How to fix underwater charitable trusts

January 18, 2011

An employee of the Korea Exchange Bank (KEB) counts U.S one hundred dollar notes at the bank's headquarters in Seoul November 11, 2008.  REUTERS/Jo Yong-Hak It was a perhaps inevitable problem after the market downturn: Charitable trusts that are underwater.

Charitable remainder trusts, or CRTs, are typically used by wealthy people who want to give a seven-figure gift to charity, and still retain an interest in the donation. They work like this: First, the donor puts the asset into a trust for charity. Then, the donor gets the income from the trust, and a charitable donation for tax purposes. At the end of the trust’s term, the asset (that is, the “remainder”) goes to charity.

The problem is that during the boom years, “people set them up with the idea that a 10 percent or 11 percent return was not difficult, so payout ratios may have been set at 8 percent,” says Joan Crain, a senior director of wealth strategies at BNY Mellon Wealth Management. Setting payouts too high has been a problem in all kinds of trusts, but for charitable trusts it’s especially problematic because the way they’re structured for tax purposes won’t let you simply go in and lower that payout target.

The result is that many of these CRTs — though no on really knows how many — are now underwater. While there aren’t a huge number of these trusts, there’s a lot of money at stake: In tax year 2007, an estimated 116,000 taxpayers reported CRTs on their tax returns, with a net asset value of nearly $96 million, according to Internal Revenue Service statistics.

When a charitable trust goes bad, the payouts start cutting into principal; each year, then, the donor will receive a smaller payout amount as the principal shrinks. In the worst case, the trust will run out of funds before the end of the term, and the nonprofit that expected the money simply won’t get it. For both the donor and the charity, that’s a rotten situation.

In recent roundtable discussions with financial advisers, Crain says, the problem of what to do with these trusts generates enormous interest: “It’s not unusual, and, because of market volatility and low rates on fixed income, there is no investment solution to the problem.”

What’s a wealthy donor to do? There are options, but none are perfect or simple.

You could keep the status quo, and take the money till it dissipates. In that case, you’ll get less each year, and risk leaving nothing to the charity you named.

You could convert the trust to a charitable gift annuity. In that case, you’d give the money to charity, and get an annuity, with a smaller payout amount, but for life. The American Council on Gift Annuities sets suggested annuity rates, which these days are relatively low based on low interest rates; some charities are lowering the annuity rates they’ll pay below those suggested levels because of market conditions.

You could terminate the trust and split the funds between the donor and the charity. This requires you to do some complicate math to determine who gets what, so get yourself a good accountant before even considering it.

Or you could hire a firm, like Sterling Foundation Management, a philanthropic advisory firm, to broker the sale of the income interests to someone else. The idea here is to get the original donor more after taxes and fees. Someone with a large tax loss carryforward, for example, might be willing to pay more for the trust income than the donor would ever see from it after taxes are paid, explains Mellon’s Crain, who has reviewed the technique but not implemented it with any clients.

“There’s not a lot of wiggle room on those trusts,” says Bill Fleming, a managing director in the personal financial services division of PricewaterhouseCoopers. “We’ve seen some people say, ‘I just want the charity to have the money.’ ”

Today, with interest rates low and the problems of these trusts more clear, advisers say, charitable remainder trusts have lost popularity in favor of other philanthropic techniques.

One comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

I’m sorry, I’m not buying this:

“people set them up with the idea that a 10 percent or 11 percent return was not difficult, so payout ratios may have been set at 8 percent,”

the only people acting on those assumptions had no intention of leaving any equity in those trusts. This was a tax scam, pure and simple.

Posted by ARJTurgot2 | Report as abusive

[…] firm at age 49 — he decided to help the orchestra and to get a tax benefit too. He used a  charitable remainder trust, or CRT, a creative strategy that allowed him to give away his money, yet still derive funds from […]

Posted by Charitable remainder trusts: How the wealthy give it away and get it back | Reuters Money | Report as abusive

[…] firm at age 49 — he decided to help the orchestra and to get a tax benefit too. He used a  charitable remainder trust, or CRT, a creative strategy that allowed him to give away his money, yet still derive funds from […]

Posted by Charitable remainder trusts: How the wealthy give it away and get it back « jonathanblattmachr | Report as abusive

[…] at age 49 — he decided to help the orchestra and to get a tax benefit too. He used a  charitable remainder trust, or CRT, a creative strategy that allowed him to give away his money, yet still derive funds from […]

Posted by Charitable remainder trusts: How the wealthy give it away and get it back | Report as abusive