Thinking About Flip'N Out?- Part II

By: Emanuel J. Kallina, II, Esquire, Jonathan D. Ackerman, Esquire and Renaissance, Inc.

Who Should Convert?

The answer is case-sensitive, complex, and more than a little subjective. Rules of thumb are inappropriate because of the uniqueness of each trust situation. The new opportunity to "trigger" a conversion upon the happening of most any event the settlor can describe, so long as its occurrence is "uncontrollable," adds both flexibility and complexity to conversion decisions.

The rule eliminating any NIMCRUT deficiency account balance to the extent it is not reduced via distributions made before the end of the year in which the conversion-triggering event occurs also complicates the analysis. Reaching the correct decision is further complicated if multiple income recipients of a given income exception CRUT disagree whether the trust should be invested primarily for "income" or solely for asset appreciation. Those in the latter camp who are champions of "income deferral" might strongly oppose a conversion. Also to be considered are the financial costs of conversion processing and the possibility in a contested case that the court having jurisdiction might not allow the conversion even after many of these costs have been incurred.

Here are some key factors to consider in light of these observations:

(1) Without the unanimous consent of all income recipients, it will be very difficult to get a court to approve the conversion reformation. In this regard, income recipients who doubt they will ever need distributions from their income exception CRUT and wish to have the realization of any distributable income suppressed, unless and until they need it in the future, can be expected to object to a conversion proposal. Any opposition by income recipients to a proposed conversion is likely to scuttle the effort before most courts. In these trust reformation proceedings, courts may feel compelled to maintain the status quo unless there are compelling reasons for making the requested changes and no beneficiaries will be harmed or object.

(2) Without the unanimous consent of all charitable remaindermen, it will be very difficult to get a court to go along with the conversion reformation. The trustee of a CRT has a responsibility to balance the interests of the income beneficiaries and the charitable remaindermen at all times. Thus, the charitable interests have a right to be heard in any trust reformation proceedings that could or will affect them.

This could be a sticking point with settlors that intended for their charitable beneficiary designations to remain private and flexible until the trust term expires. However, in many cases this concern should evaporate upon an analysis of the facts. If no charitable beneficiaries are designated specifically in the trust document, it will be possible to maintain privacy with respect to any specific charitable remainderman intended to be named later, even if the court requires someone (e.g. the state's Attorney General) to be notified of the proceeding and stand in for the class of all eligible charities. This result could also be achieved if the trust document permits all existing charitable remainder beneficiary designations to be revoked and replaced at any time.

Without question, donor privacy will be difficult to maintain in a conversion reformation proceeding with respect to any charitable remainderman whose interest is irrevocable, i.e. guaranteed to vest when the trust reaches its term. These charities will probably have to be notified and asked to consent to the proceeding. If the settlor does not object to losing privacy with respect to such charitable shares, notification usually need not be something to dread. Many charitable beneficiaries will laud the conversion if it means the trustee will be in a better position to invest for long-term growth and preserve the purchasing power of the corpus for them.

(3) A financial analysis should be undertaken in any situation where it is not obvious to the parties that the financial benefits of the reformation will outweigh the financial costs. An intelligent decision whether to convert will require a thoughtful analysis of the anticipated costs and benefits to all beneficiaries, including the charitable remaindermen. This analysis should attempt to project trust values into the future and quantify the trust's net income generating capacity over time, if the course is stayed or if the trust is converted immediately. Any differences should be noted and factored into the decision whether to seek a conversion. Such an analysis can also be of assistance to the court in its decision to approve or not approve the reformation. Exhibit 1 illustrates several case studies and examples for review.

The problem with making a forward-looking financial analysis objective is the highly subjective nature of the assumptions upon which the projections will be based. While the costs involved may be easily estimated, accurately projecting trust income flows and corpus balances into the future is a difficult and speculative matter. Assumptions about interest and asset growth rates, the mix of investments likely to be chosen both inside the trust and in any "side funds" into which CRUT distributions will be reinvested by income recipients, and the current and future needs, goals, and expectations of all the donors and beneficiaries are all highly subjective in nature and can not be forecasted in any reliable manner. As illustrated by Exhibit 1, every situation will be unique and will produce varying results that may be interpreted differently by the parties involved.

The interplay between investment return, payout rate, term of the trust, and the objectives of the donor are different in each case. Often the results of the financial analysis produce surprising results. For example, we compared three possibilities involving a trust with a value of $1,000,000. Only the payout rate was changed, with dramatic results.

