The Top Ten" Common Errors to Avoid in Charitable Trust Planning"

The Top Ten" Common Errors to Avoid in Charitable Trust Planning"

Article posted in Compliance on 24 April 2002| 1 comments
audience: National Publication | last updated: 18 May 2011


It has been said that only a fool learns only from his own mistakes. In this edition of Gift Planner's Digest, trust administrator Chuck McLucas shares ten of the most common mistakes he has encountered in connection with the design and operation of charitable trusts.

by Charles J. McLucas, Jr., CPA

Charles J. McLucas, Jr., CPA is the founder and President of Charitable Trust Administrators, Inc. (CTAI), a firm that provides third-party administrative services for donors who desire to be their own trustees and to provide full back office support for nonprofit organizations that do not have fully staffed planned giving departments. Mr. McLucas graduated from California State University, Fullerton in 1967. After employment with the Internal Revenue Service as a Revenue Agent, he entered the Public Accounting field.

He is a member of AICPA, from which he received one of the earliest designations as a Personal Financial Specialist, California Society of CPAs, and International Association for Financial Planners. He is a member of the Association of Professional Fundraisers and the Estate Planning Council of Orange County, as well as the Planned Giving Roundtables of Orange County, the Inland Empire, San Diego and Sacramento. He is on the Professional Advisory Committee for the Community Foundation of the Jewish Federation of Orange County and is on the faculty of the Certified Specialist in Planned Giving professional designation program as administered by the American Institute of Philanthropic Studies.

Mr. McLucas can be reached at 949-888-4609 or Website:

With a tax law as labyrinthine as ours, and with planned giving instruments structured to satisfy all the complexities set out by the IRS, it should come as no surprise that mistakes are frequently made in administrating charitable trusts. I've encountered a multitude of them in taking over assignments from other administration firms. Encouraged by other tax and financial professionals, I've compiled a list of many common errors I've come across in working within the planned giving community. I've listed the following pitfalls by order of their importance in the process of administrating charitable trusts--not necessarily by frequency. While many of these issues involve all types of trusts, the trust most frequently used in our firm's practice is the Charitable Remainder Unitrust. Accordingly, many of my comments will be directed towards this instrument.

  1. Inappropriate asset allocation for the trust investments

    This is a prime example of the "first, do no harm" injunction. If the assets held within a trust are not allocated and invested judiciously, the results can be highly injurious to either the donor, or the beneficiary--or both. A trustee of a charitable trust has common law standards that must be exercised in his or her role as trustee. These standards include the duty to invest and to make trust property productive, the duty to secure and safeguard the trust estate, and the duty to exercise care, skill, and prudence in administering the trust. Another duty is that of loyalty to the beneficiaries; this is probably the most difficult for the trustee to fulfill as charitable trusts have what is termed "split-interest" trust duties. The trustee has to manage the assets to gain current income for the income beneficiary (who is usually the donor), and has a duty to preserve the trust principal for the remainder beneficiary (typically, the charity). This is an enormous responsibility--especially when most of the time it is either the charity or the donor who serves in the role of trustee.

    One help for trustees in managing assets in recent years has been the passage, by most states, of the "Uniform Prudent Investor Act." The Act gives trustees the authority to delegate investment management duties to qualified professionals. These duties encompass diversifying trust investments and managing the investments for "total return." The trustee must diversify the portfolio unless, because of special circumstances, the purposes of the trust are better served without diversifying. These special circumstances must be documented.

    The most common errors I find with asset allocation for the trust investments are when the charities, as trustees, manage the assets along with their endowment funds without regard to the donor's tax bracket, current income needs, or risk profile. Another common mistake is to manage the portfolio solely for current return without regard for the growth--or at least maintenance--of the trust corpus. In many circumstances, I have found little regard for the donor's (or charity's) tolerance for risk. After the market volatility of 2000 and 2001 many investors learned that their tolerance for risk is not nearly as high as they had thought.

