Maximizing Split-Interest Charitable Deductions With New Pooled Income Funds Over CRTs

Author: Larry Eisenberg

Guest Post

Lawrence J. Eisenberg, Esquire is principal and founder of Lawrence J. Eisenberg, P.C. / Compensation Law Group, a law firm located near Nashville, Tennessee. Larry maintains an almost one-of-a-kind specialty in pooled income funds (PIFs), in particular new PIFs. What attracted Larry to pooled income funds is their unique and virtually unknown potential to solve a wide range of tax, personal, charitable, and social objectives. Larry also maintains a national-scope law practice specializing in ERISA (qualified and nonqualified plans) and compensation planning matters, for almost 40 years. Larry can be reached at larry@ljelawgroup.com or 202-246-2327. His website is: www.ljelawgroup.com.

The Pooled Income Fund (PIF) – An Underused Charitable Planning Strategy

Pooled Income Funds (PIFs) were introduced over 50 years ago with the passage of the 1969 Tax Reform Act. Fundamentally, a PIF is a charitable trust created and maintained by a public charity (described in IRC Section 170(b)(1)(A) as religious organizations, educational institutions, hospitals, medical education and research organizations, and community foundations) that pools assets contributed by multiple donors and pays lifetime income to individual beneficiaries designated by the donors… with any remainder at the death of those beneficiaries available for the charity’s own use.

Functionally, this makes the PIF similar to other ‘split-interest’ charitable vehicles like the Charitable Remainder Trust, which similarly provides income to beneficiaries for life and a remainder to a (trust-specified) charity. Accordingly, PIFs can serve as useful charitable planning tools, though in practice, they can often provide for larger charitable deductions on individual income tax returns when compared to the more popular Charitable Remainder Trust (CRT). Despite this key benefit (and other significant benefits they offer), PIFs have been considerably underused.

In fact, in 2012, the last year for which IRS information is available, only 1,324 PIFs were sponsored throughout the United States, holding about $1.25 billion in net assets (and 84% of those PIFs held less than $1 million in assets). By contrast, in the same year, there was a total of 105,866 CRTs holding approximately $91.7 billion in net assets (according to IRS data for 2012 returns filed for Charitable Remainder Unitrusts and Charitable Remainder Annuity Trusts).

The limited use of PIFs by donors and the lack of familiarity with them in the financial planning community (certainly compared to CRTs) is in stark contrast with how useful PIFs are in achieving a wide range of planning objectives and goals.

By better understanding how clients can benefit from PIFs (and the newer variation of PIFs, the “New Pooled Income Fund” or NPIF), financial advisors can offer their clients additional options that may be more flexible and advantageous than traditionally used CRT strategies.

How Pooled Income Funds (PIFs) Operate

PIFs, like Charitable Remainder Trusts (CRTs), are “split-interest” trusts that benefit the donor and beneficiaries (through lifetime income interests) as well as the sponsoring public charity (which receives the remainder). Yet, while PIFs share some common features with CRTs, there are some important differences.

One convenient feature of PIFs is that they are very easy for donors to set up and use (compared to the CRT alternative). Because they have already been established by the charity, there are few administrative requirements that PIF donors must deal with. Generally, PIF donors are simply required to (a) read and understand disclosure documents, (b) determine the appropriate property to contribute consistent with the PIF terms, (c) complete a gift agreement (which specifies the income payments that will be made to the income beneficiary), and (d) fund the PIF.

Additionally, there are no ongoing compliance or tax filing requirements for the donor (although PIF income beneficiaries do need to report their share of the PIF income for tax purposes, similar to a CRT).

PIF administration costs are absorbed by the PIF, which can reduce distributable income or the value of the charitable remainder value, depending on whether costs are allocated to income or principal. This information (about how costs will be allocated) should be provided in the PIF disclosure documents.

By contrast, the donor directly incurs significant costs to establish and maintain a CRT, which can include legal fees to establish the CRT, administrative costs to calculate and make distributions, accounting fees to prepare and file annual reports, and sometimes annual costs to value non-publicly traded assets held by the CRT.

PIF Donors And Income Beneficiaries

While Charitable Remainder Trusts (CRTs) are often created by a single donor and for a single beneficiary, a PIF is expected to be created by a charity as an ongoing charitable endeavor, and consequently must (per IRC Section 642(c)(5), together with related Treasury Regulations) have more than one donor and income beneficiary, in order to be “pooled” in the first place. (This is particularly important when the PIF is initially established, where there should be at least two donors and two income beneficiaries from the start, even if one of the donors contributes a relatively small amount or an income beneficiary receives a comparatively small share of the PIF income).

Many PIFs may have specific limits on who can be named as income beneficiaries; for example, some PIFs allow only a donor’s spouse to be named as an income beneficiary or may have an age restriction (e.g., must be at least age 55 or older). This is to prevent the charity that is serving as the remainder beneficiary from having to wait for ‘excessively long’ periods of time before they have access to remainder assets for their charitable purpose.

Notably, because the PIF is controlled by the charity that offers it, donors of PIFs have no control over assets contributed once they are received by the PIF, nor are donors allowed to serve as trustees (unlike CRT donors, who have substantial control of trust assets and may serve as trustees of the CRT).

The PIF income beneficiary(ies) designation is made at the time of the gift as a part of the gift/donation agreement. The designation is irrevocable once made, except that an individual PIF donor may reserve the right to revoke or terminate an individual income beneficiary by Will, in which case the revoked or terminated interest will be paid to the remaining income beneficiaries in accordance with the PIF terms. Reserving the right to revoke or terminate the income interest can avoid or minimize a current gift associated with the PIF donation.

PIF income beneficiaries are limited only to individuals who are living at the time of the designation (or to a class of individuals who are alive at the time of designation, e.g., the donor’s then-living children) or the public charity maintaining the PIF. By contrast, a CRT may designate an entity as a non-charitable income beneficiary, provided that the CRT operates for a specified term (not exceeding 20 years).

