Swimming in the Deep End – The Surprising Utility of Pooled Income Funds for High Net Worth Tax Planning

more+
less-

Overview

The old cliché about Charity is that “Charity begins at home.” The federal government has always recognized the social benefit of providing tax incentives for individual and corporate taxpayers in order to provide an incentive for taxpayers to donate to charity. In reference to the cliché, it is always easier to make a charitable donation if the income and estate tax benefits are substantial and the taxpayer is able to retain an income over a lifetime. These days, most people would prefer to give their money to a worthwhile charity over the federal government.

In the current tax planning environment, these incentives have become critical as individual marginal tax brackets at the federal and state level have increased. If you are a taxpayer in the top marginal bracket and a resident of New Jersey, California or New Jersey, your combined marginal bracket is over fifty percent. If you consider the phase-out of personal exemptions and itemized deductions, the combined marginal bracket increases a few more percentage points.

Over the course of the last twenty years, the use of sophisticated charitable tax planning strategies has proliferated. Professional advisors and tax exempt organization planned giving departments have not lacked in planning creativity in order to attract charitable capital. The charitable remainder trust (CRT) is one of those strategies.

Once financial advisors and life insurance agents, i.e. professionals that know how to market and sell financial products and services, entered the planned giving marketplace, the CRT proliferated in its use. Financial advisors want to provide planning solutions and sell investment and insurance products to implement the solution. Frequently, it is the financial advisor who convinces the client to move forward with the charitable strategy. The charitable lead annuity trust (CLAT) is another popular with sophisticated tax advisors but has not been marketed as heavily by financial advisors. The CLAT is another planning opportunity for financial advisors.

This article addresses the Pooled Income Fund (PIF) which contrary to popular notion, has surprising planning utility and appeal in the current low interest environment. The PIF is frequently know as a CRT Mutual Fund or the “Poor Man’s” CRT. Many large charities offer PIFs as a planned giving solution, but it is not nearly as popular as many other solutions. In fact, a national planned giving consultant recently told me that many charities are terminating their PIF options through a lack of interest. My hope is that this article will cause professional advisors and financial service professionals to consider PIFs as an option and say “Not so Fast”, to the public charities looking beyond PIFs.

What is a PIF?

A pooled income fund is a trust that is established and maintained by a public charity. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned "units of participation" in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.

Each year, the fund's entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.

Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor's deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.

Having focused on the commingling aspect of funds or contributions from multiple donors, I can find nothing in the Internal Revenue Code or treasury regulations that would preclude a PIF with a single donor it the pooled income fund. The apparent issue is an administrative issue for a charity and not a tax issue, i.e. is it cost effective to administer a PIF with a assets beneath a certain threshold of assets under management? Otherwise, why does a charity care if it receives a remainder interest in a gift worth one million dollars from a single donor instead of one thousand donors?

IRC Sec 642(c) (5) defines a pooled income fund as a trust:

  1. to which each donor transfers property, contributing an irrevocable remainder interest in the property to or for the use of a public charity while retaining an income interest for the life of one or more beneficiaries (living at the time of the transfer).
  2. in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,
  3. which cannot have investments in securities which are exempt from taxes.
  4. which is maintained by the public charity to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and
  5. from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest determined by the rate of return earned by the trust for such year.

The trust instrument of the pooled income fund must require that property transferred to the fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors. Charitable organizations are permitted to operate multiple pooled income funds, provided that each such fund is maintained by the organization and is not a device to permit a group of donors to create a fund which may be subject to their manipulation. Such manipulation is, however, highly unlikely because the regulations require the governing instrument of a pooled income fund to (1) prohibit a donor or income beneficiary of a pooled income fund from serving as a trustee of the fund, and (2) include a prohibition against self-dealing.

Nevertheless, there is nothing legally preventing a wealth management firm or registered investment advisor (RIA) from establishing multiple commingled funds or pools of assets within a public charity for clients managed on a discretionary basis by the RIA or alternatively by a registered representative of a broker-dealer. Again, the issue is not a tax issue but rather an administrative issue regarding the custodial pricing and reporting of the fund administrator operating for the public charity. As a practical matter, the administrative pricing should not be dramatically different for the fund administrator operating and administering separately managed accounts for wealthy individuals by the RIA.

The fund must not include property transferred under arrangements other than pooled income funds. However, a fund is permitted to invest jointly with other properties that are held by, or for the use of, the charity maintaining the fund. The regulations cite as an example: securities in the general endowment fund of the public charity to or for the use of which the remainder interest is contributed. In a private ruling, the Service approved the commingling of pooled income fund assets with other charitable funds, including charitable remainder trusts and excluding any tax-exempt securities, held by the organization.

Community foundations and other public charities often receive contributions that are maintained for the benefit of other charitable organizations selected by the donor, i.e. donor advised funds. A donor may designate the donor’s donor advised fund administered by the public charity as the recipient of the remainder interest.

