This workshop will address the real problems with hands on, real life solutions that I have experienced or have seen over several years of administering or helping to administer several pooled income funds, both large and small, old and new. As we know, we learn from our mistakes better than from our successes. I hope the subjects I address here will help you in not having to learn some of these lessons as I did, namely the hard way.
For openers, be sure you get a copy of the Committee on Gift Annuities' Red Book, that helps one understand how to compute the charitable deductions from gifts to a pooled income fund (Note: No longer available, since 1998) . Also, I recommend you subscribe to one of the many tax services on planned giving, so you can stay current with changes in the laws and regulations on these funds. Then, because the deductions your donors can claim for pooled income fund gifts now change annually due to the use of the new Applicable Federal Rate (AFR) interest (120 % of the annual mid-term) rate if your fund is less than 3 years old, or the actual earning of your fund, using a government formula, if you Fund is at least 3 years old, you will want to become familiar with the several computer programs now available to help you do these calculations. Prices for these programs vary widely, so check out several of them to be sure you get one that meets your needs. All do the simple computations. Some provide a wide array of other computations and illustrations', including charts and graphs (for a price).
Different Ways to Administer Pooled Income Funds
The charity can be the trustee. A Pooled Income Fund is unique, with all kinds of special rules and regulations. It is not a simple endowment fund. The average business office of a charitable institution should not try to administer the pooled income fund by itself. The pitfalls are legion and normally, that is asking for trouble. Key to this decision is to realize that is your Fund is found to be invalid by the IRS at some later date, all past gifts to the Fund are invalid and tax deductions claimed by those donors are invalid as well. Imagine the negative public relations to your organization that will result by having to tell all past donors to refile their tax return for the year(s) of their gift(s), removing their tax deduction, and paying back interest and penalties. Since the chances are remote that you will be able to correct the error in the Fund retroactively, the risk is not worth taking.
1. The charity still maintains control of the Fund if it employs a bank as trustee or if it wants to be the legal trustee, employ the bank as custodian of the assets and administrator of the Fund. The charity should get away from the day to day administrative paperwork and concentrate on donor relations and contact. Use a bank for what it does best, handling tax returns, collecting, computing and distributing income, and the like. Do not become the bank's first Pooled Income Fund client. Seek out banks with proven long term track records. They do not have to be geographically close to you. They can be a continent away without any problem. While the experience of a third party trustee is important, remember that such experience is usually, (but not always) only as good as the current staff of that trustee. Do your due diligence in this area.
2. Your organization may be related to or part of a national organization, like a church denomination or group of colleges or secondary schools, etc. that could use the pooled income fund of the umbrella organization. Be careful here, for the issue of control of your charity by the umbrella organization is important. Have your legal counsel give an opinion here. Technically, the organization that controls the Fund must control the remainderman, the organization that benefits from the gift. Again, be conservative in such decisions. You do not want to find out that you are part of an invalid pooled income fund because one or more charitable beneficiaries do not qualify as appropriate remaindermen. There is very limited case law on this issue, but there is a difference between a remainderman that is related to the organization controlling the fund and one that is controlled by it.
Some of the tests on related vs. controlled revolve around whether or not your organization's board is approved by the organization controlling the Fund and what happens to the assets of your charity if you close the doors. If the assets revert to the organization running the Fund, this is one proof that your organization is controlled by the one running the pooled income fund. Again, have legal counsel review this issue, in light of the regulations.
Starting a Fund
Despite what some bank trustees suggest, start your fund with two gifts on the same day. A pooled income fund is a fund that commingles gifts from multiple donors. It could be separate participations from a married couple, as long as each makes a separate gift, receiving income on their gift first and each naming the spouse as second income beneficiary.