Nerd Note:

While IRC Section 642(c)(5)(A) does not specifically state that individuals must be the income beneficiary for PIFs, this is implied by the requirement that payments be made for the life of the income beneficiary.

In all cases, income beneficiaries of a PIF must be lifetime beneficiaries (i.e., receiving income as long as they are alive); period certain income payouts (e.g., for a specified period of 20 years) are not permitted with a PIF, as they are with a CRT.

However, a PIF does not necessarily have to specify just one lifetime income beneficiary. Instead, a PIF donor may designate more than one individual as a PIF income beneficiary. In such situations, under Treasury Regulations Section 1.642(c)-(5)(b)(2), those beneficiaries may receive their share of PIF income consecutively (e.g., if two beneficiaries were designated, one beneficiary may receive their share of PIF income only after the other dies), concurrently (e.g., each receives a share of the current PIF income at the same time), or as a combination of both. Notably, though, while permitted by the Treasury Regulations, not all PIFs will allow the donor to specify multiple PIF income beneficiaries, especially to be paid in a consecutive manner (as it may defer the remainder too far into the future for the charity to want to offer such an option).

PIFs Are Maintained By A Public Charity Designated As The Remainder Beneficiary

The PIF must be maintained by the public charity that receives the PIF contribution. Most commonly, this is satisfied by the charity simply being the PIF administrator, holding and managing donor contributions, and making income beneficiary distributions. Though technically, this requirement is considered satisfied when the public charity exercises direct or indirect control of the PIF, including when the public charity is authorized to remove a PIF trustee and to designate a new one.

Upon the death of all of the donor’s selected income beneficiaries, the remainder related to the donor’s contribution must be paid to or set apart for the use of the specific public charity maintaining the PIF. This is different from a CRT, which allows the donor to choose (and even change) any combination of public charities, private foundations, or donor-advised funds that will receive the charitable remainder. (Of course, the donor still does effectively get to choose the charitable remainder beneficiary of a PIF by choosing which charity’s PIF to use, though the use of the PIF still means that all of the assets in that PIF will go entirely and exclusively to that one sponsoring charity and cannot be split to other charities at the income beneficiary’s death. However, as discussed later, some PIFs allow the donor to instruct the charity to take part or all of the charitable remainder interest it receives and “re-donate” it to one or more other public charities, or to a donor-advised fund.)

The remainder received from the PIF by the sponsoring charity may be more or less than the principal originally contributed and will depend on many factors, including the investment strategy used to generate the PIF income (and its associated returns), the inherent risk and volatility of that strategy (and how it was able to support ongoing payments given the actual sequence of returns), market conditions at the time of the last income beneficiary’s death (especially with respect to more illiquid assets that may need to be sold in varying market conditions), and the PIF fee structure (and its associated cost drag).

As with all split-interest charitable gifts, though, it is important to recognize that by definition, the charity will receive the remainder interest. Thus, while a donor may ask how the remainder can stay “in the family”, it is generally the case that CRTs and PIFs are generally not appropriate strategies if there is a lack of charitable intent, or if the donor wants their family to have more say in how the charitable remainder is to be used.

Distribution And Pass-Through Nature Of PIF Income

The fundamental income requirement for all PIFs is that they must distribute all of their income, at least annually, for the life of the income beneficiaries. In turn, this income payout is based on the income actually earned by the PIF (where “income” itself is defined in the PIF document), unlike CRTs which may set payouts based on a specified dollar amount (CRAT) or annual percentage of the trust (CRUT). As a result, PIF income rates are not guaranteed, and instead, the rates can and will fluctuate based on the PIF’s income generated from year to year.

In turn, PIFs are not even permitted to retain current income, but also may not distribute principal (except in the case of certain “Total Return PIFs” as discussed later). This is distinct from CRTs, which may have other payout options (e.g., a flat annuity CRAT payments that could consist of income and principal, or a CRUT with “income only”, “income with a make-up provision”, or a provision for a specific percentage distribution that would result in the distribution of principal because the payout rate exceeds the CRT’s return).

Furthermore, distribution periods for PIFs cannot be set for a fixed term (again, unlike CRTs, which can have a specified period, such as 20 years), and instead, PIF payout periods may only be determined by the lifespans of the donor’s designated beneficiaries. In addition, a PIF payout cannot change upon a future specified event (as contrasted with so-called “Flip CRTs” that may alter their provisions upon a subsequent event like the grantor’s retirement).

Ultimately, the key point is that PIFs are somewhat less flexible when it comes to the income provisions themselves and do not have the various alternative options that are available to a CRT. In the case of a PIF, it can only make distributions for life, and distributions are always based on the actual income that the PIF generates (not a fixed dollar amount or specified unitrust percentage of the entire account balance).

Definition Of “Income” For PIF Distribution Purposes

The PIF defines what counts as “income” for PIF distribution purposes, as governed by IRC Section 643(b). Historically, bond interest and dividend payments were the primary “income” items, while capital gains were typically allocated to principal.

Accordingly, in the past, PIFs were usually invested to generate only interest and sometimes dividend income (all of which was straightforward “income” for PIF distribution purposes). Today, though, that investment strategy would result in low distributable income, given the low-interest-rate environment.

However, Treasury Regulation Section 1.643(b)-1 issued in 2004 loosened the rules to reflect changes in the Uniform Principal and Interest Act. The revised rules allow a PIF to define “income” to include more types of income, such as short-term and post-contribution long-term capital gains (i.e., other than the long-term capital gains that are “built into” the appreciated property at the time it was originally donated), and even option income, so long as the characterization is permitted under local law. Which in turn, allows PIFs to adopt a more “total return” approach to investing and generating income for PIF income beneficiaries.

Beneficiary Taxation Of PIF “Income” Distributions

The tax character of PIF income (i.e., the nature of the income to the PIF itself) flows through to the PIF income beneficiaries and income is reported to the PIF income beneficiaries on a Form K-1, to be included on the beneficiary’s own individual tax return. For example, if the PIF income is comprised of (bond) interest, then the income passed through to PIF income beneficiaries also is treated as interest and, as such, is ordinary income and taxable to the beneficiary (akin to distributions from a CRT).

