I have written several articles discussing the powerful tax benefits of pooled income funds in the current low interest environment. I have also written on the tax benefits of charitable lead annuity trusts (CLAT). The pooled income fund (PIF) is an “old school” planned giving technique that has largely disappeared from the tax planning landscape. The liquidation of PIFs over the last two decades has outpaced the creation of PIFs. As of 2012, charities filed tax returns for only 1,324 PIFs. The number is even lower in 2016. The only place that you will find PIFs is in large charities and colleges. Fidelity offers several PIFs but has largely abandoned the promotion of the PIF in favor of donor advised funds.  

The split annuity concept is another “old school” insurance technique that combines an immediate annuity for a term of years with a fixed single premium deferred annuity. The immediate annuity provides a tax-favored guaranteed income to the annuitant for a term of years. The balance of the investor’s funds are allocated to a fixed singled premium deferred annuity. Theclat deferred annuity provides for a crediting rate that is “fixed” by the life insurance company issuing the annuity. The idea is that the deferred annuity grows to the original amount of the initial investment over the term of years of the immediate annuity. The charitable split annuity is a derivative of this technique. However, the strategy has powerful tax benefits that its “old school” cousin lacks.

This article reviews the use of a creative combination of planned giving techniques. The combination replicates the split annuity with tax advantages.  In this case a portion of the investor’s funds are allocated to a PIF which provides a series of tax benefits – (1) Substantial income tax deduction (2) Tax exemption on the sale of an appreciated asset (3) A lifetime income for one or multiple generations and (3) Charitable gift tax deduction.

A portion of the funds are allocated to a Charitable Lead Annuity Trust (CLAT). The CLAT provides a substantial income and gift tax deduction and provides an income to the taxpayer’s donor advised fund or charity of choice for a term of years, with the CLAT remainder interest passing to the taxpayer or taxpayer’s trust, after the term of years.

The combination of strategies provides powerful tax deductions, current income, and avoidance of capital gains taxes, estate and gift tax benefits, and a reversion of trust assets hopefully equal to the original amount or greater in a manner similar to the “old school” split annuity concept. While my own music preference favors the Fania All Stars, the introduction to the Donnie and Marie Show described itself as  a “little bit country and a little bit rock and roll”. So is the charitable split annuity!

The Split Annuity

The split-annuity concept provides you with a guaranteed income stream along with principal preservation. To accomplish this goal, the investors purchases two non-qualified annuity contracts: a fixed period annuity for income and a single premium fixed deferred annuity for growth

The fixed immediate annuity provides the investor with a safe and guaranteed income for a term of years. The term of years can range from five-forty years. The payments can be in monthly, quarterly, semi-annual or annual intervals. The growth portion of the strategy features a single premium fixed deferred annuity. The investment return features tax-deferred growth at a fixed rate of interest. Frequently, the crediting rate can be selected for one-year or greater guarantee period. 

The split annuity concept can be illustrated for an investor who needs a conservative method to supplement retirement income over a ten-year period without exposing a large portfolio to the volatility of the stock market. Assuming the principal is $100,000. The investor allocates $31,935 to a ten year fixed period annuity which produces an annual income of $3,744 per year. In this case, 95 percent of each payment is considered a tax-free return of principal. At the same time, the investor allocates $68,066 to a fixed interest deferred annuity which compounds on a tax-deferred basis at the guaranteed crediting rate of 4.25%.

The Charitable Split Annuity

The charitable split annuity concept is a combination of charitable planning techniques – the charitable lead annuity trust (CLAT) and the pooled income fund (PIF).  The CLAT is designed as a grantor trust. The CLAT provides payment to the taxpayer’s donor advised fund for a term of years. The annuity payout is designed to maximize the charitable deduction which is limited to 30 percent of AGI. The unused deduction may be carried forward for five tax years. The annuity payment scheme may be structured to backload the payments, i.e. small initial payments growing by a fixed percentage each year. This payment scheme allows the CLAT corpus to grow over a term of years back to its original amount or more.

The second part of the charitable split annuity concept is a contribution of assets to a pooled income fund (PIF). The PIF income interest may be designed to provide an income over a single or joint lifetime over multiple generations, concurrently or consecutively.

1. Pooled Income Fund

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.

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.

A cash contribution to a PIF is subject to an income tax deduction threshold of fifty percent of adjusted gross income (AGI). Appreciated assets are subject to the thirty percent of AGI threshold. Excess deductions may be carried forward for an additional five tax years. The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.

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, or multiple lifetimes, consecutively or concurrently. The taxpayer does not recognize gain or loss on the transfer of property to the PIF. If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Mid Term Rate The rate for the 2016 tax year is 1.2 percent.

In practice, this feature makes pooled income funds ideal for use by persons 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

Comparison of Charitable Remainder Trust vs. Pooled Income Fund

2. Charitable Lead Annuity Trust (CLAT)

There are two basic types of living charitable lead trusts. These are the grantor lead trust and the non-grantor, or family lead trust. In the case of a non-grantor type lead trust created during lifetime, no income tax deduction is available. In the case of a grantor lead trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed a deduction in the year the trust is established for the actuarial value of the annuity or unitrust income stream to be paid to the charity.

A consequence of a CLAT taxed as a grantor trust status allowing for the income tax deduction, is the taxation of CLAT income to the grantor during the lifetime of the trust. Nevertheless, a CLAT is a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT can be designed to produce a deduction equal to the contribution. The deduction (including cash contributions) are limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.