Or, get a supporter of your organizations to agree to make a gift on the same day you find your first donor. Have that supporter give you an undated check or promise to mail their gift on the same day you obtain the first one. In any event, get two gifts on the same day to initially fund your pooled income fund. Don't listen to banks that tell you to ignore this point. What happens if you close your trust year and you only have the first gift? Do you have a bonafide pooled income fund? Raising such questions is just asking for an IRS audit. I would not want that question to come up in the minds of the IRS. You don't want them to tell you that you have an invalid fund and that all past donors had made gifts that did not qualify for a tax deduction.
Valuation Date Problems
Become familiar with the rules and make sure your organization and your Fund's trustee follows them. Even experienced banks make errors. A case in point. We established a pooled income fund with one bank, that used the last day of the quarterly months, March, June, September, and December (MJSD-31) as the income payout dates, with a June 30 trust year ending date. The fund's administration plan called for quarterly income payments as of those dates. We changed trustees to a bank that used the last day of February, May, August and November (FMAN-31) and their payout dates with a May 31 trust year ending date.
Since the regulations require the trustee to distribute all net income within 65 days of the end of the trust year, I questioned the second bank about holding the June income until the end of August, thereby missing the 65-day deadline rule. After months of being told their counsel had reviewed it and it was acceptable, and that the trust officer had ten years' experience and I should trust them, I demanded an opinion in writing. Some five months later, I was told that after further review, I was right, the fund was not meeting the 65 day requirement and a separate distribution was made each June to meet the rules, until later regulations made all funds conform to a December 31 trust year ending date. Moral: Learn the rules yourself and question, question, question.
Another example: I was involved with a fund back in the days of the Tax Reform Act of 1969 that created this gift vehicle. We created our pooled income fund by identifying those participations in our Regular Life Income Fund that qualified as pooled income fund participations and overnight we had a pre-existing pooled income fund. We distributed income as of the last day of the quarterly months (MJSD-31). Our valuation dates were the same as the income distribution dates.
Many months later we attempted to get an IRS letter qualifying our Pooled Income Fund. We were told our fund was invalid because we did not use January 1 as the first valuation date for the year. Our counsel even traveled to Washington to argue the point, stating that the market was not open on January 1, so we used December 31 instead.
We were refused because the rules state you must go forward not back to establish valuation dates. We had an invalid fund. We added a fifth valuation date (January 1) but that "extra" valuation cost us $500 in expenses, which did not please our Board. We ended up changing the valuation dates to JAJO-01 while retaining the payment dates of MJSD-31. Problem solved. Since that was in the early days of pooled income funds, we were permitted to change our Administration Plan to qualify the Fund prior to getting our Private Letter Ruling. Recently, the IRS ruled they would no longer provide separate letters for each fund.
My first experience in starting a new pooled income fund was a nightmare. We received several small gifts of from $1,000 to $5,000 each in the first quarter of the fund. Toward the end of the that first quarter we received a gift of highly appreciated stock worth $100,000, more than all the other gifts to date. The stock gift was admitted to the fund on the gift date, as it should have been, but it was mailed to us and many days were lost in transit and getting it sold. The sale price and resulting proceeds were about ten percent less than the fair market value and no income was earned on the gift value until it was reinvested close to the end of the quarter.
We started our fund at an arbitrary $10.00 per unit with the first gift. At the end of the first quarter, the unit value was $8.95 and much of the income earned by the other gifts was assigned to the large gift. When I reviewed the proposed income distribution, I felt faint. In talking with the bank trustee, I was advised that nothing could be done since our plan did not allow for valuation dates other than the four per year specified in the plan. Our plan had been drafted by a very prestigious law firm at a high fee. The regulations provide a way to resolve the problem, but the Plan must allow the Fund to be valued on any day the trustee wishes.
By adding additional wording to our Administration Plan, we were able to fairly distribute the income to the earlier gifts and not have to give it away to the larger gift that came in late in the quarter without earning its own share of income for the Fund. Besides the stipulated quarterly valuation dates, we added the words "... and the Fund may be valued on any other day in any taxable year, including but not limited to, any day in which a transfer is made by a donor to the Fund. Income may also be distributed on additional dates as determined by the trusee."