Similarly, if the PIF income includes Qualified Dividend Income (QDI), then that part of the PIF income would be passed through to the PIF income beneficiaries as QDI, and as such, taxed more lightly at long-term capital gains rates. This is also true of any distributed long-term capital gains, assuming that the PIF permits the distribution of post-contribution long-term capital gains (pre-contribution appreciation is generally not allowed to be distributed).

Notably, because PIFs must by definition pay out all of their income, they are effectively subject to an “AIAO” (All In, All Out) tax treatment, where it doesn’t actually matter the order in which income was generated and distributed (because it will all be distributed). This is in contrast to income from a CRT, which is taxed on the “WIFO” (Worst In, First Out) method under Treasury Regulation Section 1.664-1(d) (where the CRT uses the least favorable approach with the highest-taxed ordinary income treated as distributed first, then long-term capital gains, then principal, and finally tax-exempt income), as not all income may be distributed in any particular year and consequently, it’s necessary to determine which portions of the CRT’s cumulative income are distributed in any particular year.

Allocating PIF Income Among Income Beneficiaries

Because a PIF is, by definition, a pooled income fund that generates income for multiple beneficiaries (who may have contributed varying amounts at varying points in time), when the fund generates income that will be distributed to its income beneficiaries, it’s necessary to determine how to allocate the pooled income across those beneficiaries.

Treasury Regulation 1.642(c)-5 provides precise rules for determining how PIF income is allocated among the PIF income beneficiaries. Generally, PIF income is allocated among the income beneficiaries based on units assigned to them, similar to how variable immediate annuitization payments are calculated or how one’s ownership of a mutual fund is measured.

That is, each PIF income beneficiary is allocated a fixed number of units upon becoming a PIF income beneficiary, and the annual allocation of PIF income is based on each PIF income beneficiary’s relative number of units for that year.

A PIF income beneficiary’s number of units generally depends on the value of the PIF contribution attributable to that individual, compared to the total value of the PIF at the time of the contribution. In practice, this effectively means that each PIF income beneficiary will simply receive their pro-rata share of the tax consequences of each income distribution.

Example 3: Tom contributes $100,000 to a PIF when the PIF unit value is $10/unit. Tom designated himself as the sole income beneficiary with respect to that PIF contribution.

For PIF income allocation and distribution purposes, Tom would be assigned $100,000 (contribution) ÷ $10 (value per unit) = 10,000 units.

If the PIF had a total of 200,000 units outstanding after Tom’s contribution, and no other contributions occurred, then Tom would be allocated 10,000 (units belonging to Tom) ÷ 200,000 (total PIF units outstanding) = 5% of the PIF’s income on an ongoing basis, for having comprised 5% of the PIF when Tom’s contribution was made.

Notably, as additional donors make future PIF contributions, the total outstanding units of the PIF may change over time, but the calculation process ensures that prior donors continue to receive their appropriate share based on their unit contribution relative to the ongoing total. And of course, PIF income beneficiaries may be allocated additional units if a subsequent PIF contribution is made that names the individual as a PIF income beneficiary with respect to that contribution.

In addition to changes in the number of units as new PIF contributions are made (or reductions as income beneficiaries pass away), the units themselves can fluctuate in value depending on the value of the PIF assets from time to time. This fluctuation in PIF unit values is relevant for determining the number of units that are to be issued to future PIF income beneficiaries when new contributions are made.

Deviations in a PIF’s income allocation method are permitted if the resultant outcome is similar to the standard PIF rules, or where the public charity is entitled under the terms of the PIF to a larger share of the PIF income.

Property That May Be Contributed To Pooled Income Funds (PIFs)

Contributions to PIFs are typically made with either cash or Long-Term Capital Gain (LTCG) property (similar to acceptable contributions for CRTs). For LTCG property donations made to PIFs, the donor is subject to standard tax rules for donating appreciated property to a public charity (as the PIF counts as a 50-percent-type charity), resulting in a lower 30%-of-AGI limitation for the charitable deduction to the PIF.

Technically, Short-Term Capital Gain (STCG) property may be donated to a PIF. However, this generally does not happen because no tax deduction is allowed for the appreciation of the donated STCG property (instead, the charitable contribution for STCG property is limited to its cost basis). Accordingly, some PIFs simply forbid donations of STCG property.

Notably, the only statutory exception to the types of property that may be contributed is, per IRC Section 642(c)(5)(C), that tax-exempt securities (e.g., municipal bonds) may not be contributed to or held by the PIF.

Nerd Note:

IRC Section 642(c)(5)(C) would appear to permit a mutual fund that holds tax-exempt securities to be contributed or held by the PIF on the basis that the mutual fund is subject to taxes. However, Treasury Regulations Sections 1.642(c)-(5)(c)(4) provide that a security, the income from which is exempt from taxation, may not be contributed or held by the PIF. Although the regulatory language does not fully track the Code, the more conservative approach for a PIF would be not to accept or hold mutual funds that invest in tax-exempt securities. Though obviously, a donor who wishes to contribute such assets could simply sell the fund and donate the proceeds as cash (albeit while potentially incurring any capital gains on appreciation of the fund’s NAV).

Further PIF-Specific Limitations Of Allowed Property

As a practical matter, the types of property that may be contributed to the PIF may be further limited by what the PIF itself will accept as determined by the public charity that sponsors the PIF.

For example, while the PIF rules may technically allow for contributions of privately held stock or real estate, if the stock or real estate does not generate current income, it might be adverse to the PIF income beneficiaries for the PIF to accept this type of property. This can prevent the amount of distributable PIF income from increasing and, at the same time, would still require the income to be allocated among a larger number of income beneficiaries, including the donor contributing the non-income producing property. In effect, the result would decrease all beneficiaries’ allocable shares, which would be especially problematic if the property cannot be readily sold or if significant expenses would be incurred by the PIF to hold the property (and thus why the PIF may refuse to accept such property as a contribution).

