Community Foundation As Trustee of a Charitable Trust–Issues to Consider

Community Foundation as Trustee of a Charitable Trust–Issues to Consider

By Michael J. Cooney, Esq. Nixon Peabody LLP Increasingly, donors look to community foundations to provide a complete range of tools for philanthropy. For any community foundation with an active planned giving program, the question will eventually arise as to whether and under what conditions the entity will serve as a trustee of a charitable remainder trust of which it is a beneficiary. The purpose of this article is to set forth some of the items that the community foundation board and administration should consider.

Basics on Charitable Remainder Trusts

A charitable remainder trust (or “CRT”) is a tax-exempt trust that provides for the payment of a defined amount to designated beneficiaries for a term of years or their lives. After this period expires, the trust principal is transferred to a designated charitable remainderman. The CRT must be either a charitable remainder annuity trust or a charitable remainder unitrust. It cannot combine the features of both. A charitable remainder annuity trust provides for the annual payment of a fixed dollar amount (an annuity) to the noncharitable beneficiary. The annuity amount, once established, cannot change and must be at least 5 percent of the initial net fair market value of the property placed in the trust. Annual contributions to an annuity trust after the initial funding are expressly prohibited. A charitable remainder unitrust provides for the annual payment of a fixed percentage, again not less than 5 percent of the annually determined net fair market value of the trust principal. Thus, the unitrust amount fluctuates each year based on the fair market value of the trust principal and has the potential of offsetting the impact of inflation. This is consistent with the general objectives of long-term growth because the unitrust amount will increase if the value of the trust assets increases. Of course, the unitrust amount will be reduced if the value of the trust assets decreases. Additional contributions may be made to the unitrust. A unitrust must make at least annual payments, but the payment formula may be modified to allow for the payment of an amount equal to the lesser of: the unitrust amount; or the actual income (generally interest and dividends, but not capital gains) earned by the trust. This feature is attractive if illiquid or hard-to-sell assets, such as real estate or closely held stock, are used initially to fund the trust. The CRT has a special internal set of accounting rules that govern the characterization of payments out to the trust beneficiary, a so-called four-tier method of accounting. The four tiers consist of ordinary income, capital gains, tax-exempt income and corpus (principal). One tier must be exhausted before a payment can be characterized as coming from a subsequent tier. For example, all of the trust’s current and any accumulated, but undistributed, ordinary income must first be fully paid out before any portion of the

2002 Investment Performance and Practices of Community Foundations © Council on Foundations - 2 - payment may be characterized as capital gains. In the case of capital gains, all short-term capital gains must be paid out before any portion of the payment will be considered long- term capital gains. Having exhausted the current and accumulated accounts for ordinary income and capital gains, the payment would next be characterized as tax-exempt income and finally as corpus. When the trust is funded, the donor receives an immediate income tax charitable deduction for the present value of the remainder interest that will eventually pass to charity. The deduction is computed using actuarial tables published by the Internal Revenue Service and is generally based on the payout level, the anticipated trust term, and an assumed rate of interest, which changes monthly. The deduction once computed does not change based on the actual performance of the trust. Because the CRT is tax-exempt, it can receive and dispose of appreciated assets (such as publicly traded securities) on a tax-free basis. Upon receipt, the trustee can sell the property and reinvest the sale proceeds with no intervening income tax liability. The exception is for any income subject to the unrelated business income tax, the receipt of any of which subjects all the trust income to tax for that year. This is especially a concern during a period in which an appreciated asset, donated to the CRT, is liquidated.

Role of the Trustee of a Charitable Remainder Trust

Every trust needs a trustee, responsible for the investment and payout of trust assets, the filing of information returns and so on. The scope and nature of a trustee’s duties are generally governed by state law and, as indicated above in the explanation of the workings of the CRT, these duties can be rather complex. The decision to act as trustee is therefore a strategic one, which should be made by the governing board of the community foundation after a consideration of all the advantages and disadvantages involved. As an initial step, the community foundation needs to establish whether under its state law it can legally act as trustee of a CRT, specifically one of which it is beneficiary. There is no uniform law that answers this question. For community foundations in trust form, the answer may be quite straightforward, though less so for those in corporate form. The power to act as a trustee might be contained or influenced in state corporate, banking, estate, probate, or other laws. A second consideration is whether the community foundation’s governing documents (i.e., trust agreement or certificate/articles and by- laws) are broad enough to encompass acting as trustee of a CRT. Both questions are best answered by an attorney familiar with the subject area. A CRT is not simply another charitable trust. It is a split-interest trust with special rules arising out of the sometimes divergent concerns of the income beneficiary—commonly the donor—and the charitable remainderman. As such, the CRT has a built-in conflict of interest between the income beneficiary and the charitable remainderman, leading to especially difficult decisions for the charitable trustee. For example, the trust agreement cannot include a provision that restricts the trustee from investing the trust assets in a way that could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets. As both trustee and remainderman, the community foundation subjects itself to extreme scrutiny and a high duty of care.

