FW: Charitable Remainder Trust ‘Stretch’ Alternative

Take-Away: For those IRA owner who want to use a trust to protect their beneficiary’s inheritance from the beneficiary’s imprudence or the beneficiary’s creditor claims, and also avoid having to follow the SECURE Act’s mandatory 10-year liquidation rule, naming a charitable remainder trust (CRT) for that beneficiary may be a viable option to consider.

Background:  An IRA stretch means an inherited IRA where the distributions are made gradually over the beneficiary’s life expectancy. With the SECURE Act, the general rule now is that an inherited IRA must now be liquidated within 10-years of the IRA owner’s death. [See EDB Section below for the exceptions.] That short distribution period will accelerate the recognition of ordinary income by the named beneficiary, i.e. bunching more taxable income into a shorter period of time, exposing the income to higher marginal income tax rates. As such, due to the SECURE Act’s distribution change, many IRA owners now search for an alternative to the required 10-year liqudiation period. Consider a charitable remainder trust (CRT.)

Charitable Remainder Trusts: There are effectively three types of CRTs that are used in conjunction in estate planning, and thus potentially could be named as an IRA beneficiary.

– CRAT: A charitable remainder annuity trust (CRAT) pays a fixed dollar amount annually, at least 5% of the trust’s assets, but not more than 50%, for the life of the named individual non-charitable beneficiary, or a term not to exceed 20 years;

– CRUT: A charitable remainder unitrust (CRUT) pays a fixed percentage of at least 5% of the trust’s assets each year for the life of the individual non-charitable beneficiary, or a term not more than 20 years. A CRUT is a better hedge against inflation than a CRAT as the assets held in the trust might grow from year to year acting as a hedge against inflation; and

– NIMCRUT: A net-income-make-up charitable remainder unitrust (NIMCRUT). This trust is infrequently used, often in conjunction with an LLC or limited partnership. If the NIMCRUT invests in the LLC or LP, it may be able to accumulate wealth by deferring payouts to the CRUT lifetime individual beneficiary, e.g. delaying large taxable distributions from the CRUT to a higher earning individual non-charitable beneficiary until his/her retirement years.

CRT Rules: As required by the Tax Code:

– 5%: The minimum annual payout from the CRT  to its beneficiary is 5%.

– 10%: In addition, there is a minimum 10% present value remainder allocated to the charitable remainder interest holder. That 10% is with regard to the fair market value of property, i.e. the IRA balance,  that is placed in the CRT. If less than 10% is allocated to the CRT remainder interest, then the trust is a taxable trust, it is not tax-exempt, and thus it is not classified as a CRT.

– 4-Tier Tax Structure: The taxation of distributions from a CRT are unique, which is often referred to as the WIFO system- worst income is first income paid out. The sequence in which distributions from a CRT as paid out are: (i) ordinary income; (ii) capital gains; (iii) tax exempt income; and (iv) a return of principal. Moreover, when distributions are made from a CRT, the CRT must distribute all of the ordinary income the CRT ever had before it can distribute capital gain assets. Since an IRA is ordinary income, which classification does not disappear on the transfer of ordinary income assets (income in respect of a decedent, IRC 691] from the IRA to the CRT, it is highly likely that all distributions from the CRT to the individual lifetime non-charitable beneficiary will always be taxed ordinary income. As such, the CRT works like the former stretch IRA rules in that distributions of taxable ordinary income will be made to the individual beneficiary over the beneficiary’s lifetime.

EDB: This summary ignores eligible designated beneficiaries (EDB) who are still able to stretch distributions from inherited IRAs over their life expectancy under the SECURE Act, i.e. surviving spouses, minor children of the owner, those disabled, those chronically ill, or those less than 10 years younger than the deceased IRA owner. The stretch CRT should be considered as an option only for those beneficiaries who otherwise face the SECURE Act’s 10-year liquidation rule.

Stretch Charitable Remainder Trust: There are several reasons why naming a CRT as the beneficiary of an individual’s IRA might be a smart move:

– No Immediate Income Tax: When money passes from the IRA to the CRT on the IRA owner’s death, there will be no taxable income recognized until distributions are made from the CRT to the non-charitable beneficiary, e.g. surviving spouse; surviving child. The concept is to move income in respect of a decedent, i.e. the IRA funds, from one tax-exempt trust (the IRA) to another tax-exempt trust (the CRT.) [Private Letter Ruling 199901023.]

