Viewpoints on Financial Planning
For many families, charitable giving is an important part of life and is something that is budgeted on an annual basis. While outright gifts may be appropriate even when donations are large, there may be times when family member(s) want to provide for charities, but also need to retain an income stream from the gifted asset for a period of years in order to meet other goals. In cases where the asset to be gifted is highly appreciated, an owner may also be interested in reducing potential capital gains and estate tax exposure.
One strategy designed to facilitate a family’s lifetime and charitable giving inclinations is a charitable remainder trust. According to IRS statistics, there were more than 110,000 charitable remainder trusts with just under $1 quadrillion in assets in 2010. Source: Internal Revenue Service – Statistics of Income Tax Statistics – Split Interest Tax Statistics
FREQUENTLY ASKED QUESTIONS
1. What is a Charitable Remainder Trust (CRT)?
A Charitable Remainder Trust provides an option for dealing with appreciated property for charitably inclined individuals and their families. Essentially, the donor creates an irrevocable trust during life or at death, and transfers property to the trust. In exchange for this transfer, the trust promises to pay the donor and/or his designated income beneficiaries a stream of income that is set by the trust document for a stated time period.
In situations where the income is payable to someone other than the donor, there would be gift tax consequences based upon the present value of the future income stream. The CRT trustee can sell the property transferred with no immediate income tax consequences and potentially create a more diversified portfolio. In this way, the donor has removed the property and appreciation thereon from his or her estate, received a one-time income and/or estate tax charitable deduction, and is able to fulfill philanthropic desires.
2. What types of charitable remainder trusts are allowable under IRS code and regulations?
There are two varieties of Charitable Remainder Trusts—a Charitable Remainder Annuity Trust (CRAT) and a Charitable Remainder Unitrust (CRUT). To meet the requirements for beneficial tax treatment, a CRAT requires the trustee to pay a fixed dollar amount at least annually to one or more persons for a term of years not greater than 20 or for the life or lives of the individual’s non-charitable beneficiaries. The amount payable annually to the non-charitable beneficiaries from a CRAT must be at least 5% but not more than 50% of the initial fair market value of the trust estate. For CRATs, a second requirement for tax deductibility is that there must be less than a 5% probability that the income beneficiary of the annuity trust would exhaust the trust principal. At the expiration of the trust term, the remaining trust property passes to the designated charitable beneficiary(ies). Once established, a CRAT cannot accept additional funding.
Example: Jason creates a $1 million lifetime CRAT with a payout equal to 6% annually for his lifetime. Jason would receive $60,000 per annum for as long as he lives. Upon his death, the remaining trust principal would pass to the charities named in his governing CRAT document.
A CRUT requires the trustee to pay a fixed percentage of the trust’s value determined annually to one or more persons for a term of years not greater than 20 or for the life or lives of the individual non-charitable beneficiaries. In other words, the amount payable to non-charitable beneficiaries from a CRUT can fluctuate each year as trust value goes up or down. The amount payable annually to the non-charitable beneficiaries from a CRUT must be at least 5% but not more than 50% of the initial fair market value of the trust estate. At the expiration of the trust term, the remaining trust property passes to the designated charitable beneficiary(ies). A CRUT also permits additional contributions to be made to the trust.
Example: Jason creates a $1 million lifetime CRUT with a payout equal to 6% annually for his lifetime. Jason would receive $60,000 in year one and then 6% of the then trust value on the annual trust valuation date for as long as he lives. Upon his death, remaining trust principal would pass to the charities named in his CRUT.
The IRS also permits a net income with make up unitrust (NIMCRUT). A NIMCRUT allows distributions to be made only up to the amount of net income that the trust earns with any shortfall made up in years where the trust net income exceeds the stated percentage. Finally, a net income with no make up unitrust is permitted as well by IRS code and regulations.
While both a CRAT and CRUT allow for a substantial range of annual distributions that can be made to non-charitable beneficiaries (5% minimum to 50% maximum), the value of the income tax deduction for the remainder interest to charity must be equal to at least 10% of the initial value of the trust. This often means that high payouts to non-charitable beneficiaries cannot be effectuated. See FAQ #3 for how the income tax deduction is determined.
