Creative Tax Planning With “Flip” Charitable Remainder Unitrusts

October 23, 2019

As predicted, the 2017 Tax Act appears to have impacted the state of charitable giving in the United States. The 2019 Giving USA report released June 18, 2019, indicated that giving by individuals declined by 3.4 percent after adjusting for inflation in 2018 (after growing by at least 2.4 percent in each of the four preceding years). Giving may decline again in 2019 once taxpayers complete their 2018 income tax filings and understand the full impact of the 2017 Tax Act changes.

With these tax changes and growing uncertainty over the economy, philanthropic-minded individuals should explore the benefits of establishing a flip charitable remainder unitrust.

Overview of Charitable Remainder Trusts

As background, a charitable remainder trust provides for the distribution of a specified payment at least annually to one or more persons, at least one of which must be a noncharitable beneficiary. The payment period must be for the life or lives of the individual beneficiaries (all of whom must be living at the time the trust is created) or for a term of years, not in excess of 20 years. Upon the termination of the noncharitable interest or interests, the remainder must either be held in a continuing trust for charitable purposes or be paid to or for the use of one or more qualified charitable organizations.

A qualified charitable remainder trust is generally exempt from federal income tax. Consequently, donors will frequently give appreciated property to the trust. The trust can sell the property free of capital gains tax, and the trustee can invest the full proceeds for the benefit of the donor. This is one of the major attractions of a charitable remainder trust. Further, the grantor is entitled to an income tax charitable deduction and a gift or estate tax charitable deduction based on the present value of the remainder interest ultimately passing to charity. If the noncharitable beneficiary is an individual other than the grantor, the creation of a charitable remainder trust may have transfer tax consequences.

There are two basic types of charitable remainder trusts: (1) a charitable remainder annuity trust and (2) a charitable remainder unitrust. The amount paid by a unitrust fluctuates with the fair market value of the trust assets, whereas the annual payment from an annuity trust remains constant. Additionally, a unitrust may provide for the payment of the lesser of the fixed percentage or the net income of the trust. This type of unitrust is referred to as a “net income” unitrust. A net income unitrust may have what is called a “makeup” provision. A makeup provision provides that any amount by which the trust income falls short of the fixed percentage is to be paid out in a subsequent year to the extent the trust’s income exceeds the fixed percentage in that subsequent year. A unitrust may also provide for the trust to be a net income trust initially and later convert to a straight unitrust. These types of trusts are often referred to as “flip” unitrusts.

Overview of Flip Charitable Remainder Unitrusts

Since 1998, Treasury regulations allow the creation of a net income charitable remainder unitrust (with or without a makeup provision) that converts to a straight percentage charitable remainder unitrust upon the occurrence of a specified event. Under these rules, a net income charitable remainder unitrust may convert to a straight percentage unitrust (using the same percentage) if the governing instrument of the charitable remainder unitrust meets the following requirements:

  • The change from a net income unitrust to a straight unitrust must be triggered on a specific date or by a single event, called the triggering event, whose occurrence is not discretionary with, or within the control of, the trustee or any other person.
  • The change from a net income unitrust to a straight unitrust must occur at the beginning of the taxable year of the unitrust that immediately follows the taxable year during which the triggering event occurs. Under this rule, if the triggering event occurs on July 1, 2020, the conversion of the unitrust to a straight unitrust must occur on January 1, 2021.
  • Following the conversion in the case of a net income unitrust with a makeup provision, the unitrust’s governing instrument must provide that any makeup amount not paid as of the conversion date is forfeited.

The flip unitrust rules are extremely broad and significantly enhance the planning opportunities available when establishing a charitable remainder unitrust for a donor.

Planning With Flip Charitable Remainder Unitrusts

With the advent of the flip unitrust, traditional approaches to the establishment of a charitable remainder trust no longer work. While there are certain obvious uses for a flip unitrust, there are also a myriad of circumstances for using flip unitrusts to accomplish the unique objectives and goals of the donor that are not so obvious. The wide range of planning opportunities associated with a flip unitrust arises from the broad definition of a “triggering event” under the final regulations.