PIFs And Prohibited Transactions

Another challenge of contributing certain types of property is the potential creation of prohibited transactions and related excise taxes, since PIFs are generally subject to the self-dealing transaction rules that apply to private foundations (IRC Section 4941 and Section 4947).

For example, “transferring income or assets to, or for the use or benefit of, a disqualified person” (e.g., a PIF donor) would be considered an act of self-dealing by a private foundation. Accordingly, if a donor were to donate real estate to the PIF and then rent an apartment or office from that real property they contributed to the PIF, this could be considered a prohibited transaction.

Interestingly, a PIF may avoid private foundation prohibited transactions that apply to holding so-called ‘jeopardizing investments’ and ‘excess business holdings’ by simply not allowing the public charity sponsoring the PIF to be an income beneficiary (IRC Section 4947(b)(3)). Which means in practice, a PIF may be able to hold a substantial amount of privately-held stock (which might otherwise have been an excess business holding, as private foundations are generally allowed to hold up to only 20% of a corporation’s voting stock, reduced by the stock owned by any disqualified persons), and/or to facilitate the liquidation and exit of a business owner who is looking to turn a substantial business holding into a charitable donation with a lifetime income interest.

Real Estate May Generate Unrelated Business Taxable Income (UBTI) In A PIF

While by law and by policy a PIF may choose to accept contributions or otherwise hold real estate, in practice, this can be problematic, as doing so might generate Unrelated Business Taxable Income (UBTI), which can result in the PIF being required to pay income taxes on the real estate returns despite otherwise being a charitable entity that doesn’t have to pay taxes.

For example, if the real estate is an income-generating rental property subject to a mortgage, then unrelated debt-financed income, a type of UBTI, would be generated as a result of the rental income, and the PIF would be subject to tax on this income.

In addition, the PIF rules under Revenue Ruling 90-103 require a PIF that holds real estate to establish a depreciation reserve for purposes of determining distributable PIF income.

Given the risk of prohibited transactions and UBTI (and the administrative complexity associated with each), most PIFs commonly accept only ‘traditional’ brokerage investments like stocks, bonds, mutual funds, and ETFs (of the non-tax-exempt variety, of course!), and to the extent that real estate is accepted, it may only be in order to immediately sell upon receipt for the PIF to reinvest into more ‘traditional’ investments. Nonetheless, for those who would materially benefit from more flexibility in PIF rules around permitted holdings, it may be possible to find PIFs that will accept and hold ‘non-traditional’ assets (usually an NPIF) given that the tax law itself does not prohibit such investments.

How PIF Charitable Income Tax Deductions Are Determined

Because a contribution to a PIF entails a donation to charity – albeit in the future, once the income beneficiary has passed away and the charity actually receives the remainder – the donation is eligible for a charitable tax deduction. And one of the key benefits of PIFs is that charitable deductions for contributions often compare favorably against a CRT tax deduction, even where the CRT is providing a similar amount of income.

PIF charitable tax deductions are generally determined by computing the present value (at the time of the transfer) of the life income interest(s) and subtracting that value from the fair market value of the property transferred to the PIF to determine the value of the remainder that will be left to the charity (and eligible for the deduction). Calculation of the present value of the income interest is done considering the age of all of the donor’s PIF income beneficiaries (and using factors set out in the Treasury Regulations to determine the associated life expectancy, which is determined using the 2000CM mortality tables), the net fair market value of the property transferred to the PIF, and an assumed interest rate.

Accordingly, the fewer and older the income beneficiaries are, the larger the PIF charitable contribution deduction will be. This makes sense because it is more likely that the PIF will make fewer lifetime income payments, and that the charity will receive more of the remainder and/or receive it sooner (which makes the charitable donation larger and more valuable).

The interest rate variable is very crucial, and will generally be based on the PIF’s highest annual rate of return in the last three years, per Treasury Regulation Section 1.642(c)-6(e)(3). Accordingly, the lower the returns of the PIF, the lower the interest rate variable used to value the PIF charitable remainder, and the larger the charitable tax deduction to the donor. And the fact that the PIF can be invested more conservatively in order to produce a lower return makes it possible for the assumed interest rate of the PIF to be lower than what must be used for the similar charitable tax deduction calculation for a CRT (allowing the PIF to produce a higher charitable tax deduction for a similar donor contribution and specified payout rate).

Example 1: Ann is age 60 in 2021. That year, she donates $100,000 cash to a PIF sponsored by Tick Tock Tech, her college alma mater (the “TTT PIF”). She names herself as the sole PIF income beneficiary.

The highest annual rate of return of the TTT PIF during the three years preceding her contribution, from 2018 through 2020, was 5%. Based on this rate of return and her life expectancy using Treasury Regulations factors, Ann’s income interest would be worth $60,739, and Ann is entitled to a $100,000 – $60,739 = $39,261 charitable contribution deduction.

If Ann is in the 35% combined state + Federal tax bracket, then her $39,261 deduction results in a tax benefit of $39,261 x 35% = $13,731.

This in turn results in a ‘net contribution’ to the PIF of $100,000 (actual contribution) – $13,731 (tax benefit) = $86,269.

If the TTT PIF’s actual income rate of return for a year is 4%, then Ann’s implied rate of return on her PIF contribution for that year would be 4.64% (i.e., $4,000 (4% return on the $100,000 contribution) ÷ $86,269 (net contribution) = 4.64%).

LTCG Property Donations Can Preclude Capital Gains Taxes And Net Investment Income Tax

When contributing appreciated LTCG property to the PIF, the donor permanently avoids any capital gains taxes on the donated property as they receive a charitable deduction based on the full fair market value of the appreciated property. They do not recognize any embedded capital gains in the process.

Avoiding capital gains taxes by donating to a PIF (or other charity) also avoids the associated 3.8% Net Investment Income Tax (NIIT) that may have been due had the property been sold by the donor.

This is a permanent tax saving that increases the amount that may be invested by the PIF to generate income for the donor’s PIF income beneficiaries, compared to what the donor would have had to reinvest by selling and diversifying (and paying the associated capital gains taxes) and only having the after-tax remainder available.

