Split-interest trusts, 2001

Statistics of Income Bulletin, Winter, 2003 by Melissa J. Belvedere

Split-interest trusts are, essentially, hybrid trusts having both charitable and noncharitable beneficiaries. While they are not actually recognized by the Internal Revenue Service as being tax-exempt entities, they have many tax-exempt characteristics, and offer to donors many of the same benefits available to donors to charities. There are three main types of split-interest trusts: charitable remainder trusts, charitable lead trusts, and pooled income funds. All split-interest trusts must file Form 5227 annually to report financial activity and determine if they should be treated as a private foundation.

For Tax Year 2001, there were 119,821 Forms 5227 filed, up from 113,075 filed for 2000. Split-interest trusts reported end-of-year total assets (book value) of $111.2 billion, an increase of 18.4 percent from the previous year (Figure A) [1]. Despite the increase in the number of trusts, and the reported increase in book value of total assets, total net income dropped significantly, from $15.3 billion in 2000 to $11.7 billion in 2001. Distributions by split-interest trusts increased by 16.7 percent, to $9.4 billion.

Throughout this article, trusts are described in terms of their size as being either small, medium, or large. This description is based on the trust's reported end-of-year total assets (book value) [2]. Small trusts are those that reported total assets of $500,000 or less, and those trusts that either did not report end-of-year book value of total assets, or that reported the amount as zero; medium-sized trusts are those with between $500,000 and $3.0 million in total assets; large trusts reported total assets of $3.0 million or more [3].

Charitable Remainder Trusts

Background

Under a charitable remainder trust arrangement, a stream of income is paid by the trust to one or more noncharitable beneficiaries until the trust terminates, at which point the remaining assets are transferred to a charitable beneficiary. The duration of the trust can be a specified number of years (not to exceed 20 years), or it can be for the life of a particular individual (often, the donor or donor's spouse). On creation, the donor is allowed an income tax deduction based on the estimated amount to be donated to charity at the trust's conclusion. To prevent various tax-avoidance schemes, the Internal Revenue Service requires the charitable distribution to be at least 10.0 percent of the fair market value of the initial trust assets.

Donors may structure the lifetime payments to the trust's private beneficiaries as either fixed (an annuity trust) or flexible (a unitrust), depending on the desired results of each arrangement. Payment amounts are determined by applying a specified percentage (between 5.0 percent and 50.0 percent) to the fair market value of the trust assets. In the case of an annuity trust, the percentage is applied to the fair market value of the trust assets at the time the assets are transferred to the trust. Annuity trusts offer stability, as the payment is level regardless of the fluctuations of the market. However, there is no inflation protection or way to maximize personal gains from a robust market. Under unitrust arrangements, the trust percentage is applied to the fair market value of the trust assets as they are valued in each year. Unitrusts introduce more risk but also allow for greater gains when the market is favorable [4].

To complicate matters further, charitable remainder unitrusts can have net income provisions, and these can be classified into trusts with or without makeup provisions. Net income charitable remainder unitrusts do not have makeup provisions, meaning that they pay the private beneficiary either the unitrust amount or the annual income of the trust, whichever is less. In years where the income is less than the unitrust amount, a deficiency is created, which is not "made up for" in future years. Net income with makeup charitable remainder unitrusts also pays the lesser of the unitrust amount or the trust's annual income, but any deficiency (or accumulated deficiency, depending on the trust's income over years) can be paid in future years when the trust's income exceeds the unitrust amount.

Balance Sheets

Charitable Remainder Annuity Trusts

There was a 1.3-percent increase in the number of Forms 5227 filed by charitable remainder annuity trusts for 2001; 22,958 were filed, up from 22,669 from 2000. The majority (82.1 percent) were small trusts with less than $500,000 in end-of-year total assets; 16.0 percent had asset amounts between $500,000 and $3.0 million; only 1.9 percent reported assets in excess of $3.0 million (Figure B).

Annuity trusts reported $10.2 billion in aggregate total assets, a decrease of 3.5 percent from 2000 (Figure B) [5]. This is an interesting development, in that the pace of growth slowed significantly between 1999 and 2000; the decline between 2000 and 2001 seems to continue the trend. Also interesting is the fact that, while small and large trusts reported a decrease in total assets (0.7 percent and 14.9 percent, respectively), mid-sized trusts reported an increase in total assets of 8.7 percent (up to $4.1 billion in 2001). Approximately 85.4 percent of aggregate total asset holdings by annuity trusts were in investments ($8.7 billion); approximately 81.3 percent of aggregate total investments were in securities ($7.1 billion). Small trusts held 21.4 percent of total assets and 21.3 percent of total investments; medium trusts held 40.4 percent of total assets and 40.7 percent of total investments. The largest trusts, which comprised less than 2.0 percent of the total number of annuity trust returns, held 38.2 percent of aggregate total assets and 38.0 percent of aggregate total investments. Overall, charitable remainder annuity trusts reported only $210.6 million in total liabilities, which represents a 57.7-percent decline from 2000 [6,7].