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...both 2005 and 2006. The total end-of-year book value of assets in Filing Year 2006 was more than $108.2 billion, a 1.6-percent increase from 2005.
A split-interest trust (SIT) can be created by a will or a trust instrument. The trust instrument specifies the term of the trust, designates the trustee(s), as well as the beneficiaries, and provides parameters for managing assets and distributing income to the beneficiaries. The instrument usually specifies the contents of the trust. The individual who owns, and then transfers, the assets that make up the trust corpus is known as the grantor.
A trustee is charged with holding, investing, and distributing the income and assets of the trust. A trustee may be an individual, a group of individuals, or an entity such as a bank or charity. Each trustee must ensure that all transactions, including distributions, conform to the requirements of the trust document and to any applicable laws. Additionally, trustees must coordinate the preparation, verification, and submission of all required State and Federal tax forms.
There are three distinct types of split-interest trusts: charitable remainder trusts, charitable lead trusts, and pooled income funds. In 2006, some 116,062 returns for charitable remainder trusts were submitted (Figure A). Trustees for charitable lead trusts submitted 6,298 returns in 2006, while pooled income fund trustees submitted 1,676 returns.
Charitable Remainder Trusts
Under a charitable remainder trust (CRT) agreement, an income stream is distributed annually to one or more noncharitable beneficiaries for a defined period. The period may be either a fixed duration, statutorily limited to 20 years, or the lifetime of a noncharitable beneficiary. (2) At the conclusion of the period, the trust is dissolved, and the remaining value is distributed to predetermined charitable beneficiaries. (3) The present value of the expected future charitable distribution must equal at least 10.0 percent of the initial fair market value of the assets placed in the trust. (4)
The donor must file a U.S. Gift Tax Return (Form 709) for all assets contributed to the trust. For tax year 2005, reflected in 2006 filings, any gift exceeding $11,000 is taxable and is included in the donor's lifetime exclusion. (5) At the time of trust creation, the donor receives an income tax deduction based on an estimate of the charitable distribution. The donor is also eligible for a gift tax deduction if the charitable beneficiary has been named. A beneficiary must report the distributions as gross income on his or her U.S. Individual Income Tax Return (Form 1040).
There are two types of charitable remainder trusts. Charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs) differ in the calculation of the noncharitable distribution amount. Charitable remainder annuity trusts annually distribute a fixed percentage, between 5.0 percent and 50.0 percent, of the initial fair market value of the property in the trust. As a result, the amount of the distribution to noncharitable beneficiaries from a CRAT should be the same each year. Charitable remainder unitrusts distribute a fixed percentage, between 5.0 percent and 50.0 percent, of the fair market value of the trust property, valued annually. Therefore, the value of the distribution to noncharitable beneficiaries from a CRUT, called the unitrust amount, may vary from year to year, depending on the value of the assets in the trust.
There are two common variants of charitable remainder unitrusts that allow for added flexibility ofnoncharitable distributions. One variant, a net income charitable remainder unitrust (NI-CRUT), permits the trustee to distribute only the amount of trust income for that year, should that amount be less than the distribution that would otherwise be required. (6) This allows the trustee to limit distributions in years when the trust's income is low, to avoid depletion of the trust corpus. A related variant is called the net income with makeup charitable remainder unitrust (NIM-CRUT). (7) A NIM-CRUT works like a NICRUT, in that the trustee is allowed to distribute the lesser of the trust income or the required percentage of fair market value. However, the reductions in required distributions accumulate. The trustee must make up for previous distribution deficiencies when trust income permits.
Charitable remainder unitrusts may accept property transfers throughout the life of the trust. These are called "additional contributions." These contributions may be in the form of any asset, including cash and stock. All additional contributions must be detailed on an attachment to the Form 5227 filed for the year in which the contribution was received. The presence of additional contributions complicates the calculation of the unitrust amount. Preparers must prorate the value of the contributions based on the date they were donated to the trust. (8) The unitrust amount is then calculated by multiplying the sum of the balance sheet fair market value and the prorated value of the additional contributions by the unitrust percentage.
Charitable Lead Trusts
Under a charitable lead trust (CLT) agreement, a charitable organization receives the income interest in the trust assets, while the remainder interest is assigned to a noncbaritable beneficiary, usually the grantor or the grantor's spouse. Annual distributions are made to a predetermined charitable beneficiary. The amount of CLT distributions is not constrained by minimum or maximum payout restrictions. The distributions continue for the lifetime of the noncharitable beneficiary. (9)
Charitable lead trusts are classified as annuity trusts or unitrusts depending on the calculation of the distribution amount. Charitable lead annuity trusts (CLATs) distribute a fixed dollar amount of the initial fair market value of the trust property. Charitable lead unitrusts (CLUTs) distribute a fixed percentage of the net fair market value of the trust property, determined annually. CLATs tend to be favored over CLUTs. CLATs do not require that the trust property be revalued annually, therefore reducing the trustee's costs, and allow the noncharitable remainder beneficiaries to benefit from the appreciation of trust assets.
