IRS Allows Charitable Remainder Trusts to Invest in Endowment Funds
Most colleges and universities, as part of their overall fundraising program, encourage individuals with a special interest in the school's goals to establish a charitable trust in favor of the institution. The most popular type of charitable trust is the charitable remainder trust (CRT) where the income from the trust is paid to the donor or other noncharitable beneficiary for life with an irrevocable remainder interest paid to the college or university upon the death of the life beneficiary.
The Problem
When a donor creates a CRT in favor of a college or university, the school also typically serves as the trustee of the trust, with the responsibility for investing the assets in a prudent manner, including maximizing the investment return on the assets. Section 664(c)(2)(A), however, says that if a CRT earns any unrelated business income on its investments, it is required to pay an excise tax equal to 100% of the amount of such unrelated business income.
This rule prevents colleges and universities, with their trustee hat on, from investing the CRT's assets in the same aggressive and highly profitable manner that they invest the assets of their own endowment fund because many of these aggressive investments (such as those involving private equity, venture capital, real estate, and energy) generate unrelated business income. In addition to the loss of appreciation on the CRT's assets, many colleges and universities have encountered public relations problems when CRT donors compare the substantial investment returns earned by the school's endowment with the
relatively paltry returns of their CRT.
The Solution
In 2003, one institution (reportedly, Harvard University) came up with a way around these CRT investment problems. The university's solution was to create an "endowment unit" investment program that would effectively allow its CRTs to receive an investment return commensurate with the typically higher return experienced by the school's endowment fund. This endowment fund investment program is described in detail in the IRS ruling letters issued to the institution (PLRs 200352018 and 200352019), but it essentially involves an investment contract under which the CRT purchases "endowment units" from the
endowment. The major components of this investment are:
- The CRT has a contractual right against the university, but no interest in the underlying investment assets of the endowment;
- The CRT receives payments on the units held by it equal to the payout rate the university establishes for the endowment;
- A CRT can choose either to reinvest part of the payout or redeem its endowment units, depending on its cash requirements; and
- The CRT has no power or right of any kind to control or direct the university's business decisions with respect to the endowment and has no right to veto or opt out of any of the underlying endowment investments.
In its ruling letters issued to the university and the CRT, the IRS held that (1) the issuance of the endowment units from university to the CRTs, (2) the making or receipt of payments with respect to the endowment units, and (3) the holding or redemption of endowment units will not generate unrelated business income to the university or the CRTs. These rulings were based on the IRS's factual finding that "the [CRTs] would not have any ownership interest in the underlying assets of the endowment."
While the 2003 letter rulings permitted charitable lead trusts (where the charity receives the income during the donor's life and the donor receives the remainder interest) to participate in the endowment unit investment program, in late 2006 the IRS revoked this aspect of the 2003 rulings and said that it would not issue any favorable rulings where a charitable lead trust was able to participate in the endowment unit investment program. To date, the IRS has issued approximately 40 favorable ruling letters to colleges and universities seeking approval of their endowment unit investment programs, and all of them
are limited to CRTs only.
The Capital Gains Issue
Under the typical endowment unit investment management contract entered into by the university and the CRT, the CRT is permitted to periodically redeem endowment units by selling the units back to the university at the units' then fair market value. These redemption sales may be part of a realignment or reallocation of the CRT's investment portfolio, or the redemption may be necessary for the CRT to generate cash to meet its periodic distribution requirements. These redemption sales may result in a gain (when the value of the endowment unit sold is greater than the acquisition cost of the unit), while in
other cases, the redemption may result in a loss (when the value of the unit sold is less than the acquisition cost).
While none of the letter rulings issued to universities or CRTs on the unrelated business income tax issue discusses the capital gains issue, the IRS issued a separate letter ruling last year addressing this issue. This ruling (PLR 200735019) was issued in response to a request by a charitable remainder unitrust that its redemption sales of endowment units be treated as long-term or short-term capital gain or loss depending on the holding period of the unit. The IRS agreed with the CRT's position and held that the capital gains treatment for these redemption sales is appropriate.
Additional CRT Beneficiaries
One of the operative facts in virtually all of the favorable rulings issued to date is that only those CRTs for which the college or university is the sole beneficiary would be allowed to participate in the endowment unit program. Some of these rulings, in fact, go even further and set forth as an express condition of the favorable ruling the fact that the only trusts that will participate in the program are those for which the university is the sole beneficiary of the trust. (See, for example, PLRs 200732021 and 200723031).
In 2007, however, the IRS ruled favorably on an endowment unit investment program where both the university and section 501(c)(3) public charities controlled by the university were co-beneficiaries of the CRT. (PLRs 200733032 and 200733033). The unstated basis for these favorable rulings seems to be that the university will still be the beneficiary of the CRT, albeit in an indirect fashion, since the activities and assets of the controlled section 501(c)(3) organizations will eventually be used for the benefit of the university. The IRS has not yet ruled, however, on a situation where the
co-beneficiaries of the CRTs are affiliated with, but not controlled by, the university.
Conclusion
Any college or university (or any charitable/educational organization with both an endowment and CRTs) that wishes to engage in similar "endowment unit" transactions would be wise to study carefully the series of IRS private letter rulings to ensure that the contemplated endowment unit structure complies with all of the conditions imposed by the IRS. Also, because this is a volatile area where the IRS can conceivably change the rules of the game in midstream, schools would likewise be wise to seek and obtain their own private letter ruling from the IRS before entering into an endowment unit transaction instead of
relying on the ruling letters issued to other institutions. | 