The addition of those words to your fund's Administration Plan will help you in the unlikely event that you get a very large gift compared to the total value of your fund and that large gift does not earn its fair share of the fund's income immediately after its admission to your fund.
Terminating Income Interests
There is much confusion in this area. It is my feeling that many funds compute the terminating interest incorrectly. Several Private Letter Rulings have been superceded by a Revenue Ruling, but it is not clear how many funds may still be doing it wrong.
Two methods are acceptable, but your Plan must spell out which you use. The income interest could terminate with the date of death or the last regular quarterly payment before the date of death. The latter method is easier to administer. That just means that the right to income ends on that date. It has nothing to do with the removal of the remainder value from the Fund.
One removes the units from the Fund on the Fund's valuation date immediately following the termination of the income interest. If you do not learn of the death for some time, you remove the funds on the next valuation date following your learning of the death, but at the unit value of the valuation date immediately following the termination of the income interest, not at the unit value on the date you remove the principal. Any income earned on the units in the fund until their removal payable to the remainderman. You will want to review Revenue Ruling 76-196 and be guided by the examples given.
Types of Gifts to a Pooled Income Fund
From the viewpoint of the donor, the best gift is appreciated property, because long term capital gain tax is avoided and the donor is assigned units on the fair market value of the gift. While stock traded on a major exchange or over the counter is probably the most obvious example, the key to avoiding problems is to make sure you know the donor's acquisition date.
Do not accept any gift that does not qualify for long term capital gain handling. If you accept short term gain property, be sure you hold it until it becomes long term gain before the Fund sells it. The Fund takes over the donor's holding period and cost basis.
The fund pays short-term capital gain tax if it sells short-term gain property. Since the transaction must be shown on the Fund's annual tax return, paying the tax just invites an IRS audit. It is a red flag that tells the IRS the trustee doesn't know how to run the fund, so perhaps they should take a closer look at the fund. Do not let your bank trustee sell (withdraw) short-term gain assets (units) to pay themselves their fee.
If you transfer your fund to a new bank trustee that invests your fund in its common investing fund, the entire fund is short term capital gain property until the assets qualify for long term capital gain handling beginning with the investment date in the new bank's fund. Pay the trustee fees from income or from other organization funds, but do not remove principal units to pay the fees until the units qualify for long term capital gain handling. Remember that the holding period is a year and a day or six months and a day, depending on the rules in effect on the date the asset was purchased. Don't get caught by not waiting that extra day. The rules keep changing, so know them well.
You can avoid paying capital gain tax on the sale of short-term gain property by distributing pro rata to each participant, but you can do that only if your Plan says you can do it. If you distribute it, at least your Fund's tax return does not have to show it as a taxable event, for which your fund must pay the tax. Paying the tax is a good way to invite an audit, in my opinion.
Do not invest in or accept into your Fund any asset that is free from Federal Income Tax. Know every gift a donor wants to give your fund. If you are dealing with the donor's broker in completing the gift, be sure you are told each asset the donor is gifting and its cost basis and holding period. If it is earning tax-free income or is short term gain property, don't accept it into your Fund, and don't let your bank trustee accept it either. Know the rules and be sure your trustee does as well. One "bad apple" ruins the barrel and you could end up with an invalid pooled income fund.
Earnings Record vs. Fund Yield
It is important to know the difference between your Fund's Earnings Record and the net income it earns and distributes. Since your fund operates something like a mutual fund, would you invest in a mutual fund that could not tell you its unit value and income per share history? Why should a donor make an irrevocable gift to your fund if you cannot provide the same data? An example of a Pooled income Fund's unit value and yield history is found in Exhibit A.
