Legal and Tax Implications of Investing Planned Gifts

Legal and Tax Implications of Investing Planned Gifts

Article posted in Investing on 15 January 1999| comments
audience: National Publication | last updated: 16 September 2012


In this edition of Gift Planner's Digest, Pittsburgh attorney Carolyn D. Duronio examines the application of the Prudent Investor Act, unrelated business income and self-dealing rules, and opportunities for pooling investments with respect to the investment of charitable remainder trusts and other planned giving vehicles.

by Carolyn D. Duronio

Carolyn D. Duronio is an attorney with Reed Smith Shaw & McClay LLP, in Pittsburgh, PA. Duronio's practice involves matters for exempt organizations, including public charities, private foundations and trade associations. She has particular expertise in legal issues affecting investments by nonprofit organizations. Duronio is a graduate of Harvard University and received her JD from Harvard Law School.

Legal and Tax Implications of Investing Planned Gifts

Recent changes in and/or interpretations of state fiduciary laws and federal tax laws relating to investments by trustees of planned gifts, particularly charitable remainder trusts, have resulted in tremendous flexibility for trustees. Many types of investments that were deemed to be too speculative under prior law would be permitted depending on the other assets in the portfolio. The rules in this area are, however, very technical, and trustees would be well-advised to analyze each unusual investment and overall investment policy to ensure that the planned investment not only complies with state law fiduciary requirements, but also does not result in unrelated business taxable income or self-dealing. The issues can be particularly thorny when pooling of planned gift assets is undertaken.

Prudent Investor Act

State laws generally govern whether an investment is permissible and whether the trustee of a charitable or other trust may be surcharged for making an impermissible investment. The general rule has been the "prudent person" standard, which tends to focus on individual investments. The Uniform Prudent Investor Act (Act), which has been adopted in 24 states and introduced in another seven states to date, adopts modern portfolio theory, and changes the previous laws with respect to investing by fiduciaries in five ways:

Total Portfolio -- The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. Portfolio refers to all of the entity's assets. Thus, an investment is viewed in terms of the role it plays in the total portfolio; meaning that a more speculative investment, such as shorts, may be perfectly acceptable when viewed in the context of the total portfolio. This is very different than the "prudent man" rule, which analyzed investments on an investment-by-investment approach.

Risk and Return -- The fiduciary's central consideration is the tradeoff between risk and return. Thus, investments bearing more risk may be permissible as long as there is a sufficiently higher potential for return.

No Per Se Prohibited Investments -- All categorical restrictions on types of investments have been eliminated. The fiduciary may invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust, and that meets the other requirements of prudent investing. This means that investing in derivatives is not per se prohibited, but must be viewed in the context of the total return.

Diversification -- Diversification is generally required. This is likely to be the most difficult requirement to deal with for trustees of planned gifts in a politically neutral manner because many donors have specific ideas of how they want the portfolio invested.

Delegation -- The fiduciary may delegate investment and management functions subject to certain safeguards. This is particularly welcome for individual trustees of planned gifts. These changes provide much more flexibility for the investment of planned giving assets, such as the assets in a charitable remainder trust or charitable lead trust. It also permits the trustee, who may be a family member of the donor, or a small charitable organization, to delegate investment functions to professional investment advisors, such as a bank or other money manager. The Act may have some adverse impact on charitable trusts because of the duty to diversify, although, to some extent, the duty to diversify is modified based on the specific facts of the trust, such as the amount of gain to be recognized for tax purposes. This could be more relevant in a charitable lead trust than in a charitable remainder trust, where the donors desire to have certain property distributed to their heirs on the termination of the trust. There may, however, be more impetus to sell and diversify than some donors would desire, and this particular provision of each state's law should be reviewed prior to creating a particular charitable trust.

Section 4-406 of the Prudent Investor Act provides as follows:

"If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust property, taking into account any differing interests of the beneficiaries."

This issue comes into play when a donor desires a particular investment that may harm one or more other beneficiaries, particularly the charitable remainder beneficiary in a charitable remainder trust. For example, the donor may desire to have the trust invest in tax-free obligations that result in an erosion of value for the charitable remainderman. It is important to note that in most states, the Attorney General, as parens patriae, may intervene regardless of the acquiescence of the charity in the investments.

In Estate of Feinstein,1 a Pennsylvania case, the Attorney General of Pennsylvania sought to have the trustees of a charitable remainder trust surcharged on the theory that they had not adequately protected the interests of the charitable remainderman. The trust was invested wholly in tax-exempt bonds because the income beneficiaries had indicated that they wanted tax-free income. Inflation and high interest rates resulted in low values for the bonds, and thus, the charitable remainderman suffered a significant loss in value.

