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. 2002 Investment Performance and Practices of Community Foundations © Council on Foundations - 3 - 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.