Pooled Income Funds - Overview

Operation of a Pooled Income Fund

A pooled income fund is a type of trust, established by a charitable organization with a third party trustee, that allows a donor, or another beneficiary, to receive income for life from the gift while (a) getting a charitable deduction and (b) avoiding capital gains taxes on appreciated securities gifted.

In operation, a pooled income fund is similar to a mutual fund because a donor’s gift is joined with other donors’ gifts and assigned a proportionate interest in the fund. Each beneficiary, and a succeeding beneficiary, receives an income stream for life. One of the greatest advantages of making a gift to pooled income fund is that if a gift is made with appreciated securities the donor avoids capital gains taxes. The donor may direct that their gift benefit a particular program, or, it may be an unrestricted gift that will be used by the charity where it is needed most. The entry gift to a pooled income fund is typically around $5,000 so a diverse group of donors may participate.

Advantages of a Pooled Income Fund

The most celebrated benefit of the pooled income fund is the ability to dispose of low basis appreciated assets without recognition of capital gain. This increases the yield, or return, to the donor by eliminating their federal capital gains tax, currently 20%, while simultaneously receiving income from those assets. In addition, the donor receives an income tax charitable deduction equal to the present value of the remainder interest, thereby significantly reducing their taxable income. Accordingly, 100% of the fair market value of the assets can be re-invested with the benefits of diversification and/or higher income yielding securities with a first year charitable income tax deduction adding to the donor’s yield.

With a pooled income fund a donor does not incur the costs of establishing an individual charitable remainder trust. Also, a donor may make additional gifts as often as they like. Dependent upon the donor’s circumstances including appreciation, tax bracket, age, life span and re-invested yield, the advantages of choosing a pooled income fund can be significant.

From the charity’s perspective a pooled income fund allows several key advantages. First, the charity has greater control of the remaining assets because they determine both the rate of return and the trustee. Second, the charity has full knowledge of the assets that will be available in the future.

In sum, the pooled income fund is a vital part of any charity’s planned giving program because it is accessible to many donors.

Taxation of Pooled income funds

Trust Document

IRS Rev. Proc. 1988-53 contains a model pooled income fund trust document. In our experience there are two modifications we recommend to clients, which, in our opinion, retain substantial compliance with the original revenue procedure:

1. Trustee Powers - For the administration benefit of future trustees, including the charity if it so chooses to name itself as a trustee, we would recommend trustee powers be spelled out with the proviso that such powers shall not violate the provisions qualifying the trust as a pooled income fund. The document currently references rather than incorporates the specific provisions. Administratively, it is cumbersome and expensive, to research each administrative decision against State and Federal tax law. Accordingly, now is the time to enumerate permitted powers.

2. Article Eleven, Depreciable Property Prohibition - In order to increase trustee flexibility to accept business assets, including those held by pass through entities, we recommend that depreciable property be permitted within the constraints of Rev. Rul. 1990-103. That ruling mandates that a trustee must establish a GAAP depreciation reserve to protect against the perceived abuse of trust principal while benefits go to the income beneficiary. In general, the depreciation reserve retains cash in the trust which would otherwise be disbursed to the income beneficiaries, however, the beneficiaries must still pay income taxes on those cash flows to the extent tax depreciation is lower than the GAAP depreciation computation. A trustee accepting such assets must be aware of the application of the unrelated business income tax (UBIT) and private foundation rules governing business interests. For example, subject to exceptions, when a trust acquires excess business holdings it has five years to dispose of them. This provision does not effect the charity’s taxes or excise status since these rules apply at the trust level; that is, the trust is specifically exempted from the grantor trust rules and its tax attributes do not flow through to the charity. Rev. Rul. 1990-103 provides recommended language for a depreciation reserve provision.

Taxation Compliance

Pooled income funds are required to file the following forms and informational letters. In general, the requirements are similar for all pooled income funds.

Federal and State Tax Compliance

Form 1041, U.S. Income Tax Returns for Estates and Trusts. In general, all ordinary income of the trust is disbursed to income beneficiaries and the trust issues them a Schedule K-1 annually reporting their taxable income, similar to a form 1099. There is no long-term capital gain tax even though the trust’s basis in donated assets is the same as the donor’s basis because the trust receives a 100% charitable deduction offset. Short-term capital gains are taxable to the trust without offset and are not distributed to the income beneficiaries.

NH Interest and Dividends Tax Return - The Trust will pay the NH 5% interest and dividends tax rather than the income beneficiaries because income interests are not transferable.

Form 1041-A, Trust Accumulation of Charitable Amounts. This return would, in general, only be due in transition years where a donor passes away and there remains unpaid accrued income.

Form 5227, Split-Interest Trust Information Return. This is an annual information return used to determine if the trust is subject to excise taxes.

Form 4720, Return of Certain Excise Taxes on Charities. This is only due if there is an excise tax liability. In certain circumstances excise taxes applicable to charitable foundations also apply to pooled income funds.

Reports to Donors

A. In any year of contribution the trust should send the donor a statement of the computation of the donor’s charitable deduction amount, the present value of the charitable remainder, that the donor will attach to their income tax return. The donor would also file with their income tax return (Form 1040) Form 8283, Noncash Charitable Donations, in support of their charitable deduction.

B. Lastly, the trust must provide the donor with a written acknowledgment of the gift, although the acknowledgment is not filed with the return.

Financial Statement Accounting for Charitable Remainders of a Qualified Pooled Income Trust

The accounting of the Pooled income fund arrangement is currently governed by Statement of Financial Accounting Standards No. 136, Transfers of Assets to a Not-for Profit Organization of Charitable Trust That Raises or Holds Contributions for Others.

In general, that statement requires that the Charity measure its beneficial interest in the charitable remainders at fair value using actuarial valuation techniques.

In addition, since the donors may place restrictions upon the Charity’s use of the remainder principal, the valuation must also be broken down between endowment and temporarily restricted gifts.

We recommend that the trustee of the pooled income fund value the remainder interest at the date of donation and as of client’s year end utilizing the income beneficiaries life expectancies and the discount rate utilized for the FAS 87 Pension Benefit Obligation. From time to time adjustments may be required to obtain fair value on account of anomalies; accordingly, the actuarial assumptions used by the trustee must be subject to audit firm review.

The trust agreement provides the mechanisms utilized to isolate each donor’s interest in the pooled income fund. Those computations will provide the base for the above accounting valuation.

From an internal control viewpoint, we recommend that a client add the pooled income fund’s activity to the treasurer’s accounts and establish general ledger control by recording its activities at par and discounting down to financial statement presentation values using separate valuation accounts.

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