The ‘Flip’ Side of Giving

New rules issued by the IRS on charitable remainder trusts are likely to bring more money to charities and donors alike

Some charities are urging donors to move quickly to take advantage of new Internal Revenue Service rules that are likely to make certain types of planned gifts more lucrative for both contributors and non-profit organizations. The rules, issued last month, clarify how the tax agency will treat “flip” trusts, in which a donor converts one type of charitable remainder trust into another.

Experts say the rules make flip trusts increasingly attractive. And, under the new rules, many donors who could not do so before are now able to convert existing trusts to flip trusts to gain certain financial advantages. Donors must act before June 8 to make the switch.

Through a charitable remainder trust, a donor gives cash, stock, real estate, or other assets to a charity, which then invests the gift. In exchange, the charity provides regular payments to the donor, a beneficiary, or both. When the donor and any beneficiaries die, all the assets in the trust go to the charity.

Flip trusts are attractive to donors who want to use real estate or other non-liquid assets to set up a charitable trust because they allow the donor to bypass payout requirements normally associated with the trust until the donated property can be liquidated. Meanwhile, the donor can take a tax deduction right away, as well as avoid the capital-gains tax that would be incurred by selling the asset.

A flip trust initially bases payments to donors on the amount of income generated by the trust; therefore, if there is no income until a non-liquid asset like land or closely held stock can be sold, no payment to the donor is required. Once the assets have been sold, the trust is “flipped” to provide a different type of payout. Donors can then receive payments based on a fixed percentage of what the trust’s assets are worth each year — not on the income generated by those assets.

Many donors prefer the percentage payments, partly because they are thought to be a better hedge against inflation and stock-market volatility.

The new rules have been greeted enthusiastically by charities and financial experts, largely because they allow donors who had avoided flip trusts to amend their trusts to take advantage of percentage-based payouts and other financial benefits associated with flip trusts. Many donors with non-liquid assets shied away from such trusts because, until last year, the I.R.S. had indicated that flip trusts violated the tax code.

Even though some charities offered them anyway, many donors with non-liquid assets believed that their only option in creating a charitable remainder trust was income-based payments, and they set their trusts up accordingly.

Such donors, however, have often been unhappy with the amount they receive through the income-based payouts. Once their non-liquid asset was sold, the terms of the trust required that the money be invested in bonds or other investments that generate income. The income-based payout requirement ruled out more diversified investments, including many stocks, which in recent years have yielded a much higher return than bonds. Charities have also missed out, experts say, because trust assets invested in a more diversified portfolio would build up the principal inside the trust, ultimately yielding a greater amount for charity.

According to the I.R.S., there are now more than 76,000 charitable remainder trusts, though no one knows for sure how many of them provide income-based versus percentage-based payouts — or how much the trusts will ultimately yield for charity. But experts say that converting existing income-based trusts into percentage-based trusts now will substantially increase the funds ultimately left to charity.

Under the new regulations, donors who act by the June deadline can add a flip provision to receive a fixed-percentage payout at a date of their choosing.

“These new rules give charities the chance to go back and talk to donors, and they can salve the wounds of people who are not happy with income-based payouts,” says Eric Swerdlin, president of Swerdlin White Huber, a Cedar Knolls, N.J., firm that manages the planned-giving assets of several charities.

And, he says, “it gives charities the chance to invest these trust assets for better growth. But this is a window that will soon close. It’s a huge opportunity.”

One organization that does not want to lose that opportunity is the Lutheran Church Missouri Synod Foundation, a St. Louis charity that oversees the planned-giving programs of several Lutheran colleges and other charities. The foundation, which manages more than 600 trusts worth some $80-million that generate income-based payouts to donors, is planning to notify donors this month that the trusts may now be amended. The charity is also considering creating a video to explain favorable aspects of the new flip trust regulations to donors and potential contributors.

The Jewish Community Federation, in Baltimore, which has only two donors with income-based trusts, is taking a slightly different approach: In addition to alerting those donors about the new regulations, it has sent out an e-mail message about the new rules to nearly 100 financial advisers who work regularly with federation donors. The federation also plans a follow-up mailing to those advisers, as well as a separate mailing to an additional 150 financial experts in the region. Federation officials will offer to make presentations to them about how flip trusts work under the new rules.

“We see tremendous utility for the donor in using these new flip trusts,” says Michael Friedman, the federation’s director of endowment and planned-giving services. “In many cases, the income beneficiary can get more income and the charity will get more money at the end of the trust.”

That is not the only reason that the new rules are being greeted warmly by both charities and planned-giving experts. In addition to allowing for amendments to existing trusts, the new rules grant more flexibility, particularly with regard to flip trusts, than many experts had expected. In April 1997, the I.R.S. had proposed regulations to govern charitable remainder trusts, but the final regulations contain more options than the earlier proposal. Among the key provisions of the new regulations:

* Donors now face no restriction on the percentage of assets in a flip trust that must be non-liquid or “unmarketable,” such as real estate or closely held stock — although at least some of the assets must be in that form. For instance, a donor can set up a flip trust with a mix of real estate, stock, and cash in which the real estate is worth only 30 per cent of the total value of the assets put into the charitable remainder trust. Under the 1997 proposal, at least 90 per cent of the assets put into the flip trust would have had to have been non-liquid.

* Donors can control when their trust will “flip” to the fixed- percentage payments, using a wide array of options spelled out in the new regulations. The payout change can occur when a donor or beneficiary reaches a certain age (which is determined when the trust is initiated) or by the passage of a predetermined number of years, the death of a spouse, or several other events. The proposed rules would have been far more restrictive, saying that the only time the payout change could be made was after 50 per cent of the assets in the trust had been sold.

* The annual payments to donors and beneficiaries in many cases can be made after expiration of the calendar year in which they are due. In the proposed rules, the service had said that the payments had to be made by the end of each calendar year. Many charities and financial advisers had objected to that requirement because they said that it was often difficult to figure out by that deadline how much was owed. Under the new rules, trust managers in most cases have until April 15 to make the payments.

* The requirements for determining the value of assets in a charitable remainder trust when the donor, beneficiary, or a non-charitable organization serves as the trustee have been relaxed. To avoid situations in which such trustees inflate the value of assets to obtain higher trust payments, the assent of a second trustee, who was qualified to provide an objective valuation, was previously required. But many charities complained that that was an overly complicated procedure. The regulations now allow donors, beneficiaries, and non-charitable organizations to be sole trustees, as long as they obtain accurate appraisals of trust assets by qualified professionals who meet certain requirements.

The I.R.S. regulations were published in the December 10 issue of the Federal Register, Pages 68,188-194. The new rules are also available on the Federal Register’s World-Wide Web site.