Philanthropic individuals have a broad and perhaps bewildering array of products and techniques available to express their intentions. Their gifts can be made in a bequest in a will or trust, donation to a private foundation, to a donor-advised fund, or through a charitable lead trust, just to name a few.
Each gift has particular advantages and disadvantages. One tool that has gotten less attention than other charitable vehicles is the pooled income fund. Its unique benefits merit a closer look.
A Comparison of CRTs and Pooled Income Funds
The Charitable Remainder Trust (CRT) and the pooled income fund are conceptually quite similar. In each, an individual gives property to a trust while retaining an income interest. Upon the conclusion of the income interest, the balance of the trust property passes to a charity.
The income interest is valued according to rules and regulations established by the Internal Revenue Service. The value of that interest is subtracted from the value of the assets transferred to the trust and that is the “remainder” that passes to the charity.
The central advantages of both the CRT and the pooled income fund are: 1) the individual making the gift (the grantor) is entitled to an income tax deduction in the year assets are transferred to the pooled income fund or CRT; 2) the grantor can retain an income interest for life or the grantor can give a life income interest to another individual or individuals; 3) the remainder interest passing to the charity typically qualifies as a deduction for federal gift tax purposes and is not included in the grantors taxable estate; and 4) no tax is incurred on the transfer of appreciated assets to a charitable remainder trust or to a pooled income fund.
Although CRTs are quite similar, important differences exist (see chart). The biggest difference and the advantage of pooled income funds over the CRTs, is the cost of establishment and administration. When an individual creates a CRT the person must hire an attorney or other professional to draft the trust. The terms of the trust are not necessarily complex, however the trust must be prepared properly to conform with the IRSs requirements to ensure the tax benefits. In addition, the CRT has significant ongoing filing and record keeping requirements.
This is in contrast to a pooled income fund. Usually no fees or expenses are incurred upon the contribution to a pooled income fund. And, because these funds are almost always organized and run by charities, the ongoing administration expenses are not the burden of the grantor.
So, exactly what is a pooled income fund? Generally speaking, it is a fund maintained by a charitable institution. In fact, this is a requirement of a pooled income fund, although the actual administration can be delegated to an extent by a charity.
The fund commingles contributions from all donors and distributes the income to the income beneficiaries. This commingling or “pooling” gives the funds their name. A donor can retain an income interest on her own behalf or can create an income interest for the life of any other individual or individuals she chooses.
The creation of a life income interest in another person is, of course, a gift for federal gift tax purposes, although another deduction may be available (e.g. the marital deduction for gifts to a spouse). The income interest can be for several lives and can be concurrent for consecutive interests.
For example, a donor can reserve a life income interest and upon his death, the life income interest can pass to a child. A key feature of these funds is that the interest retained must be an income interest for the life of an individual or individuals.
This is quite different from a CRT where the interest retained can be for a term and the payments can be in the form of an annuity or unitrust payment.
The Charitable Income Tax Deduction
To calculate the amount of the charitable deduction for both income and gift tax purposes, the IRS has issued detailed regulations. These are based on the life expectancies of the income beneficiaries and the assumed rate of return for the fund.
The life expectancies are determined using IRS tables and the expected return is essentially the highest annual interest rate earned by the fund for the three years prior to the contribution. For funds in existence for less than three years an alternate calculation is made based on rates published by the IRS.
For example, if a 70-year-old individual makes a contribution of $100,000, retains a life income interest and the assumed interest rate is 6.6%, the charitable deduction will be $46,194. Note that the deduction may be limited by other factors such as the donors adjusted gross income or limitations applicable because of the type of property contributed.
At the end of the income interest the remainder passes to the charity that established the fund. It is this transfer that generates the charitable deduction. The contribution to a pooled income fund is irrevocable and with limited exceptions the designated charity must be established at the time of the gift to the fund.
Donor-advised funds, which are qualified charities, have established pooled income funds. These funds give the donor, or more importantly the donors heirs, say as to which charity or charities will ultimately receive the benefits of the gift to a pooled income fund.
Planning with Pooled Income Funds
A popular and helpful planning technique often used in connection with CRTs is equally useful with pooled income funds. The technique is loosely referred to as “wealth replacement.”
The way this works is the income interest from the contribution to the pooled income fund and any savings resulting from the income tax deduction are used to purchase a life insurance policy, which upon the death of the income recipient “replaces” the assets contributed to the pooled income fund. A properly structured trust exempts proceeds from the grantors taxable estate.
An estate subject to federal estate tax has added benefits. Pooled income funds can also be used like CRTs to shelter capital gains liability. A contribution to a pooled income fund with appreciated assets does not trigger a capital gain. If the fund sells these assets, the gains are not attributable to the donor.
Therefore, the donor has been able to obtain an income interest from the full value of assets contributed without reduction for capital gains.
The pooled income fund is a very useful and overlooked technique for the multiple purposes of making a charitable gift while producing an income interest in a tax efficient manner. As shown in this article, in most planning situations where CRTs are discussed, pooled income funds should be considered as well.
, JD, LLM, is director, estate and business planning forMassachusetts Mutual Life Insurance Company, out of the Hartford Conn. location. Josh can be reached via e-mail at [email protected]
Reproduced from National Underwriter Life & Health/Financial Services Edition, December 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.