In early December 1998, the Internal Revenue Service released long-awaited final regulations that ushered in new planning opportunities utilizing the charitable remainder unitrust. In these regulations, the IRS approved the use of what had come to be known among charitable gift planners as the “FLIP unitrust.”
Under the terms of a FLIP trust, a charitable remainder unitrust may be established as a net income trust that pays a specified percentage of the trust assets as valued annually, or the net income of the trust, whichever is less. Upon the occurrence of a specified event or at a particular time, the trust “flips” and becomes a straight unitrust that from that point forward pays the specified percentage of the asset value, regardless of the earnings of the trust.
FLIP trusts had traditionally been employed when trusts were funded with real estate or other assets that were not readily marketable, in order to give the trustee sufficient time to sell the assets before being called upon to generate income.
The 1998 regulations broadened the conditions under which a net income trust may flip and become a straight unitrust to include other “trigger” events in addition to the sale of property, including births, marriage, the expiration of a time period, among other occurrences outside the donor’s direct control. As in the case of other charitable remainder trusts, a FLIP trust may be created to exist for one or more lifetimes or for a specific period of time, not to exceed 20 years.
Among a variety of other uses, the FLIP trust for a term of years opens up interesting educational expense planning opportunities.
For example, assume that Mr. and Mrs. Martin, both age 38, have a two-year-old daughter and are interested in setting aside funds for higher education. They are also interested in participating in the endowment component of a campaign being conducted by one of their charitable interests.
The Martins own stock worth $100,000 in a high-tech company. The stock has a cost basis of $25,000 and pays no dividends. They believe the stock may have peaked in value, but are reluctant to sell it and generate $15,000 in capital gains taxes.
They might consider using the stock to establish a 10% net income FLIP unitrust for the benefit of their daughter for a term of 20 years. The trust is structured so that it will become a straight payout trust at the end of 16 years. It is anticipated that the trust will be invested for growth and thus generate little income for the first 16 years. In year 17, the trust begins paying 10% of the value of the trust to the daughter for the remainder of its 20-year term.
During the final four years of the trust, the daughter will be aged 18 to 22 and presumably pursuing higher education. If the trust grows at an annual rate of 8% during the first 16 years, it can be expected to contain assets worth approximately $342,000 at the end of that period of time. (See chart at left.)
Under the terms of the trust, in the seventeenth year the trust becomes a straight unitrust and pays 10% of the value of the trust to the daughter. Under these assumptions, the daughter and the charitable remainder can be expected to receive the following amounts:
At the end of the 20-year term, the trust will terminate and distribute the balance of the trust, over $320,000 given the above assumptions, to the charitable beneficiary named at the outset. The donors could retain the right to change the ultimate beneficiary if they so desired.
Note that in addition to avoidance of $15,000 in capital gains taxes in the year they fund the trust, the Martins will be entitled to a charitable income tax deduction of some $13,400, well within the 10% minimum deduction requirements to qualify for favorable tax treatment. The remaining $86,600 will be considered a gift to their daughter for gift tax purposes. This amount could be offset against the $1,350,000 the Martins can between them give to their daughter tax free during their lifetime or at their deaths. The amount of the unified credit used in conjunction with the gift to their daughter will, in effect, be replaced by scheduled increases in the unified credit equivalent amount in coming years.
Through carefully planning their gift utilizing IRS-approved planning techniques, the Martins have used an asset worth $100,000 to make a gift commitment that could after tax-free buildup within the trust be worth over $320,000 when received by their charitable interest, while enjoying beneficial tax savings and assuring a generous flow of income for educational purposes at a time when it could be a very valuable supplement to their daughter’s income.
Note also that this gift, by virtue of its termination at the conclusion of a term of years, is not dependent on the age of the donor but rather the donors’ wealth and life circumstances. A trust for a term of 20 years created by a 38-year-old couple will be expected to be received in the same time frame as a similar trust for the lifetime of a 68-year-old couple. Planning strategies such as the one described above can be expected to be of immense value as a younger generation replaces its parents and grandparents as the primary source of major funding for charitable organizations and institutions in America.