Tuesday March 5, 2024
Article of the Month
Unitrust V - Crops and Other Tangible Personal Property
Part five of this article series will provide an explanation of how to use crops, cattle and other tangible personal property (TPP) as funding assets for unitrusts. The information should help donors understand how a charitable remainder trust (CRT) can fulfill his or her philanthropic goals.
Tangible Personal Property Treatment
Tangible personal property (TPP) can be defined as personal property items that can be physically touched and moved. Common types of TPP include jewelry, coins, art, vehicles and crops. TPP items may qualify as either long term gain assets or ordinary gain type assets. Usually, TPP will generate a cost basis charitable deduction for the donor. The charitable deduction for TPP will be limited to the lesser of the cost basis or the fair market value.
Long-term gain TPP may include coins, art or other items that have been held for over a year for investment purposes. If the taxpayer is a dealer of the type of property or engages in an active trade or business that involves that type of asset, then it is likely an ordinary gain asset. If instead, a taxpayer is an investor and sold long term gain TPP, it would generate capital gains on the sale.
If the TPP is a long-term gain asset and the charity can use the item in a manner related to its exempt purpose, the donor may be entitled to a charitable deduction based on the item's fair market value. Gifts to charitable remainder unitrusts (CRUTs) will not qualify for related use deduction values because CRUTs are tax-exempt trusts, not charitable organizations. A penalty of $10,000 can be imposed for misrepresentations of related use under Sec. 6702B.
Works of art created by an artist, farm products raised by a farmer and most cattle owned by a rancher would generate ordinary income upon a sale. These assets would be considered inventory assets, which generate ordinary income when sold by the taxpayer. In many cases, the donor has fully depreciated the ordinary gain asset, meaning the cost basis is $0 at the time of the charitable contribution.
CRUTs Funded with TPP
The previous four parts of this article series have highlighted the benefits of CRUTs funded with long-term capital gain assets. The principal benefit of a tangible personal property unitrust is the ability to spread out recognition of ordinary income. If a taxpayer holds an ordinary income asset, it may be desirable to create a unitrust to receive that asset.
When TPP is transferred into a unitrust, the donor faces a delay in being able to claim a charitable deduction due to an "intervening interest" under Sec. 170(a)(3). Even though the donor has relinquished possession of the asset to the CRUT, the deduction is delayed until the asset is converted into cash. With a charitable remainder trust, no deduction is permitted until the asset is sold by the trustee per Sec. 170(a)(3). During an "intervening interest" period, the donor must follow the Sec. 4941 rules regarding self-dealing.
Example – Artist's Unitrust
Susan, age 53, creates beautiful and popular handcrafted ornamental garden sculptures. She contributes a sculpture that she created to a charitable remainder unitrust. On the date of the contribution, based on a qualified appraisal, the piece of art is valued at $100,000. The materials to create the sculpture cost $500. If the sculpture were sold, Susan would realize $99,500 in ordinary income. The charitable gift amount on which her deduction is calculated is reduced by $99,500 from $100,000 to $500. The artwork, if contributed to a trust, results in a charitable deduction based upon the $500 cost, not the fair market value of $100,000. Based upon the IRS factors at her age and an AFR of 4.6%, her charitable deduction is $150, which may be claimed after the sale of the sculpture by the trustee of the CRUT.
Crops and Cattle
Crops may be transferred outright to a charity or to a charitable remainder trust. It is best to harvest or sever the asset from the land prior to the transfer. For example, it is preferable to harvest the wheat, cut the hay or cut the timber prior to a transfer to charity or into a charitable trust. This avoids any potential partial interest problems since the entire harvested crop is transferred to the CRUT.
If the donor is funding the trust with cattle or other livestock, the trustee should be aware of Internal Revenue Service Private Letter Ruling (PLR) 9413020. While PLRs are not binding precedent, they can be helpful to determine the Service's treatment of certain transactions. In the PLR, the donor requested rulings on various topics, including the determination that the donation of cattle and farm equipment to a CRUT would not generate unrelated business income (UBI). The donor was able to bypass recognition of the ordinary gain so long as the trust was not engaged in an active business. Conducting an active trade or business would violate the UBI rules. In the PLR, it was specifically represented that efforts to "fatten the cattle for market" would not occur and the IRS deemed no UBI would be generated.
It is important to note that if the animals in the CRUT are raised for consumption, the trustee should carefully oversee that the feeding will be for maintenance purposes only. This may avoid the CRUT being deemed to be engaged in an active trade or business.
Trustees often use auction houses, agents or elevators to complete the sale of crops, cattle and other farming equipment. The trustee must be under no legally binding obligation to sell the assets being donated to the unitrust. In addition, to show evidence that the crops or cattle have been transferred, the bill of sale must show that the crops or cattle were sold by the trustee of the CRUT. It may be wise for a donor to have an independent trustee for the sale of the TPP assets.
