The Benefits of Greater Meaning and Purpose in Charitable Trusts, DAFs, and Family Foundations

Have you ever noticed that there seem to be cycles or fads which occur in the world of taxation and estate planning? Within the life cycle of a tax technique we will often find each of the following elements: the good (that which should be refined and preserved); the bad (that which if not thoughtfully weighed and counterbalanced may lead to unintended consequences) and the ugly (that which will truly lead to serious harm or disappointment).

In the late 1980's and throughout the 1990's we saw an explosion in the use of charitable split-interest trusts and family foundations. We also witnessed the birth of the Donor Advised Fund (DAF) as a popular alternative to family foundations.   The supporting organization, a sophisticated cousin of the DAF, began to rise in popularity and its proliferation so alarmed Congress that we saw legislation in 2006 which would create new rules governing both supporting organizations and donor advised funds.

During the last fifteen to twenty years large financial organizations have routinely encouraged their financial consultants and financial planners to demonstrate the tax savings power of Charitable Remainder Trusts (CRTs).   Virtually every client working with an investment banking firm which also provided wealth management services would send me an illustration of the “magic” of CRTs as a device to help the founder of a business retain the value of that enterprise by reducing the immediate blow of a capital gain tax.

Whenever a planning fad begins to generate too much visibility in terms of how it can be stretched to reduce our legal obligation to pay income taxes, it is likely to gain the attention of the IRS and/or Congress.

I believe the planning fever surrounding CRTs led Congress to conclude the CRT was being exploited as a tax savings tool.   The legislative reaction was to create the 10% minimum remainder value test.   The purpose of that test is to insure there would be at least a significant value in the CRT which would eventually pass to charity.

While the use of CRTs has declined since these rules were enacted I believe the decline in the use of the CRT probably has a lot more to do with the diminished tax deduction they generate during periods of low interest rates than it does with the requirement that charities are actuarially projected to receive at least ten percent (10%) of the fair market value of the assets contributed to the CRT.

Since the start of the 21st century we have witnessed an almost unprecedented drop in interest rates. When interest rates drop Charitable Remainder Annuity Trusts wane in their attractiveness but Charitable Lead Annuity Trusts become very attractive. So a new wave has started. It isn't being pushed as hard by the brokerage houses and other financial planning machines. But there is no question that the number of CLATs being created has risen dramatically in the last ten years.

So just a little over a year ago the IRS proposed new regulations which would require that a provision in the governing instrument of a Charitable Lead Trust (CLT) creating an ordering rule for the source out of which charitable payments are to be made must have economic effect independent of income tax consequences if it is to be respected for federal tax purposes.    Several commentators have not only questioned the IRS' authority to issue such proposed regulations but argue persuasively that the effect of such a regulation would be detrimental to existing CLTs and would discourage the use of CLTs in the future. These proposed regulations may not be the final effort to impose additional requirements on CLTs.

The risk of Congressional reaction isn't the only danger when a tax technique gets hot and begins to move through the good and bad stages of a planning cycle to the ugly results Congress calls abuse.

I believe there are two other dangers which we don't talk about enough...