Example 2: Ray wants to diversify out of $100,000 of IBM stock with a $50,000 cost basis, but isn’t sure whether he should donate the stock to a PIF and receive the associated income, or sell the stock and then invest the proceeds from which he can generate personal income and perhaps do some charitable giving in the future.

His financial advisor explains that by donating the stock, Ray can avoid capital gains taxes (potentially including the 3.8% NIIT tax) on the $50,000 appreciation.

Ray’s combined Federal, state, and NIIT tax rate on that capital gain would be 30%, which means he would save ($100,000 FMV – $50,000 basis) x 30% = $15,000 in income taxes, and the entire $100,000 would be ‘available’ to generate income for Ray (as PIF income distributions).

By contrast, if Ray were to sell his shares and contribute the cash proceeds, he would only have a net total of $100,000 FMV – $15,000 income tax = $85,000 to invest and generate income for himself.

The tax treatment on LTCG appreciation for a PIF donation is substantively different than when a similar contribution is made to a CRT. The reason is that in the case of a CRT, while the CRT itself will not pay taxes on the capital gain, under the CRT tax rules, when the CRT distributes its annual stated amount or percentage, a portion of the distribution may be deemed to comprise capital gains which are taxable to the CRT beneficiary. In other words, the capital gains tax on donated assets to a CRT isn’t necessarily eliminated; instead, the gains are held inside of the CRT and are just deferred… until the CRT makes its income distributions, and the income beneficiary receives the dollars and must then report the associated capital gains tax consequences.

By contrast, the capital gains that are generated by a PIF when the donated appreciated property is sold are simply claimed by the charity – which doesn’t have to pay the gains as a tax-exempt entity – and are never distributed to the income beneficiary. In fact, PIFs are specifically prohibited from making distributions of pre-contribution capital gains that were embedded in the donated property (and consequently can’t/won’t ever be distributed and taxed to the beneficiary!).

Estate and Gift Tax Implications Of PIFs

A donation to a PIF involves a gift of a remainder interest to a charity, along with a retained income interest to a non-charity individual (or multiple individuals).

With respect to the charitable remainder portion of the gift, contributions to a PIF not only receive a charitable income tax deduction, but for gift and estate tax purposes also qualify as charitable deductions (avoiding any adverse gift or estate tax consequences for the PIF donation).

However, when it comes to the income interest for a (non-charitable) individual, gift or estate taxes can arise. Of course, if the PIF donor themselves are named the income beneficiary, there is no gift to oneself. And if the PIF donor’s spouse is the income beneficiary (or a charity is named), an unlimited spousal (or charitable) deduction is allowed. However, if a third-party individual is named as a beneficiary, their income interest is treated as a taxable gift for the (present value) amount of that income interest. However, current gift taxes can be avoided by the PIF donor reserving the right by Will to revoke the gift of this lifetime interest (though the value of the remaining income interest, if the income beneficiary outlives the donor, will be taxable at the donor’s death if the income interest is not subsequently revoked). Where the PIF donor reserves the right to revoke a beneficiary’s income interest, taxable gifts are deemed to be made by the donor as income payments are actually received by the PIF income beneficiary. Such amounts are treated as gifts of a present interest and as such qualify for the annual gift tax exclusion.

Notably, in cases where the donor is the income beneficiary, the contribution to the PIF constitutes a gift with a retained interest, which means upon the donor’s death, the full value of his or her PIF units is includible in their estate. However, the full value of those PIF units is deductible from the taxable estate at that time via the estate tax charitable deduction because the remainder interest will go fully to charity at that time (i.e., the remainder value is included, but there is a charitable deduction offset for estate tax purposes).

How New Pooled Income Funds (NPIFs) Enhance Traditional PIFs

While the various benefits offered by PIFs can be attractive, they can be further enhanced if contributions are made to what is known as a “New” PIF (NPIF). While NPIFs are not defined in the Internal Revenue Code, they typically consist of a PIF that has been in existence for less than three taxable years preceding the year of contribution.

The significance of an NPIF is that, when it is so new, there is no history of PIF returns to determine the assumed interest rate used to calculate the value of the income interest and the concomitant value of the charitable remainder interest and associated charitable tax deduction. In the absence of a 3-year history of returns, an Internal Revenue Code and Treasury Regulations provide an ‘alternative’ approach that ultimately produces a lower (i.e., more favorable for tax purposes) interest rate assumption.

Accordingly, the main benefit of an NPIF is that, in a low-interest-rate environment such as the one we are in now (and that we might stay in for a long while), contributions can potentially result in a significantly larger charitable tax deduction than if the same contribution were made to a PIF in existence for more than three taxable years preceding the year of contribution (sometimes referred to in this article as a “traditional” PIF) or, importantly, to a CRT (given how the deduction is calculated, as discussed in more detail below).

As a result of these dynamics, once an NPIF is more than three years old, its primary function focuses more on generating income than on facilitating deductions. In fact, some public charities will then create a new NPIF to operate over the next three-year period (even if it is a clone of the original NPIF), simply to re-up the more favorable NPIF interest rate assumption. Contributions can then be made to the “new” NPIF for the next three years and so on for each subsequent 3-year period. (Concurrent multiple NPIFs also may be established with different investment objectives as long as the multiple PIFs do not function as a device to be manipulated by the PIF donors, per Treasury Regulation Section 1.642(c)-5(b)(3)).

Along with a larger charitable contribution deduction relative to a traditional PIF, NPIFs also seek to better balance the PIF benefits between the donor and the charity by using the flexibility inherent in the PIF rules. This might be viewed as better recognizing the “split-interest” nature of the trust. In this way, an NPIF offers somewhat more of a ‘win-win’ strategy than a traditional PIF.

Favorable NPIF Charitable Tax Deduction Rules In Low-Yield Environments

Charitable tax deductions allowed for PIFs are generally larger in a low-interest-rate environment, as the lower the interest rates, the smaller the income payouts, and the larger the remainder for the charity (and the larger the associated charitable deduction). However, a traditional PIF deduction is usually not as large as it would be if the contribution were made to an NPIF. This is because there is a special rule in place that mandates the rate required to be used by an NPIF. And this rate is often lower than that for the traditional PIF.

