ELITE ADVISOR BEST PRACTICES
The re-emergence of the Pooled Income Fund
By Randy Fox
- A PIF is a tax-advantaged way for multiple donors with common goals to join forces.
- Contributions to PIFs qualify for charitable income, gift and estate tax deductions.
- Savvy practitioners are establishing new PIFs to take advantage of current low applicable federal rates.
Pooled income funds (PIFs) have been around for a long time and, until recently, had fallen out of favor.
A PIF is a type of charitable giving program that combines the tax advantages of charitable giving with the benefits of a lifetime income stream for two or more beneficiaries, which usually includes the donors.
As a trust that is established and maintained by a public charity, the PIF receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned “units of participation” in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.
Each year, the fund’s entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which, the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.
Contributions to pooled income funds qualify for charitable income, gift and estate tax deduction purposes. The donor’s deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.
New perspective on PIFs
Perhaps because interest and dividend rates have been at historical lows for several years and because most PIFs were established some years ago, the combination of low return and low tax deduction reduced their broad appeal. Recently, though, the tide seems to have turned, with savvy practitioners establishing new funds to take advantage of current low applicable federal rates (AFRs).
Under IRS regulations, a PIF’s charitable income tax deduction is normally computed using a complicated formula based on the prior three years’ highest rate of return on the assets in the PIF. Older PIFs yield relatively low tax deductions and, with the flexibility and control available in the Charitable Remainder Trust (CRT) world, there’d be no really good reason to compromise and utilize a PIF.
The IRS regulations tell planners: “If a pooled income fund has existed for less than three taxable years immediately preceding the year in which a transfer is made, then the highest rate of return is determined by first calculating the average annual applicable federal midterm rate (as described in IRC §7520 and rounded to the nearest 2/10ths) for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate.” With recent rates extremely low, income tax deductions are being pushed proportionately higher. While giving to charity is not normally motivated by the income tax deduction, it doesn’t hurt to have a larger deduction.
For example, I was recently brought into a business owner’s family situation in which they were negotiating the sale of their $5 million enterprise, which was an S corporation. The family was very charitable and wanted to commit $2 million to charitable purposes. The advisors were attempting to utilize a CRT to help accomplish the family’s charitable goals and save some taxes at the same time. However, CRTs are not considered qualified S corporation shareholders and the S corporation status would have to be revoked if the company stock were contributed to the CRT. While this wasn’t inherently bad, the significant issue, as in many private sales, was that the buyer didn’t want to purchase the stock of the S corporation—he wanted to purchase the assets. There didn’t seem to be a good way for everyone to win. However, a post-sale contribution to a new PIF indicated that a $2 million cash contribution would produce around $1.7 million of deduction at the donors’ current ages. The deduction would offset a great deal of the income tax liability created from the asset sale, and thus avoid a lot of complication and headaches for the advisory team. The buyer would get to purchase assets, not stock, and the seller would get his full asking price.
Further, recent opinions about what constitutes “pooling” for the sake of qualifying for PIF status has led several commentators to agree that “more than one” life is enough. This means that a new PIF can be established for a very targeted group of donors who may have a specific investment policy they want adhered to.
While it seems that it might be administratively prohibitive for a charity to maintain many different pools, current technology reduces that stress a great deal. Furthermore, charities must become more creative and flexible to attract donors in a very competitive giving environment. As it happens, though, there are several donor-friendly and advisor-friendly organizations that see a tremendous opportunity. Donors want more flexibility and control, as shown by many recent surveys and proven by the explosive growth of Donor Advised Funds (DAFs). However, DAFs don’t return any income to donors. CRTs allow the donor to receive income, but often fail the 10 percent remainder test because of the donors’ ages. Including children is almost always out of the question. PIFs stand somewhere in the middle; they return income, they have no 10 percent remainder qualification, which allows a multigenerational income opportunity, and they provide a sizable tax deduction.
While income in a PIF is often limited to “rents, royalties, dividends and interest”—typical charitable trust accounting definitions of income—there is a recent school of thought that posits that some “post- gift gain” may be counted as income as well. Certainly short-term gain should not be an issue, and some trustees may be willing to allow a portion (usually less than 50 percent) of long-term gain to be allocated to income. This should do much to stabilize or normalize cash flows and make the PIF seem more like a CRT. Additionally, PIFs are not tax-exempt trusts like CRTs, so skilled investment advice is quite important.
While it may cost more to establish a PIF than a CRT, a PIF may well be worth considering, depending on the size of the gift and other family considerations. Certainly advisors must become more knowledgeable and aware of the options to better advise the clients.