10 Deadly Sins: common errors to avoid in charitable trust administration.

With so many IRS requirements surrounding planned giving instruments, it's no surprise that mistakes are made in establishing and administrating charitable trusts.

Here are some common errors, based on importance.

1. Inappropriate asset allocation 

If a trust's assets are not allocated and invested judiciously, the donor, beneficiary or both may find themselves with financial problems.

Often, when charities work as trustees, they manage the assets along with their endowment funds without regard to the donor's tax bracket, income needs or risk profile.

But when fiduciaries do not meet their responsibilities--percentage payouts are too high or investment decisions are made without considering the donor's objectives--the donor and beneficiary may lose a lot of money.

2. Inappropriate payout percentage

Attention must be given to the distribution percentage, as this cannot be changed. Some points to consider when establishing the percentage include the donor's age and objectives, as well as the investment/economic landscape.

For example, it's not appropriate in today's weak investment environment to set a high payout percentage (more than 8 percent) for young donors (those in their early 60s or younger).

3. No written investment policy

Without a written investment policy, trustees do not have a target to aim for. Fiduciaries are legally held to a "prudent investor" standard, and formal asset allocation guidelines and benchmarks are essential to meet a well-reasoned investment policy.

4. Inaccurate distributions

Many donors who have not been educated on their fiduciary responsibilities seem to take a cavalier attitude toward required income distributions. Not making distributions as set forth in the trust may trigger the IRS to disqualify the trust. Also, the value of the trust at year end may be inaccurate if certain distributions have not been made.

5. Inaccurate calculation of the trust amount

Inaccurate calculations of the amount to be distributed to the beneficiary usually involve not deducting year-end distributions from the trust amount since many times these deductions are made in January or February of the next year. This results in an overpayment to the income beneficiary in the subsequent year because the amount is recorded in the wrong year.

6. Errors preparing IRS forms

One of the most common errors in completing IRS Form 5227 is using the incorrect fair market value in computing the "unitrust amount." This amount should be the prior year's fair market value, not the current year's value.

7. Margin accounts

Using a margin account--borrowing money from the trust to make investments--can create financial and legal headaches and should be avoided.

If there is even $1 of unrelated business taxable income from property that is "debt financed," then the entire trust income is taxable for that year.

Trusts are tax-exempt by following rules, one of which prohibits borrowing and investing money from the trust. If you borrow from the trust, invest that money and make money, the income is taxable. And it's against the rules.

8. Gift annuity funds not reserved or invested

Nonprofit organizations operating gift annuity programs must follow guidelines that, for example, detail how much of a gift annuity can be held where and how much the program must have in reserves.

California requires any organization that administers a gift annuity program to provide adequate reserves for any annuities sold in California or to California residents.

9. wrong type of charitable trust

There are various types of trusts and the key is to select one tailor-made to the donor's objectives and needs. This also is important because the type of trust selected can't be changed.

10. Failure to follow the four-tier accounting system

IRS Reg. Sec. 1.664-1(d) outlines the ordering system of accounting for income and expenses of a trust. Distributions to the beneficiary must be accounted for in the following order: ordinary income (current year and any past year carry-over), capital gains (short-term first, then long-term), other income and principal (or corpus).

Not following this method could spell tax problems for the donor and beneficiary. For example, the donor may lose tax deduction benefits and the beneficiary may lose tax-exempt status.

Many recent charitable trust documents have used the provisions of IRC Sec. 643(b), which permit the drafter of a charitable trust to define income and principal in the trust document, and to provide for the distribution of long-term capital gain as income.

If the trust document permits, the trustee has the discretion to allocate expenses to reduce the net ordinary income and thereby have more capital gain-type income to distribute.

An opportunity often overlooked is the trustee's power to allocate fees and expenses to ordinary income instead of to corpus or long-term capital gain. The same attention should be given in allocating expenses to short-term versus long-term gains.

Timothy J. Anderson, CPA, is a principal and shareholder of Halbert, Hargrove/Russell LLC in Long Beach. You can reach Anderson at [phone].