Example – Farmer's Unitrust
Paul had an excellent crop this year. He sold most of his corn crop, recovered all expenses and has a current profit. In addition, Paul has 50,000 bushels of corn in his storage bin. Because he has recovered his costs, there is zero basis on the 50,000 bushels. Since the corn is inventory, if he were to sell, the federal and state income tax rate will be over 40%. Paul uses a Deed of Gift to transfer the corn into a charitable remainder unitrust. To minimize any potential risk with respect to prearranged sale, his financial advisor serves as initial trustee. The financial advisor immediately has the corn transported to market and then sold. The market administrator signed a statement that the corn was sold by the CRUT. Under Sec. 170(a)(3), Paul's deduction is delayed until the corn is sold. The corn is sold for $350,000. Since this is a gift of TPP to a CRUT, the deduction is limited to cost basis. Because the cost basis is zero, there is no charitable income tax deduction. However, Paul and Karen saved the ordinary income tax on the sale, and effectively "banked" the $350,000 value tax-free. Paul and Karen will now receive income for two lives from the trust. Because the value of their income for two lives may equal the after-tax value from an outright sale, the unitrust is an excellent solution for Paul and Karen.
Charitable Deduction Rules
Because the charitable deduction is often limited to cost basis, there is a modest or no charitable deduction for TPP assets. In many cases the assets funding the CRUT are fully depreciated by the taxpayer, meaning the cost basis is zero. The avoidance of ordinary income tax on the sale of the asset could result in substantial savings and, therefore, makes a CRUT an attractive gift vehicle for a donor.
TPP assets must comply with charitable substantiation rules. If similar items of property are donated in the same taxable year, the donor is required to comply with the appropriate substantiation requirements for the aggregate value of the similar items. In addition, the condition of the property must be described. Reg 1.170A-16(c)(3)(iv)(B).
The requirement to obtain a qualified appraisal for assets valued at $5,000 is applicable. If there is an agreement or understanding that relates to the use, sale or other disposition of the contributed property, it must be disclosed in the qualified appraisal. Reg. 1.170A-17(a)(3)(ii). If the charity does not have the full power and authority to designate the recipient of the contributed property's income, possession or rights to acquire, this must be disclosed in the qualified appraisal. Reg. 1.170A-17(a)(3)(ii)(B).
How To Complete Funding
State law governs the transfer of ownership in crops, cattle or other tangible personal property. Thus, state law determines whether a specific title or registration document is required for the assets. If there is a state document of title, it is preferable to transfer the asset using that document, such as a title transfer for a motor vehicle. For assets that do not have state title documents, such as crops or collections, a deed of gift or letter indicating the description of the asset, the date and the intent to make an irrevocable transfer to charity may be deemed appropriate by the donor's attorney.
The effective date of the transfer is the date under state law when there is a legal and permanent transfer. If the gift is transferred in late December and there is a document of title under state law, it is also preferable to have the transfer recorded by the appropriate state agency before December 31 of the year in which the gift is made. Nevertheless, so long as the transfer meets state law requirements, it should be recognized for federal tax purposes if it is completed by December 31.
To fund a charitable trust with crops, there must be documents of transfer. Because it is essential to transfer the corn, wheat, hay, soybeans or other crops into the trust and then sell tax-free through the trust, three documents should be created. The first document is a deed of gift. It is a simplified version of a deed of real property. The second document is a receipt to be signed by the trustee or receiving company on behalf of the trustee. It acknowledges the ownership by the unitrust and confirms that the transfer is under the control of the trustee. Finally, the third document is a confirmation of the sale by the elevator operator or other purchaser. Once again, the purchasing party must state that the sale has been completed by the trustee on behalf of the trust.
A sample deed of gift is included for reference.
Deed of Gift
I, John Farmer, owner of EIEIO Farm and the following agricultural products, hereby irrevocably give and transfer the products described by type, quantity and location, to First Bank as Trustee of a Charitable Remainder Unitrust dated 3/4/2023, for the initial benefit of John and Mary Farmer.
Property Location, Quantity and Description
50,000 Bushels of Corn currently stored in Bin #104 on EIEIO Farm, Green County, Illinois.
I, John Farmer, state that the above crops are unencumbered, that they are the products of EIEIO Farm and I have full authority to irrevocably transfer these items to First Bank as trustee. First Bank shall have full and complete rights to hold, move, sell or otherwise manage the above property.
In Witness Whereof, I have signed this Deed of Gift on ______________, _________.
The donor's counsel should draft the deed of gift or similar instrument to execute the transfer under state law. If there is a department within the state or county to record or register the transfer deed, the charity may want to take that step to formalize the transfer.
Professional advisors will find it useful to understand what charitable solutions are available for clients with tangible personal property, crops and cattle. Donors will benefit from guidance on retirement planning, investments, tax strategies and charitable giving.
Charitable giving can be crafted to meet the goals of a particular client, whether those goals are financial, familial, philanthropic or a combination of all three. By creating a charitable remainder unitrust, donors will be satisfied that they have created income for life. Donors will gain peace of mind and enjoy knowing they have made a positive impact through their charitable gifts.