The Attorney General's position was that the choice of investment unduly favored the income beneficiaries. The court did not agree, stating that "[a]bsolute evenhandedness is impracticable and, in most cases, impossible. We can only expect our fiduciaries to act with sound judgment and proper motives under the particular circumstances of each case." In analyzing the issue, however, the court did investigate why the fiduciary believed that it was serving the best interests of both the income and remainder beneficiary.

Consequently, even though the Attorney General did not prevail, to preclude a surcharge, fiduciaries should justify all investments in a charitable trust on the basis of the value to both the income beneficiary and the remainder beneficiary. Some of the partiality issues may be handled through the drafting of the trust. For example, if a donor desires a high rate of return from the charitable remainder trust, the trust may be drafted so that any gain accruing after creation of the trust will be allocated to income. This eliminates some of the pressure between investing for income and investing on a total return basis.

Unrelated Business Taxable Income

Income is unrelated business taxable income (UBTI) if it is generated in an "unrelated trade or business" or if it is "debt-financed income." The federal income tax treatment of certain charitable vehicles will be affected if they recognize unrelated business taxable income as a result of their investments.

Charitable Remainder Trusts -- Under Section 664(c) of the Internal Revenue Code of 1986 (Code), Treas. Reg. § 1.664-1(c), and Leila G. Newhall Unitrust v. Commissioner,2 if a charitable remainder trust recognizes any UBTI during a year, it is taxable on its entire income for that year. Consequently, a small amount of UBTI may cause a significant amount of income or gain to be taxable. This can be particularly devastating if the UBTI is recognized in the year in which the trust disposes of any appreciated corpus contributed to the trust on its formation. Thus, the rule with respect to charitable remainder trusts is to take all appropriate steps to preclude UBTI.

Charitable Lead Trusts -- The deduction by a charitable lead trust for the amount distributed to a charity is adversely affected by UBTI. Under Section 681 of the Code, the charitable deduction under Section 642(c) of the Code is reduced by the amount of income allocable to UBTI. Although the deduction is limited under Section 642(c) of the Code, a charitable lead trust may, pursuant to Section 512(b)(11) of the Code, deduct amounts paid to a charity and allocable to UBTI subject to the limitations under Section 170 of the Code. This means that a charitable lead trust can generally deduct 50% of UBTI for distributions to a public charity, and 30% of UBTI for distributions to a private foundation. Nonetheless, the deduction can be severely limited with adverse consequences for the charitable lead trust if UBTI is recognized.

Unrelated Trade or Business -- There are three requirements for an unrelated trade or business under Section 513 of the Code: 1) the activity must be a trade or business; 2) the activity must be continuously carried on; and 3) the activity must not be substantially related to the organization's exempt purpose. Activities, such as investments, which are undertaken with intent to make a profit, are deemed to be trades or businesses for this purpose. Investing of planned gifts is continuously carried on. The courts have consistently held that investments are not substantially related to an exempt organization's exempt purposes.3 As a result of satisfying all three prongs of the test, investments may generate UBTI for charitable trusts even though investments are the purpose of such trusts.

Exclusions for Ordinary and Routine Investments -- Despite the fact that investments satisfy the definition of unrelated trades or businesses, they do not generally generate UBTI because of specific exclusions for "ordinary and routine investments." Thus, for the most part, investments do not give rise to UBTI dividends. Dividends from stocks are excluded from UBTI under Section 512(b)(1) of the Code.

Interest -- Interest and consideration received for making loans are excluded from UBTI under Section 512(b)(1) of the Code. Securities Loans--As long as securities loans are structured to satisfy certain requirements, payments with respect to securities loans are excluded from UBTI under Sections 512(a)(5) and 512(b)(l) of the Code.

Notional Principal Contracts and Royalties -- Income from notional principal contracts, such as interest rate and equity swaps, are excluded from UBTI under Treas. Reg. § l.512(b)-l(a). Royalties, including income for the use of intangible assets, are excluded from UBTI under Section 512(b)(2) of the Code. Rent--Rent from real property and incidental personal property is excluded from UBTI under Section 512(b)(3) of the Code. Capital Transactions--Gain from the sale of assets that are not inventory or held for sale to customers is excluded from UBTI under Section 512(b)(5) of the Code. Thus, gain from the sale of investments is generally not taxable.

