Tim and Julia Brennan, both
66 years old, created a standard charitable unitrust and sold some highly appreciated
bank shares through it three years ago.
It made great sense as a way to minimize their capital gains liabilities,
and passing the remainder to a charity was an acceptable cost, even though
neither was particularly charitably oriented.
Their financial advisor on the transaction convinced them that the “perfect
investment” tool inside their CRT should be a deferred variable annuity. While using a deferred annuity is frequently
a legitimate planning tactic inside a NIMCRUT that operates as a “spigot”
trust, it is generally not the best
tool inside a traditional CRUT. Why not? Because
there is no need for the trustee to accept the compromise of highly taxed ordinary
income payments instead of more tax efficient tier two capital gains. Using a deferred annuity turns a capital
asset into an ordinary income stream, and since the top rate for tax on
ordinary income is nearly twice that of capital gains, there is an unacceptable
penalty for the use of this product. If
this was a net income trust there would be a need to control distributable net
income, but a commercial deferred annuity usually does not work that way inside
a SCRUT or CRAT. While there may be
reasonable differences of opinion about the best funding mechanisms, in the
Brennan case, their financial advisor seemed to have motives that put his needs
ahead of his clients’.
Where did this train wreck
fall off the rails? Prior to helping the
Brennans set up their charitable remainder trust, the
life insurance agent had no experience with CRT management issues or the
obscure rules associated with §664 trusts, but he knew there were opportunities
to provide wealth replacement in the form of a life insurance contract. The agent attended an advanced marketing
program and learned that in addition to the insurance, a variable annuity was touted as the “perfect investment” inside a CRT. Unfortunately, the marketing staff was more
interested in pushing product instead of solving problems, and they neglected
to disclose the down side of using an annuity inside the charitable remainder
trust.
What down
side?
The first problem that popped up was that this annuity
contract had a limit on the number of distributions and the value of penalty
free withdrawals. Where this developed
into a serious problem was when the equity market free-fall in 2000 through
2002 dropped the annuity value to a level that restricted the required
quarterly unitrust distributions. Once
the annuity dropped in market value by over 50 percent, then the required
payments triggered the insurance company’s penalty. Because the annuity company had no experience
with charitable trusts, it was issuing a 1099-R for all of the payments made to
the income beneficiary, but that causes a problem because income beneficiaries should
receive a K-1 from the CRT, not a 1099 from the carrier. The second problem was that the agent who sold
annuity had himself named trustee, and he convinced the Brennans
that because the annuity was not liquid enough to make the required
distributions, the trust would not be able to meet its obligations. The third problem is that the trustee
neglected his fiduciary responsibilities, i.e., the duty to look out for both
the income beneficiary and the charitable remainder beneficiary. By keeping the charitable trust invested in an
underperforming annuity, he harmed both beneficial interests. The trustee, as an insurance producer, knew
that if the trust terminated the contract he might be required to refund the
sales commission on the initial purchase and lose the ongoing trail commission,
so there was an existing conflict of interest that may have influenced his
decision to do nothing about dumping the annuity. This is one reason why insurance carriers and
the National Association of Securities Dealers (NASD) prohibit a registered
representative from acting as a trustee for a client’s trust.
Even if the CRT is a properly
drafted irrevocable trust, as long as it does not operate as a CRT it is not
going to qualify as a tax-exempt charitable remainder trust. It is important to understand that standard unitrusts
and annuity trusts do not have discretionary authority to pay less than the
appropriate amount as stipulated by the trust document. Occasionally trustees make errors, and make
incomplete distributions, but an ongoing pattern of missed or improper payments
exposes the trust to grantor status and loss of its charitable remainder trust
protections. *
* Atkinson v. Commissioner, No 01-16536 (11th Cir.,
© 2003 -- Vaughn W. Henry
Gift
and Estate Planning Resources
217.529.1958
-- 217.529.1959 fax
VWHenry@aol.com
on
the web at gift-estate.com