The CLAT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. The CLAT does not have a limit for a term of years. A CLAT may be created for thirty or thirty five years, with the CLAT remainder going to grandchildren at the expiration of that term.

In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the §7520 rate (currently 1.8 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.

Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year), varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies.

Strategy Example #1

1. The Facts

Lenny Da Litigator, age 60, is a personal injury attorney, who just settled a $10 million settlement. His personal income from the settlement will be $4 million. Lenny has had a very successful practice and does not need a substantial amount of personal income. He would like to provide some retirement income for himself and his children over their consecutive lifetimes, i.e. income first in Lenny’s lifetime and then for his children’s lifetime. Lenny’s projected AGI in 2016 is $15 million.

2. Solution

Lenny creates a CLAT with a sixteen year term with a $2 million contribution. The CLAT is structured as a grantor trust. The IRC Sec 7520 rate for April 2016 is 1.8 percent. The projected investment growth rate within the CLAT is 7.5 percent per year. The CLAT payments are made to Lenny’s donor advised fund. The income tax deduction is equal to the initial contribution and is limited to 30 percent of AGI. The excess deduction may be carried forward for five additional tax years. The CLAT payments will increase by 20 percent each year for sixteen years. The projected remainder interest at the end of Year 16 is $2.9 million and will pass to a family trust established for his children. The initial payment to the donor advised fund in Year 1 is $28,000. The final payment in Year 16 is $435,000. The assets are outside of his taxable estate.

Lenny creates a PIF with a contribution of $2 million. The PIF will provide an income for Lenny’s lifetime and his children’s lifetime. His children are twins and are 35 years old. Due to the consecutive lifetime income interests, i.e. payments for Lenny’s lifetime and the lifetimes of his two children following Lenny’s death. The income tax deduction is equal to 70 percent of the contribution. The deduction is limited to 50 percent of AGI. The projected income from the PIF is four percent or $80,000 per year. The assets are outside of his taxable estate.

Lenny’s total income tax deduction is $3 million which can be used entirely in 2016. The CLAT assets projected to be worth $2.9 million when the CLAT terminates in Year 16, will revert to his family trust for the benefit of his children in Year 16. The PIF will provide an income for Lenny’s lifetime and for the lifetime of his children. The projected income is $500,000 per year. The entire amount of the settlement will be outside of his taxable estate.

Strategy Example #2

3. The Facts

Bob Smith, age 50, is a hedge fund manager. He expects to receive a distribution of his offshore carried interest in December 2016, a full year before the 2017 deadline. His offshore carried interest is expected to be worth $10 million. Bob would like to minimize the impact of income taxation as well as future estate taxes. He would like to retain an income for his lifetime, but also transfer a portion of the funds to future generations. Bob’s fund generates short term capital gain income primarily. Bob’s expected AGI in 2016 is projected to be $14 million.

4. Solution

Bob creates a CLAT with a sixteen year term with a $5 million contribution. The CLAT is structured as a grantor trust. The IRC Sec 7520 rate for April 2016 is 1.8 percent. The projected investment growth rate within the CLAT is 10 percent per year. The CLAT payments are made to Bob’s donor advised fund. The trustee of the CLAT invests the contribution in Class B Preferred interests of a new investment limited partnership, managed by Bob’s investment management firm. The Class A Common interests are owned by a family trust created by Bob’s wife Marilyn. Bob is an income beneficiary of that trust. The Class A interests will be entitled to the investment growth in excess of the Class B preferred return of 4 percent.

The limited partnership purchases a private placement policy on Bob’s brother Sammy that features an insurance dedicated fund managed by Bob. The investment growth within the policy will accrue on a tax-free basis. The policy death benefit will also be income tax-free. The limited partnership may access policy loans and withdrawals on a tax-free basis in order to make CLAT payments to the donor advised fund.

The income tax deduction is equal to the initial contribution and is limited to 30 percent of AGI. The excess deduction may be carried forward for five additional tax years. The CLAT payments will increase by 20 percent each year for twenty years. The projected remainder interest at the end of Year 20 is $11.64 million and will pass to the designated family trust. The initial payment to the donor advised fund in Year 1 is $28,000. The final payment in Year 16 is $435,000. The assets are outside of his taxable estate.

Bob creates a PIF with a contribution of $5 million. The PIF will provide an income for the joint lifetime of Bob and his wife. The income tax deduction is equal to 70 percent of the contribution. The deduction is limited to 50 percent of AGI. The projected income from the PIF is ten percent or $500,000 per year. The assets are outside of his taxable estate.

Bob’s total income tax deduction is $8.5 million; of which $7 million can be used in 2016 based on his AGI. The CLAT assets are projected to be worth $2.9 million when the CLAT terminates in Year 16.  These assets will revert to his family trust for the benefit of his children at that time. The PIF will provide an income for Bob’s lifetime and for the lifetime of his children. The projected income is $80,000 per year. The entire amount of the charitable contribution will be outside of his taxable estate.

Summary

The charitable split annuity has a number of planning applications for any current taxpayer with a need for income, estate and gift tax benefits while retaining an income for one or multiple generations. The strategy examples outlined above address two scenarios. There are many more. The current interest environment favors the pooled income fund and charitable lead annuity trust. These techniques can be paired to provide a substantial income tax deduction; charitable gift tax deduction; a lifetime income; a reversion of assets to a family trust, and elimination of capital gains taxes. Not bad! As you evaluate your planning options, consider the charitable split annuity.