Payout Rate	5%	8%	15%
Lifetime Income	+92%	+91%	+72%
Remainder	+125%	+10%	-80%

Even though it appears that the income beneficiary benefits from every scenario, the income beneficiary of the trust with a 15% payout actual receives a decreasing stream of income, thereby leading to a dramatic loss of purchasing power over the years. For more detailed examples of the financial impact of the reformation, please see Exhibit 1.

Furthermore, it is possible that the total costs of effecting a conversion may exceed the benefits if the trust corpus is too small. Just how small is too small for a trust to eschew a conversion because of the processing costs (court costs, attorney's fees, etc.) will be a subjective decision each trustee will have to make and will depend, in part, on the size of the corpus and the costs to convert.

The analysis should also take into consideration the financial consequences of losing a positive deficiency (make-up) account balance when a NIMCRUT converts to an S-CRUT. Such a loss could be upsetting to income recipients if there is a reasonable likelihood the make-up account balance could be distributed if the trust does not convert.

The income recipients of income exception CRUTs having fairly high payout rates (e.g. 10% or more) should also be keenly interested in a financial analysis of a potential conversion. If the fixed percentage unitrust amount is relatively high, the conversion could shrink the total sum of all future income distributions by cannibalizing principal, retarding the growth of corpus, and therefore leading to annual reductions in what will be paid out to the income and remainder recipients.

(4) Additional factors to consider in making a decision to convert an income exception CRUT into an S-CRUT include:

(a) income recipients who either need or will at some point have a need for guaranteed, full annual distributions of the unitrust amount;

(b) a trust corpus predominantly comprised of unmarketable assets (e.g. real estate, closely held common stock or tangible personal property) that will be sold;

(c) a fixed percentage payout rate that is either much higher or lower than the blended rate the trust is earning on all, reasonably prudent, ordinary-income producing investments;

(d) a NIMCRUT deficiency (make-up) account balance, the forfeiture of which would be unacceptable to the income recipients;

(e) a trust corpus with a value that is so low, the processing costs of the conversion would erode it unconscionably;

(f) charitable remainder beneficiaries who will not contest the conversion; and,

(g) the presence (or lack) of a trust document provision that permits realized post-contribution gains to be treated as distributable income.

Case Study Examples

In real life situations, each case will be unique. A careful analysis should be made before proceeding with a conversion reformation even if the client is anxious to convert for purely subjective reasons. Intuition may not be a very reliable guide in making a decision whether to convert. In many scenarios, a thoughtful analysis of the potential long-term financial implications may override the subjective considerations. However, the financial analysis may reinforce the subjective considerations in other cases.

The examples that follow do not take into consideration the costs of processing a conversion reformation (e.g., court costs and legal fees). These costs are apt to vary widely from case to case and jurisdiction to jurisdiction and should be factored into any final analysis once they can be estimated with reasonable accuracy by the appointed local counsel. The following fact pattern is very specific and may not be indicative of the issues in your specific circumstances:

The Case of Fred and Ethel Hardy

Fred and Ethel Hardy set up a NIMCRUT four years ago. At that time, Fred and Ethel were 59 and 57 years old, respectively. Fred was planning to work for another 5 years and did not need supplemental income from the trust until he retired. The need for income deferral led him to choose a NIMCRUT with a 5% payout rate. He did so with the understanding that he could invest trust funds so as to defer generating any distributable trust income until his retirement. He funded the trust with publicly traded securities then having a $1,000,000 fair market value and a $500,000 cost basis. Fred appointed himself the trustee and repositioned the initial portfolio into stocks with high growth potential and negligible dividends.

Shortly after establishing the trust, Fred was involved in a serious automobile accident that left him permanently unable to work. His disability benefits are significantly less than his employment earnings and he also has medical expenses that were not covered by insurance. Fred and Ethel now need as much income as they can get from their NIMCRUT.

Fred's disability is also seriously distressing the trust's investment manager; it forced him to reposition all of the appreciated growth stocks into corporate bonds generating only 6% ordinary income (the portfolio average). When the appreciated growth stocks were sold, the realized gains were not distributable because the NIMCRUT document (like most) did not authorize the distribution of net realized post-contribution gains. This means that any realized appreciation on the bond portfolio (approximately 1% annually) will not be distributable either. It should come as no surprise that Fred, Ethel and their investment manager are all unhappy with the NIMCRUT form of their trust. The intuitive solution is an S-CRUT conversion reformation, which would allow the investment manager to invest for total return rather than being limited to bonds in order to create distributable income. Intuition, however, may not always lead to the "best" solution. Whether they should convert will be explored in the following series of examples. Please note how the projected outcomes vary with modifications of the facts assumed.