    With all of the competing duties and fiduciary standards, what should a trustee do (whether the trustee is the donor or the charity) to fulfill their responsibilities? I believe the first step is to put in writing the specific goals, objectives, and tolerance for risk for both the income and remainder beneficiaries. Once this is accomplished, an appropriate asset allocation can be determined for the portfolio by the use of the computer modeling tools of both mean-variance analysis and Monte--Carlo simulation. Most investment management organizations have these tools at their disposal; there are also Internet locations that can assist in this process.

    Unfortunately, it is not uncommon for the trustee to overlook one or more of his or her duties under common law and/or the Uniform Prudent Investor Act. This will probably be the most litigated area over the next 20 years, as either the family of a donor or the charitable organizations themselves will feel they have been short-changed on funds they should have received.

    In summary, it is critical to the long-term success of a charitable trust that the trustee address fiduciary standards, capital market considerations, tax considerations of the donor, portfolio management tools, cost considerations, time and volatility considerations, and cost and rebalancing issues. Trustees should give serious consideration to the use of professional asset management by a firm familiar with the unique needs of charitable trusts.

  2. Inappropriate payout percentage in the trust for a donor's objectives

    A percentage payout or type of trust that's inconsistent with the donor's objectives is the second most frequent mistake that I find in the establishment of planned gifts. It is not appropriate in today's investment environment to set a high payout percentage (over 8%) for young donors (in their early 60's or younger). This error can be mitigated by educating planned giving officers on realistic expectations for investment returns in the current environment. As we return to more historical rates of return, planned giving officers should be actively involved in managing expectations of the donors they're assisting in establishing charitable trusts. When the trust provides for current distribution of income, historical rates of return are in the 5 to 6% range because a significant allocation of the assets must generate income. Most planned giving officers are not aware of this fact and therefore build unrealistic expectations in a donor's mind, along with an impossible task for the investment manager of the trust.

    The best approach, in my opinion, is to communicate to the respective parties that "less is more" in setting the payout percentage. Most donors with long-term time horizons are looking for larger payouts annually for their Unitrust. The only way to accomplish this objective is to have a distribution percentage that's lower than the total average return of the trust. Accordingly, several illustrations at possibly 5, 6, or 7% payout should be presented to prospective donors to review how the payout percentage they select might impact their future income distributions.

    To conclude: A 9 to 10% payout range for a younger donor who is expecting some growth in income over the years is not appropriate. An exception to this suggestion might be a NIMCRUT with a make-up provision, where the donor is only paid a nominal current income and is planning on higher distributions in later years. It's difficult to generalize concerning all the possibilities that might be appropriate in a given situation, but serious attention must be given to the distribution percentage, as this cannot be changed once it's established.

  3. No written investment policy for the trust

    Many of the trusts for which we have taken over administrative responsibilities have not had a written investment policy in place. Without a target to aim for, how can a trustee know if he is on track? I believe that often investment policies are not written because no one wants to take responsibility for performance results.

    Why are investment policy statements important? First and foremost, they are necessary for a fiduciary to fulfill his or her responsibilities. Fiduciaries are legally held to a "prudent investor" standard. In order to do this, well-reasoned investment policies--that provide for formal asset allocation guidelines and benchmarks against which to compare results--are absolutely necessary.

    Secondly, written guidelines provide the investment discipline to protect the trust from market-driven departures from a sound long-term policy. This process is sometimes termed PMU (propensity to mess-up) by behavior finance theorists. It's sometimes difficult for a trustee to resist the outside pressure (from himself or others) to jump on the "hottest" investment vehicle. In the technology sector, we have seen recently what happens in a segment of the market when sound asset allocations are thrown to the wind for the "hot" product.

    Thirdly, an investment policy serves as the guideline for all of the "players" in the fiduciary process. Both the income and remainder beneficiaries will understand what the goals and objectives are when it's in writing. Also, as potential new trustees are appointed, a well-defined investment policy will serve as the guideline for them to follow.

