The current sub-2% applicable federal midterm rates (§7520 rates) continue to result in reduced deductions for charitable remainder trusts and charitable gift annuities.  But the forgotten player in the world of split-interest gifts – the pooled income fund – (more precisely, pooled income funds established in 2010, 2011 and 2012) will provide remarkably high deductions for donors in 2012 – as much as twice the size of those afforded by CRTs.

PIFs historically have not been popular, partly because payouts are taxed 100% as ordinary income.  But pooled funds that invest largely in dividend-producing stocks can provide participants with payouts that are taxed at only 15% (or even less, for those in low tax brackets) through the end of 2012.  Tax treatment of payouts after 2012 will depend on results of the November elections.  Here are the basics of pooled income funds:

• Donors transfer cash or securities to the fund, which is maintained by a public charity;
• Donors name one or two recipients, who receive shares (units) in the fund;
• All gifts are “pooled” and invested by the trustee;
• Participants divide income based on their units of ownership;
• Charity receives value of units at death;

Deductions for PIFs are based on a fund’s highest rate of return during the prior three years.  But funds that do not have three years’ investment experience must employ a deemed rate of return, which is one percentage point less than the highest annual average of monthly §7520 rates for the past three calendar years.  Deductions for PIFs established in 2010, 2011 and 2012 are calculated assuming only a 1.8% payout to participants, creating unusually large remainder interests, even though income beneficiaries likely will receive far more than 1.8% during their lifetimes.

Deductions for “New” PIFs

Deductions for 5% Unitrust (1.6% §7520 rate)

Age	Deduction	Age	Payout	Deduction
55	64%	55	5%	32%
60	69%	60	5%	38%
65	74%	65	5%	45%
70	78%	70	5%	52%

New pooled income funds are relatively easy to establish, using specimen forms provided by the IRS (See page 9A-7, Charitable Giving Tax Service).  Donors will have to enlist the cooperation of a public charity, of course, since pooled funds cannot be created by individuals.

Record low §7520 rates also make charitable lead trusts attractive in 2012, perhaps even to owners of S corporations who are seeking large income tax charitable deductions this year and transfer tax savings, as well.
 
S corporation stock can’t be used to fund a charitable remainder trust [Code §1367(c)]. But the IRS has ruled that a donor could transfer S stock to a grantor-type charitable lead annuity trust and charitable lead unitrust that would each pay a private foundation for six years, then distribute all assets to children (PLR 199908002).

The trust was drafted as a so-called intentionally defective grantor trust that would provide the donor with both income tax and gift tax charitable deductions.  The donor would be taxable on all trust income, but none of the trust principal would be taxable in the donor’s estate.  This lengthy ruling provides a blueprint for donors and gift planners who may find it attractive to fund a charitable lead trust with stock in an S corporation (bearing in mind that private letter rulings may be relied upon only by the requesting taxpayer).

Clients who used up their $5 million gift tax applicable exclusion in 2011 have an additional $120,000 of shelter available for 2012 gifts to friends and family members, thanks to inflation indexing.  Several charitable gift arrangements offer an opportunity to get more mileage from the extra exemption, including:

Charitable gift annuities.  A daughter could transfer $224,291 for a charitable gift annuity benefiting her mother, age 76, with a 6% payout for the rest of the mother’s life.  Using quarterly payments and a §7520 rate of 1.6%, the present value of the mother’s annuity works out to $133,000, which would be sheltered by a combination of $120,000 of additional 2012 gift tax exemption and a $13,000 annual exclusion.  The daughter receives $91,291 in charitable deductions (both income tax and gift tax).

Charitable lead annuity trust.  A parent could transfer $500,000 to a lead annuity trust paying $20,000 (4%) annually to charitable organizations for 22 years.  The remainder interest would be roughly $120,000 (1.4% applicable federal rate) for gift tax purposes, but children could receive $500,000 or more when the trust ends, depending on the investment experience of the trust.  The $13,000 annual exclusion is unavailable because the remainder is not a present interest.

Prior to the Tax Relief and Health Care Act of 2006, a charitable remainder trust that had any unrelated business taxable income (UBTI) lost its exemption from income taxes.  The law was changed to provide that UBTI is now subject to a 100% excise tax, but the trust keeps its tax-exempt status [IRC 664(c)].   UBTI is defined by statute to also include debt-financed income — that is, trust income that can be traced to indebtedness incurred by the trust.  If the trustee has borrowed funds to prepare real estate for sale, the trust will incur taxable income for so-called acquisition indebtedness under IRC 514(c)(1) and that can result in significant taxation when the property is sold. The problem is especially acute where trust property has a low cost basis.  Here is a simplified example:

Suppose an office building having a value of $1,000,000 is contributed to a unitrust.  The trustee has a carryover basis in the property of $100,000 and borrows $50,000 to refurbish the property prior to placing the property on the market.  Under IRC §514, the taxable portion of income realized from sale of the property is based on the ratio of the average acquisition indebtedness ($50,000) to the average basis in the property ($100,000), or 50%, with the result that 50% of the gain from sale of the property ($450,000) is considered UBTI  and taxed at a 100% rate.  The unitrust is left with only $550,000 after taxes. Clearly, any borrowing by the trustee needs to be approached cautiously.  Ideally, the donor will have funded the trust with some additional cash or securities that can be liquidated to prepare property for sale.  Assuming the trust permits additional contributions, the donor alternatively could transfer funds to the trust to pay the fix-up expenses.

Note:  A charitable remainder trust may have small amounts of unrelated business income that will be protected from being unrelated business taxable income because of a $1,000 specific deduction.  IRC §512 defines UBTI as unrelated business income minus allowable deductions and a $1,000 exemption.