Understanding and using privatepooled income funds for retirement
In our roles as tax, legal and financial advisors, we have encountered many clients who can be fairly classified as ‘reluctant’ charitable donors. To clarify, we frequently remind them that, when it comes to their ‘gross’ income and their consequent income tax obligation, there are only three choices: (1) Pay yourself; (2) Pay the Government (i.e., taxes) or (3) Donate the money to charity. With their options presented in those ostensibly confining terms, most taxpayers quickly develop an appreciation for charity.
For the informed taxpayer, advanced charitable tax planning strategies provide a number of different pathways to “have your cake and eat it too!” Specifically, for many physicians with whom we’ve worked, the main goal is not the retention of investment principal per se, but rather the continued ability to retain and control 1. investment management, 2. “income” and 3. final disposition of their assets. This article focuses on how a Pooled Income Fund (PIF), a type of charitable trust, can help physicians accomplish all three of those objectives.
What is a PIF?
A PIF is a Trust that is established and maintained by a public charity. The PIF receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned “units of participation” in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.
Each year, the fund’s entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A PIF could, therefore, also be described as a ‘charitable remainder mutual fund.’
Contributions to PIFs qualify for charitable income, gift, and estate tax deduction purposes. The donor’s deduction is based on the ‘discounted present value’ of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property (such as individual stock or closely held business interests) to the fund.
After carefully examining the commingling requirements of funds or contributions from multiple donors, we can find nothing in the Internal Revenue Code (IRC) or treasury regulations that would preclude establishing a PIF with a single donor. Historically then, one can infer that the absence of the Private PIF (PPIF) is attributable more to administrative burdens than tax issues. Clearly, the administration of many PPIFs with assets beneath a certain threshold of assets under management could become somewhat unwieldy for the charity. Otherwise, why would a charity care if it receives a remainder interest in a gift worth one million dollars from a single donor instead of the same amount from one thousand donors?
Tax and Regulatory Mandates
The Trust document of the PIF must specify that property transferred to the Fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors. Charitable organizations are permitted to operate multiple PIFs, provided that each such Fund is maintained by the organization and is not a device to permit a group of donors to create a Fund which may be subject to their manipulation. Such manipulation is, however, highly unlikely because the regulations require the governing instrument of a PIF to (1) prohibit a donor or income beneficiary of a PIF from serving as a trustee of the Fund, and (2) include a prohibition against self-dealing.
Interestingly, there is nothing legally preventing a wealth management firm or Registered Investment Advisor (RIA) from establishing multiple commingled Funds or pools of assets within a public charity for clients of the RIA or alternatively, by a registered representative of a broker-dealer. Again, the issue is not a tax issue but rather a potential administrative burden for the fund administrator operating the Fund on behalf of a public charity. Analogously, however, the administrative pricing should not be dramatically different for the Fund administrator operating and administering separately managed accounts for individual clients of the RIA.
According to the relevant tax law, the Fund must not include property transferred under arrangements other than PIFs. However, a Fund is permitted to invest jointly with other properties that are held by, or for the use of, the charity maintaining the Fund. For example, community foundations and other public charities often receive contributions that are maintained for the benefit of other charitable organizations selected by the donor, i.e. Donor Advised Funds (DAFs). Importantly, a donor may designate the donor’s DAF administered by the public charity as the recipient of the remainder interest.
Each lifetime beneficiary of a PIF receives a pro rata share of the total rate of return earned by the fund for such taxable year. When a donor transfers property to a PIF, one or more units of participation are assigned to the beneficiary or beneficiaries of the retained income interest. The number of units of participation assigned is obtained by dividing the fair market value of the property by the fair market value of a unit in the fund at the time of the transfer. Like a Charitable Remainder Trust (CRT), the PIF may make distributions on a monthly, quarterly or annual basis to meet the income requirements of the taxpayer.
Tax Benefits of PIFs
There are several major tax benefits to employing the PIF as a planning tool. Perhaps most significant, the taxpayer does not recognize gain or loss on the transfer of property to the PIF. In practice, this feature makes the PIF ideal for use by affluent taxpayers who desire to dispose of highly-appreciated, low-yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. So, double tax leverage can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.
