Friday April 26, 2024
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3.4.7 Unitrust to Gift Annuity Rollover
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In PLR 200152018, a unitrust donor was interested in rolling over the income interest of the unitrust into a gift annuity. The donor had created a standard 5% unitrust that made payments quarterly for his lifetime. A single charity was a remainder recipient and held a vested interest.
The charity desired to use the remainder value as a current gift. While it is possible for a nonprofit with a vested remainder interest for a current project, the donor and charity proposed a better solution. The donor desired to receive income and was not willing to gift the entire income interest to the charity at present. However, if the income interest from the 5% unitrust could be converted to a gift annuity, the donor could receive a reasonably similar income stream for life and the charity could use the remainder value immediately for a current project.
Ruling Requests
The donor and his counsel requested four specific rulings. These were as follows:
1. That the donor would receive an income tax deduction for a portion of the value of the income stream transferred to charity for the gift annuity.
2. There would be a charitable gift tax deduction for the same portion.
3. The transfer of the unitrust income interest for a gift annuity would not accelerate underlying capital gain in the income interest.
4. The percentage of capital gain and basis as of the date of creation of the trust could be utilized for calculating the tax-free portion of the gift annuity payouts.
Income Tax Deduction
A charitable gift to a public charity normally qualifies for an income tax deduction. Sec. 170(a)(1). However, if an individual makes a transfer of a partial interest, then the deduction is usually denied. There are several exceptions to the partial interest rule. A charitable deduction is allowed for a partial interest gift if the transfer is to a charitable remainder unitrust, a charitable remainder annuity trust, a retained life estate or a pooled income fund. Sec. 170(f)(3)(A).
In addition, a gift annuity is considered a bargain sale. When a property interest is transferred in exchange for a gift annuity, there is a charitable income tax deduction under the bargain sale rules. Reg. 1.1011-2(a)(1).
If a donor created a partial interest in a manner to attempt to circumvent the rules, a charitable deduction could be denied. Reg. 1.170A-7(a)(2)(i). However, in this case, the unitrust was properly created and qualified for a charitable income tax deduction. Since the decision to convert to a charitable gift annuity occurred at a later time, there was no circumvention of the partial interest rule. Therefore, the income tax deduction was permitted.
Example 3.4.7A Unitrust to Gift Annuity Rollover
Assume that at the time of conversion to a gift annuity, the charitable remainder unitrust holds assets valued at $100,000. Based on the Sec. 7520 Applicable Federal Rate and IRS Pub. 1458, assume that the value of the income interest is determined to be $60,000, with the value of the vested charitable remainder interest equaling $40,000.
Susan Donor transfers the $60,000 income interest in exchange for a charitable gift annuity. The gift annuity is determined under Sec. 72 and applicable regulations to have a charitable gift value of $35,000 and an annuity contract value of $25,000. Based upon these assumptions, the charitable deduction will be $35,000. Susan benefits from the charitable deduction and receives the annuity payments for life. The assumed value of the income for the $60,000 gift annuity is $25,000.
Valuation of UT Income Interest
Unitrust income and remainder interests are valued using the methods of Reg. 1.170A-7(a) and IRS Publication 1458. Based upon the age or ages of the income recipients on the date of the income interest gift, the applicable federal rate, the frequency of payment, the unitrust corpus value and the unitrust amount, the present value of the income interest may be determined. If the entire unitrust income is transferred to charity, then the amount calculated using the Treasury method is usually the deduction value. Section 664(e) of the code provides that the value of the income interest is based on the stated payout percentage.
Because this is a gift of an appreciated asset with value over $5,000, both a contemporaneous written acknowledgement and an appraisal by a qualified appraiser are required.
Editor's Note: At one point, the valuation of the income interest for a net plus makeup unitrust (NIMCRUT) or net income unitrust (NICRUT) required to use the lesser of the AFR or the stated unitrust payout percent for the unitrust payout percentage. With the passage of the Protecting Americans from Tax Hikes Act of 2015, Sec. 664(e) was amended to provide that the valuation of an income interest in a NIMCRUT or NICRUT may use the stated payout percentage.
Selection of Gift Annuity Rate
Most charities follow the rate schedules established by the American Council on Gift Annuities. However, with rollovers or conversions from life estates, pooled income funds, unitrusts or annuity trusts, the donor may be interested in a higher rate than the standard ACGA number. For example, if a unitrust has $100,000 in corpus and is a 5% trust, then the payout could equal $5,000 per year. Assuming that the income interest is valued at $60,000, then a 7% annuity would pay $4,200 per year. Thus, it may be preferred by the donor that the charity would pay a higher-than-normal rate in order for the income from the gift annuity to be reasonably close to the unitrust payout.