    The old adage is, "If you don't know where you're going, any route will get you there." Not only will a well-defined and written policy "get you there," but it will make each stage of the trip less open to hazard and the way will be smoother.

  4. Distributions that are not in accordance with the terms of the trust

    This mistake seems to be made more by individual trustees and organizations than by corporate trustees, but I have also seen it made by larger institutions. Many donors, who have not been educated on their fiduciary responsibilities, seem to take a cavalier attitude towards required distributions of income.

    Why is this a big concern? Not making the distributions as explicitly set forth in the trust agreement may trigger the IRS to disqualify the trust since it hasn't been administered under the terms of the trust. Another concern is that the valuation of the trust at the year-end may not be accurate if the appropriate distributions have not been made.

  5. Inaccurate calculation of the unitrust or annuity amount

    In the review of many trusts, I have found inaccurate calculations of the amount to be distributed to the income beneficiary. The most common error is in not deducting year-end distributions, which many times are not made until sometime in January or February of the next year, from the unitrust amount. This results in an overpayment to the income beneficiary in the subsequent year.

    Another common mistake is made in the calculation of the distributions for the first year of the establishment of the trust. This calculation should be made using the valuation of the property, times the ratio of the number of days until the end of the year divided by 365.

    Calculation mistakes should be corrected as soon as possible after discovery. Failure to pay the correct amount may subject the trust to penalties under Chapter 42 of the Internal Revenue Code. Regardless of whether an additional amount or a shortage is paid, the "incorrect amount" will not meet the definition of a unitrust or annuity trust amount.

  6. Errors in the preparation of Form 5227 and related state returns

    In reviewing over 100 previously prepared IRS Form 5227s, I have found only three that were prepared completely accurately. While many of the mistakes were minor and had no material effect on the return, others were significant. One of the most common--which has a significant impact--was the use of incorrect fair market value in computing the "Unitrust amount" on line 49b of page two. The fair market value in column C on page 2 is the prior-year fair market value--not the current year's value. Many of the professional software programs available to prepare the forms may indicate on the data input sheets that it is the current year. In the case of a net-income-with-make-up trust, this incorrect calculation will also result in an incorrect carryover amount.

    Another very common error occurs when the current year-end market value in box C on page 1 of the Form 5227 is not reported. While this blunder will not result in a notice from the IRS Service Center, it will not provide a check figure for the next year's calculation as described above and could result in penalties for not submitting a complete and accurate return.

    The third most common mistake regarding the use of this form is not reconciling the "Accumulation Schedule" amounts reflected in Part II of Form 5227 with the amounts in the "Net Assets" section of the Balance Sheet in Part IV of the return. The totals in the various tiers of income should be equal on both parts of the return.

    It is also important to make sure the current-year distributions are made from the appropriate "tier" of income and that the Part III schedule of current distributions reconciles with the K-1 form issued to the income beneficiary.

    Another error that occurs with regularity is failure to report distribution deficiencies on pages 2 and 3 of Form 5227. It is important to reflect these amounts both to prepare an accurate return and to provide the amounts to all parties so that subsequent income distributions may be accurately calculated. The distribution deficiency calculations, of course, need only be provided for net-income-with-make-up trusts.

  7. The use of margin accounts when brokerage accounts are established

    While most corporate trustees are aware that any debt-financed property creates "unrelated business income" (UBTI), most individual trustees and brokerage firms are not aware of this issue. If there is even $1 of unrelated business taxable income from property that is "debt-financed," then all of the trust income is taxable for the year. If this occurred in the first year the trust was established, and the property contributed to the trust was sold, the entire gain would be taxable (which would obviously defeat the income tax purpose for which the trust was established).1

    Many individuals and brokers who prepare the initial paperwork for opening investment accounts are accustomed to adding margin features to accounts and therefore might automatically--and inappropriately--check the box on the application to add the margin feature to the trust account. If a margin account has been established, a liability situation may be triggered if a series of events occur. For example, when a quarterly distribution is made, a wire or check may be sent out before a security is sold to cover the cash need. If the check clears prior to the settlement of the security sale, the check could be covered by the margin account. While this is not the intent of the trustee, the mechanical application of the margin feature triggers this liability for the trust. If a dividend happens to be paid at the same time, then UBTI may be created and the trust income is taxable for the entire year. This is not an intended or good result, and could prompt a lawsuit by a remainderman, who may have lost a significant amount of assets.

