The other family tree: leaving your legacy in a private foundation.

• Author: Jones, Matthew F.

1. INTRODUCTION

   Recent drivers may not know that there was once a time when roads did not have those painted white lines along their shoulders. Originally, the lines were only in the middle. In the early 1950s, engineer Dr. John V. N. Dorr hypothesized that when driving at night during a rain or snowstorm, impaired vision caused drivers to hug the painted lines in the middle of the road.(1) This, Dorr believed, led to numerous collisions. Dorr asserted that car accidents could be decreased if lines were painted on the edges of the roads(2) and Dorr convinced highway officials in New York's Westchester County to test his theory on a long stretch of highway with curves and gradients.(3) The results were dramatic. A follow up test in Connecticut proved the same.(4)

   In order to publicize the demonstration's results, Dorr used his own private foundation, the Dorr Foundation of New York.(5) State funds that now pay for the painting of lines in the middle and on the edges of roads are attributable to Dorr and his private foundation.(6)

   Private foundations play a valuable role in American society.(7) Working as a partner with government and business, private foundations are one of society's research and development arms exploring cutting-edge solutions to current problems.(8) Many foundations have expertise in specialized areas and serve as informal clearinghouses of information.(9) Other foundations have created cultural infrastructures through the funding of museums, art collections, and concert halls.(10) Foundations also have founded or developed numerous colleges and universities.(11) On a more personal level, private foundations have allowed families to undertake projects of common interest. They have also allowed the original grantors to leave behind legacies of philanthropy, through which descendants learn about their relative's character and values.(12)

   The next forty years will witness the largest transfer of wealth in American history.(13) Members of the baby boomer generation are anticipating an estimated 10.4 trillion-dollar transfer from their parents, a generation which has "earned and saved more wealth than any of its predecessors."(14) With this incoming wealth, there is expected to be "a huge surge in charitable giving."(15)

   This Comment focuses on the use of trusts and private foundations in estate planning. Its first purpose is to inform the reader of the basic principles that govern trusts and private foundations. The second purpose is to explain how a trust can be used in conjunction with a private foundation to maximize the benefits of charitable giving. Specifically, such benefits are maximized by constructing an arrangement of three trusts (three trust arrangement) through which contributions are made to a private foundation.(16) When this arrangement is used, the trust is allowed to deduct charitable contributions up to 100% of its adjusted gross income, a deduction higher than any other entity is allowed.(17) The third purpose of this paper is to discuss how a trust or a private foundation can be used to create "the other family tree" through which traditions, values, and a family heritage can be passed down to successive generations.

   Part II of this Comment introduces this three-trust arrangement and describes the basic principles governing trusts and the benefits they offer.(18) Part III provides a similar analysis of private foundations.(19) Part IV summarizes the estate planning opportunities available through trusts and private foundations.

2. THE TRUST AND THE THREE TRUST ARRANGEMENT

   1. The Three Trust Arrangement

      At the outset, let it be said that this Comment is not meant as an exhaustive review of trusts and the applicable tax laws. Enough background is given so that the reader can appreciate this estate-planning tool. The basic structure is as follows: Trust B is an irrevocable complex trust that owns and operates a business, and has as its sole beneficiary, Trust A, to which it disperses income yearly at the sole discretion of the trustees. Trust A is also a complex trust that receives the income, which becomes taxable at this point. However, after deducting its ordinary expenses of operation, Trust A makes a contribution to a third trust, a private foundation, which then can either make grants to another nonprofit organization or conduct its own charitable programs depending upon its purport.(20)

   2. What Is a Trust?

      The trust has been called the crowning achievement of Anglo-American law.(21) It is the most flexible way to dispose of property, limited only by the imaginations of its creators.(22) The grantor can decide how long the property will be held, how the assets will be managed and invested, to whom it will be dispersed, and what conditions must precede disbursement.(23)