Is it permissible for a charity to pay a higher rate in order for the gift annuity payout to be reasonably close to the unitrust income? There are two potential limitations on paying a higher rate. First, a charitable gift annuity must qualify with a minimum 10% charitable deduction. Sec. 514(c)(5). The rate on the $60,000 gift annuity may be increased, but not to the point where the charitable deduction would be reduced below $6,000. Second, some state insurance commissioners will not permit an individual annuitant to receive a higher annuity percentage. For example, in California, the same maximum rate must be paid to all annuitants of a given age. In some regulated states, a charity may file a rate schedule different from the American Council on Gift Annuities rates, but that nonprofit is required to follow that schedule uniformly for all annuitants.
Charitable Gift Reduction Rules
The donor desired a charitable deduction for a gift of a capital asset. If the income interest were deemed to be an ordinary asset, the charitable income tax deduction would be reduced by the value of the ordinary interest. Sec. 170(e)(1)(B). Fortunately, a life interest is a capital asset. Rev. Rul. 72-243, 1972-1 C.B. 233. Thus, the transfer in exchange for the gift annuity does produce an appreciated property-type charitable deduction.
Gifts to public charities are subject to a limitation of 60% adjusted gross income for cash gifts and 30% for appreciated property gifts. Sec. 170(b)(1)(C). Since this is a gift of a capital asset, the deduction limit in the year of the gift is 30%, with a carry forward for up to five additional years of any excess deduction.
Gift Tax Deduction
Transfers to public charities ordinarily qualify for both income and charitable gift tax deductions. Sec. 2522(a). A charitable gift deduction for a partial interest results from a transfer to a charitable remainder trust or a pooled income fund. Sec. 2522(c)(2).
However, under Rev. Rul. 86-60, 1986-1 C.B. 302, a person who created a charitable remainder annuity trust was permitted to transfer the entire annuity interest to the charitable remainder recipient. In situation 1 of this ruling, the entire income interest was transferred to the remainder charity and qualified for a charitable deduction.
Since the split interest in the charitable remainder unitrust was created for a charitable purpose, rather than a private purpose, the transfer will be permitted. The transfer of the income interest in exchange for the gift annuity will result in a charitable gift tax deduction for the value of the charitable interest in the gift annuity.
No Capital Gain Acceleration
The income interest in the unitrust was previously determined to be a capital asset. The transfer of this capital interest in exchange for a gift annuity is a bargain sale. Sec. 1011(a). If a gift annuity is created with appreciated property and the donor is the annuitant, the gain may be prorated over the donor's life expectancy. Reg. 1.1011-2(c), Example 8.
Normally, there is no acceleration of gain upon transfer of a capital asset to charity unless there is some specific "trigger." For example, the transfer of an installment note or a commercial annuity to charity or to a charitable instrument triggers the underlying capital gain.
However, since the donor is the annuitant in this case and there is no specific triggering of gain for transfer of an income interest that is a capital asset, there is no immediate recognition of capital gain.
Prorated Basis Allocated to Annuity
With a charitable gift annuity, a portion of the return is ordinary income, and a portion is the excluded amount. The excluded amount equals the contract value divided by the expected return over the lifetime of the individual. Reg. 1.72-9, Table V. This ratio of each payment is tax free if the annuity is funded with cash, or partly capital gain and partly tax-free return of basis for an annuity funded with appreciated property.
If a gift annuity is funded with a long-term capital gain asset, the gain may be recognized over the lifetime of the donor/annuitant. Reg. 1.1011-2(c), Example 8.
With the unitrust to gift annuity rollover, the owner of the unitrust life interest would prefer to allocate a prorated amount of cost basis to the annuity contract. A unitrust grantor would hope to determine the ratio of basis to fair market value at the time the trust was created and to assume that same ratio for purposes of calculating the basis allocable to the gift annuity agreement.
However, when a transfer is made of an income interest, the prorated basis is generally disregarded. Sec. 1001(e)(1). The exception to this rule is when the donor transfers his or her entire interest in a single transaction. Sec. 1001(e)(3).
Since the transfer was created in two steps, with the creation initially of the charitable unitrust and then a subsequent conversion to the gift annuity, the Service determined that the prorated basis should not be allowed. Therefore, the payout from the gift annuity of the excluded amount will be all capital gain under this interpretation.
Example 3.4.7B Gift of an Income Interest
Megan created a net income plus makeup charitable remainder unitrust ("NIMCRUT") about 20 years ago with $1 million of appreciated stocks. Because interest rates were substantially higher at that time, Megan's NIMCRUT was drafted with a 10% payout. Unfortunately for Megan, interest rates have now plummeted to 3%. As a result, her trust distributes about $30,000 a year, which is all taxed as ordinary income. In addition, because her trust is invested almost solely in bonds, Megan's trust is still valued at about $1 million. While Megan would like realized capital gain to be paid out of her trust, that trust provision and strategy was not contemplated when she funded the trust.
Knowing of Megan's disappointment and needing to fund a building project now, the charitable remainder beneficiary of the NIMCRUT has approached Megan about a possible change to her plan. How can Megan receive a tax deduction, retain part of her income and make a large charitable gift today? Can charity also benefit from her solution?
