The goal of any planned giving program is to leverage every gift to its highest value while satisfying the wishes of the donor. Common trust arrangements usually serve this purpose quite well. But there are times — especially in a slumping economy — when a different plan is more suitable and beneficial for both parties.
One vehicle with special features is the pooled income fund (PIF), rarely used by rank and file charities but often found in the portfolios of colleges and universities.
Created in 1969 under Section 642(c) of the Internal Revenue Code, pooled income funds are similar to charitable remainder trusts in that they provide lifetime income for the donor, with the remainder of the fund going to the designated charity when the last beneficiary dies.
However, unlike a charitable remainder trust, a pooled income fund is not a tax-exempt entity. And unlike a charitable remainder trust, which has one or two donors and income beneficiaries, a pooled income fund has numerous donors and beneficiaries. Some of the unusual restrictions on pooled income funds include a ban on investing in tax-exempt securities, a requirement that they be maintained by the charity receiving the remainder interest and a ban on donors or income beneficiaries from serving as trustees of the fund.
Pooled income funds are similar to mutual funds in that their value is divided into units used to determine how much income the donors will receive while they are alive. When donors make the original gift to the pooled income fund, they receive a tax deduction for the value of the remainder that will go to charity. That assessment is based on the full market value of the assets donated to the fund, the age of the income beneficiaries and the investment return of the fund.
Pooled income funds are normally set up with the expectation of receiving a large number of small gifts. The age limits for the donors varies. The older the donor, the larger the remainder deduction and the sooner the charity will receive the donation. Pooled income funds pay out variable returns and are considered an alternative to gift annuities, which pay out fixed amounts.
Traditional pooled income funds tend to mature in the range of $1 million to $5 million, depending on the fundraising activities of the charity. Income beneficiaries typically receive returns of 3 percent to 5 percent.
For PIFs in existence three years, the return is the highest of the returns for the preceding three years. For those in existence less than three years, the return varies each year and is determined using an Internal Revenue Service (IRS) formula.
The donors are also entitled to a gift tax deduction and an estate tax deduction, but their annual income distribution from the fund is taxable. The fund, meanwhile, is entitled to a charitable deduction for all capital gains permanently set aside for the charity.
In explaining how its pooled income fund works, the Massachusetts Institute of Technology (MIT) describes a scenario in which a hypothetical alumnus named Anthony Brown decides to give MIT $20,000 worth of stock that he originally bought for $8,000.
At the time he makes the gift to the pooled income fund, the fund is paying 5.4 percent in income, a much better rate than the 1.1 percent dividend yield on the stock. Since the fund’s principal is also growing, his annual return is expected to grow over time. By making a gift to the pooled income fund, Brown has:
- Received an immediate income tax deduction equal to the value of MIT’s remainder interest;
- Avoided $2,400 in capital gains taxes;
- Increased his income and created the potential for increased income in the future;
- Supported a scholarship fund to benefit an MIT student. MIT offers donors three pooled income funds, the first of which — the William Barton Rogers Fund named for the university’s first president — was established Sept. 2, 1975. Since then, the Richard C. Maclaurin and Karl T. Compton pooled income funds have been created. Each of the pooled income funds has different goals.
Harvard University — the most well endowed university in America — offers six pooled income funds, each with a separate investment objective.
- The Harvard Life Return Fund, opened in 1986 seeks a high sustained rate of income over the long term. With a yield of about 7 percent, the fund is open to beneficiaries who are at least 50-years-old;
- The Harvard Balanced Fund, established in 1973, is geared toward donors interested in current income and long-term growth and principal. Open to beneficiaries at least 40 years old, the fund’s most recently reported yield was 3 percent;
- Harvard Growth Fund, established in 1976 seeks a more immediate return and greater long-term growth of principal and income. Reporting a lower yield of about 1.7 percent, the fund offers a higher immediate tax deduction and is open to beneficiaries who are extremely young at 25 years old;
- Harvard International Bond Fund, established in 1992, seeks income by investing in high-quality international bonds. The fund provides diversification of income for its beneficiaries, with a target yield of about 5.8 percent. The fund is open to beneficiaries who are at least 40-years-old;
- Harvard International Equity Fund, created in 1992, seeks long-term growth of principal and income, mainly through investing in companies that do business primarily outside the United States. With a target yield of 1.8 percent, the fund is open to beneficiaries 40 and older.
- Harvard Equity Income Fund, established in 1992, seeks long-term growth of principal and income, primarily through investing in undervalued, income-producing stocks. The fund aims for a yield of about 3 percent and is open to beneficiaries at least 40 years old.
Among the donors to Harvard’s pooled income funds was one of its own faculty members, Professor Raymond Vernon. he geared his donation to support the Kennedy School at Harvard. “Supporting the school through a gift to Harvard’s pooled income fund is another way I can further this work,” he said.
Although colleges and universities are the major players in the pooled income funds, charities also manage funds for their donors. Shriners Hospitals for Children in Tampa, Fla., uses the pooled funds to support its mission, making quarterly payments to beneficiaries while taking no annual fee for acting as trustee. Shriners also pays all custodial and investment fees.