It is the triggering event that causes the flip unitrust to convert from a net income charitable remainder unitrust to a straight charitable remainder unitrust. Examples of permissible triggering events include the following:

  • Sale of an unmarketable asset
  • Sale of a personal residence
  • Attainment of a certain age by the noncharitable beneficiary of the flip unitrust
  • Marriage or divorce of the noncharitable beneficiary
  • Birth of the first child of the noncharitable beneficiary
  • Death of the noncharitable beneficiary’s parent(s)

Use of Flip Unitrust for Unmarketable Assets

The most obvious use of a flip unitrust is in connection with the gift of an illiquid or unmarketable asset, such as real estate or closely held stock. Use of a flip unitrust when dealing with an unmarketable asset, with the triggering event defined as the sale of the unmarketable asset, will avoid problems associated with a net income unitrust and allow the assets of the unitrust to be invested for total return following the sale of the unmarketable asset. The flip unitrust enables the initial problems associated with funding a charitable remainder trust with unmarketable assets to be handled during the period before the unmarketable asset is sold, but has solved the long-term problem associated in the past with net income charitable remainder unitrusts and an investment strategy designed to produce income. Now, if a flip unitrust is used, the trust assets can be invested for growth or total return following the sale of the unmarketable asset to the ultimate benefit of not only the charitable remainderman, but also the noncharitable beneficiary of the charitable remainder unitrust.

Planning for Retirement

The flip unitrust is an excellent alternative to the net income unitrust in connection with retirement planning for the donor. The triggering event in the flip unitrust would be either a set date or the date upon which the donor attains a certain age, such as age 65. Before that time, the unitrust would be invested for growth or total return and the donor would receive the actual income earned by the charitable remainder unitrust under the net income limitation. Upon the conversion of the flip unitrust to a straight charitable remainder unitrust, the donor will begin receiving a straight percentage of the value of the trust assets as revalued each year. Thus, the donor’s retirement objectives have been met without having to alter the unitrust’s investment strategy to achieve these goals. The investment of the trust assets for total return throughout the donor’s lifetime should have the added advantage of generating a higher unitrust amount in later years, assuming the assets increase in value during the term of the unitrust.

Planning for Surviving Spouse, Children and Grandchildren

Many donors are not concerned about their income needs while they are living, but instead worry that, after their deaths, their spouses, children or grandchildren may need greater income. In these circumstances, the donor should consider a flip unitrust, with the surviving spouse, child or grandchild as a noncharitable beneficiary and the triggering event defined as the donor’s death.

Donors may be concerned that their children may not have the necessary financial resources in the event of certain occurrences during their children’s lives, such as divorce or birth of a child. In these circumstances, the donor may consider a flip unitrust, with the child as a noncharitable beneficiary and the triggering event defined as the child’s divorce or the birth of the child’s first child. Other possibilities would include defining the triggering event as the death of the donor or the death of the child’s spouse to ensure that the child is adequately provided for following that death.

Many donors have provided funds for grandchildren’s education under favorable gift tax provisions. Often, there are younger grandchildren who are not yet of school age. If the donor is concerned that he may not be living when the grandchild reaches school age, the donor may consider a flip unitrust for a term of years, with the triggering event defined as the date the grandchild reaches a certain age. Particular care should be taken to examine the transfer tax ramifications upon the creation of the trust.

Planning for Uncertainty

Many donors do not have a current need for income but worry about a possible need for income in the future. In these circumstances, a flip unitrust may be advisable with a triggering event tied to an event such as involuntary termination of employment or total disability. The examples under the final regulations also make it clear that it is permissible to use a triggering event tied to the sale of an unmarketable asset even when other assets of the unitrust consist of marketable assets. Because it may not be possible to plan for an unknown event, some flexibility could be created by funding a flip unitrust with marketable assets and one unmarketable asset, such as real estate or a share of closely held stock, and defining the triggering event as the sale of the unmarketable asset. If the donor had a need for greater income in the future, the trustee could then sell the unmarketable asset to trigger a conversion of the unitrust from a net income charitable remainder unitrust to a straight charitable remainder unitrust.

Planned giving officers, lawyers and other advisers to individuals desiring to establish charitable remainder trusts must now explore more fully the estate planning objectives and goals of the donor. Depending upon these objectives and goals, more attention must be given to determine the type of charitable remainder trust that is most beneficial.