Tuesday April 16, 2024

3.10.4 Types of Unitrust Payouts

Types of Unitrust Payouts

Optimum CRT Payouts:   Payouts are among the most important areas for the advisor to communicate to the recipient.

Type I or Standard Unitrust:   The Type I or Standard Unitrust is reasonably straightforward.

Type II or Net Plus Makeup Unitrust (NIMCRUT):   The Type II or Net Income Plus Makeup Trust pays the lesser of trust income or the unitrust percentage.

Type III or Net Income Only Unitrust:   The Type III or net income only trust is very similar to the Type II trust, except there is no makeup provision.

Type IV or FLIP Unitrust:   The Type IV or FLIP unitrust was created by regulations effective on December 10, 1998.

Optimum CRT Payouts

Payouts are among the most important areas for the advisor to communicate to the recipient. With a charitable remainder unitrust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.

This distribution sounds reasonably simple. However, the options and the accounting can be fairly complex. The challenge for the advisor is to explain these rather complex options and concepts in simple terms to donors and clients.

There are four principal formulas for payments of unitrust amounts. An attorney drafting unitrust documents must understand clearly the four different methods, the appropriate language for each method and the correct use of each of the four options. The four options are commonly referred to as "Type I - Standard Unitrust (Reg. 1.664-3(a)(1)(i)(a)), Type II - Net Income Plus Makeup Trust or NIMCRUT, (Reg. 1.664-3(a)(1)(i)(b)(2)), Type III - Net Income Only Unitrust (Reg. 1.664-3(a)(1)(i)(b)(1)), and Type IV - FLIP Unitrust (Reg. 1.664-3(a)(1)(i)(c))."

Type I or Standard Unitrust

The Type I or Standard Unitrust is reasonably straightforward. In most cases, the valuation date for the trust is January 1 of each year. The selected unitrust percentage is multiplied times the value of the trust and that is the annual amount. If the amount is paid semiannually, quarterly or monthly, the unitrust amount is divided by two, four or twelve to calculate the distributions.

This plan has several advantages. It is easy for the donor to understand, for the CPA or attorney to explain to the client and it is possible for a portion of the distribution to be capital gain. For these reasons, the standard unitrust is preferred by donors, trustees and the Internal Revenue Service. While the IRS does not publicly advocate specific trust types, the standard unitrust is logically preferable, since it increases the probability of compliance by trust administrators. The standard unitrust is commonly used when public stocks or other liquid assets are transferred to a CRT.

Type II or Net Plus Makeup Unitrust (NIMCRUT)
The Type II or Net Income Plus Makeup Trust pays the lesser of trust income or the unitrust percentage. A NIMCRUT was initially included in the 1969 legislation because donors often contribute real property to charitable trusts. The real property may not earn sufficient income to enable the trustee to make the required payment. Thus, the trust may pay the lesser of the unitrust amount or the actual income earned until the real property is sold. After the real property has been sold and the proceeds reinvested, the trust will pay the regular unitrust amount. If there are excess earnings over the unitrust amount, any shortfall or deficit in the initial years could be repaid. The latter amount is referred to as the "makeup" portion of the payout.

This method has become quite popular for those donors who desire an "income control" unitrust. Through careful selection of either growth or income assets, the trustee may allow growth for a period of time, such as prime earning years prior to retirement. After retirement, the trustee could shift from a growth to an income-producing investment and then make distributions of both the regular unitrust amount plus the makeup amount.

Under Reg. 1.664-3(a)(1), income is defined under Sec. 643(b) and the applicable regulations. Reg. 1.643(b)-1 notes that income shall be defined under the "governing instrument and applicable local law."

In states that have passed the Uniform Principal and Income Act, a trustee of many trusts may be given the power to allocate capital gains to distributable income or to principal. However, a charitable remainder unitrust under Reg. 1.664-3(a)(1)(i)(b)(3) is precluded from permitting the trustee to have a purely discretionary power to allocate capital gain. The unitrust drafter may allocate all recognized capital gain to income, no recognized capital gain to income or a fixed fractional part of gain to income. An alternative to permit discretionary distribution of capital gain is to place the unitrust assets in a partnership or single-member LLC. When a trust payout is desired, recognized capital gains are distributed from the partnership or LLC to the unitrust, and then to the income recipients. The NIMCRUT defines income as a cash distribution from the LLC or partnership and there is no obligation to make the trust income payments until receipt of the LLC or partnership distribution.

There also is a limit on recognized capital gain allocated to income with a NIMCRUT. Under Reg. 1.664-3(a)(1)(i)(b)(3), the pre-gift gain must be allocated to corpus. Only post-gift capital gain may be allocated to income and distributed to income recipients.