  8. Gift Annuity funds not adequately reserved and/or invested

    This error applies only to non-profit organizations that are operating a "gift-annuity" program. For example, California requires any organization that administers a gift annuity program to provide adequate reserves for any annuities sold in California or to California residents. The Department of Insurance for California also requires that 90% of the reserves be invested in a limited number of fixed income securities.

    Other states may or may not have reserve requirements or investment restrictions. The important issue here is to make sure you're aware of the guidelines and restrictions in any states where gift annuities may be sold. As these types of agreements are becoming popular due to the volatility of many investment vehicles, it is important for both the charity and the donor to be aware of the rules so their program is not shut down by any government agency.

  9. The type of Charitable Trust is not appropriate for the donor's objectives

    I run into this issue more and more frequently as I have occasion to visit with the donors of many trust agreements. There are five basic types of Charitable Remainder Trusts. Four are "Unitrusts" and one is an "Annuity" trust. Space does not permit a thorough review of each type in detail, but I offer the following brief summary:

    Annuity Trust--Provides for a fixed % payout based upon the initial value of the property donated.

    Unitrust Type 1 (also known as a standard payment Unitrust)--A fixed percentage is paid out each year based upon the fair market value of the trust each year.

    Unitrust Type 2--This type is similar to Type 1, only the distributions are limited to the smaller of the trust % or the trust income earned for the year.

    Unitrust Type 3--This type of trust is the same as Type 2 except it contains a provision to make up any deficiencies from prior years if excess income over the % payout is earned in the current year.

    Unitrust Type 4--This is the "new kid on the block" and starts out as a Type 2 or 3 and "flips" to a Type 1 upon a triggering event such as the sale of an illiquid asset, age of the donor, birth of a child or some other event outside of the control of the donor.

    Each of the above styles of trust may or may not be appropriate based upon the purpose of the trust as structured by a donor's needs or objectives. This is one of many features of the trust document that cannot be amended or modified. It is important that each type as well as the percentage payout be reviewed carefully with a potential donor to make sure it will be a satisfactory arrangement for both the donor and the charity involved in a transaction.

    There are three common errors in choosing the type of trust that are worthy of mention. The first involves a donor who is conservative and has the objective of leaving a substantial contribution to their favorite charity--and who does not need a lot of income. To my mind, the Type 2 or 3 trust may be the most appropriate. The trustee can, with a focused investment policy, generate sufficient income on an annual basis to meet the need of the donor and provide the growth needed to leave a substantial gift to the charity. This growth would also provide a larger asset base to provide increasing income distributions in future years, if needed.

    The second common error I find in trust design is to set up a Type 2 trust for someone who may be older and more conservative in their investment risk tolerance and have a need for regular income. In this situation it might be best to set up the Type 4 "Flip" Unitrust to ensure the best of both worlds if this donor reaches the stage in his or her life where a more regular income is required.

    The third common error I encounter is when a Type 1 Unitrust is set up with a larger payout percentage than the trust can bear for a younger, healthy beneficiary. The new IRS tables will not allow a trust to be qualified without a calculation to provide an estimate of at least 10% remainder interest going to the designated charity. However, very few, if any, donors are going to be happy if their annual distributions start to decrease significantly and they can see the possibility of "running out of money."

    It is critical that the type of trust as well as the payout percentage match the donor's objectives, risk tolerances and future realistic expectations of capital market performance. I am not suggesting that this is an easy task, but I would caution the parties involved in the transaction to err on the side of caution and conservatism in establishing these potentially great tools for philanthropy. Donors rarely have any regrets when they receive more than they expected. Great harm for philanthropy, and many lawsuits, can result when either the donor or the charity receives far less than was anticipated.