Specifically, under Treasury Regulation Section 1.642(c)-6(e)(4), the mandated NPIF income rate is the highest annual average of the so-called “Code Section 7520” rate during the three years preceding the contribution, less 1%. This rule exists because the NPIF does not have a three-year track record over which to otherwise determine its income rate, as does a traditional (longer-running) PIF.

This is a crucial point because, in a low-interest-rate environment such as now, the mandated Section-7520-rate-minus-1% ends up being quite low, which usually results in very small projected income distributions and an “oversized” tax deduction, especially compared to a traditional PIF or a CRT. For instance, the NPIF “mandated rate” is 2.2% in 2021 and is anticipated to be 1.6% in 2022 (which is derived from the average Code Section 7520 rate of 2.6% in 2019, the highest average rate during the 2019-2021 cycle, less 1%).

It is important to note that there is no correlation between the interest rate used to calculate an NPIF charitable contribution deduction and the rate of return actually earned by the NPIF in any year. So even if the NPIF actually earned 10% income in the contribution year or a subsequent year, this would have no effect on the NPIF charitable contribution deduction amount that was already ‘locked in’ at contribution. This allows for a potentially large ‘arbitrage’ between the interest rate used to calculate the deduction upfront and the rate of return used for distribution purposes if the NPIF is invested for better returns in the future.

Example 4: As discussed in Example 1, Ann contributed $100,000 in 2021 to her alma mater’s traditional TTT PIF. In 2021, her income rate was 5%, and the deduction calculated based on this rate was $39,261.

However, if the TTT PIF had been an NPIF, the same contribution would have provided Ann with a $64,039 charitable contribution deduction. This is 63% larger based on the same dollar contribution and would apply even if, in practice, Ann’s NPIF later did achieve the same 5% income returns as the original PIF and thus paid out to Ann the same 5% rate!

Nerd Note:

The factors in the Treasury Regulations used to determine life expectancies for PIF deduction purposes are the same for the traditional PIF and the NPIF. However, both are arguably out of date (and in fact, the IRS is in the midst of at least partially updating the RMD tables for 2022), and both are based on the general population. This means that the assumed life expectancy for PIF deduction purposes is likely to be substantially shorter than if the life expectancy of a typical PIF income beneficiary was used because a typical PIF income beneficiary tends to be much healthier than the general population (if only because those in poor health with limited life expectancies don’t choose life-contingent PIF income strategies in the first place!).

As such, healthy beneficiaries who self-select income from such PIF strategies will likely live longer than the generic non-self-selection-biased PIF deduction factors assume. Stated another way, the PIF deduction factor tables assume that the charity will receive the PIF remainder far earlier than is likely to be the case, which has the effect of artificially increasing the PIF charitable contribution deduction.

A related point is that PIF income beneficiaries can expect to receive PIF income for longer than the IRS assumes. This is a valuable aspect of the current NPIF opportunity, in particular, because the NPIF is invested to generate a higher income than a traditional PIF.

How NPIFs Can Invest For Higher Returns Than PIFs

PIF rules generally permit investment strategies that allow the PIF to generate income for its PIF income beneficiaries and allow flexibility to select investments, which also may be more favorably taxed (e.g., by investing in stocks that pay qualified dividend income). Even so, traditional PIFs still tend to be invested relatively conservatively as a natural bias by the sponsoring PIF charity, given that, as the remainder beneficiary, it holds an interest in preserving principal (at the cost of income/yield generated), which can result in lower annual distributable income. In addition, higher-income yields and higher-income payout rates can reduce the tax deduction for new PIF contributors and dissuade them from making new donations (given that higher PIF yields result in lower PIF tax deductions), which further disincentivizes PIF sponsors from investing for higher returns.

NPIF rules, on the other hand, attract new contributions by leveraging the special rules applicable to PIFs in their first three years (which ignores the actual returns of the PIF), and if/when an NPIF generates higher returns and becomes more mature, new donors can simply be directed to a new NPIF (rather than be dissuaded from contributing to the existing PIF that now has higher returns).

In turn, NPIFs may further try to attract new donors by choosing a higher-returning and more flexible investment approach. In particular, this is accomplished by leveraging the 2004 Treasury Regulations to re-define “income” for the PIF to include a wider range of income items (i.e., to treat post-contribution long-term capital gains and qualified dividends as income for distribution purposes), to the extent permitted by the PIF rules and applicable state law, which can continue even after the NPIF is no longer “new”.

The secondary benefit of this approach is that by leveraging more total-return investments – in particular, equities, and the long-term capital gains and qualified dividend income they can generate – NPIFs can also produce income that is more favorably taxed to the income beneficiary (given the preferential 0%, 15%, and 20% tax rates for long-term capital gains and qualified dividends). This can especially help PIF income beneficiaries in the lower tax brackets, where some or all of the higher NPIF income might escape Federal income taxes altogether, thanks to the 0% long-term capital gains rates that apply to those in the bottom two ordinary income tax brackets.

Example 5: Ally, who is in the top income tax brackets (37% for ordinary income and 20% for capital gains), contributes $100,000 to Tick Tock Tech’s (TTT’s) NPIF.

Ally chose the NPIF because TTT’s traditional PIF was invested in a bond portfolio that yields 3%, all of which is ordinary interest income.

The NPIF, by contrast, uses an amended approach with a broader definition of income, and its assets are invested to generate favorably taxed qualified dividend income and Long-Term Capital Gains (LTCG).

If this revamped portfolio generates a 4% return, the combined effect of more income that is more lightly taxed results in net after-tax income of $4,000 (qualified dividend income and LTCG) × [1 – 20% (capital gains rate)] = $3,200 from the NPIF.

By contrast, the income from the bond portfolio of the traditional PIF, subject to ordinary income tax, would have resulted in net after-tax income of $3,000 (ordinary income) × [1 – 37% (ordinary income rate)] = $1,890.

