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George F. Bearup, J.D. Senior Legal Trust Advisor

5-Jul-18

Charitable Remainder Trust Primer

Take-Away: Many individuals should consider the adoption of charitable remainder trust. In part, because of the dramatic increases in the stock market last year, many are sitting on appreciated investment portfolios. Others may need to diversify their investment portfolio which will cause them to incur capital gains in that diversification process to reduce overweighting risks.  Then others may want to bunch their charitable giving into a single tax year in order to obtain the benefit of a large charitable income deduction if they are philanthropically inclined,  an income tax charitable deduction which might not otherwise be available to them due to the increase in the federal income tax standard deduction amount. There are plenty of good reasons for an individual to consider a charitable remainder trust, but only if the individual is charitably inclined.

 

Background: At its core, a charitable remainder trust (CRT) is simply a charitable gift. A portion of the trust (the remainder interest) will someday go to a charity or charities. If an individual is not charitably inclined, then that person is not good candidate for a CRT, despite the tax advantages that come from establishing a CRT. Most CRT’s benefit a married couple; the assets  held in CRT then pass on to a charity on the death of the couple, although CRTs can be created for other family members, e.g. the couple’s children, but with related transfer tax consequences if non-spouses are named as CRT income beneficiaries.

CRUT or CRAT: If the plan is to transfer assets to the CRT over time, then the donors must establish a Charitable Remainder Unitrust (CRUT), and not a Charitable Remainder Annuity Trust (CRAT). The tax law is clear that there can be only one transfer of assets to a CRAT; a CRAT must contain a provision that prohibits additional contributions to it.

CRAT:  A CRAT pays a set amount to the income recipients based on the initial value of the CRAT; this amount does NOT change from year to year, hence it performs like an annuity for the income beneficiary’s cash flow budgeting purposes.

CRUT: A CRUT pays a percentage of the annually determined value of the CRUT. This means the annual amount can vary from year to year based on the CRUT’s value, presenting a challenge to budgeting.  But CRUTs are inflation hedges.

NiCRUT or NimCRUT or Flip NimCRUT: If the asset to be transferred to the CRT does not generate much income to be paid to the CRT’s income beneficiaries,  then probably a special form of CRUT needs to be adopted, probably a net income charitable remainder unitrust (NiCRUT). If the expectation is that the trust’s income will improve with the passage of time, then a net income with make-up unitrust (NimCRUT) can be used, which is often a viewed as a retirement income supplement device. A FlipNimCRUT allows the CRT to pay the lesser of its income and its stated percentage payout initially, and then flip to a simple percentage amount CRUT upon the occurrence of a trigger event. The triggering event for a FlipNimCRUT must be a specific date or an event or occurrence that is not within the discretion or control of the trustee or any other person, e.g. upon my 75th birthday, I will receive 5% of the CRUT’s assets, until then, only the income from the CRT. [Treas. Reg. 1.664-3(a)(1)(i)(c).]

CRT Basics:

  • Income Beneficiary: The CRT must pay a sum certain to one or more persons, at least one of whom is not a charity. Persons can include a trust, estate, partnership or corporation, but in that case the CRT can only be for a set number of years. [IRC 7701(a)(1).] The possible use of a trust as a person is permissible for a CRT that is established for a disabled individual. [Rev. Rul. 2002-20 and PLR 200240012.] As a generalization,  the names of income beneficiary individuals must be used in the CRT instrument, which implies that the beneficiary must be living, but it is possible to name a class of beneficiaries for the CRT if the term of the CRT is a set to last for a specific number of years, which means that after-born children could become CRT beneficiaries if they are part of the identified class of income beneficiaries.
  • Remainder Beneficiary: A CRT must either be transferred irrevocably to or ‘for the use of’ a charitable organization that is described in IRC 170 (c) when the income interest ends. The CRT must contain a provision that requires the trustee to distribute the CRT assets to a qualified charity if the named remainder charity is not then qualified at the time the CRT terminates. The CRT instrument could also contain a provision that gives the then serving CRT trustee the authority to select the charities to receive the CRT’s assets on its termination. Caution: There are several types of charities under the Tax Code, and not all of them fall within IRC 170 (c). In addition, the type of charity that is selected as the CRT remainder beneficiary will impact the income tax deduction that is allowed the donor. As such,  it is important to know what type of charity is to be named as the CRT remainder beneficiary, so the settlor knows the limits on the charitable income tax deduction.
  • Duration: A CRT must use a term that is measured by one or more lives in being, or it must be established for a term of years not to exceed 20 years. These two conditions can be combined, so that a CRT can exist for lives in being plus 20 years, but no longer.
  • Contingencies: A CRT can terminate on the occurrence of a qualified contingency. I have mentioned this before:  a CRT, unlike a QTIP trust, can terminate on the spouse-beneficiary’s remarriage. [IRC 664(f).]
  • Annual Payments: The CRT must make payments at least annually to the income beneficiaries. The payments are required from the time the CRT is established until the expiration of the CRT’s term. However, payments can terminate on the last payment preceding death of the income beneficiary in order to avoid having to calculate a prorated final payment to the deceased beneficiary’s estate.

Qualifying Tests for a CRT: The IRS imposes several ‘tests’ in order to qualify as a charitable remainder trust, in addition to imposing several rules that are normally associated with private foundations.

  • Maximum and Minimum Payout Test: A CRT must pay out an amount that is equal to at least 5%, and not more than 50%, of the initial net fair market value of the CRAT, or the annually determined net fair market value of the CRUT, paid at least annually.
  • Minimum Charitable Benefit Test: A CRT must result in a charitable benefit of at least 10% of its value when the CRT is first created. In the case of a CRUT any addition to the CRUT must result in a 10% benefit to the charity that is the remainder beneficiary.
  • Exhaustion Test: In addition to the minimum charitable benefit rule, there must be at least a 5% probability that the charitable remainder beneficiary will receive any trust corpus. Since a CRAT pays a set dollar amount annually, regardless of the CRAT’s then current value, in a period of low AFR rates (like now)  a CRAT can be exhausted. Fortunately Treasury recently provided a provision to be included in the CRAT that will be treated as a qualified contingency and thus prevent a CRAT from failing the 5% probability of exhaustion ‘test.’ [Rev. Proc. 2016-42.] With regard to a CRUT, which only pays out a percent of the CRUT’s then current value, theoretically a CRUT can never reach zero, so the 5% probability test should always be met when using a CRUT.

Income and Transfer Tax Consequences of a CRT:

  • Tax Exempt: A critical point is that a CRT is tax-exempt under the Tax Code. As a result it:  (i) allows the CRT’s assets to grow tax-free for the benefit of the income beneficiary and the charitable remainder beneficiary; (ii) but it precludes the CRT from holding assets that will jeopardize its tax exempt status (applying the private foundation prohibited investment rules.) A CRT files a Form 5227 annually.
  • Income Tax Deduction: The donor to a CRT is entitled to claim a charitable income tax deduction in the year that assets are transferred to the CRT. But how the CRT is structured will impact the amount of the income tax charitable deduction. If the CRT terminates at the end of its term, e.g. the donor’s death, this allows the donor’s income tax charitable deduction at the higher adjusted gross income (AGI) allowed under the Tax Code. However, if the CRT continues after the income term, continuing to pay income to the charity, then the donor’s income tax deduction will be limited to 30% of AGI,  as the CRT will be treated as being considered ‘for the use of’ charitable purposes and not ‘for the benefit of’ the charity. In addition, if the CRT continues after the expiration of the income beneficiary’s interest, the CRT will convert to a private foundation, which then requires the trust to pay out at least 5% of its assets annually. [IRC 4947.] In short, if a larger charitable income tax deduction is desired by the donor, it is best to require the distribution of the remaining CRT assets directly to the charity as opposed to continuing the trust for the charity’s benefit.
  • Nature of Charitable Beneficiary Controls Amount of  Income Tax Deduction: The amount of the donor’s charitable income tax deduction will also be affected by the tax-exempt status of the charitable beneficiary. The income tax charitable deduction will be limited to 60% of the donor’s tax contribution base (i.e. adjusted gross income calculated without regard to any net operating loss carrybacks) if the remainder charity is a public charity and the CRT is funded with cash. The deduction will be limited to 30% of the donor’s tax contribution base if the remainder beneficiary is a public charity and the CRT receives long-term capital gain property, or if the CRT will be ‘for the use of’ a public charity. The charitable income tax deduction will be limited to 20% of the donor’s tax contribution base if the remainder beneficiary is a private foundation and the CRT receives marketable securities. Any unused income tax charitable deduction in the year the CRT is funded can be carried over and used for up to five additional years- after that, the unused income tax charitable deduction is lost to the donor.
  • Deduction Substantiation: The donor must attach a statement to his/her income tax return that identifies the computation of the present value of the charitable remainder interest in the CRT, including all other information required to support the income tax deduction.
  • Transfer Tax Implications of a CRT: If a spouse is named as the CRT income beneficiary, the donor will be entitled to a gift tax marital deduction. [IRC 2523(g).] But this will not be the case if the donor’s spouse is a beneficiary along with another individual, e.g. the donor’s spouse and daughter are the CRT income beneficiaries. If a non-spouse is the income beneficiary, then the income interest conferred will be a taxable gift by the donor; if the gift begins immediately, this will be a gift that can be sheltered, in part, using the donor’s annual exclusion gift exemption amount ($15,000.) If the donor retains a testamentary power to revoke or terminate an income interest in the CRT, that retained power of revocation will prevent that income interest from being a taxable gift by the donor of a future interest at the time the CRT is funded. The gift of the remainder interest to the charity will qualify for the gift tax charitable deduction; if the donor retains the ability to change the charitable remainder beneficiary, there is no completed gift for gift tax purposes, in which case the charitable gift tax exemption is not applicable. An estate tax marital deduction is allowed for the spouse’s interest in a testamentary CRT if the spouse is the sole non-charitable beneficiary of the CRT created on the other spouse’s death. [IRC 2056(b)(8).] If other non-charitable beneficiaries are also included as income beneficiaries along with the donor’s spouse, then special rules will apply to calculate the value of that gifted income interest to the surviving spouse under the CRT. On the donor’s death an estate tax charitable deduction is allowed for the remainder interest in a testamentary CRT. [IRC 2055(e)(2)(A).] As a broad generalization, normally the generation skipping transfer tax is not an issue with a CRT, as a younger beneficiary would have a longer life expectancy which, in turn, would cause the CRT to fail the minimum charitable benefit test or the 5% probability test. However, if a skip person is a CRT income beneficiary,  each distribution from the CRT to the skip person would result in a taxable distribution from the CRT, and the skip person, not the CRT, will be charged with paying the GST tax on that distribution from the CRT.

Taxed Tiers of CRT Distributions: The payments from the CRT to the income beneficiaries are characterized based on four separate tiers of income.

  • Tier #1: Distributions from the CRT are first deemed as ordinary income. The deduction for net operating losses is not taken into account to determine the CRT’s ordinary income, but ordinary income losses are taken into account.
  • Tier #2: Next, the distribution from the CRT is treated as capital gains. The provisions of the Tax Code that relate to carrybacks and carryovers are not applicable when calculating the CRT’s capital gains. [IRC 1212.]
  • Tier #3: Next, the distribution from the CRT is treated as ‘other income’, including tax-free or tax-exempt income.
  • Tier #4: Finally, the distribution from the CRT is treated as a return of principal. [IRC 172, 642(d), and 664] which is not taxed to the individual who receives the CRT distribution.
  • Carryovers: If any tier of income is composed of income that is taxed at a different rate than other items in that tier, the income will be taxed at the higher rate, which  is then distributed first from that tier, e.g. capital gains incurred on the sale of a collectible, which is different from the sale of appreciated marketable securities. [Reg. 1.664-1(d)(1).] CRT income that is not distributed in any one year, is carried over to future years.