  10. Failure to track income and expenses under the four-tier accounting system

    Regulation section 1.664-1(d) outlines the ordering system of accounting for income and expenses of a charitable trust. Sometimes known as the "worst-in, first-out" system of accounting, distributions to the income beneficiary must be accounted for in the following order:

    1. Ordinary income (current year as well as any past year carryover)
    2. Capital gains (short-term first then long-term)
    3. Other income (normally tax-exempt income)
    4. Corpus (after all other types of income have been used)

    Many of the charitable trust documents written in recent years have used the provisions of IRC section 643(b), which permit the drafter of a CRT to define income and principal in the trust document, and to provide for the distribution of long-term capital gain as "income." While the IRS currently allows this, hearings were held in Washington DC in June 2001 to discuss the proposed regulations under this section to possibly limit some of the flexibility.

    Because the capital-gain rates are lower than the ordinary income rates, it is beneficial to the income beneficiary to be able to distribute long-term capital gains. Accordingly, if the trust document permits, the trustee has the discretion to allocate expenses to reduce the net ordinary income and thereby have more capital gain-type income to distribute. Without the flexible provisions in the document, state probate law determines the allocation of expenses. This allocation is normally an equal allocation between income and corpus.

    A common error that I find is that the trustee has invested in tax-exempt securities with the belief that the tax-exempt income in the current year can be distributed for the year. The tax-exempt income cannot be distributed to an income beneficiary until all of the current and prior years' ordinary and capital-gain income has been distributed.

    An opportunity that is often overlooked is the trustee's power to allocate fees and expenses to ordinary income instead of to corpus or long-term capital gain. If the trustee has the flexibility to allocate expenses, there is a fiduciary responsibility to do so in a tax-efficient manner when possible. The same attention should be given in allocating expenses to short-term gains versus long-term when possible--and the tax rates are significantly lower for long-term gains.

    These accounting decisions are important; differing responses depend on the type of trust that is being administered. If solely ordinary income can be distributed per the trust agreement, then the focus of the trustee should be to maximize current income, also taking into account the responsibilities to the remainder beneficiaries. This balance between the interests of the donor and the charity is applied most practically in the allocation of income and expenses on an annual basis. Accounting policies should be set out in writing to provide for equitable and consistent bookkeeping procedures. Many of the "self-trusted" trusts pay little attention to the bookkeeping function.

To sum up, I've attempted to highlight some common errors that I often run across in the operation of CRTs--along with suggestions concerning how these may be corrected or avoided. When administered efficiently and accurately, charitable trusts provide both donors and charities with enormous benefits. I hope you'll find these approaches of great use in avoiding "The Top Ten Common Errors."

  1. It is important to distinguish between unrelated business income and unrelated business taxable income. Only the presence of the latter causes the trust to lose its exemption for the year. UBTI is defined in IRC section 512(a)(2) as "the gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it, less the deductions directly connected with the carrying out of such trade or business, both computed with certain modifications." Among the modifications permitted is a specific deduction of $1,000.back

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Preventing Investment Mistakes: Ten Risk Minimizers