Thus, by shifting from the PIF to the NPIF with more favorable allowable investments, Ally’s after-tax return increases by almost 70%! And at the same time, her charitable contribution to the NPIF would be higher, an NPIF interest rate assumption of 2.2% in 2021 (as compared to the traditional PIF that would have been required to use its actual 3% payout rate).

In turn, an NPIF may accept a wider range of assets than a traditional PIF, which may be donated free of capital gains taxes and free of the 3.8% NIIT. Such assets may include business interests, real estate, and other assets. Ultimately, though, this is still up to the NPIF about what ‘alternative’ assets it will or will not accept (and not all NPIFs accept a wide range of assets).

On the other hand, the risk still remains for the NPIF sponsor that seeking higher current income and/or leveraging a wider range of investments means that the NPIF principal value may decline, resulting in a lower income base, a smaller charitable remainder for the PI sponsor, or both.

NPIFs Permit A Broader Range of Income (And Remainder) Beneficiaries

Traditional PIFs may often limit potential PIF income beneficiaries to the donor and their spouse, with some requiring that income beneficiaries attain a certain age (e.g., age 55), so that the public charity will receive the charitable remainder sooner rather than later (as allowing children or grandchildren to be named as beneficiaries might mean the PIF won’t actually receive the charitable remainder until the beginning of the 22^nd century!).

However, sponsors offering NPIFs are using them to try to proactively attract more donors, and consequently, the rules tend to be more flexible, allowing a broader range of income beneficiaries. Often, any living individual is allowed to be selected as an NPIF income donor, regardless of their age or relationship to the donor!

Additionally, there may also be no limit on the number of income beneficiaries that may be designated. As a result, the NPIF income beneficiaries may include family members (children, grandchildren, brothers, sisters, cousins, aunts, uncles, nieces, and nephews), non-family individuals, and even strangers. This broad range of income beneficiaries allows an NPIF to support unique groups of people in need (e.g., individuals with disabilities or who may be socially disadvantaged, first responders, and their families).

Keep in mind, though, that naming younger or more income beneficiaries lowers the upfront charitable contribution tax deduction when donating to the NPI. And there are gift tax implications when naming income beneficiaries besides the donor and/or their spouse. However, the lengthened period of time during which income payments are projected to be made may be considered an adequate “trade-off” for the lower deduction.

Example 6: As noted in Example 4, Ann has contributed $100,000 to the TTT NPIF. However, instead of naming herself, she has named her daughter, Nancy, age 35, as the TTT NPIF income beneficiary.

By making this change, Ann’s charitable contribution deduction is reduced from $64,039 to $35,808. Although this reduces Ann’s NPIF contribution tax benefit by ($64,039 – $35,808) × 35% = $9,880, the lifetime payment stream related to her contribution may be projected to increase by 24.1 years.

If the NPIF earned 6% annually in practice with a conservative growth portfolio, then the $9,880 tax benefit reduction may be projected to result in $6,000 per year × 24.1 years = $144,600 in additional pre-tax income.

Where the objective is to benefit younger beneficiaries such as children or grandchildren, an NPIF can be much more useful than a CRT (and also often more useful than a traditional PIF, which may sometimes have age limitations for designated beneficiaries).

This is because, in many cases, a CRT will not even be available on account of the CRT requirement under IRC Sections 664(d)(1)(D) and 664(d)(2)(D) that the charitable remainder benefit is projected to equal at least 10% of the initial fair market value of the CRT contribution. This requirement usually cannot be satisfied through CRTs that involve younger beneficiaries and when payments are to be made for life (because the income interest would last so long and be so large that it would amount to more than 90% of the contribution to the CRT). PIFs (and NPIFs), on the other hand, are not subject to this 10% minimum remainder requirement.

Another distinction in the permissible beneficiaries of NPIFs (as compared to traditional PIFs) is that some NPIF sponsoring charities will agree to ‘re-donate’ some or all of the remainder to other public charities selected by the NPIF donor and/or to a donor-advised fund. (And some NPIF sponsors will even permit the donor to change his/her selected public charities after contribution but before death when the actual payout would occur.) Of course, the NPIF sponsor generally hopes to receive at least some of the proceeds – thus the purpose of sponsoring the NPIF in the first place – but certain NPIFs anticipate that by attracting more donor assets and becoming known as ‘flexible NPIFs’, they will still benefit for their ‘fair share’ (while also gaining more economies of scale in the operation of their NPIFs for the benefit of all participants).

Factors To Consider And How To Find An NPIF

While an NPIF can offer valuable benefits, it remains crucial to determine if an NPIF is in fact the appropriate gifting technique for the prospective donor, especially since NPIF contributions are irrevocable.

The first step is to determine whether the NPIF advantages will benefit the donor. At its core, NPIFs will be used in similar situations as other ‘split-interest’ charitable vehicles – such as a Charitable Remainder Trust – where there is a desire to support both income beneficiaries (the donor or other family members) and a charity, with a desire to generate a current-year tax deduction for the contribution. Except that, due to the rules for how NPIF charitable contributions are calculated and the discount rate that is applied, NPIFs can provide a superior upfront tax deduction relative to a CRT for the same contribution amount.

On the other hand, NPIFs will retain less control for the donor than a CRT. Not only can the donor not be the trustee or direct how the charitable assets will be invested, but the donor cannot designate a non-public charity (e.g., a private foundation) as the remainder beneficiary, and will be constrained to whatever assets the PIF or NPIF will accept as contributions. Though by utilizing the services of the NPIF sponsor, the donor also avoids legal fees and other setup costs common to CRTs, and will not incur direct ongoing administration costs (e.g., annual trust tax returns for a CRT) either.