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Baseline Assumptions

Of course, community foundations should not take the responsibilities of trustee of a CRT lightly. The reason for assuming this fiduciary obligation is generally to satisfy the desires of the donor, who wants to avoid the cost of a bank trustee and the complications of administering the CRT himself or herself. At the same time, CRTs provide a great deal of flexibility to the donor that the community foundation might prefer to limit. The community foundation is therefore well advised to settle on a form of CRT agreement with which it is both familiar and comfortable in serving as trustee. This important step can avoid grave complications later where the community foundation must assess each CRT on a case-by-case basis with the benefit of legal counsel. For example, upon the creation of the CRT, the trust instrument can reserve a power for the noncharitable beneficiary to appoint the charitable remaindermen by will. Upon the creation of an inter-vivos CRT (that is, a CRT established during the grantor’s lifetime), the grantor may reserve a power to substitute another charity as the remainderman in place of the charity named in the trust document. This flexibility could change the legal ability of the community foundation to serve as trustee, not to mention provide a very different practical incentive for doing so. A standardized community foundation agreement can avoid this pitfall. The community foundation’s governing board is well advised to establish clear procedures and lines of responsibility over CRT administration. This role might be contained in the entity’s gift acceptance policy, or a separate board policy on point.

Investment of Trust Assets

Investment of trust assets is a central consideration for any trustee. As state law varies, we shall use New York law as a template. New York follows the Prudent Investor Act (the “Act”), which is based on the Uniform Prudent Investor Act. The Act is similar in many ways to the standards set forth in the state’s Not-for-Profit Corporation Law with respect to investment assets, but not identical. Corporate directors must therefore subject themselves to, and familiarize themselves with, a different statute than that with which they are likely familiar. Trust law and non-profit corporation law both share in the origins of the “prudent man rule,” arising out of an 1830 Massachusetts case, Harvard College v. Amory, in which the court instructed trustees “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.” Under the Restatement Second of Trusts § 227 (1959), trustees must “make such investments and only such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of income to be derived.” These are nice words, but devilishly difficult to administer. The prudent investor rule, as stated in the Restatement Third (1990), and the Uniform Prudent Investor Act contained in it, makes six fundamental changes to the traditional “Prudent Man” standard a fiduciary must meet:

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• the standard of prudence is applied to the entire portfolio (rather than individual investments); • the balancing of risk and return is identified as the fiduciary’s central concern; • diversification is generally required, unless it is reasonable not to do so; • categoric investment restrictions are abolished; • delegation of investment responsibility is permitted, subject to certain safeguards; and • the standard requires protecting the remainder against inflation, in balance with looking after the current income beneficiary.

New York’s Act includes these points, but establishes them as default provisions, variable by the governing instrument or court order. Each of these points deserves special attention. Analysis of the entire portfolio. This shift in the analysis of the trustee’s investment judgment is very important. It requires that the standard of prudence be applied to the portfolio as a whole instead of reviewing particular investments in isolation. The courts also focus on the entire investment process and strategy, instead of only the results achieved. This permits, for example, the trustee to maintain an investment in a non- income producing asset if the balance of the assets in the portfolio meets the predetermined income objectives of the trust. A special point should be made with respect to CRTs. The tax-exempt nature of the trust is dependent, in part, on the complete avoidance of unrelated business taxable income. In the context of a CRT, this income is most likely to arise from partnership investments, where the tax law treats even a “passive” partner as one in the business of the partnership, or from debt-financed investments, again often arising in the partnership context. The revocation of the exempt status of the CRT for a given year (especially one in which the gain from the sale of contributed property is triggered) could be catastrophic for trustee and income beneficiary alike. Risk and return. The Act explicitly recognizes the impact of risk and return on investment process and strategy. The trustee must identify risk and return objectives appropriate for the particular fund, and pursue an investment appropriate to those objectives. In doing so, the fiduciary is required to consider a number of factors: the size of the portfolio; the duration of the fiduciary relationship; the liquidity and distribution requirements as determined by the governing instrument; the general economic condition; the possible effects of inflation or deflation; the tax consequences of investment decisions and distributions of principal and income; the role of each investment in the overall portfolio; the expected total return of the portfolio; and the needs of the beneficiaries (as reasonably known to the fiduciary). Diversification. The Act requires that fiduciaries diversify assets, unless it is reasonable not to diversify. As is the case with any well-written gift acceptance policy, decisions to retain or dispose of initial assets must be made within a reasonable time after the creation of the fiduciary relationship. Of course, while the Act emphasizes the importance of diversification in limiting the risk of a particular investment, it provides no