CLTs are further classified by the role of the donor. If the donor of the trust assets is the noncharitable beneficiary, the trust is classified as a grantor charitable lead trust. In this case, the grantor will receive an income tax deduction up to the amount of the present value of the future charitable distributions as well as a gift tax deduction. (10) Because a grantor CLT is not considered a separate taxable entity, the grantor must pay tax on income earned by the trust. Grantor CLTs are generally used to convert future charitable contributions into a current tax deduction. A trust is classified as a nongrantor charitable lead trust if the donor of the trust property is not a beneficiary. In the case of nongrantor charitable lead trusts, the grantor receives only a gift tax charitable deduction at the time of the trust creation equal to the present value of the future charitable distributions. The nongrantor CLT is considered a fully taxable separate entity for income tax purposes. As a result, the grantor is not liable for tax owed on trust income. Nongrantor CLTs are generally used as a transfer tax reduction technique.
Pooled Income Funds
Under a pooled income fund (PIF) arrangement, donors to a charitable organization contribute assets to a pool of donated assets and, in return, receive income payments for the remainder of the grantors' lifetimes. (11) The transfer of assets to the fund must be irrevocable, meaning it cannot be altered or cancelled without consent of the beneficiary. Generally, donors contribute to existing pooled income funds, thus incurring far lower administrative costs to the grantor than a charitable remainder trust. At the time of donation, the grantor receives income and gift tax deductions equal to the estimated value of the eventual charitable contribution. The donee charity, commonly a large educational institution, is responsible for the maintenance of the fund, including investing assets and making distributions to beneficiaries. PIFs are prohibited from investing in tax-exempt securities. Each year, grantors receive a distribution from the fund based on the ratio of their contributions to the value of the investment pool and the return on the fund assets for that year. These distributions are reported as gross income on the grantor's Form 1040. At the time of the donor's death, the charity receives the grantor's prorated share of the value of the PIF.
Analysis Overview
A Split-Interest Trust Information Return (Form 5227) must be submitted for each calendar year a split-interest trust is in existence. (12) Form 5227 must be filed with the IRS by April 15 of the year following the applicable calendar year. Form 5227 is used to disclose the financial activities of the trust, not to calculate tax liability. Ira trust incurred any taxable income during the calendar year, a Form 104 I, United States Income Tax Return for Estates and Trusts', must be completed.
The number of Forms 5227 filed decreased from 124,292 during Filing Year 2005 to 124,036 in 2006 (Figure A). Charitable remainder unitrusts remained the most common type of split-interest trust. Pooled income funds made up the smallest percentage of the SIT population. The majority of returns filed in 2006 were for ongoing trusts, in neither the first nor last year of existence. However, some 4,213, or 3.4 percent of the population, were filed with an initial status (Figure B). (13) Final returns were even less common; in 2006, preparers for terminating trusts filed 3,720 returns. The average lifetime of a terminating trust in Filing Year 2006 was almost 12 years. (14)
Paid preparers completed 75.6 percent of returns filed in 2006 (Figure C). However, in some instances, the trustee type may indicate the presence of a professional preparer even when the return does not indicate a paid preparer. Of those returns that did not indicate a paid preparer, 89.1 percent reported institutions, such as banks or charities, as the trustee. When entities such as these are acting as trustee, it is likely that the return was professionally prepared even if a paid preparer did not sign the return. For example, while paid preparers completed only 44.5 percent of the returns filed for pooled income funds, institutional trustees were reported for 91.1 percent of the PIF returns that did not indicate a paid preparer. CLTs were the type of trust most likely to be completed by a paid preparer. In 2006, only 17.2 percent of forms filed for CLTs did not utilize a paid preparer.
Form 5227 is divided into several parts, many of which are only completed for one type of split-interest trust. All trusts report the total fair market value of assets in the trust at the end of the tax year, as well as distribution information. The balance sheet portion of Split-Interest Trust Information Return is a detailed listing of the assets and liabilities of the trust and is completed, at least in part, by all SITs. There are three separate valuations for each asset and liability category: beginning-of-year book value; end-of-year book value; and fair market value. The beginning- and end-of-year book values are reported for all types of trusts. For all SITs, the end-of-year book value of trust assets increased from $106.5 billion in Filing Year 2005 to $108.2 billion in 2006. The fair market valuation is only required for charitable remainder unitrusts. Tax law requires the fair market value to be assessed on the same crate and by the same method each year that a Form 5227 is filed for a CRUT. Assets are apportioned into several categories, including cash, receivables, and investments. Investments are further separated into five categories: U.S. and State government obligations; corporate stock; corporate bonds; land, buildings, and equipment; and other. Liabilities are also separated into four categories, including accounts payable and deferred revenue.