The charitable remainder beneficiary suggested that Megan transfer her income interest to the charity in exchange for a charitable gift annuity. It is important to note that Megan may transfer only her income interest and not the entire value of the trust for a gift annuity, since the remainder already belongs to the charity.
The value of Megan's income interest is determined by doing a present value calculation (in accordance with Sec. 7520). Because the PATH act of 2015 applies to valuation of NIMCRUT income interests, the higher 10% stated payout in the unitrust document is used (not the applicable federal rate for the month of the conversion). Based upon her age, using the the AFR as the assumed payout and the $1 million value of the trust, Megan's income interest is $459,860. At her age, the American Council on Gift Annuities rate is 7.5%. Therefore, Megan will receive an annuity of $34,489.50 every year with no further fluctuations.
Megan will also receive a charitable income tax deduction for the transfer of her income interest for a gift annuity. The deduction will equal the excess of the value of her unitrust income interest over the value of her gift annuity contract. This deduction is a capital gain-type gift, so it will be limited to 30% of her AGI. In addition, Megan's income taxes will be lower. With the NIMCRUT, all the income was taxed as ordinary income. However, with a gift annuity, the income will be taxed at much lower capital gain rates.
Finally, the charity will benefit greatly from this solution. After Megan transfers her income interest, the charity will own both the income and remainder interest. Therefore, the trust will merge and the trustee may distribute all the trust assets to the charity. The charity will place $459,860 in the gift annuity reserve, and benefit from a current gift of the $540,140. See PLR 200152018.
Example 3.4.7C Specimen Unitrust Income Interest for Gift Annuity Language
Trustee
Organization
Address
City, State Zip Code
Re: Charitable Remainder Unitrust ______________
Dear Trustee:
I am currently the income recipient of a one life charitable remainder unitrust that was created on July 4, 2022 with trust grantor George Washington, 123 Main Street, Anytown, Illinois 00000 and initial trustee Charitable Organization, 456 Main Street, Anytown, Illinois 00000. The unitrust federal ID number is __________________.
As life income recipient, I have retained the power under section ________________ of that trust document to add, remove or modify by name or percentage the qualified exempt charitable remainder recipients. I declare my intention through this signed and dated writing to modify the charitable remainder recipients by irrevocably designating a percentage of both income and remainder interests to a qualified exempt charity and retaining the balance of the income interest and the right to modify the charitable remainder recipients for the balance of the trust.
It is my intention to use my income interest in this charitable remainder unitrust to establish a charitable gift annuity. Therefore, I hereby irrevocably designate qualified exempt charity ____________________________, of City, State, as the recipient of _____% of both the income and remainder interests in unitrust number _________________, with the income interest being exchanged for a charitable gift annuity.
The trustee is authorized to recognize that under the doctrine of merger of income and remainder interests, the named exempt charity now owns all interests in the specified percentage of this remainder unitrust. Therefore, the trustee may distribute that portion of the trust principal to the named exempt charity.
I understand that this transfer to a charitable organization may qualify under IRC Sec. 170 provisions for a charitable income tax deduction for the actuarial value of the gift passing to charity via the charitable gift annuity.
[Optional (Depending on state law): I am forwarding a copy of this letter to the state attorney general for the state of __________________.]
Sincerely yours,
____________________________ Date: ____________
Unitrust Income Recipient
Annuity Trust to Gift Annuity
It is possible to convert an annuity trust payout to a gift annuity. This plan permits the charity to receive a current gift of part of the annuity trust corpus and provides the donor with an additional charitable deduction. Usually, there will be a smaller payout from the gift annuity than from the annuity trust.
The annuity interest is valued using the methods of Reg. 1.170A-7(a) and IRS Publication 1457. Based upon the age or ages of the annuity recipients on the date of the income interest gift, the applicable federal rate, the frequency of payment and the annuity amount, the present value of the annuity may be determined. If the entire annuity is transferred for the gift annuity, then the amount calculated using the Treasury method is the funding value for the annuity contract.
However, there is one possible limitation on this calculated annuity value. Under Sec. 170, all charitable deductions are limited to fair market value. If the annuity trust principal has declined in value to an amount less than the calculated Treasury annuity value, then the annuity value will be limited to the lower fair market value of the annuity trust corpus on the date of the income interest gift.
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Case Studies on Unitrust to Gift Annuity Rollover
Changing a Lackluster NIMCRUT into a Shiny New Gift Annuity:
Megan Moss created a net income plus makeup charitable remainder unitrust (NIMCRUT) about 16 years ago with $1 million of appreciated stocks. Because interest rates were substantially higher at that time, Megan's NIMCRUT was drafted with a 7% payout.
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Private Letter Rulings
PLR
200152018 Unitrust to Gift Annuity Rollover:
In PLR 200152018 (26 Sep 2001), a unitrust donor was interested in rolling over the income interest of the unitrust into a gift annuity. The donor had created a standard 5% unitrust that made payments quarterly for a lifetime. The charity desired to use the remainder value as a current gift.
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