      In its simplest form, a trust is a three-party contract that forms a "legal entity," which then allows one to hold legal title to property for the benefit of others.(24) In order for a trust to exist, five elements must be present.(25) First, there must be a grantor, the person who creates the trust and supplies it with assets.(26) Second, there must be trustees, to whom "legal title" and a fiduciary duty are given to manage the assets for the beneficiaries.(27) Third, there must be beneficiaries.(28) Fourth, there must be assets. A trust cannot exist "unless there is trust property."(29) Fifth, the trust must have a purpose as expressed in its "terms."(30) The trust may be created for any purpose provided it does not violate law or public policy.(31) An example of an illegal purpose includes defrauding creditors or depriving a spouse of marital rights.(32)

      Even if these five elements are present, only trust--the noun exists. In order for the trust to fully come to life, trust--the verb--must exist as well. This means that the trust must take the appropriate action, whether it be the donor placing the assets in the trust or the trustees dispersing the assets to the beneficiaries. One can imagine that without this action, the trust is not functioning. When the appropriate action is taken, this is said to give "rise to a trust."(33)

   3. Tax Classification of Trusts

      A trust that is treated as a separate taxable entity and treated for tax purposes as a trust is called an "ordinary trust."(34) An ordinary trust is further divided into two types: simple or complex.(35)

      A trust is a simple trust if it: (1) is required to distribute all current income currently, (2) does not make distributions for the year in excess of its current income and (3) does not make distributions to charity.(36) A trust is complex if it does not meet the definition of a simple trust.(37) Therefore, a trust becomes a complex trust if it (1) accumulates income, (2) distributes assets exceeding current income, or (3) gives to a charity.(38) A distinction can be made, therefore, that a complex trust has discretionary powers and a simple trust does not. As a result, a trust can be a simple trust in one year and complex in another providing the governing instrument so allows.(39) The trusts referred to in this paper will eventually make contributions to charity, and thus are complex trusts.

      In order for the complex trust to be taxed as a trust on a 1041 form, which is the form for a "U.S. Income Tax Return for Estates and Trusts," the trust must be designated as "irrevocable."(40) This means that the donor cannot change the terms of the trust.(41) If the trust is not irrevocable, it is revocable and can be changed by the grantor.(42) In this situation, however, the grantor is taxed on the income in the trust as if the trust did not exist.(43) In such a case, the grantor must fill out a 1040 form for income taxes, which applies to individuals. The trusts used in this three-trust arrangement are complex trusts, and are designated irrevocable.

   4. Principles Governing Trusts

      1. Legal and Equitable Title

         Distinguishing between legal title and equitable title is essential to understanding trusts. As stated above, the trustee takes legal ownership of the trust, while the beneficiaries take equitable title.(44) The distinction between these originates in England; for centuries England operated separate courts of common law and chancery, where the distinction between legal and equitable interests came into being.(45) Despite the merger of law and equity in England and the United States, the distinction in trust law still persists.(46)

         Generally speaking, the trustee, as possessor of legal title, has control over the management of the trust according to the rules expressed in the governing instrument.(47) The beneficiaries, as holders of the equitable title, are entitled to the benefits of the assets, but do not have control over when or in what amounts the assets are dispersed to them.(48)

      2. Relinquishing Ownership

         A trust is a legal entity.(49) This means that it is a "non-real person" and like a human being, it can own and manage assets, operate a business, make investments, sue or be sued, or be a partner in a partnership.(50) Therefore, any assets that are transferred to the trust belong by equitable title to the beneficiary according to the conditions of the trust instrument, not the grantor.(51) Furthermore, as a separate tax entity, an ordinary truest must report and pay tax on its income.(52)

      3. Conduit Taxation

         Another fundamental feature of the tax rules of Subchapter J is "conduit taxation." This allows a trust to exempt itself from taxation on the income dispersed to the beneficiaries, who are then taxed directly on it.(53) It is as if the trust "did not intercede between the payor of income and those beneficiaries."(54) The trust is generally granted a deduction for the amount of income dispersed,(55) and the beneficiaries are required to include the same amount in their gross income.(56) So complete is the pass through of income to the beneficiaries that amounts received by the trust and then distributed to the beneficiaries...