Debt-Financed Income -- Investments that are "debt-financed" do, however, give rise to UBTI. For this purpose, investments are debt-financed if they are subject to "acquisition indebtedness." Acquisition indebtedness is generally defined as: 1) debt incurred to acquire or improve property; 2) debt incurred prior to the acquisition or improvement of property if such debt would not have been incurred but for the acquisition or improvement; and 3) debt incurred after the acquisition or improvement of property if such debt would not have been incurred but for the acquisition and improvement, and the incurrance of the debt was reasonably foreseeable at the time of the acquisition or improvement. Most UBTI recognized for investments will result from debt-financed investments.

Calculation of UBTI -- The proportion of the income or gain from the debt-financed property that is UBTI is essentially the percentage of the property's basis subject to debt. For example, if stock is acquired by borrowing 40% of the purchase price, 40% of the dividends paid with respect to the stock, and 40% of the gain on the sale of the stock would be UBTI as long as the debt is outstanding. With a charitable remainder trust, however, any UBTI is sufficient to cause the income for the year to be taxable.

The following are specific investment examples:

Short Sales -- An open issue for quite some time was whether short sales gave rise to debt-financed UBTI because of the borrowed stock used in short sales. The Internal Revenue Service (Service) ruled in Letter Ruling 8832052, May 18, 1988, in response to a request by the Common Fund, that short sales did not give rise to debt-financed UBTI because the borrowing of stock did not create true indebtedness. The Service then announced that it was studying the issue and refused to rule on the issue again. In January 1995, the Service issued Revenue Ruling 95-8, 1995-1 C.B. 107, and held that the short sale of publicly traded stock through brokers did not give rise to debt-financed UBTI. The Service specifically reserved the issue of whether short sales of other property would give rise to debt-financed UBTI.

Margin Stock -- Stocks or other securities purchased on margin, where the margin account represents true debt of the organization, are debt-financed property giving rise to UBTI.4 Thus, income and gains from such investments will be subject to tax to the extent of the percentage of debt financing. Futures and Forwards--The Service has ruled that margin accounts for futures contracts do not represent acquisition indebtedness. In Letter Ruling 8717066,5 the Service found that margin accounts for futures contracts represented indebtedness of the broker to the exempt organization rather than indebtedness of the exempt organization. In effect, the margin accounts are no more than security deposits. Consequently, margin accounts for executory investment contracts are not acquisition indebtedness and do not result in UBTI. The Service ruled that this is the case whether or not funds are borrowed to finance the margin deposit, as long as funds are not borrowed to acquire the securities.

Real Property -- In general, rental real property acquired with debt will be debt-financed property giving rise to UBTI. There are special rules applicable to certain exempt organizations, not including charitable trusts, which may exempt the income of debt-financed real property from UBTI. There is a special exception relevant to all entities subject to UBTI for donated property, if the property: 1) is subject to a mortgage that was placed on the property more than five years before the transfer to the trust or the private foundation; and 2) was held by the donor more than five years before the transfer. If the two conditions are met, the property will not be treated as debt-financed property for a period of 10 years from the date of transfer.6 If the two conditions are not met, mortgaged real property, regardless of whether the trust is liable for the debt, gives rise to UBTI.

Partnerships -- Because partnerships are flow-through vehicles for tax purposes, the activities of the partnership are attributed to the partners for purposes of UBTI.7 For example, if an investment partnership were engaged in a trade or business, the income from such trade or business would be UBTI to the exempt partner unless the trade or business were related to the exempt partner's exempt purpose. This would be the case even though the charitable trust is only a limited partner and plays a passive role in the partnership.8 In addition, if the partnership used debt to acquire assets, some portion of the income from the partnership would be debt-financed UBTI to the partner. This generally precludes a charitable trust from investing in a hedge fund formed as a partnership.


In reviewing investment considerations, self-dealing is a tax provision that applies to charitable remainder trusts and charitable lead trusts. An excise tax is imposed on each "act of self-dealing." In general, an act of self-dealing includes any transaction between a "disqualified person" and the charitable trust. The excise tax is 5% of the amount involved for each direct or indirect act of self-dealing between an entity and a disqualified person. The excise tax is imposed on the disqualified person.

In addition, a tax equal to 2½% of the amount involved is imposed on a foundation manager who knowingly participates in an act of self-dealing, unless the participation is not willful and is due to reasonable cause. With respect to investments, there are three situations in which self-dealing may be an issue: 1) compensation to investment advisors or managers; 2) use of assets for the benefit of disqualified persons, such as joint investments, co--ownership, the timing of sales and the choice of investment; and 3) receipt of certain property subject to debt.

