The higher federal income tax rates and Medicare surtax, both taking effect for the first time last year, have heightened the appeal of charitable remainder trusts (CRTs), which enable donors to diversify out of highly appreciated securities tax efficiently.

Often, donors establish CRTs to ultimately benefit universities or other institutions that also happen to have a significant endowment of their own.  In many cases, such endowments hold alternative investments as part of their portfolio allocation. 

Donors who wish to have their CRT participate in the sophisticated strategies of the institution’s endowment may face the potential obstacle of the excise tax for unrelated business taxable income (UBTI) for the CRT, because the receipt of any debt-financed or partnership income from an unrelated trade or business constitutes unrelated business income.1   As a result, the CRT would become liable for a 100 percent excise tax on such income.2

 

Bypassing UBTI

A recent private letter ruling (201408032 (Feb. 21, 2014)), confirms a strategy that other institutions have utilized in prior PLRs3 to bypass UBTI in these instances, but with a certain disadvantage for CRT distributions.

In this ruling, an educational institution serves as both trustee and remainder beneficiary of numerous CRTs.

Its endowment is invested in a diversified manner with investments in nontraditional assets such as private equity, real estate and natural resources, as well as more standard asset classes.  Much of the income earned by the endowment consists of passive income including dividends, interest and long and short-term capital gains, but some income is debt-financed or otherwise is treated as UBTI.

The institution proposed to create a contractual obligation, through which each CRT would own a proportionate share, or “unit,” of its endowment.  The contract right would entitle the CRTs to receive periodic payments based on the number of units owned.  The CRTs would thereby receive an investment return equal to that of the endowment.  The institution wouldn’t charge a fee for internal management costs of the trusts’ assets, although it may ultimately recover its actual costs of management of the endowment as a charge against total return.

As a result, a CRT would acquire a unit in the endowment that would give it a contractual right against the institution, but no interest whatsoever in the underlying investment assets of the endowment. The contract between the CRTs and the institution would provide that the price of the units would equal their value at the time of acquisition. In addition, each CRT would receive payments on the units held by it based on the distribution rate established by the institution for its endowment, with payouts made monthly. The CRT trustee could choose either to reinvest part of the payout or redeem additional units, depending on its cash requirements.

As an important caveat, the CRTs would treat payouts as ordinary income, regardless of the character of the underlying income of the endowment, whether capital gain, ordinary income or return of capital, and regardless of whether the payout is made entirely by distributions of income or in part by redemptions of units.  The CRTs would also treat redemptions of units (over and above receipt of the distribution amount) as generating long or short-term capital gain (or loss), depending on the holding period of the redeemed units.

 

IRS Ruling

The Internal Revenue Service concluded that because the CRTs don’t have a position of ownership in the underlying assets of the charity's endowment and the contractual relationship isn’t in the nature of a partnership or agency, the income received by the CRTs for the units reflects ordinary income and doesn’t take on the character of the income of the underlying assets or debt-financed or UBTI.  Instead, the institution’s endowment would pay any tax owed on UBTI earned by the endowment portfolio.

“As a result, the issuance of units, the making or receipt of payments with respect to the units, and the holding and redemption of the units, wouldn’t generate UBTI to the CRTs.

While this contractual ownership bypasses any UBTI for a CRT, it’s important to note that any CRT distribution attributable to income received pursuant to the endowment units would be characterized as ordinary income to the recipient, despite the capital gains treatment that may apply to CRT distributions under the regular 4-tier system.

Note also that for charitable lead trusts, the IRS has withdrawn favorable PLRs for similar endowment unit strategies.4

This is provided to you by Credit Suisse Securities (USA) LLC ("CSSU") for your information only. This is not intended to be an offer or solicitation to purchase or sell any security or to employ a specific investment strategy. CSSU does not represent, warrant or guarantee that this material is accurate, complete or suitable for any purpose or any particular investor and it should not be used as a basis for investment decisions. It is not to be relied upon or used in substitution for the exercise of independent judgment.  Information and opinions expressed by us have been obtained from sources believed to be reliable. CSSU makes no representation as to their accuracy or completeness and CSSU accepts no liability for losses arising from the use of the material presented.  This material does not contain all of the information that you may wish to consider and it does not take into account your individual situation or circumstances. CSSU does not provide, and nothing contained herein should be construed as, tax, accounting or legal advice; you should consult your personal accounting, tax, and legal advisors to understand the implications of any investment specific to your personal financial situation.

Endnotes

  1. Internal Revenue Code Sections 512(a)(1), 514(a). 
  2. IRC Section Section 664(c)(2)(A).
  3. Private Letter Ruling 200749023 (Dec. 7, 2007); PLR 201016086 (April 23, 2010); PLR 201123042 (June 6, 2011).
  1. PLR 200702036 (Jan. 12, 2007) (while the charitable lead trust (CLT) may continue to reinvest money previously held in the endowment as of the date of the letter ruling without generating unrelated business taxable income, this ruling doesn’t apply to new money invested in M's endowment after the date of the letter), PLR 200702040 (Oct. 17, 2006) (no additional rulings planned by the Internal Revenue Service regarding the participation by a CLT as an investor in the charity’s endowment).