PRESENTATION TO PHILANTHROPY AND TESTAMENTARY CHARITABLE LEAD TRUSTS

PRESENTATION TO PHILANTHROPY AND TESTAMENTARY CHARITABLE LEAD TRUSTS August 27, 2008 By ROBERT S. BALTER 1

The Nature of Philanthropy – To Me • It seemed to me that an introduction was in order…. • America’s “Passing Gear”* – A lot more than “giving away money. ” – Free of the Profit Motive. – Free of “earnings requirements. per share” – Free (perhaps too often) of budget constraints. * Paul Ylvisaker quoted by Peter Goldmark. See text at note 1. 2

The “Passing Gear” – Page 2 • Philanthropy produces change SOLELY because it is perceived as “good. ” • Change for the sake of good is a dynamic concept. • It can even be argued that this country might not have come about except for the idea of change for the sake of good. * – A dynamic and exciting world. – Takes us to the frontiers. * See, inter alia, “A Chronological History of Philanthropy in the United States” (National Philanthropic Trust (2008). 3

Charitable Vehicles – An Incomplete List • Legal Form – Trusts – Corporations • Tax Categories – Public Charities • Pooled Income Trusts • Charitable Gift Annuities • Supporting Organizations (quasi public). – Private Foundations • Operating Foundations • Non Operating (grant making) Foundations. • We cannot cover these in an hour! 4

Split Interest Trusts • 1969 Tax Reform Act. – Charitable Remainder Trusts • Pays non-charitable beneficiaries for term of trust, remainder to charity. – Charitable Lead Trusts • Pays charitable beneficiaries for term of trust, remainder to noncharitable beneficiaries. • Annuity Trusts – Payments are a fixed percentage of value as determined on date of contribution for term of trust at contribution- payments do not change. • Unitrusts – Payments are a fixed percentage of value determined annually each year of the trust- payments change each year. 5

Charitable Remainder Trust Chart Donor gets income and gift tax deductions for present value of remainder to charity. Donor pays gift tax on present value of annuity payments unless retained or given to spouse. Charitable Remainder Trust Noncharitable beneficiaries receive payments for term of trust. Noncharitable Beneficiaries After noncharitable term Charity 6

Charitable Lead Trust Chart Donor pays gift tax on present value of remainder unless retained or given to spouse. Donor gets income and gift tax deductions for present value of remainder to charity. Grantor Charitable Lead Trust Charitable beneficiaries receive payments for term of trust Charity After charitable term Noncharitable Beneficiaries 7

Charitable Deduction Rules and Limits • The percentage limitations and types of property rules are set forth in the text at page 6. • Suffice it to say here that many of those rules are complex and highly technical, confining some deductions to basis while permitting full fair market value for others in what can only be considered a patch-work quilt— – A quilt that has come into being over many years, responding to widely varying concerns with little in the way of underlying rationale. 8

We have now come to a fork in the road! 9

Context of the Problem • The problem, in a word, is growth. – An estate of $100 million today is not likely to be worth $100 million tomorrow. • The income and capital growth will likely increase the value of the estate so that the $100 million will become $107 million or $115 million in short order – and the plan based on the $100 million value – will not work. • So the problem is definitional: How do we confine the estate to a given value long enough to be effective? 10

Enter the Formula Charitable Lead Trust • The approach we are considering today is the use of a residuary provision in the will or revocable trust along the lines: – “All the rest, residue and remainder of my estate, I give, devise and bequeath unto the trustees of that certain charitable lead trust described more fully in Article __ of this instrument”. • Can such a provision be used to limit the taxable estate to the pre-residuary gifts? 11

Deduction Rules for CLTs • The amount of the estate tax charitable deduction for a transfer of property under a will is equal to the present value of the charitable interest conveyed. Regs § 20. 2055 -2(e)(2)(vi). • This determination is made using interest rates that are promulgated monthly by the IRS under IRC § 7520 and by the IRS’s adoption of actuarial assumptions from tables promulgated by the IRS from time to time. • I pause to point out a trap: If a life period rather than a term of years is used, an elaborate exhaustion test is applied to determine whether the tables can be used at all. Among other things, these require assumption that the individual whose life is being used will live to age 110. Regs § 20. 7520 -3(b)(2). The simple answer is to make sure that a term of years rather than a life period is used. 12