Note that of the three annualized yield percentages shown, only column 3 is an accurate one. Columns 1 and 2 use assumptions which make the numbers slightly inaccurate. Note also that column 1 is the method used by all mutual funds to show their "current" rate of return. It is the most inaccurate method of the three. When is the last time you received an income check on the day you made an investment? The problem is illustrating yields is that the fund has a daily changing unit value. Since a gift is assigned the units on the day it enters the fund, that fixes the unit value that determines the yield. Each donor is getting a different yield on their gift with each income check.
Do not use the column 1 method to quote your Fund's rate of return. No participant is receiving the rate and to tell all participants that this is the rate will anger those entered your fund at a higher unit value than the one on the distribution date, since their yield will be lower than the number you are quoting. If possible, compute the annualized yield for each participant in your fund as you make each quarterly distribution and advise them of their current rate of return, not the Fund's current rate of return. Good gift administration is good gift development. Don't anger or confuse your donors unnecessarily.
Your Fund's Earnings record is the rate of return used to compute a new donor's charitable deduction for a gift to your fund. After your fund has a three year history, (trust years not calendar years) the highest rate of the last three years must be used to compute the charitable deduction. Exhibit B illustrates a Three Year Earnings Record. Since the donor's advisor cannot compute a charitable deduction without knowing the highest rate of the three years prior to the year of the gift, the charity must be able to provide the prospective donor's advisor with the computations as shown in Exhibit B.
Be sure you maintain such a record and begin using it in the forth trust year of your fund. Note that the first year of anew fund may be less than a full calendar year. Under present rules, all pooled income fund trust years end on December 31. A short trust year can result from the changeover to December 31 trust year ending dates (in 1987) and with new funds whose first gifts are received after January 1. A new fund whose first two gifts are received in October has a three month first year trust.
Your Offerings Brochure
You must publish an Offering Brochure, (Disclosure Statement or Prospectus) for you Fund which includes a layman's description of how the fund operates, your Administration Plan, copies of your declaration of Trust and your Instrument of Transfer. The detailed requirements for the latter two items are found in Tax Code and regulations. As your Fund matures, you must provide a historical record of the five year history of a $10,000 gift in that document, showing the number of units assigned, and the annual net income from that gift for each year, as well as the rate of return of the income annually. This can be done by printing paste-over labels updating that record annually and affixing the labels to your published Prospectus.
Be sure that each donor is given a copy of this Disclosure Statement before making the gift. Make a paper trail record of this fact by referring to the donor's prior receipt of the document at the time you acknowledge the gift in writing. In a future audit, you may need to prove to the IRS that each donor did receive this document prior to their making the first gift.
Commingling of Assets
The invested assets of your Pooled Income Fund can be commingled with other invested assets as long as the participations of your Pooled Income Fund and each participant can be identified through unitization. This could include investment in your charity's endowment fund as long as it and your pooled income fund are both unitized, or it could be invested in a bank's common investing fund which is always unitized.
Though unitization, your Fund owns a proportionate share of all the assets in the larger investment fund. Your charity could provide the seed money for the Pooled Income Fund by placing part of its endowment fund in a separate investment and using that as the initial pooled income fund investment.
Investing your Pooled Income Fund
It is important that the larger fund have the same investment goals as your Pooled Income Fund. If your Endowment Fund does not, then you will have to place some monies in an investment fund that can be invested with the same goals as your Pooled Income Fund.
The easy way out is to use a commercial bank's common investing funds, using the percentages of their equity, bond and money market funds that will produce the investment goal you are seeking. You should monitor the performance regularly, and be willing to make changes in the percentage mix that will result in the investment goals you need. This constant monitoring and periodic changes in investment mix to accomplish your goals is critical to your fund's long term success. Every quarter that goes by is building a permanent fund history that cannot be undone retroactively. Note again Exhibits A and B.
Note the prohibitions of investing in municipal bonds or any assets that are free from federal income tax as outlined above in the section on Types of Gifts.