The Salvation Army in Alexandria, Va., is another charity that offers pooled income funds, as is the San Diego Foundation. The San Diego Foundation sets a minimum contribution of $5,000. The fund is managed by City National Bank, which takes a management fee of 0.75 percent.
Unlike San Diego, the Chicago Community Foundation has avoided pooled income funds because of potential legal complications in administering them.
In Dallas, the Baylor Health Care System Foundation also avoids the pooled income funds in favor of charitable remainder trusts and charitable lead trusts. But the foundation is not shutting the door permanently. “We might offer them in the future,” said foundation Vice President Ken Holden.
While cash and securities are the most common assets given to a pooled income fund, donors have contributed everything from rare books to real estate. In some cases, cash can be converted to real estate.
Attorney Emmanuel J. Kallina, managing partner in the Baltimore firm Kallina & Ackerman, and Robert Seaberg, managing director of Salomon Smith Barney in New York City, presented a seminar on pooled income funds at the 14th National Conference on Planned Giving. They both pointed to the real estate pooled income fund as particularly noteworthy for nonprofits in the current economy. When the economy is down, cash-strapped charities find that raising funds through outright gifts becomes more difficult, they said.
A real estate pooled income fund can help colleges, universities and other nonprofits manage construction and renovation, acquire new property, refinance old debt or create an endowment.
Kallina and Seaberg described a scenario in which a charity chooses to lease land surrounding its buildings to a pooled income fund on a long-term basis at nominal rent. At the same time, the fund buys from the charity a building for $5 million, paying the charity 7 percent interest on the loan. Thus, each year, the charity pays the fund $350,000 in rent and the fund balances the scales by paying the charity $350,000 in interest.
Then, a husband and wife donate $5 million of appreciated stock to the pooled income fund. The fund can sell the stock tax-free and pay off the loan on the building. The pooled income fund would then use its $350,000 in rent to provide income for the husband and wife.
At the death of the husband and wife, their units in the pooled income fund would pass to the charity, ending the pooled income fund and leaving the charity as the owner of the building.
According to Kallina and Seaberg, here are the benefits of that scenario:
- The charity has $5 million cash and can use the money to finance construction or renovate another building, pay off or restructure debt, acquire new property or create an endowment;
- If the charity uses the $5 million to buy a new building, it has done so at a significantly reduced cost. A real estate PIF can save a charity upwards of 34 percent of the cost of conventional bond financing;
- The charity owns the building in the end and does not have to be concerned with reacquiring the building as it would under a sale/lease-back arrangement;
- The charity, as tenant, trustee and remainderman, never parts with control of the building;
- The charity creates a broader donor base, since many charities have found that contributors to pooled income funds are usually not significant former donors;
- Because of the benefits to the income beneficiaries, gifts tend to be larger than they might be otherwise;
- The charity controls the trust.
For the donors, the benefits include a return of 7 percent, which is probably higher than the return on the contributed stock, and they are able to liquidate an investment tax-free. They are also able to diversify assets without paying taxes and are able to leave more to their heirs than if they had sold the asset and reinvested the proceeds or held the asset until their deaths.
The donors also receive a current income tax deduction, offsetting ordinary income and other forms of taxable income, which may be carried forward for an additional five years. They also are entitled to a pass-through of the depreciation deduction and are entitled to estate and gift tax deductions.
Kallina and Seaberg said that the popularity of pooled income funds has been vacillating toward a downhill slide, chiefly because most charities say their income beneficiaries are dissatisfied with the rate of return. Thus, many traditional pooled income funds are being terminated, with the income interest being sold for a gift annuity or simply given to the charity.
One cloud hanging over pooled income funds is a proposed ruling from the IRS to clarify traditional definitions of principal and income raised by various state laws.
“Some state statutes permit the trustee to make an equitable adjustment between income and principal if necessary to ensure that both the income beneficiary and the remainder beneficiary are treated impartially,” the IRS wrote in announcing its proposed ruling. “Thus, a receipt of capital to be allocated by the trustee to income is necessary to treat both parties impartially. Conversely, a receipt of dividends or interest that previously would have been allocated to income may be allocated by the trustee to principal if necessary to treat both parties impartially.”
While some charities may be considering launching pooled income funds, others are planning to end theirs. According to the Planned Giving Design Center (PGDC) in Maryland, nonprofits may want to terminate PIFs if they lack critical mass to retain investment management cost effectively or are too small to make portfolio diversification realistic. Other reasons include dissatisfied beneficiaries and rules that limit annual distributions to income.
The pooled funds can also become a marketing distraction when similar vehicles such as charitable remainder trusts are available, according to the PGDC.
For a PIF that still has charitable and non-charitable beneficiaries, the assets should be divided based on the interests of the remainder beneficiaries when the fund is terminated. Gains from the sale of assets are usually allocated to the charity, according to the PGDC.
Richard Williamson is a Dallas-based reporter for the Denver News Bureau.