The following are specific examples:

Compensation to Disqualified Person Investment Advisors -- Section 4941(d)(1)(D) of the Code provides that an act of self-dealing includes any direct or indirect payment of compensation, or payment or reimbursement of expenses, by a charitable trust to a disqualified person. An exception is provided in Section 4941(d)(2)(E) of the Code, which states that the payment of compensation by a charitable trust to a disqualified person for "personal services" that are reasonable and necessary to carrying out the purposes of the trust is not an act of self-dealing as long as the compensation is reasonable. Investment advice is generally considered to be a personal service.9 Thus, compensation paid to an investment advisor who is also a disqualified person vis-a-vis the charitable trust will not be an act of self-dealing as long as the compensation is reasonable. Reasonable compensation for this purpose is the amount that ordinarily would be paid for like services by like enterprises under like circumstances.10 For example, a charitable trust that was a partner in a commodities partnership managed by a disqualified person would not be engaged in an act of self-dealing provided the fees paid to the manager of the partnership were identical to those paid by other investors in the partnership and were similar to those paid to other commodity investment advisors in the industry.11

Compensation for Property Management -- The Service and the Tax Court have ruled that property management services are not personal services.12 Thus, if a charitable remainder trust owns an interest in a partnership that has real property managed by a disqualified person, any compensation paid to the disqualified person would result in a self-dealing excise tax.

Joint Investments -- An act of self-dealing occurs when a disqualified person benefits more than incidentally from the use of a charitable trust's assets. Joint investments, such as investments by disqualified persons and a charitable remainder trust in the same investment partnership, may give rise to an excise tax on self-dealing. The Service addressed whether joint investments by private foundations and disqualified persons would be an act of self-dealing in Letter Ruling 9448047,13 In the ruling, the limited partnership investment had minimum investment requirements. The disqualified person invested the minimum amount necessary, but the foundation did not, and instead was able to use the disqualified person's investment to satisfy the required minimum investment. The Service ruled that the joint investment did not result in an act of self-dealing because the disqualified person invested the minimum amount and did not need to rely on the assets of the private foundation to satisfy this requirement.

Given earlier rulings on co-ownership by disqualified persons and foundations, there would be an act of self-dealing if the disqualified person relied on the investment of the charitable trust's assets to satisfy the minimum investment requirements. A charitable trust may benefit from the use of a disqualified person's investment, but the converse is not permissible.

Co-ownership of Property -- The Service has ruled that co-ownership of property by a disqualified person and a charitable trust may result in the self-dealing excise tax if the disqualified person has the right to use the co-owned property. For example, co-ownership of a vacation home would be an act of self-dealing if the disqualified person could use the vacation home. Co-ownership may, however, be structured such that self-dealing does not occur.

In Letter Ruling 9651037, the Service ruled that disqualified persons and a private foundation could co-own real property because: 1) the property was given to all owners as co-owners; 2) the property was leased to a third party; and 3) the tenant paid the rent to the co-owners directly and there were no payments between co-owners. Thus, the charitable remainder trust would receive rent directly from the tenant of the co-owned property, such as a strip-mall.

Investment Decisions -- If investment decisions are made in a manner to benefit disqualified persons, the decision may be an act of self-dealing. For example, the regulations provide that if stock sales are timed to benefit a disqualified person, the sale will be an act of self-dealing.14 In addition, the Service has recently taken the position that the timing of sales by a charitable remainder trust may give rise to an excise tax on self-dealing. This is particularly the case in accelerated charitable remainder trusts where the sale of property is timed specifically to ensure the least amount of tax for the income beneficiary.

Decisions with respect to the type of investment may also give rise to self-dealing. In an important recent Technical Advice Memorandum, Letter Ruling 9825001,15 the Service held that a charitable remainder trust could invest in deferred annuities without engaging in an act of self-dealing. The following language in the Technical Advice Memorandum is instructive:

"In as much as a donor (a disqualified person), is entitled to receive the income interest from the trust, it is difficult to argue that the disqualified person receives an inappropriate benefit by deferring the income interest, particularly where such deferral is permitted under Section 664 of the Code. The underlying problem is that the income beneficiary interest is in itself a use for the benefit of the disqualified person of the assets of the trust. "

"Inherently, any investment decision regarding the trust assets that increases or decreases the amount of payout of this income interest is a use for the benefit of the disqualified person (assuming the disqualified person does not object). Section 4947(a)(2)(A) provides that Section 4941 will not apply to any amounts payable under the terms of the trust to the income beneficiary. The amounts of income deferred by the investment decision in this case were payable to the income beneficiary under the terms of Trust X. Accordingly, these uses must be permitted under the income exception of Section 4947(a)(2)(A) unless the disqualified person controls the investment decision, and uses this control to unreasonably affect the charitable remainder beneficiary's interest."