Type III or Net Income Only Unitrust
The Type III or net income only trust is very similar to the Type II trust, except there is no makeup provision. Once again, the trust pays the lesser of the income or the unitrust percentage. This formula is used infrequently. Generally, it is helpful for individuals who desire income, but want to ensure a substantial remainder to the charity.

Type IV or FLIP Unitrust
The Type IV or FLIP unitrust was created by regulations. In Reg. 1.664-3(a)(1)(i)(c), the Service permits a trust to function initially as a Type II or Type III trust. After a "trigger event," the trust will change the following January 1 to a Type I or standard unitrust. The triggering event may be a sale of unmarketable assets, marriage, divorce, death or birth of a child.

With a FLIP, any existing deficit is forfeited when the trust changes to a Type I unitrust on the January 1 after the trigger event. If there has been appreciation of the assets prior to the trigger event, then an initial NIMCRUT formula with recognized capital gain allocated to income could permit repayment of part or all of the makeup account. However, in most cases it may be preferable to retain the gain tax-free in the trust and benefit from added income for life, rather than distributing the makeup in one year and paying the tax in one year.

Generally, the FLIP unitrust is used for sale of unmarketable assets. Nearly all unitrust drafters will now use a FLIP unitrust rather than a NIMCRUT for real property. The real property is transferred into the FLIP unitrust, sold during the first year and the trust subsequently FLIPs to a straight unitrust.

Case Studies on Types of Unitrust Payouts

Michael "FLIP's" for Spouse:   Michael Williams just turned 70 ½ and has begun the mandatory withdrawals from his individual retirement account. The assets of the IRA have been invested primarily in equities over the past ten years and Michael has been pleased with the growth of the account over that period. What was once a very moderate account has grown to over $1.5 million in value and, therefore, he will be required to withdraw over $100,000 per year based on his life expectancy. He plans to leave the balance of the account to charity upon his death, but he has become concerned about providing for his spouse when he is gone. They do have $3 million in other assets, but the majority of the $3 million is in income-producing real estate which he manages. The real estate produces a very nice income stream (over $200,000 net per year), but this is primarily because of Michael's management expertise. He is very concerned that should he predecease his spouse that the real estate will not produce near this kind of income because he will not be available to provide the savvy management skills.

Three Thousand Shares of Stock, Two Possible Trigger Dates, and One FLIP:   Sarah Stevens, a 42 year-old CEO and MBA graduate, has managed to build a very successful technology company from scratch. Over the past ten years, her closely held company has grown exponentially. In order for it to maintain this incredible growth, Sarah decided many months ago to take the company public this December. Based upon its business model and current success, Sarah's company is expected to be a "hot" IPO. Sarah also knows that despite her company being worth a great deal, she will continue to receive a lower income until the company can start to turn larger profits. In fact, during the past several years, Sarah has paid herself only a moderate salary as she poured money back into her company.

FLIP Unitrust v. NIMCRUT - And the Winner is ...:   Samantha and Kevin Donaldson, both 55, have been married for over thirty years. They are professional musicians and have been members of the city orchestra for twenty years now. Not surprisingly, Samantha and Kevin are passionate supporters of music. They hold workshops to teach young people musical instruments, and can be frequently found passing out flyers to encourage attendance at the city orchestra's performances. In a recent visit with the orchestra's gift planner, Jamie Evans, the Donaldsons indicated their desire to leave a gift to the orchestra upon their death. The Donaldsons estate was valued at $2 million, and they envisioned a bequest of $200,000. Jamie then described the benefits of a Charitable Remainder Trust (i.e. tax deduction now, bypass of gain, increase income) and suggested it as an option. The Donaldsons loved the idea they could receive an income tax deduction now for a gift they planned to make in the future. Furthermore, they had a large block of appreciated assets that would be well suited for the CRT. The only reservation the Donaldsons had was the increased income. They were currently in their highest income earning years, and did not need to boost their taxable income. Preferably, the Donaldsons would like to defer the income until they retire. Therefore, they ask Jamie if there was a way to structure the CRT to act like a retirement vehicle. Jamie recalls a session she attended that discussed the use of FLIP Unitrusts and NIMCRUTs as retirement vehicles, however, she was unsure which CRT was more appropriate in the Donaldsons situation. Which CRT should the Donaldsons utilize for their situation, a FLIP Unitrust or a NIMCRUT?

Exit Strategies for Real Estate Investors, Part 2:   Karl was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate and he was very successful in his investments.

