The Internal Revenue Service has given a full-blown blessing to investors who want to piggyback off the stellar investment returns of major university endowments.
In a series of private letter rulings issued this winter and spring, the Service has removed any doubt: Charitable remainder trusts (CRTs) can be invested in university endowments without generating the dreaded unrelated business taxable income (UBTI), which is punishable by a 100 percent penalty.
This is an enormous benefit to anyone who wants to leave a sum to a university when they die, but, while they live, receive a hefty income stream from those funds. It means that they can put their money in the hands of some of the finest investment mangers in the country and have access to the kinds of alternative investments that their portfolios probably couldn't command otherwise. In short, the deal helps those who have less; now they can invest like the wealthiest people in the country.
The only downside is that the tax rate on CRT payouts may be higher than investing directly in the stock market, because the rulings require that a certain percentage of the CRT payout -- up to endowment crediting amount -- be taxed at ordinary income rates, rather than capital gains.
For years, donors had been clamoring to share in Harvard University's superior endowment performance. It's averaged a whopping annualized 15.2 percent over the past 10 years while the Standard & Poors 500 averaged 8.3 percent. To generate such high returns, Harvard's endowment invests heavily in alternative investments, such as hedge funds and private equity -- the kinds of investments that, to take advantage of, people usually need a minimum of $5 million in investable assets.
But such investments can generate UBTI. Harvard and its legal counsel devised a clever solution that went into effect in 2003. Rather than having CRTs and charitable lead trusts (CLTs) invest directly in the endowment, Harvard created a contractual arrangement whereby the CRTs and CLTs invest in units that track the endowment's investments. The IRS' initial reaction came on Dec. 23, 2003, in private letter rulings that found this contractual right, rather than a direct investment in the endowment, did indeed purify the CRTs and CLTs of UBTI.
Fast forward to Oct. 17, 2006, when the IRS issued PLRs 200702036, 200702040 and 200702041. The Service reaffirmed that CRTs could invest in Harvard's endowment using the contractual units. But it threw doubt the ability of CLTs to do the same. The IRS said it needed to study whether a CLT noncharitable beneficiary would receive an inappropriate tax benefit from the strategy. The Service feels that there is too great a benefit to the noncharitable remainder beneficiaries from allowing CLTs to invest in Harvard's endowment.
The CLTs remain frozen. But the floodgates on CRTs opened with the release of the PLRs in March 2007 (on March 9, 2007, PLRs 200710013, 200710014 and 200710015) and (on March 16, 2007, PLRs 200711027, 200711028, 200711029, 200711030, 200711031, 200711032, 200711033, 200711034, 200711035, 200711036, 200711037, 200711038 and 200711039.) These came on top of a handful of similar rulings issued in October 2006 and January 2007.
Many universities that have been generating superior investment returns from their endowments offer this benefit to investor/donors, or plan to soon. That includes Princeton University, Stanford University, the Massachusetts Institute of Technology and the University of Notre Dame.
How It Works
So how do CRTs that invest indirectly in endowments actually function? The recent spate of letter rulings make matters clearer. They and related university marketing materials explain how the unitrust amount is calculated and how it will be taxed:
- First, and foremost, for the strategy to be worthwhile, the charity's endowment must have outperformed the markets for an extended period of time.
- Second, the IRS requires that the charity be both the trustee and irrevocable beneficiary of 100 percent of the CRT's remainder.
- Finally, the rulings override the usual four-tier system for taxing payments to a CRT's noncharitable beneficiaries. Instead, the amounts distributed to the noncharitable beneficiary will be taxable as ordinary income -- up to the amount of the endowment payout each year -- regardless of the income's underlying tax character. Any remaining amounts necessary to satisfy the CRT payment will be treated as a redemption of units generating either long- or short-term capital gain (or loss), depending on the holding period of the unit and any previously undistributed ordinary income or capital gains.
The strategy works only for charitable remainder unitrusts (CRUTs), where the charitable remainder organization and the noncharitable income beneficiaries share in the investment return. It would be of no benefit to the noncharitable beneficiary of a charitable remainder annuity trust (CRAT), where the annuity payment is fixed as of the date the trust is funded.
So let's assume a CRUT has an 8 percent payout and, in the current year, ABC University has a spending policy of 4 percent on its endowment. The first 4 percent of the 8 percent unitrust payout, attributable to the endowment spending policy, are taxable at ordinary income tax rates of up to 35 percent. The remaining 4 percent of the 8 percent unitrust payout are considered to be a redemption of units and will be taxable at either short-or long-term capital gains rates, unless the trust has undistributed ordinary income or capital gains from previous years.
Although a significant portion of the payout (up to the endowment spending amount) will be taxable as ordinary income (up to 35 percent), which might result in a higher tax rate than a typical CRT, the extraordinary investment performance of the endowment more than makes up for any negative income tax consequences.
Even though the noncharitable unitrust beneficiary benefits from the ability to share in endowment returns, it is the charitable remainder beneficiary that is the real winner. If past performance of these endowments is any indication, it should have a much larger pot of gold to use for its charitable purposes upon the death of the non-charitable beneficiaries than it would have were the CRT invested in the stock market.