You could also use mutual funds but you should be aware of the dates of income and dividend distribution and make sure they fit with your Pooled Income Fund quarterly distribution dates. If they don't, you have unhappy donors who expected four checks a year and find they are receiving less due to your mutual fund investment choices. If mutual funds are used, use only no load funds, for you want all the assets working for your participants. Investigate telephone switching and check writing privileges, so you have flexibility in control and administration. Only use mutual funds if you are knowledgeable about how such funds work and the funds you use have along track record that meets your goals. The expenses, fees and minimum investment amounts in such investments can cause you problems. Investigate before you invest.
Your Board Member as a Donor
Contrary to an initial cursory reading of the regulations, your Board members can be donors to your Pooled Income Fund, if the Board member resigns or will refrain from making investment or any other decisions relating to your Pooled Income Fund and your Board Minutes always state that fact when such decisions are made, referring to the donor/board member by name.
Gifts of Real Property
The problems with accepting real estate into a pooled income fund are too many to try to resolve. It is best to avoid accepting such assets into your Pooled Income Fund. With the advent of necessary appraisals by qualified appraisers, the amount of shrinkage of market value to net proceeds due to high sale and transfer costs, having to hold non-income producing property in the fund while a buyer is sought, as well as other problems in administering the gift, it is not worth the headaches involved in trying to find ways to accept real property into a Pooled Income Fund. Simply put, don't do it. At the very least it is unfair to those who trusted you by giving you irrevocable gifts before your real property donor appeared, for the real property donor will be receiving some of the income that was actually earned by the prior donors' gifts. Use an income only charitable remainder unitrust for such gifts.
Corporate Donors to a Pooled Income Fund
You will want your counsel to investigate the possibility of the acceptance of gifts from corporate donors to your Pooled Income Fund. You should be aware that it is possible to do so. See revenue Ruling 85-69.
Real Property Investing
Pooled Income Funds can now invest in certain types of real property and the depreciation and investment credits can be passed on to the income beneficiaries to reduce the taxability of their income. Be sure your counsel reviews this carefully before you launch into this approach. Your Fund's Administration Plan must state whether or not your fund accepts real property. Since you must set up a reserve in your fund if you do, you may want to think twice before going down that road, for it will penalize the donors of other assets to your fund, since they will not get a direct pass through of ALL the net income by the Fund. You will want to do your own "due diligence" on this point before deciding in the affirmative.
In Closing
While the above paper was written in 1989, it is still totally valid today. Hopefully, it will be a guide to both charity and third party trustee (i.e.: bank or trust company) alike, in making sure that BOTH parties understand what is possible and what is NOT possible in the proper trusteeship of a Pooled Income Fund.
If the charity learns nothing else from reading this, I hope they will bring away from it, the realization that as the "owner" of the Pooled Income Fund, they must know at least as much as does the trustee, about how to correctly administer a Pooled Income Fund. The charity needs to monitor what actions the trustee takes on behalf of the charity and the participants in the Fund.
For instance, innocently accepting municipal bonds into the Fund will irrevocably damage the fund, since that is forbidden (accepting assets that do not earn taxable income) and there is no mechanism to correct an error of this type to make the fund whole again. Technically, it makes the Fund invalid at that point.
Or, accepting short term gain property and selling it before it becomes long term gain, subjects the Fund to the payment of capital gains tax, which come directly out of the gross income of the fund, which negatively affects the existing income beneficiaries. So, accepting anything other than cash, without FIRST getting the answers to a list of questions about the asset is very poor trusteeship, which is just an "accident" waiting to happen, with no means to recover and make the Fund viable again. Such an "accidental" wrong decision could have irrevocable consequences to the ability of the Fund to accept further gifts and provide a charitable deduction to later donors. So who has the authority to accept gifts to the fund (trustee staff or charity staff and which of each) is an important decision.
So, relying totally on the Trustee to guide the charity and make decisions for the charity and the Fund in this area is NOT good "due diligence" on the part of the charity. I hope that this will be both informative and helpful to both charity and third party trustees alike.