Each beneficiary of a pooled income fund receives a pro rata share of the total rate of return earned by the fund for such taxable year. When a donor transfers property to a pooled income fund, one or more units of participation are assigned to the beneficiary or beneficiaries of the retained income interest. The number of units of participation assigned is obtained by dividing the fair market value of the property by the fair market value of a unit in the fund at the time of the transfer. Like a CRT, the PIF may make distributions on a monthly, quarterly or annual basis to meet the income requirements of the taxpayer.

Tax Benefits of PIFs

At this point, you may still be asking “What’s the point?” Let me lay it out for you. The taxpayer does not recognize gain or loss on the transfer of property to the PIF. In practice, this feature makes pooled income funds ideal for use by wealthy taxpayers who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.

 If a pooled income fund has existed for less than three taxable years, the charity is able to determine the interest rate used in calculating the charitable deduction. The rate is determined by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC Sec 7520 for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate. The rate for the 2014 tax year is 1.4 percent. The IRC sec 7520 rate for July 2014 is 2.2 percent.

This interest rate provides a significantly larger deduction than a comparable contribution to a CRT.  The following chart compares the percentage of tax deduction based upon a charitable contribution of $100,000. The CRT assumes a minimum CRT payout of five percent for the taxpayer’s lifetime. Deductions for cash contributions are subject to the fifty percent of adjusted gross income limitation threshold. Deductions of appreciated property are subject to the thirty percent of AGI threshold. The taxpayer may carryover excess deductions for an additional five tax years beyond the current year.

                        Comparison of Charitable Remainder Trust vs. PIF

                                                   (% of Deduction)

                          Age                         PIF                              CRT

                         40                           59.1                              17.7

                         50                           66.8                              26.4

                         60                           74.8                              38.1

                         70                           82.5                              52.3

                         80                           89.2                              67.3

Unlike charitable remainder trusts, which are conditionally exempt from income taxes, pooled income funds are, with one important exception discussed below, taxed as complex trusts. Pooled income funds seldom pay any tax, however, for several reasons. First, pooled income funds receive an unlimited deduction for all amounts of income distributed to fund participants. Because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed.

Second, pooled income funds are permitted a special deduction for long-term capital gains that are set aside permanently for charity. In essence, long-term capital gains produced by a pooled income fund are allocated to principal. Because principal is earmarked for charity, such amounts escape income taxation. For purposes of tracking income and gain attributable to contributed assets, pooled income funds take on the donor's holding period and adjusted cost basis in the contributed property.

Nevertheless, the trust document for most pooled income funds typically defines income as that term is defined in IRC Sec 643(b). Under this section, the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law. The Uniform Income and Principal Act or Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties. Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, pooled income funds can expand the definition of income to include capital gains. Pooled income fund beneficiaries are required to include in their gross income all amounts properly paid, credited, or required to be distributed to them during the taxable year or years of the fund ending within or with their taxable year.

Distributions from pooled income funds are taxed under the conduit theory applicable to IRC Sec 661 and 662. Because pooled income funds distribute all income earned during the taxable year, the tax character of amounts distributed to each income beneficiary is directly proportional to the tax character of investment income earned within the PIF.

The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.

Summary

The PIF provides substantially larger income tax deductions in the current interest rate environment when compared to the very well-known and “time-tested” CRT. Nothing precludes a financial advisor or RIA from establishing a new PIF operated as a separately managed account (SMA) with a specific investment objective tailored to the needs of the charitable donor and beneficiary. Fund and SMA administrators have substantial experience and expertise operated customized arrangements.

Undoubtedly, the administrative and custodial charges to the public charity will be reflected in its pricing to the charity. These fees can be recouped by the public charity. Suffice it to say, the proposed arrangement is not for the donor making a ten dollar contributions but mostly likely has a minimum level of $100,000-250,000 due to administrative cost considerations.

Taxpayers and their advisors are hard-pressed to find charitable solutions that can provide a meaningful income tax deduction; retention of an income for a lifetime, and capital gains avoidance upon the sale of an asset. From the perspective of the financial advisor (people who see products and services for a living), the arrangement is very attractive from the standpoint of client benefits and the ability to customize the investment arrangement and retention of assets under management.

My planning recommendation is that public charities should delay plans to terminate PIF arrangements and find a way to partner with financial advisors in order to capture the assets from the perspective of new charitable donations.

Topics:  Estate Planning, Income Taxes, Pooled Investment Vehicles, Tax Planning

Published In: General Business Updates, Finance & Banking Updates, Tax Updates, Wills, Trusts, & Estate Planning Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

Don't miss a thing! Build a custom news brief:

Read fresh new writing on compliance, cybersecurity, Dodd-Frank, whistleblowers, social media, hiring & firing, patent reform, the NLRB, Obamacare, the SEC…

…or whatever matters the most to you. Follow authors, firms, and topics on JD Supra.

Create your news brief now - it's free and easy »