Additionally, from a tax-deductibility standpoint, the prolonged low interest rate environment makes this an ideal time for the taxpayer to consider a PIF. To illustrate, if a PIF has existed for less than three taxable years, the charity is able to determine the interest rate used in calculating the charitable deduction by using the following two-step formula: 1. First, calculate the average annual Applicable Federal Midterm Rate (as described in IRC Sec 7520) for each of the three taxable years preceding the year of the transfer; 2. Second, reduce that rate by one percent (1%) to produce the applicable rate used for deduction purposes. In recent terms, the rate for the 2014 tax year was 1.4 percent (2.4% minus 1%).
For comparison purposes, this interest rate provides a significantly larger deduction than an identical contribution to a CRT. The following chart compares the percentage of tax deduction based upon any size charitable contribution. The CRT assumes a minimum CRT payout of five percent (5%) for the taxpayer’s lifetime (which would provide the maximum tax deduction possible).
Taxability of Income from PIF to Beneficiary
Although PIFs are ‘taxable’ trusts, they seldom pay any income tax for two reasons. First, PIFs receive an unlimited deduction for all amounts of income distributed to fund participants. And, because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed. Second, PIFs are permitted a special deduction for long-term capital gains that are set aside permanently for charity.
The Trust document for most PIFs typically defines ‘income’ as that term is defined in IRC Sec 643(b). Under this section, the term income, when not preceded by the words ‘taxable,’ ‘distributable,’ ‘undistributed net,’ or ‘gross,’ means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law. The Uniform Income and Principal Act adopted by most states defines ‘income’ to include interest, dividends, rents, and royalties. Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, PIFs can expand the definition of ‘income’ to include capital gains. On their personal tax returns, PIF beneficiaries must include in their gross income all amounts properly paid, credited, or required to be distributed income during the taxable year or years of the Fund.
Because PIFs distribute all income earned during the taxable year, the tax character (i.e., capital gain or ordinary income) of amounts distributed to each income beneficiary is directly proportional to the tax character of investment income earned within the PIF. Finally, the taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.
Historically, taxpayers and their advisors have been hard-pressed to find charitable solutions that provide maximum tax deductions; retention of lifetime income and capital gains avoidance upon the sale of an asset. Although esoteric, we have found the PPIF to be a far superior option to better-known and ‘time-tested’ structures such as CRTs when it comes to accomplishing the above-referenced objectives. Predictably, we have begun to educate other financial and tax planners on how the PPIF can transform even their most ‘reluctant’ physician clients into committed charitable donors.
About the Authors:
Christopher Hynes, JD, CFP® Attorney and Certified Financial PlannerTM
Advisor to the Advisors Worcester, Massachusetts
As one of approximately 1,800 attorneys who are also Certified Financial PlannersTM, Chris Hynes’ education, training and experience furnish him with a unique perspective on complex financial structures, issues and products. Since his admission to the Massachusetts Bar almost 20 years ago, Chris has provided estate planning, insurance planning, financial and tax counsel to hundreds of individuals, businesses and non-profit entities. While serving as Senior Partner and Director of Advanced Planning for an independent, 10-advisor Massachusetts-based wealth management team, Chris quickly earned a reputation among his peers as a financial innovator in the insurance and fixed product arena.
Gerald R. Nowotny, JD, LLM Attorney Osborne & Osborne, P.A.
Mr. Nowotny was raised in the Panama Canal Zone where his family lived for twenty five years. He attended Culver Military Academy in Culver, Indiana and graduated in 1978. He attended the United States Military Academy at West Point, New York and graduated in 1982. He served on active duty for five years as a Transportation Corps officer and left active duty as a captain in 1987. At West Point, he had a double concentration in foreign languages B Spanish and Portuguese and achieved the highest level of non-native proficiency in both languages. Mr. Nowotny attended the University of Miami Law School where he completed the JD and LL.M programs while working full time in the financial services industry. He has completed the Certified Financial PlannerTM (CFP®), Chartered Life Underwriter (CLU®), and Chartered Financial Consultant® (ChFC®) professional designations.