The Service permitted the use of an insurance policy as a unitrust investment. Since the taxpayer retained no rights except the right to change charity, the payments were deductible.
PLR
8405005 Municipal Bonds in Charitable Trust:
Under the four-tier structure of IRC Sec. 664, payments are first ordinary income, then capital gain, then other or tax free and then return of principal. In this ruling, the taxpayer desired tax-free income and planned to obtain that by funding the trust with municipal bonds. Since the trust would have no ordinary income and recognize no capital gains, the distributions would be third-tier tax-free income. While the Service did not expressly approve the plan to distribute tax-free income, it stated that this would be a qualified trust, even though it invests in tax-free bonds. Trustees should also note that state prudent investor laws can impact this investment strategy.
PLR
8745013 Insurance Policy as Unitrust Investment:
Taxpayer desired to fund a two-life unitrust with appreciated property, sell the property and purchase an insurance policy. The Service permitted the use of an insurance policy as a unitrust investment.
PLR
9009047 Commercial Annuity in a Unitrust:
In PLR 9009047, the Service approved a net income with makeup unitrust that invests the principal or corpus in a commercial annuity. Since under Sec. 72(u)(1), the trust is not a natural person, the ordinary income is received and accrued each year. However, while the ordinary income is received by the trust, it is not unrelated business taxable income and thus has no adverse effect on the trust. Under the ruling, the account value is used to set the net fair market value each calendar year.
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