Caveats:

  • Capital Gain Deferral, Not Elimination: As a result of this priority in tiers of  the taxation of distributions, it is important to understand that while funding a CRT with appreciated assets does not result in an immediate taxable gain recognized by the donor when the appreciated assets are sold by the CRT trustee,  the CRT will have carryover basis and thus a CRT is only a capital gain deferral As distributions are made from the CRT to the income beneficiary, first distributions out from the CRT will be ordinary income, then capital gains to the extent the CRT sold the appreciated assets contributed to the CRT by the donor.
  • Ordinary Income Tax First: In addition, ordinary income, taxed at higher rates, will be deemed distributed to income beneficiaries, and only after that ordinary income is fully distributed, will then capital gains be distributed, followed lastly tax-free income. For example, a decedent could direct the payment of his IRA to a testamentary charitable remainder unitrust for the benefit of his surviving spouse. All distributions from that CRT to the decedent’s surviving spouse from the CRT would be taxed as ordinary income to her; depending on the size of the IRA paid to the CRT, arguably all the surviving spouse will ever receive during her lifetime from the CRT is ordinary income, since all ordinary income comes out to her from the CRT, first, before capital gains are distributed from the CRT to the surviving spouse.

Examples: Assume husband, age 72, and wife, age 69, create a CRT. They transfer $500,000 marketable securities to the CRT, which is to make an annual payment to them jointly for their lives. The AFR for June was 3.40%. The assumed growth rate for the assets held in the CRT is 5% per year. If their income tax basis in the securities was $200,000, and the couple wanted to liquidate the securities or diversify their investment in those appreciated securities, a straight liquidation would cause them to incur a capital gain of $300,000. The federal income tax on that $300,000 gain would be 20% with another 4.25% paid in state income taxes. Thus, the net amount the couple would have to reinvest would be $427,250. By transferring the $500,000 in securities to a CRT and then have the CRT liquidate the securities, the full $500,000 will remain in the CRT to be reinvested (not $427,250.) But the capital gains will ultimately be recognized by the couple as they receive distributions from the CRT for the rest of their lives, following the tiered taxation of distributions from the CRT, with ordinary income paid to them first before they begin to recognize any capital gain income. Restated, the $72,750 of capital gains taxes will not be paid ‘up-front’ by them;  rather,  that gain amount will be recognized over time by them as distributions are received by them from the CRT, but that amount will be invested and generate (hopefully) income that will first be distributed to them from the CRT. Using the same facts in the example:

  • CRAT: If the couple create a CRAT,  the annual annuity payment to them is $27,385. The charitable income tax deduction that they receive is $140,870.37, which deduction can be used to shelter this year’s taxable income and carried over for the next 5 years to also shelter their taxable income. Thus, the donors’ deduction as a percentage of the amount that they transfer to the CRAT is 28%.
  • CRUT: If the couple create a CRUT, using the same assumptions, the percentage payout to them each year will be 14.4% of the fair market value of the CRUT’s corpus each year, paid to the couple quarterly. The first year’s payment to them from their CRUT will be $72,000 [14.4% X $500,000= $72,000.]Their income tax charitable deduction will be $50,000, which is 10% of the amount that they initially transferred to the CRUT. This calculation was made with the goal to maximize the amount the couple will receive each year using the CRUT, while still satisfying the IRS’s several qualification ‘tests.’ Obviously the couple could reduce the percentage amount that they annually receive, which in turn would increase the size of the charitable income tax deduction.

Conclusion: A charitable remainder trust can be effective tool to improve the donor’s retirement income without having to pay, up front, capital gains taxes if appreciated assets are to be liquidated. A CRT is also useful these days to create an income tax charitable deduction, which allows the donor to retain more income after-tax (i.e. the deduction shelters taxable income from  taxation.) For those individuals who currently have charitable bequests in their wills and trusts, it is important to discuss with them accelerating those charitable bequests into lifetime gifts, when the income tax charitable deduction helps to improve their cash-flow, understanding as well that with a $11.1 million federal estate tax exemption, a charitable bequest will probably not help save any federal estate taxes on their death.