– Charitable Deduction: Transfers to a charity using pretax dollars makes the most sense, as the charity, being tax-exempt, does not have to pay income tax, unlike an individual designated beneficiary. An individual who inherits an IRA will incur both income and estate taxes on the inheritance of an IRA. Consequently, a gift to a charity will not cost much, and a CRT is a tax exempt entity (but not a charitable lead annuity trust, or CLT.)

– Lifetime Distributions: If the IRA is made payable to a charitable remainder trust, under the CRT rules the lifetime beneficiary receives distributions either for his or her lifetime, or a term period not to exceed 20 years, in effect emulating the former stretch IRA rules. This is where the stretch option comes into play.

– Tax Exempt: Under the Tax Code, a CRT is exempt from tax, so it can receive the owner’s IRA and not have to pay an income tax. Earnings on the IRA-now -CRT funds are also tax deferred until distributed.

– Double Stretch: A CRT can be structured for two lives, i.e. a two generation CRT.  Example: A husband names a CRT as the beneficiary of his IRA, where his elderly wife is named as the ‘lifetime’ beneficiary who receives 5% distributed each year and then 5% is distributed to their child who is the second ‘lifetime’ beneficiary, further stretching distributions from the CRT, with the remainder then passing to charity.

– Potential Double Estate Tax Deduction: If the husband names both his spouse (income beneficiary) and a charity (remainder beneficiary) as beneficairies under the CRT, the husband’s estate will receive a full deduction from federal estate taxes, some associated with the marital deduction and some associated  for the charitable estate tax deduction.

– DAF: A lifetime transfer of IRA assets to a donor advised fund (DAF) is not tax efficient. In contrast,  a testamentary bequest of the CRT’s remainder interest can pass to a DAF over which the decedent’s family members may have advisory privileges.

Practical Considerations: Obviously using a CRT as an IRA beneficiary is not for everyone. The IRA owner must be charitably inclined, since at least 10% of his/her IRA must be dedicated ultimately to the charity. There may be other reasons why a CRT might not be the best solution even if it functions much like a stretch IRA under the old distribution rules

– Estate Taxes: If the IRA owner’s estate must actually pay federal estate taxes,  leaving the IRA to a CRT might not be as tax efficient. If the IRA passes to individual beneficiaries, those beneficiaries will be able to claim a deduction against their income for the estate taxes associated with the IRA included in the owner’s taxable estate. [IRC 691(c).] It is better to leave the IRA directly to those individual beneficiaries who will be able to claim the estate tax paid as a deduction against their taxable income when the IRA is distributed to them. This is not the case if the IRA is paid to a CRT, which is tax exempt.

– Private Foundation: A CRT is subject to the highly technical private foundation self-dealing rules. For example, a family member cannot purchase assets from a CRT.

– Non-Charitable Beneficiary Dies: If an individual non-charitable beneficiary dies too soon, then the IRA owner’s estate did not maximize the benefit of the stretch IRA, ‘over-funding’ the charitable gift but not obtaining as high a federal estate tax charitable deduction.

– Maximum Duration: If a term of years is selected for the CRT, the maximum life of the term CRT is 10 years when the IRA is liquidated. Compare that with the SECURE Act’s mandatory 10-year liquidation requirement. In short, there is not that much of a deferral associated with the CRT if its maximum duration is 20 years, not 10 years.

– Age Constraints: Due to the 5% minimum distribution amount and the requirement that the present value of the charitable remainder interest must be at least 10% of the assets contributed, some individual lifetime non-charitable beneficiaries will not be eligible for the CRT. For example, with these statutory constraints, in 2021 a CRT will pass the 5%/10% ‘test’ only if the beneficiary  is at least age 28. If there were two CRT individual beneficiaries both the same age, each would have to be at least 39 years old because of the combined life expectancy of two people is more than one person. Similarly, If a CRUT is used, the highest possible payout rate in 2021 is 10.9% due to the 5%/10% ‘test’ constraints imposed by the Tax Code.

Conclusion: Naming a CRT as the beneficiary of a decedent’s IRA can provide some interesting tax benefits, closely mimicking a stretch IRA and perhaps affording better creditor protection for the CRT non-charitable beneficiary than if he or she is otherwise directly named as the designated beneficiary of the IRA, i.e. no creditor or bankruptcy protection. Balanced against the perceived stretch benefit with the CRT are the Tax Code limitations imposed on a CRT which might cause a younger CRT non-charitable beneficiary to not qualify as a CRT, thus triggering immediate taxation of the entire IRA balance (with no 10-year deferral since the CRT is not an individual.)

So what is  the ‘best case scenario’ when contemplating a CRT as an IRA beneficiary?  The proverbial ‘sweet spot’ is a 5% CRUT that will last a minimum of 30 years for the non-charitable individual beneficiary.