Conversion Analysis Number One

Assumptions:

• NIMCRUT established four years ago
• Pays income to Fred and Ethel, or the survivor, for life (joint life expectancy = 24 years)
• Payout rate: 5%
• Unitrust amount distribution frequency: Quarterly
• Investment return: 6% ordinary income, 1% annual appreciation
• Renaissance administration fees charged: Quarterly
• The Hardy's federal income tax rate is 39.6% on ordinary income and 20% on realized net long term capital gains. (State Income taxes have been ignored in this example).

Scenario 1: The trust is not converted and remains a NIMCRUT

Scenario 2:

• The NIMCRUT converts to an S-CRUT on 1/1/2000
• The NIMCRUT make-up account is not distributed before conversion
• The S-CRUT earns annually: 1% ordinary income, 8% realized capital gain, and 1% unrealized capital gain

	Scenario 1	Scenario 2	Change
Lifetime Gross Income	1,727,870	2,693,654	+696,466
Lifetime Net Income	1,043,633	1,997,188	+953,555
Lifetime Income Tax	684,237	696,466	+12,229
Benefit to Charity	1,526,881	3,435,399	+1,908,518
Make-up account	0	0	0

Conclusions:

• This is a situation where all parties appear to benefit from taking advantage of the reformation opportunity, even if Fred was not disabled in an automobile accident. For instance, the Hardys may be unhappy with the investment mix or created the NIMCRUT to alleviate concerns regarding a contribution of an unmarketable asset to the trust.
• The Hardys receive more income and the remainderman receives a larger gift because the trust is able to invest for total return instead of being forced to limit the investment to bonds.
• Much of the income the Hardys receive after the reformation will be taxed at the lower capital gain tax rate rather than at the ordinary income rate that increases the net spendable cash to the Hardys.
• The Hardys will receive a predictable stream of income instead of a possibly variable return from bond investments.
• By reforming the trust, however, the Hardys will give up the flexibility that may have been the primary reason for initially choosing a NIMCRUT form.

Caveats:

Even though the Hardy's should receive more total income with a conversion if they live to life expectancy, they may receive less income in a particular year for two reasons:

• The trust will continue to operate as a NIMCRUT until December 31st of the year the conversion-triggering event occurs. If assets are repositioned for total investment return early in that year, there could be little or no distributable income produced in that year.
• This summary analysis assumes a level annual rate of return on trust investments. Actual returns will vary. In years when the investment return is less than the 5% payout, SCRUT principal will be reduced. This will cause the subsequent year's income distribution to be reduced as well.

Conversion Analysis Number Two

Fact Modifications:

The facts and assumptions are identical to those in Analysis Number One except the payout rate is 8%, rather than 5%.

Scenario 1: The trust is not converted and remains a NIMCRUT

Scenario 2:

• The NIMCRUT converts to an S-CRUT on 1/1/2000
• The NIMCRUT make-up account is not distributed before conversion
• The S-CRUT earns annually: 1% ordinary income, 8% realized capital gain, and 1% unrealized capital gain.

	Scenario 1	Scenario 2	Change
Lifetime Gross Income	1,769,967	2,697,506	+927,539
Lifetime Net Income	1,069,060	2,041,988	+972,928
Income Tax Paid	700,907	655,518	-45,389
Benefit to Charity	1,313,381	1,455,525	+142,144

Conclusions:

• The Hardys should have more total income if they reform the trust.
• The Hardys should pay less income tax in scenario 2, even though they have more income. This positive result occurs because some of the income will be taxed at the lower capital gain tax rate.
• In scenario 2, the projected charitable remainder is marginally enhanced at the projected termination of the trust.
• The Hardy's income distribution needs can be met investing for total return rather than just ordinary income in scenario 2. Thus, if the trust is converted, they will have upside potential if the investments perform well, but downside risk only if there are years when the investment return is less than the 8% payout rate.

Caveats: Same as Analysis Number One

Conversion Analysis Number Three

Fact Modifications:

The facts and assumptions are identical to those in Analysis Number Two except the payout rate is 15%, rather than 8%.