The flexibility of NPIF beneficiaries also provides some additional specialized use cases for those with charitable intent. For instance, NPIFs have been used to benefit community members who are disadvantaged or in need, armed forces veterans and their survivors, first responders and their survivors, elderly citizens as an income supplement plan, young children (as a way to provide a long-term income and retirement program), employees (as a “quasi-deferred compensation plan”), ex-spouses (as a replacement for alimony), and plaintiffs who receive a taxable recovery where the attorney fee is nondeductible. They can also be used as a way for employers to provide their employees with a “charitably-focused deferred compensation plan” that is exempt from qualified and nonqualified plan rules, and which is not subject to ERISA. In addition to more ‘common’ uses of establishing a split-interest trust to offset income in high-income years (e.g., for those with high salaries, large bonuses, sales of businesses, deferred compensation or change-in-control payments, sizable Roth conversions, etc.).

Although PIFs and NPIFs are ‘out there’, though, unfortunately no directory exists for them (that we are aware of). Google searches can help, or go to a public charity/university website or ask their planned giving coordinator. It follows that it is difficult to readily compare one PIF or NPIF to another.

If an NPIF is the right planning device, and a desired sponsoring charity is found, then the next step is to evaluate the provisions of a particular PIF. Fortunately, PIFs must provide a disclosure statement that explains its rules and relevant provisions. Such disclosure statements typically provide most necessary information, though unfortunately some disclosure statements are quite sparse (such that it will be necessary to dig further). In any event, it also is worth asking for the PIF trust agreement, investment policy, performance information, and fee information. We’d also suggest asking for a copy of the PIF’s Form 5227 (the annual tax reporting form for split-interest charitable vehicles).

When evaluating an NPIF, the following are important considerations to address:

• Who may be an income beneficiary? Some limit the income beneficiaries to the donor and his or her spouse. Others allow for a broader range.
• How old must the income beneficiary be (or how young may an income beneficiary be)? Some limit income beneficiaries to individuals who are older than age 55. Others allow income beneficiaries of any age (which is great for long-term “dynasty-like” planning).
• How many income beneficiaries may there be? Some limit the number to two. Others allow up to 10 income beneficiaries.
• How much flexibility is allowed in terms of the order of income payments when multiple income beneficiaries are utilized (concurrently, consecutively, or both)?
• Who may be the “ultimate” charitable beneficiary? Some limit the charitable beneficiary to only the PIF sponsor, which is common with university-sponsored PIFs, while others allow the donor to direct the charity to “redirect” some or all of the remainder payment to other public charities, or even offer a donor-advised fund.
• What assets are accepted? Some accept only cash and publicly traded securities. Others accept a broader range of assets, such as real estate or business interests.
• How is “income” defined? Some limit income to traditional sources, i.e., dividends and interest. Others define income more broadly, for instance, to include post-contribution long-term capital gains or LLC distributions.
• How much income will be generated? Some NPIFs are invested conservatively to grow the remainder, so the income amounts will tend to be low. Others are more “donor friendly” and are invested to generate more for the income beneficiaries.
• How will the income be taxed? Some NPIFs are tax indifferent as to the income they generate, and consequently may generate income that is mostly ordinary in nature. Others focus on generating income that will be more lightly taxed, such as qualified dividend income.
• Can an NPIF be formed that allows only a limited number of income beneficiaries? This may be of interest to donors who want to limit the NPIF to family members, which most likely applies in large contribution situations.
• What are the NPIF expenses? A reasonable “all-in” expense range for both investment and administration services appears to be in the 1-2% range, with most centering around 1-1.5%. Some NPIFs have a larger contribution minimum, with a corresponding lower expense rate.
• Will the NPIF compensate a registered investment advisor or a broker, and if so, how much and for how long? This information should be in the disclosure statement or should be readily available.
• What input is the NPIF willing to accept regarding NPIF investments? Some NPIFs completely slam the door on this. There are others that effectively allow the donor to recommend who the NPIF investment advisor will be, even though the donor cannot control the ultimate decision.
• What is the minimum or maximum NPIF contribution?

The world of charitable giving entails a veritable alphabet soup of charitable strategies, from the “split-interest” PIF and NPIF and CRT strategies discussed here (along with the charitable gift annuity or CGA) to other charitable planning strategies that donors routinely consider to “fully” donate outright (with no retained income benefits), including donor-advised funds (DAFs), qualified charitable contributions (QCDs), private foundations, and outright charitable gifts.

Accordingly, one of the first core decisions to make when giving is whether the donor wishes to donate outright, or whether to create some form of split-interest (where part of the gift goes to charity, but part is retained for the donor, their spouse, family members or heirs, or other individuals). Ultimately, PIFs – and NPIFs – are of the split-interest variety and should only be considered when there is a split-interest goal in the first place; they are not appropriate for those who want to simply donate outright, nor are they appropriate for those who don’t have at least some charitable intent (otherwise, it’s generally still better to pay the applicable income and/or estate taxes, and bequest the rest as desired).

Still, though, when it comes to split-interest charitable gifts, arguably PIFs and especially their new NPIF brethren are an underutilized strategy compared to their more popular brethren, the Charitable Remainder Trust (CRT). Even though in today’s environment, well-crafted NPIFs are capable of producing larger charitable tax deductions, healthy income distributions for income beneficiaries, and even an ‘arbitrage’ between the favorable interest rate assumptions of an NPIF and the return that can subsequently be achieved with even a conservative total return NPIF investment strategy. And typically at a lower cost than what it takes to administer a CRT, especially when considering all legal and accounting costs for setup and maintenance.

Of course, while there are many benefits of traditional PIFs and NPIFs, like other planning strategies, contributing to them is not for everyone. It requires completely giving up access to the principal and control over the donated asset and delays when the charity receives its benefits (although income beneficiaries are free to contribute current PIF income to the charity as they wish). And if the donor does not have sufficient requisite charitable intent, there may be significant misgivings or remorse in permanently donating the asset that will at least partially (with its remainder) go to the charity.

Still, though, PIFs and NPIFs present a unique opportunity for clients who are charitably inclined to accomplish multiple goals at once: large charitable contribution deductions, estate tax deductions, meaningful lifetime income for the donor, his or her family, and other selected individuals, completely tax-free donations of appreciated property, and the fulfillment of long-term charitable goals.