This article is Part II in a series of tax planning strategies for year-end tax planning for the 2015 tax series. The article addresses the Pooled Income Fund (PIF) which as this article demonstrates, has surprising planning utility in the current low interest rate environment. Planned giving officers of tax exempt organizations are very familiar with the planning utility and popularity of Charitable Remainder Trusts (CRT). However, in the low interest rate environment which has existed for a number of years, the CRT has lacked significant income tax deduction potential. Instead, its cousin the Charitable Lead Trust has garnered greater attention.
The PIF is frequently know as a CRT Mutual Fund or the “Poor Man’s” CRT. Many large charities offer PIFs as a planned giving solution but it is not nearly as popular as many other solutions. In fact, a national planned giving consultant recently told me that many charities are terminating their PIF options through a lack of interest. My hope is that this article will cause professional advisors and financial service professionals to consider PIFs as an option and say “Not so Fast”, to the public charities looking beyond PIFs.
What is a PIF?
A pooled income fund is a trust that is established and maintained by a public charity. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned “units of participation” in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.
Each year, the fund’s entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.
Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor’s deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.
Having focused on the commingling aspect of funds or contributions from multiple donors, I can find nothing in the Internal Revenue Code or treasury regulations that would preclude a PIF with a single client. The apparent issue would be an administrative issue for a charity instead of a tax issue.,i.e. is it cost effective to administer a PIF with assets beneath a certain threshold of assets under management?
IRC §642(c)(5) defines a pooled income fund as a trust:
- to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of a public charity while retaining an income interest for the life of one or more beneficiaries (living at the time of the transfer,
- in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,
- which cannot have investments in securities which are exempt from taxes imposed by this subtitle,
- which is maintained by the public charity to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and
- from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest determined by the rate of return earned by the trust for such year.
The trust instrument of the pooled income fund must require that property transferred to the fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors. Charitable organizations are permitted to operate multiple pooled income funds, provided that each such fund is maintained by the organization and is not a device to permit a group of donors to create a fund which may be subject to their manipulation. Such manipulation is, however, highly unlikely because the regulations require the governing instrument of a pooled income fund to (1) prohibit a donor or income beneficiary of a pooled income fund from serving as a trustee of the fund, and (2) include a prohibition against self-dealing.
Nevertheless, there is nothing preventing a wealth management firm or registered investment advisor (RIA) from establishing multiple commingled funds or pools of assets within a public charity that are managed on a discretionary basis by the RIA or alternatively by a registered representative of a broker-dealer within a series of commingled arrangements sponsored by the wealth management firm. Again, the issue is not a tax issue but rather an administrative issue regarding the custodial pricing and reporting by the fund administrator. As a practical matter, the pricing should not be dramatically different for the fund administrator that the pricing to operate and administer a separately managed account by the RIA.
The fund must not include property transferred under arrangements other than pooled income funds. However, a fund is permitted to invest jointly with other properties that are held by, or for the use of, the charity maintaining the fund. The regulations cite as an example: securities in the general endowment fund of the public charity to or for the use of which the remainder interest is contributed. In a private ruling, the Service approved the commingling of pooled income fund assets with other charitable funds, including charitable remainder trusts and excluding any tax-exempt securities, held by the organization.
Community foundations and other public charities often receive contributions that are maintained for the benefit of other charitable organizations selected by the donor. A donor may designate the donor’s donor advised fund administered by the public charity as the recipient of the reminder interest.
Each beneficiary of a pooled income fund receives a pro rata share of the total rate of return earned by the fund for such taxable year. When a donor transfers property to a pooled income fund, one or more units of participation are assigned to the beneficiary or beneficiaries of the retained income interest. The number of units of participation assigned is obtained by dividing the fair market value of the property by the fair market value of a unit in the fund at the time of the transfer.
Like a CRT, the PIF may make distributions on a monthly, quarterly or annual basis to meet the income requirements of the taxpayer.
Tax Benefits of PIFs Strategies
At this point, you may still be asking “What’s the point?” The taxpayer does not recognize gain or loss on the transfer of property to the PIF. In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.
If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §75200 for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate. The rate for the 2014 tax year is 1.4 percent.
This interest rate provides a significantly larger deduction than a comparable contribution to a CRT. The following chart compares the percentage of deduction based upon a charitable deduction of $100,000. The CRT assumes the minimum CRT payout of five percent for the taxpayer’s lifetime. Deductions for cash contributions is subject to the fifty percent of adjusted gross income threshold. Deductions of appreciated property are subject to the thirty percent of AGI threshold. The taxpayer may carryover excess deductions for an additional five tax years beyond the current year.
Comparison of Charitable Remainder Trust vs. PIF
(% of Deduction)
Age PIF CRT
40 59.1 17.7
50 66.8 26.4
60 74.8 38.1
70 82.5 52.3
80 89.2 67.3
Unlike charitable remainder trusts, which are conditionally exempt from income taxes, pooled income funds are, with one important exception discussed below, taxed as complex trusts. Pooled income funds seldom pay any tax, however, for several reasons. First, pooled income funds receive an unlimited deduction for all amounts of income distributed to fund participants. Because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed.
Second, pooled income funds are permitted a special deduction for long-term capital gains that are set aside permanently for charity. In essence, long-term capital gains produced by a pooled income fund are allocated to principal. Because principal is earmarked for charity, such amounts escape income taxation. For purposes of tracking income and gain attributable to contributed assets, pooled income funds take on the donor’s holding period and adjusted cost basis in the contributed property.
Nevertheless, the trust document for most pooled income funds defines income as that term is defined in IRC Sec 643(b). Under this section, the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law. The Uniform Income and Principal Act or Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties. Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, pooled income funds can expand the definition of income to include capital gains.
Pooled income fund beneficiaries are required to include in their gross income all amounts properly paid, credited, or required to be distributed to them during the taxable year or years of the fund ending within or with their taxable year.
Distributions from pooled income funds are taxed under the conduit theory applicable to IRC Sec 661 and 662. Because pooled income funds distribute all income earned during the taxable year, the tax character of amounts distributed to each income beneficiary is directly proportional to the tax character of investment income earned within the PIF.
The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.
Summary of Strategies
The PIF provides substantially larger income tax deductions in the current interest rate environment when compared to the very well-known and “time-tested” CRT. Nothing precludes a financial advisor or RIA from establishing a new “fund” operated as a separately managed account (SMA) with a specific investment objective tailored to the needs of the charitable donor and beneficiary. Fund and SMA administrators have substantial experience and expertise operated customized arrangements.
Undoubtedly, the administrative and custodial charges to the public charity will be reflected in the pricing to the charity. These fees can be recouped by the public charity. Suffice it to say, the proposed arrangement is not for the donor making a ten dollar contributions but mostly likely has a minimum level of $100,000-250,000 due to administrative cost considerations.
Taxpayers and their advisors are hard-pressed to find charitable solutions that can provide a meaningful income tax deduction; retention of an income for a lifetime, and capital gains avoidance upon the sale of an asset. From the perspective of the financial advisor (people who see products and services for a living), the arrangement is very attractive from the standpoint of client benefits and the ability to customize the investment arrangement and retention of assets under management.
My recommendation is that public charities should delay plans to terminate PIF arrangements and find a way to partner with financial advisors in order to capture the assets from the perspective of new charitable donations.
[box]
Gerald Nowotny
Law Office of Gerald R. Nowotny
266 Lovely Street
Avon, CT 06001
United States
860-404-9401
TaxManDotCom.com
[/box]
Leave a Reply