3. How is the charitable income tax deduction determined on either a CRAT or CRUT?
The donor of a lifetime CRT is entitled to an income tax deduction for the remainder interest that will ultimately pass to charity. The deduction is an actuarial calculation that is dependent upon several factors, including the following:
- Type of trust (annuity or unitrust)
- Trust term: How long will payments be made to non-charitable beneficiaries (life expectancy or stated trust term in years)?
- When payments begin to non-charitable beneficiaries
- Discount factor (IRS tables)
The interest rate used in the discount factor for a CRT is equal to the 120% of the applicable federal mid-term rate (AFR) commonly referred to as the §7520 rate. The AFR is equal to yield on federal mid-term securities (defined as more than three years but not more than nine years in duration) and is published monthly by the US Treasury. The §7520 rate for January 2013 is 1.00%. A donor to a CRT can elect to use the rate in the current month or from either of the two months preceding the transfer. In all events, the calculated remainder interest income tax deduction must equal at least 10% of the initial value initially transferred to the trust.
A donor’s current deduction also depends on the type of property gifted as well as the type of charity that is named. Gifts of appreciated property to public charities are limited to 30% of the donor’s adjusted gross income in any one year. Any deductions not used in the year the CRT is established can be carried forward for up to five years.
4. What income tax consequences are faced by a CRT or beneficiaries?
A CRT is exempt from general income taxes regardless of whether the grantor or his or her spouse is a non-charitable beneficiary. However, excise taxes applicable to private foundations as well as on unrelated business taxable income (UBTI) may be payable. UBTI may come into play where a CRT holds assets such as trade or business partnerships and S corporations.
Income received by a non-charitable beneficiary of a CRT is subject to tax in one of four tiers or categories. Only when a higher category of income is exhausted does the next tier come into play.
- Tier 1 – Ordinary Income: investment income that is not derived from qualified dividends is taxed first. Income from qualified dividends is taxed next. Qualified dividends are subject to a 15 percent rate for most taxpayers – but the rate rises to 20 percent for higher-income taxpayers in the 39.6 percent federal income tax bracket.
- Tier 2 – Capital Gains in the following order: short-term capital gains, gains from collectibles, un-recaptured §1250 gains, and other long-term capital gains
- Tier 3 – Other Income: typically tax-exempt income
- Tier 4 – Principal
Within each category the first deemed distribution is treated as made from that portion that would be subject to tax at the highest income tax rate.
Example: Linda transferred $1 million of stock she has held for many years with a cost basis of $900,000 to a 6% CRAT, and the trust sold the stock and re-invested the proceeds into a bond portfolio of taxable and tax-exempt bonds. During year one, the trust earned $25,000 of taxable interest and $15,000 of municipal bond interest. The $60,000 payout in year one would be taxed to Linda as $25,000 of taxable interest and $35,000 as a long-term capital gain. None of it would be taxed as tax-exempt income (Tier 3) until the first two tiers of current and accumulated income have been exhausted.
5. What are the estate tax implications of a CRT?
Upon the death of the grantor, 100% of the trust is includable in his or her estate. However, the estate is entitled to a deduction for the remainder interest passing to charity. In a situation where the deceased was the donor and only income beneficiary, 100% of the value of the trust would be deductible as a charitable deduction for estate tax purposes. Unlike income tax rules that have limits on the size of charitable deductions as measured by adjusted gross income, there are no such limits on charitable deductions for estate tax purposes.
Because the transfer of property to a CRT is irrevocable and passes to charity at the expiration of the trust term, this can mean a “lost inheritance” for the family. To remedy this situation, life insurance owned by family members or an irrevocable life insurance trust for their benefit (wealth replacement trust) can be utilized. If purchased, owned and payable to the children and/or irrevocable life insurance trust, the insurance proceeds would neither be includable in the grantor’s estate nor subject to transfer taxes at death.
A CRT is particularly beneficial where the donor is philanthropically inclined, has appreciating assets and is interested in increasing current cash flow. The ability to sell appreciated assets without having to pay an immediate capital gains tax and retain an attractive income stream for many years—as well as an immediate charitable income tax deduction—can help families that are charitably inclined enhance current lifestyle, reduce overall portfolio risk, and fulfill multiple lifetime and testamentary financial objectives.