Thus, to have an act of self-dealing, the donor or other disqualified person must both: 1) control the decision; and 2) adversely affect the other beneficiaries. If there is an independent trustee, the first factor is not present.

Mortgaged Property -- If property is subject to a mortgage, the transfer of the property to a charitable trust is an act of self-dealing unless the mortgage was placed on the property more than 10 years before the transfer.16 If the mortgage was refinanced, but no additional amount was added to the debt, the refinancing is ignored for purposes of determining when the debt was placed on the property. Because the rules concerning the contribution of mortgaged property are different for self-dealing (10 years) as opposed to unrelated business tax purposes (five years), a transfer may not result in tax, as described above, but may result in self-dealing. For this and other reasons, it is generally difficult to transfer mortgaged property to a charitable trust.

Pooling of Planned Gift Vehicles

Because of economies of scale and diversity of investments that may be attained by pooling investments, many organizations are considering pooling planned giving vehicles, especially remainder trusts, either with similar vehicles or with the organization's endowment. Pooling is permissible and would not jeopardize the qualification of charitable remainder trusts.17 There are, however, several issues that should be addressed before undertaking pooling.

Partnership Treatment -- Pooling results in a separate taxpayer, that is, a partnership. This means that partnership accounting must be used to determine the allocable share of each trust or other entity in the pool and the pool's income and gain. While there should be no adverse tax consequences, the accounting is complicated when appreciated assets are pooled, and it will mean significant additional record keeping. The issue then becomes whether the investment gains of pooling offset the additional administrative burden.

Unrelated Business Taxable Income -- The investment manager of the pool needs to be cognizant of the UBTI consequences for a charitable remainder trust--one-dollar of UBTI in a year will ostensibly cause the entire year's income to be taxable for a charitable remainder trust. If the trusts are pooled with a university's endowment, for example, there may be real issues. Many university endowments invest in debt-financed real property because universities have a special exemption from UBTI for debt-financed real property. If some portion of the debt-financed real property is allocated to a charitable remainder trust because it is a participant in the pool, then the charitable remainder trust, which cannot take advantage of the exemption, will recognize UBTI. Similarly, many endowments choose to recognize some UBTI because the return supports the tax, but the UBTI could be devastating for participating charitable trusts.

Fiduciary Issues -- Another issue is ensuring that the pool is taking into account the needs of the income beneficiaries of the charitable remainder trusts. If the pool invests on a total return basis, for example, because the organization is pooling with its endowment, and the trust's documents do not permit distribution of gain as well as income, then the income beneficiary may see a significant decrease in his/her return.


As can be seen, the flexibility introduced by the Prudent Investor Act opens up other considerations. When planned giving vehicles were invested solely in stocks and bonds, there were very few tax considerations. As the types of permissible investments expand, the federal tax consequences of such investments, particularly unrelated business taxable income and self-dealing, must be analyzed.


  1. Estate of Feinstein, 364 Pa. Super. 221,527 A.2d 1034, 1987.back

  2. Leila G. Newhall Unitrust v. Commissioner, 104 T.C. 236, 1995, aff'd, 105 F.3d 482, 9th Cir. 1997.back

  3. See, e.g., Elliott Knitwear Profit Sharing Plan v. Commissioner, 614 F.2d 347, 3d Cir., 1980.back

  4. See, e.g., Revenue Ruling 74-197, 1974-1 C.B. 143, and Elliott Knitwear Profit Sharing Plan v. Commissioner, 614 F.2d 347, 3rd Cir., 1980.back

  5. Letter Ruling 8717066 was issued on January 20, 1987.back

  6. Section 514(c)(2)(B) of the Code.back

  7. Section 512(c) of the Code.back

  8. This was the issue in Leila G. Newhall Unitrust v. Commissioner.back

  9. Treas. Reg. § 53.4941(d)-3(c)(2) Example (2).back

  10. Treas. Reg. §§ 53.4941(d)-3(c)(1) and 1.162-7.back

  11. See, e.g., Letter Ruling 9237035, June 16, 1992.back

  12. See Ltr. Rul. 9325061, April 1, 1993, and J. W. Madden, Jr. v. Commissioner, 74 TCM (CCH) 440 (1997).back

  13. Letter Ruling 9448047 was issued on September 8, 1994.back

  14. Treas. Reg. § 53.4941(d)-2(f)(1).back

  15. Letter Ruling 9825001 was issued on October29, 1997.back

  16. Treas. Reg. § 53.4941(d)-2(a)(b).back

  17. See, e.g., Revenue Ruling 83-19, 1989-1 C.B. 115.back

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