Karl continued to buy and sell real estate at the age of 85. His latest venture led him to a great investment property. It was a "fixer-upper" commercial building in a great area. While other buildings nearby sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.

The condition of the building turned many buyers away. It was being sold as is, but Karl was not deterred. He could see great potential with the building and knew it would not take much work to get it into market condition. Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.

After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl as he knew the building was a great buy.

There was one downside, however, to the idea of selling. Karl held the property only four months, which meant the gain from the sale would be short-term capital gain. In other words, the applicable tax rate would be 40.8%, not 23.8%. Karl cringed at the thought of paying much of his gain to the government. At the same time, Karl knew the real estate market could change directions in the next year. Although Karl wanted the 23.8% tax rate, he did not want to risk holding the property another eight months.

After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. It looked like the perfect solution. However, there were still two potential downsides to this plan.

What are the charitable income tax deduction rules for gifts of short-term capital gain property? If Karl moves forward with this plan, how would the FLIP CRUT payouts be taxed?
Exit Strategies for Real Estate Investors, Part 14:   Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.

Lucky Lucy Lindstrom's Unitrust :   Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy realized that "shorting" financial stocks was going to be a bonanza. She was so successful in the down market that she now only manages her own large personal portfolio.

Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and has learned that giving a helping hand to someone in need is even more gratifying than making another million in the futures market. After reading in a charity's weekly enewsletter about a charitable remainder trust, Lucy called Clara Johnson, a gift planner at her favorite charity.

Lucy suggested that she would transfer $5,000,000 of securities to a 5% net plus makeup unitrust (NIMCRUT). She would serve as trustee, make the investments and the charity would be the remainder recipient. Since Lucy normally earns 18% per year on her futures and commodities investments, she feels that it would be easy to make the unitrust grow to $10,000,000 or more.

Would this plan work? May Lucy serve as trustee? Is it permissible to invest unitrust assets in the futures market?
Turning a Farm into a "Field of Dreams":   Duane and Ruth Bradley, both age 65, have farmed their homestead for the past 35 years. Ruth inherited this land consisting of 85 acres from her grandfather in the late 1950s. At the time of the inheritance, the acreage was valued at only $100 per acre and therefore, the basis in the property is only $8,500. Over the last ten years, the local community has experienced substantial development and now the property is located right on the outskirts of town. The property in the area is now selling for $12,500 per acre and therefore, the fair market value of their land is currently over $1 million. Duane and Ruth have been planning to use the property for their retirement as they have been unable to put any substantial sums aside over the years for this purpose. They have sacrificed greatly to put each of their five children through college and now must think about their retirement. Fortunately, the land has appreciated greatly over the last few years and they can now look to the property to provide a comfortable retirement.

Still Time To FLIP?:   Jake and Kristine McCarthy, both age 75, created a two-life plus 15-year term net income with makeup charitable remainder unitrust (NIMCRUT) about 10 years ago. They chose a payout rate of 5% and funded the trust with $500,000 of highly appreciated stock. Since Jake was a keen stock investor (and since he liked to keep control of their investments) he decided to self-trustee the unitrust. Since they really did not need the income from the trust, Jake made the decision to invest 100% of the trust assets in an aggressive portfolio consisting of stocks and mutual funds. Periodically, he would buy and sell but, for the most part, he followed a buy-and-hold strategy. Over the years, the dividend yield on these investments has averaged 2% and the capital growth yield has averaged about 10% for a total return of 12%. Because of Jake's investment strategy, the trust has grown to over $1.2 million and the deficit account is now about $250,000.

Related Topics on Types of Unitrust Payouts

3.10.1  Unitrust Duration and Recipients:    A charitable remainder unitrust (CRT) pays a fixed percentage for a life, lives, a term of up to 20 years, or a combination of a life or lives and a term up to 20 years. Reg. 1.664-3(a)(5)(i). In most circumstances, the income is paid to the donor for one life or to donor and spouse for two lives. Alternatively, the unitrust amounts may be paid for a term of no more than 20 years, or for a combination.

3.10.3  Unitrust Payouts:    A unitrust payout percentage must comply with three basic rules. The trust must pay a minimum of 5%, a maximum of 50% and a percent that produces a charitable deduction of 10% or greater. The 5% minimum and 50% maximum requirements are easy to understand. The 10% Minimum Deduction Interest (MDI) is understood if one reviews the basics of the charitable deduction.

3.11.2  Retirement/FLIP Unitrust:    The retirement/FLIP charitable remainder unitrust (CRUT) includes several options. A person may wish to contribute equal amounts until retirement.

      Quiz-Basic



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