Learning from IRC 457A

Procrastination is human nature. So, since the deadline for compliance with Internal Revenue Code section 457A, which requires repatriation of any hedge fund manager’s deferred compensation held offshore, isn’t until December 31, 2017, we haven’t seen a headlong rush to comply. Professional advisors, however, may be less procrastination-prone than others, and have been discussing how to make compliance less painful for those affected.

“There’s a healthy hedge fund and private equity community in Boston, but it’s hard to say how many people here may be affected by this law change,” says Matthew R. Hillery, a Director in the Private Client Group at Goulston & Storrs PC. And yet, he adds, a lot can be learned from the situation, whether your clients are hedge fund managers or not. A potentially beneficial planning technique in response to the law comes in the form of a charitable lead annuity trust (CLAT).

With a CLAT, there are one or more charitable beneficiaries of the trust who are followed by one or more non-charitable beneficiaries (such as children or trusts for their benefit). Chosen charities receive set annuity payments from the trust, over a fixed term of years or for the donor’s lifetime; whatever is left when the charitable term of the trust ends goes to the non-charitable beneficiaries. If the CLAT is designed in a particular way, the donor receives an income tax charitable deduction in the year the trust is funded for the actuarial value of the charities’ interest. This charitable deduction can be used to help offset an increase in the donor’s income during the first year of the trust. (For this type of CLAT, the donor would, however, pay tax on the trust’s income for the duration of the charitable term without additional deductions for the annuity payments to the charitable beneficiaries.) After deducting the value of the charities’ interest in the trust, the remaining value of the trust property at the trust’s inception is treated as a gift by the donor to the non-charitable beneficiaries. “Professional advisors should consider suggesting the CLAT option to somebody who is going to have a spike in income in a particular year—whether that’s repatriating offshore wealth, having a liquidity event with a company, receiving a particularly large bonus payment or something else,” Hillery explains. “The person has to be philanthropically inclined, of course.”

Michael Mingolelli, CEO of Pinnacle Financial Group and a member of the Boston Foundation’s Professional Advisors Committee, agrees. “By no means is this mainstream; you have to have a certain type of client—it’s very niche.”The assumption about returns on one’s investments can be important. “There’s a lot of math behind a charitable lead trust,” Hillery describes. “Some people will design a zeroed-out CLAT, which means there is zero gift, from a mathematical standpoint, to your [non-charitable beneficiary] as measured at inception. The actual investment performance of trust assets will determine what passes to your family.” The math assumes a rate of return in trust assets based upon an interest rate that the IRS publishes each month, called the Section 7520 rate. “This month [As of September 2016] the rate is at or near historic lows, at 1.4 percent. So if the trust assets can appreciate at a rate faster than 1.4 percent, then—even though you designed the CLAT so that from a mathematical tax standpoint nothing should pass to your family—you will be able to pass on [the return in excess of 1.4 percent] tax free.” That’s a nice situation for somebody who can do a good job investing the trust property. And investment managers with millions of dollars of deferred income are likely to fit that description.

Another potential enhancement to a CLAT is having a private placement life insurance (PPLI) policy as part of the CLAT. The PPLI will keep funds from being taxed while in the charitable trust. Mingolelli’s firm puts together financial models to show clients the value of various options. “They can get really complex,” he notes, “but for these types of dollars, families will tolerate that kind of complexity.” A tip on the use of insurance with a CLAT, however: “You need to know the tradeoffs and restrictions. Hedge fund managers can’t control investments inside of a PPLI policy,” explains Mingolelli. “They must use other managers. And a rule called 170(f)10 will bring a substantial excise tax if you [improperly fund the policy]. So I’d advise clients that they must work with very experienced people.”

It also helps to have a charitable lead beneficiary that is easy to work with. “It’s best if you name one or more beneficiaries and don’t change them for the duration of the trust,” says Hillery, as changing complicates the legalities of the trust. Coupling a CLAT with a Donor Advised Fund sponsored by a charitable organization like the Boston Foundation gives the donor great flexibility, both Hillery and Mingolelli say. The donor may request grants to various different organizations from the Donor Advised Fund without changing the charitable beneficiary of the CLAT (which remains the Boston Foundation or another charity sponsoring the Donor Advised Fund). Donors to Boston Foundation Donor Advised Funds can support causes and organizations of all kinds in Greater Boston or around the world. “The Boston Foundation has been very accommodating and open to charitable arrangements,” adds Hillery.