Scenario 1: The trust is not converted and remains a NIMCRUT

Scenario 2:

• The NIMCRUT converts to an S-CRUT on 1/1/2000
• The NIMCRUT make-up account is not distributed before conversion
• The S-CRUT earns annually: 1% ordinary income, 8% realized capital gain, and 1% unrealized capital gain

	Scenario 1	Scenario 2	Change
Lifetime Gross Income	1,769,967	2,351,732	+ 581,765
Lifetime Net Income	1,069,060	1,865,475	+ 796,415
Lifetime Income Tax	700,907	486,257	- 214,650
Benefit to Charity	1,313,381	254,898	- 1,058,483

Conclusions:

• The trustee of a CRT has a responsibility to balance the interests of the income beneficiaries and the charitable remaindermen.
• In scenario 2, it is clear that the interests of the income beneficiaries have been improved at the expense of the remainder beneficiaries.
• The federal government and many state governments are becoming more concerned about protecting the interests of the charities that CRUTs are supposed to benefit. It could be difficult to justify a conversion reformation based on these numbers if the remainderman or state's attorney general challenges the proceedings.

Caveats:

Even though the Hardy's should receive more total income with a conversion if they live to life expectancy, this result is deceptive for the following reasons:

• If annual investment returns ever fall below 10% (which is entirely possible), trust principal will be reduced even more than this example projects. Such reductions could create significant reductions in both future unitrust amount payments and the final value of the charitable remainder.
• The total income advantage the S-CRUT appears to have over the NIMCRUT is not as great as it seems. Under our hypothetical, net income distributable in the first year after conversion would be $119,426. However, the annual distribution would drop to only $35,094 in the projected final year of the trust. Why? The trust will have paid out more than it earned in many of the proceeding years, reducing the principal on the annual valuation dates. Considering the impact of even mild inflation on the purchasing power of a dollar over the term of the trust, this conversion is not likely to produce a desirable outcome.
• If the trust is not converted, it will distribute an ever-increasing stream of income to the Hardy's. The projected distributions would range from $34,628 in the current year up to $43,518 in the projected final year of the trust.

Conversion Analysis Number Four

Fact Modifications:

In this scenario, Fred was not in an automobile accident and continued to work. He is now ready to retire. Fred invested the trust corpus in a variable annuity contract four years ago, after selling the stocks he originally contributed to the trust. As before, the trust is not authorized to treat realized, post-contribution gains as distributable income. Now that the federal capital gains income tax rates have been lowered, he is considering surrendering the annuity after converting to an S-CRUT and reinvesting the proceeds in growth investments that will generate distributable capital gains, rather than ordinary income, only. He would prefer not to lose his makeup account balance in the conversion but is concerned about the income tax consequences if he surrenders the annuity before the trust becomes an S-CRUT. He would also like reasonable assurances that the conversion is likely to produce more net after-tax income to him and Ethel than what they can expect if the status quo is maintained.

Assumptions:

• NIMCRUT established four years ago
• Pays income to Fred and Ethel, or the survivor, for life (joint life expectancy = 24 years)
• Payout rate: 8%;
• Unitrust amount distribution frequency: Quarterly
• Trust investments: a variable annuity with a net annual return of 10%.
• Renaissance administration fees charged: Quarterly
• The Hardy's federal income tax rate is 39.6% on ordinary income and 20% on realized net long term capital gains. (State Income taxes have been ignored in this example).

Scenario 1: The trust is not converted, it remains a NIMCRUT, and the 8% unitrust amounts are made annually.

Scenario 2:

• The NIMCRUT converts to an S-CRUT on 1/1/2000.
• A total gross make-up account distribution of $263,830 is made in 1999 before the conversion occurs. This distribution nets the Hardy's $157,242 after federal income taxes.
• The annuity contract is surrendered before the trust converts and there is no surrender charge.
• The S-CRUT earns annually: 1% ordinary income, 8% realized capital gain, and 1% unrealized capital gain.
• The Hardy's federal income tax rate is 39.6% on ordinary income and 20% on realized net long term capital gains. (State Income taxes have been ignored in this example).

	Scenario 1	Scenario 2	Change
Lifetime Gross Income	3,263,313	2,736,182	-527,131
Lifetime Net Income	1,292,272	670,110	-622,162
Lifetime Income Tax	1,971,041	2,066,072	+95,031
Benefit to Charity	2,012,292	1,452,964	-559,328
Left in Make-Up Account	369,235	0	-369,235

Conclusions:

• Both the income and remainder beneficiaries are detrimentally impacted by this conversion.
• In scenario one the income beneficiary has even retained the flexibility of being able to withdraw $369,235 from the make up account.
• However, this is a fact sensitive analysis based on specific annuity and trust attributes and may not be indicative of your situation. For example, if the make-up account were not withdrawn, the results would vary dramatically.