This article primarily focuses on split-interest trust reporting for Filing Year 2006, reporting, primarily, information and activities that occurred in Calendar Year 2005. Throughout this article, trusts are described in terms of size as small, medium, or large, based on the trust's reported end-of-year total book value of assets. Small trusts are defined as those that reported total assets of $500,000 or less, including those trusts that either did not report end-of-year book value of total assets or that reported the amount as zero. (15) Medium trusts are defined as those with between $500,000 and $3.0 million in total assets. Large trusts are defined as those that reported total assets of $3.0 million or more.
Analysis by Type of Trust
Charitable Remainder Trusts
The income and deductions portion of Form 5227 is completed only for charitable remainder trusts, for which 116,062 returns were filed in 2006 (Figure D). Reported ordinary income is divided into seven classifications that include interest income, ordinary dividends, and business income or loss. Total ordinary income of $3.0 billion was reported for CRTs in 2006, of which $2.7 billion, or 90.3 percent, was reported for CRUTs. Deductions allocable to ordinary income are divided into three classifications: interest, taxes, and other deductions totaled $547.6 million in 2006. (16) The total ordinary income less deductions allocable to ordinary income is referred to, in this article, as "net ordinary income." In 2006, this amount was $2.4 billion.
Capital gains and losses are reported separately from net ordinary income. The total short-term capital gain or loss amount, as well as the total long-term capital gain or loss amount, is taken from Form 1041 Schedule D, Capital Gains and Losses. for the corresponding tax year. Deductions reduce the short- and long-term amounts, resulting in a "net short-term capital gain (loss)" and a "net long-term capital gain (loss)." Charitable remainder trust returns reported total net capital gains of $7.4 billion in 2006 (Figure D). This is an increase of 16.6 percent from $6.4 billion in 2005. A possible explanation for this increase may be continued effects of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, which reduced the long-term capital gain tax rate from 20.0 percent to 15.0 percent, and, therefore, spurred the sales of capital assets. The 2005 tax year, reflected on returns filed in 2006, was the second full year that the law was in effect. Net long-term capital gains made up approximately 96.1 percent, or $7.2 billion, of total net capital gains reported for CRTs in 2006. This is an increase of nearly $1.2 billion over the net long-term capital gains reported for CRTs in 2005. This change is minor compared to the $2.5 billion, or 81.3 percent, increase seen between Filing Years 2004 and 2005, when the JGTRRA was initiated.
In this article, total net income is defined as the sum of net ordinary income, net capital gains, and nontaxable income. Nontaxable income, primarily from municipal bonds, is also reported separately from ordinary income. Charitable remainder trusts reported $127.4 million in nontaxable income in 2006, a decrease of 4.5 percent from the $133.4 million reported in 2005 (Figure D). Total net income reported for charitable remainder trusts increased by 10.6 percent, from $9.0 in 2005 to $10.0 billion in 2006, despite the relatively small increase, 0.3 percent, in the number of returns filed. This increase is attributable to the $1.1 billion increase in the total net capital gains reported for CRTs.
The accumulation schedule section of Form 5227 shows the flow of income through the trust from January 1 to December 31 of the tax year. (17) This section is also only completed for charitable remainder trusts. Income is reported in two categories: undistributed income from prior years and current-year income. Income in these two categories is further disaggregated by source: ordinary; net short-term capital gains and losses; net long-term capital gains and losses; and nontaxable. Returns filed for CRTs in 2006 reported total accumulations, including ordinary income, short-term and long-term capital gains, and nontaxable income, of $66.3 billion (Figure D). Approximately $56.3 billion of the accumulations were undistributed from prior tax years. The accumulation schedule shows undistributed income at the end of the tax year, which is the amount of income held by the trust on the last day of the calendar year, once all payouts and distributions have been recorded. In Filing Year 2006, some $59.7 billion was reported for end-of-year undistributed income. As shown in Figure D, returns filed for charitable remainder trusts reported $7.2 billion in distributions and $90.2 billion in end-of-year book value assets of in Filing Year 2006.
Charitable Remainder Annuity Trusts
During Filing Year 2006, some 21,296 Forms 5227 were filed for charitable remainder annuity trusts. This is a 1.7-percent decrease from Filing Year 2005, when 21,667 returns were filed. As in 2005, the majority of CRATs included in Filing Year 2006 were small trusts, with end-of-year book value of total assets less than $500,000 (Figure E). Approximately $854.0 million in total net...
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