Preventing Investment Mistakes: Ten Risk Minimizers Most investment mistakes are caused by basic misunderstandings of the securities markets and by invalid performance expectations. The markets move in totally unpredictable cyclical patterns of varying duration and amplitude. Evaluating the performance of the two major classes of investment securities needs to be done separately because they are owned for differing purposes. Stock market equity investments are expected to produce realized capital gains; income-producing investments are expected to generate cash flow. Losing money on an investment may not be the result of an investment mistake, and not all mistakes result in monetary losses. But errors occur most frequently when judgment is unduly influenced by emotions such as fear and greed, hindsightful observations, and short-term market value comparisons with unrelated numbers. Your own misconceptions about how securities react to varying economic, political, and hysterical circumstances are your most vicious enemy. Master these ten risk-minimizers to improve your long-term investment performance: 1. Develop an investment plan. Identify realistic goals that include considerations of time, risk-tolerance, and future income requirements--- think about where you are going before you start moving in the wrong direction. A well thought out plan will not need frequent adjustments. A well-managed plan will not be susceptible to the addition of trendy speculations. 2. Learn to distinguish between asset allocation and diversification decisions. Asset allocation divides the portfolio between equity and income securities. Diversification is a strategy that limits the size of individual portfolio holdings in at least three different ways. Neither activity is a hedge, or a market timing devices. Neither can be done precisely with mutual funds, and both are handled most efficiently by using a cost basis approach like the Working Capital Model. 3. Be patient with your plan. Although investing is always referred to as long- term, it is rarely dealt with as such by investors, the media, or financial advisors. Never change direction frequently, and always make gradual rather than drastic adjustments. Short-term market value movements must not be compared with un-portfolio related indices and averages. There is no index that compares with your portfolio, and calendar sub-divisions have no relationship whatever to market, interest rate, or economic cycles. 4. Never fall in love with a security, particularly when the company was once your employer. It's alarming how often accounting and other professionals refuse to fix the resultant single-issue portfolios. Aside from the love issue, this becomes an unwilling-to-pay-the-taxes problem that often brings the unrealized gain to the Schedule D as a realized loss. No profit, in either class of securities, should ever go unrealized. A target profit must be established as part of your plan. 5. Prevent "analysis paralysis" from short-circuiting your decision-making powers. An overdose of information will cause confusion, hindsight, and an inability to distinguish between research and sales materials--- quite often the same document. A somewhat narrow focus on information that supports a logical and well-documented investment strategy will be more productive in the long run. Avoid future predictors. 6. Burn, delete, toss out the window any short cuts or gimmicks that are supposed to provide instant stock picking success with minimum effort. Don't allow your portfolio to become a hodgepodge of mutual funds, index ETFs, partnerships, pennies, hedges, shorts, strips, metals, grains, options, currencies, etc. Consumers' obsession with products underlines how Wall Street has made it impossible for financial professionals to survive without them. Remember: consumers buy products; investors select securities. 7. Attend a workshop on interest rate expectation (IRE) sensitive securities and learn how to deal appropriately with changes in their market value--- in either direction. The income portion of your portfolio must be looked at separately from the growth portion. Bottom line market value changes must be expected and understood, not reacted to with either fear or greed. Fixed income does not mean fixed price. Few investors ever realize (in either sense) the full power of this portion of their portfolio. 8. Ignore Mother Nature's evil twin daughters, speculation and pessimism. They'll con you into buying at market peaks and panicking when prices fall, ignoring the cyclical opportunities provided by Momma. Never buy at all time high prices or overload the portfolio with current story stocks. Buy good companies, little by little, at lower prices and avoid the typical investor's buy high, sell low frustration. 9. Step away from calendar year, market value thinking. Most investment errors involve unrealistic time horizon, and/or "apples to oranges" performance comparisons. The get rich slowly path is a more reliable investment road that Wall Street has allowed to become overgrown, if not abandoned. Portfolio growth is rarely a straight-up arrow and short-term comparisons with unrelated indices, averages or strategies simply produce detours that speed progress away from original portfolio goals. 10. Avoid the cheap, the easy, the confusing, the most popular, the future knowing, and the one-size-fits-all. There are no freebies or sure things on Wall Street, and the further you stray from conventional stocks and bonds, the more risk you are adding to your portfolio. When cheap is an investor's primary concern, what he gets will generally be worth the price. Compounding the problems that investors face managing their investment portfolios is the sensationalism that the media brings to the process. Step away from calendar year, market value thinking. Investing is a personal project where individual/family goals and objectives must dictate portfolio structure, management strategy, and performance evaluation techniques. Do most individual investors have difficulty in an environment that encourages instant gratification, supports all forms of speculation, and gets off on shortsighted reports, reactions, and achievements? Yup. Steve Selengut Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

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