I’m frequently asked whether a certain private equity investment, non-traded REIT, or limited partnership interest is a suitable investment for a charitable remainder trust (CRT). My response is a resounding, “Maybe!” With any investment other than cash, a security traded on an exchange, or an investment such as a mutual fund for which a daily net asset value (NAV) is available, there are five specific areas of concern I advise a client (or their advisor) to evaluate:
- Is the investment “prudent” within the applicable investment standard?
- Is it possible that the investment will produce unrelated business taxable income (UBTI)?
- Is there the potential that the trustee could enter into a prohibited act of self-dealing with a disqualified person?
- At all relevant times, will it be possible to place a value on the CRT’s position that is consistent with the Treasury Regulation valuation standard?
- Will there be access to sufficient cash to pay distributions and other obligations of the CRT when they come due?
I will review the first two areas in this blog post and the other three areas in the next post.
Forty-eight states and the District of Columbia have adopted a version of the Uniform Prudent Investor Act (Act) or something similar. Under the Act, when making investment decisions, the trustee must consider “the purposes, terms, distribution requirements, and other circumstances of the trust.” The Act requires that a trust’s investment portfolio be diversified, but cautions that an investment in illiquid or unmarketable assets “be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” The requirement to consider the trust portfolio as a whole coupled with a duty of diversification lends support to the possible inclusion of a position in an illiquid or unmarketable asset as a portion of a CRT’s investment portfolio if it is otherwise consistent with the CRT’s “purposes, terms, distribution requirements, and other circumstances.” Additionally, the Act allows trusts to include language that authorizes the trustee to acquire and hold illiquid or unmarketable assets.
Unrelated Business Taxable Income
Unrelated business taxable income (UBTI) is income from a regularly-carried-on, unrelated, trade or business. In the nonprofit world, “unrelatedness” is determined by examining the relationship between a charitable organization’s exempt purpose and the business activity being conducted. In the CRT context, the IRS has consistently held that a CRT has no exempt purpose of its own and cannot impute the exempt purposes of its remainder beneficiaries to itself. Consequently, income from any business activity of a CRT that does not qualify for an exception is unrelated business income.
There are exceptions to the classification of income as UBTI that permit a CRT to own certain types of business interests. For example, interest, dividends, most real property rents, royalties, annuities, and realized gains from the sale of capital assets are excluded from the definition of unrelated business taxable income. Accordingly, as a general rule, only the operating income of a trade or business that is attributable to a CRT, either by its direct participation in the operating activities of the business or its indirect participation in a passthrough entity, are problematic.
UBTI in a CRT is a particularly troublesome problem because it is subject to a 100% excise tax at the federal level and is frequently subject to an income tax at the state level. Add to this the fact that the UBTI is also added to the four-tiers without a deduction for the federal excise tax and consequently will also be taxed to the income beneficiaries, and the effective tax rate is well in excess of 100%.
To determine if UBTI is a potential problem for a particular investment, I recommend that the tax matters section of the prospectus or other offering document be reviewed for any warning to tax exempt investors, including IRA owners. In addition, if the activity is a passthrough entity such as a limited liability company or partnership, pay specific attention to the types of activity in which the entity will engage and whether debt will be used to finance any of the entity’s operations. These are key red flags that UBTI may be present.
In the next post, I will review self-dealing, valuation, and liquidity issues with regard to potential gifts to a CRT.
Contact us to find answers to any of your other charitable planning questions.