Estate Tax Charitable Deduction: An Example of the Mechanics* • Assume an otherwise taxable transfer of $1 million to a charitable lead annuity trust with a term of 10 years and paying 5% annually would create an annuity with a present value of $401, 535 and would thus make a gift of the balance, $598, 465, to the non-charitable remainder beneficiaries. • If the payout to charity is increased to 10% the gift to charity increases to $819, 230 and a non-charitable gift of $196, 930. • If the charity’s annual payout is increased to 12. 452215%, the non-charitable remainder interest is worth zero assuming the IRC § 7520 rate applicable in August of 2008 of 4. 2%. * All calculations done using S. Leimberg’s Number. Cruncher. 13

Formula Dispositions – The Structure • So how does this plan work? – The will or revocable trust makes gifts amounting to just about what we think the taxable estate is right now – on a preresiduary basis • That is prior to the residuary formula described above. • The balance (if any) is disposed of by the residuary formula in favor the charitable lead trust. – The result is a zero estate tax on the balance to the CLT! – If it works, this can be done by a formula (see text at 11). 14

Formula Dispositions and Procter • The IRS and Treasury have essentially argued that almost any formula– outside of the marital deduction context– that works is contrary to the public policy announced in Procter. * • While IRS had approved such formulas in IRS Private Letter Rulings, recently Treasury challenged such formulas in Christiansen, decided in January, 2008. * Procter v. Commissioner, 142 F. 2 d 824 (4 th Cir 1944), affirming 1943 LW 9169 (Tax Ct. Memo). ** See text at note 36. 15

Christiansen, 130 T. C. 1 (1 -24 -2008) • While close, this case involves– in part– an additional issue: – Decedent left everything to her daughter, subject to the daughter’s right to disclaim, in which case, the disclaimed amounts went to a charitable lead trust as to 75% and to a foundation as to 25%. • The lead trust was structured to pay 7% for 20 years, producing an 80% deduction. 16

Christiansen - 2 • As to the disclaimer in favor of the CLT, the Christiansen holding is based on the requirements for a qualified disclaimer. – The short of that is don’t do that! See text pages 8 -9. 17

Christiansen - 3 • The Procter policy argument was before the Christiansen Court, however, with respect to the disposition in favor of the foundation. – The Service argued that no deduction for any increased value should be allowed with respect to the charitable gift to the foundation • “because it would, at the margins, discourage the IRS from examining estate tax returns because any deficiency in estate tax would just end up being offset by an equivalent additional charitable deduction. ” 130 T. C. at page 9. 18

Christiansen – 4 • This contention the Tax Court rejected: – The disclaimer in this case involves a fractional formula that increases the amount donated to charity should the value of the estate be increased. We are hard pressed to find any fundamental public policy against making gifts to charity—if anything the opposite is true. Public policy encourages gifts to charity, and Congress allows charitable deductions to encourage charitable giving. United States v. Benedict, 338 U. S. 692, 696 (1950). • 130 T. C. at 10 (emphasis supplied). 19

Christiansen - 5 • When the Commissioner pressed the analogy to Procter, the Tax Court replied: “This case is not Procter. The contested phrase would not undo a transfer, but only reallocate the value of the property transferred among Hamilton, the Trust, and the Foundation. If the fair market value of the estate assets is increased for tax purposes, then property must actually be reallocated among the three beneficiaries. That would not make us opine on a moot issue, and wouldn't in any way upset the finality of our decision in this case. ” 20

Christiansen - 6 • Finally, the Tax Court held: “We therefore hold that allowing an increase in the charitable deduction to reflect the increase in the value of the estate's property going to the Foundation violates no public policy and should be allowed. ” • This holding, while not directly on point, is clearly very, very close to the plan we are considering and seems governed by the same public policy in favor of charitable giving that would clearly apply to our plan, as well. 21

Other Advantages & Disadvantages • Other Advantages – Since all of the property transferred to the charitable lead trust is fully included in the decedent’s estate, basis is stepped up to fair market value on date of death. – Since the charitable lead trust is a taxable trust under the rules of Subchapter J, the basis step up will likely be useful. 22

Other Advantages & Disadvantages • Other Disadvantages – Prohibited transaction rules (IRC § 4941) forbid sales and loans between the charitable lead trust and the estate. • There is an exception called the “probate exception” which will permit the sale of assets by the charitable lead trust if: – – – The trustee has the power of sale under the trust; The transaction is approved by the local probate court; The sale is made before the estate is terminated; The sale is for fair market value; and The charitable lead trust’s liquidity does not diminish after the sale. Regs § 53. 4941(d). – This can be very useful. 23

Summary & Conclusion • The testamentary formula charitable lead trust seems valid under the Christiansen holding earlier this year. • Articulation of donor’s charitable intentions should help ameliorate Procter concerns. • A testamentary charitable lead trust should therefore be considered in planning estates for high net worth and ultra high net worth families. • I would be glad to take questions. 24