- 5 - formula, relying upon the trustee to provide an investment mix appropriate to the particular fund’s purpose. The fiduciary is permitted to make a reasonable determination not to diversify. In doing so, the fiduciary should consider any special relationship or value that an asset has to some or all of the beneficiaries. For example, if a trust holds a closely held business for the purpose of keeping it in the family, a trustee may reasonably determine that it is in the best interest of the beneficiaries and consistent with the settlor’s intent not to diversify. Such special considerations in the context of a charitable remainder trust are, however, problematic and probably should not be given great weight. When a charity acts as trustee of a charitable remainder trust of which it is also the remainderman, the charity generally liquidates the initial trust assets and reinvests them with no intervening tax liability (this is one of the advantages of a charitable remainder trust). Often the proceeds are reinvested with the charity’s endowment fund. The propriety of this action depends on whether the endowment fund itself contains a diversity of holdings (presumably it would). Categoric restrictions. The Act abolishes all categoric restrictions on investments. Thus, under the Act, no investment can be deemed per se imprudent. As stated above, the merits of each investment will be reviewed in light of the entire portfolio to ascertain the prudence of the overall investment strategy and its implementation. For a charitable remainder trust, the Internal Revenue Code (the “Code”) does not impose any categoric restrictions on the type of investment. For example, neither the excess business holdings rule (Code Section 4943) nor the jeopardizing investments prohibition (Code Section 4944) apply. Certain actions, such as self-dealing (Code Section 4941) and taxable expenditures (Code Section 4945), however, are prohibited. Delegation. Perhaps the biggest change the Act brings to New York is the right of a fiduciary to delegate responsibility to investment advisors if the delegation is consistent with the fiduciary’s duty to exercise skill. The fiduciary must exercise caution, skill, and care in choosing and instructing the delegee, as well as in reviewing the delegee’s conduct. In choosing a delegee, the fiduciary must consider the delegee’s credentials, experience, expertise, and financial responsibility. Once chosen, the fiduciary and the delegee must establish the scope of the delegation. The Act requires that the delegee comply with the scope and terms of the delegation and exercise its established function with reasonable care, skill, and caution. The legislative history of the Act suggests that, as a matter of public policy, any exculpation clause in a delegation agreement cannot reduce the standard of care, skill, and caution imposed on the delegee. By accepting the delegation, the delegee submits to the jurisdiction of the courts of New York even if the delegation agreement provides otherwise. Because the Act authorizes the delegation of investment and management functions, it also authorizes the fiduciary’s payment of the costs associated with those functions to the extent that they are appropriate and reasonable. The Act in New York gives a court the jurisdiction to review the reasonableness of the cost of delegation. The Act and the legislative history are silent on whether the cost of an investment advisor who has been delegated authority will be borne by the trust or whether fiduciary commissions will be reduced to cover the expense. Whether a charity acting as trustee of a charitable remainder trust receives a commission for its services depends on what the donor provides in the trust instrument. Trustees are,

- 6 - however, often reimbursed for any expenses incurred in the administration or investment of this trust, and the trust agreement should provide for this reimbursement. The ability to delegate is of particular importance because most charity-trustees retain investment advisors. Note that the trustee of the unitrust holding assets other than cash or marketable securities has to obtain a qualified appraisal to value those assets, or alternatively appoint an independent co-trustee to do so. Providing for inflation. Time value of money is important in any planned gift or endowment. While the Uniform Management of Institutional Funds Acts makes specific reference to preserving purchasing power, institutions take varying approaches to the effect of inflation on preserving historic dollar value. The Act provides guidance to trustees that inflation is a legitimate concern for the benefit of the remainderman, so the trustee may invest and expand accordingly.

Trust Reporting

The trustee is responsible for making timely and correct payments to the income beneficiary, as well making necessary tax filings. These are tasks that may be delegated, but the responsibility remains that of the trustee. The trustee is obligated to file on behalf of the CRT Form 1041-A and 5277 with the Internal Revenue Service. The returns are due by April 15 of each year, though the CRT will want to prepare them early so that the noncharitable beneficiary with have the information provided on the returns, as reflected in Schedule K-1, to prepare an individual tax return. State returns and reports may also be necessary.

Summary

By following the steps described here, in addition to others, the community foundation can help limit its liability and improve its performance as trustee. Points to keep in mind with respect to CRTs are: • The commitment to act as trustee should be closely considered and clearly delineated by the governing board. The legal authority to act must be clear. • The community foundation should consider using its own form of CRT agreements in order to lower costs and provide greater certainty. • Be mindful of the perception of local banks, trust companies and other businesses that might look askance at the community foundation as a trustee. • Investment responsibility in this situation is inherently conflicted, so selection of proper investments is that much more important. You must know the applicable laws and follow them. • Donor relations and reporting are vital parts of the deal. Be sure that you are adequately staffed to deal with them.