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

26-Jul-17

Charitable Remainder Trusts: Sales and Rollovers of the Income Interest

Take-Away: The income interest in a charitable remainder trust (CRT) is treated as a capital asset that can be bought, sold, or reinvested just like other capital assets, e.g. real estate. The income interest can be sold to,  or rolled over into, a new CRT if the goal is to change the CRT’s terms.

Background:  In a series of private revenue rulings the IRS has held that the income interest in a CRT can be sold. The sale is treated as the sale of a capital asset.  Letter Ruling 200739004.  A sale of the CRT income interest will  generate capital gain recognition by the seller.  Rev. Ruling 72-243  suggests the sale of the income interest in the CRT will be taxed as a long term capital gain. The basis for the sale of this capital asset is the the client’s portion of the uniform basis of the underlying CRT assets reduced (but not below zero) by undistributed ordinary income and net capital gain in the CRT.

CRT Sale: If the client who created the CRT decides that they need money, often quickly, then the formal termination of the CRT will not help them much. The sale of the income interest in the CRT will often generate more wealth to the client, too. The sale of the income interest is often much quicker than a formal termination of the CRT which usually entails a trip to the probate court to obtain judicial approval of the CRT’s termination.

Reasons to Sell a CRT Income Interest:  Some of the reasons why a client who initially established a CRT might want to sell their retained income interest (annuity or unitrust) in the CRT include the following:

  • Value Maximization: As noted earlier, the client may net more by selling their income interest in the CRT than they can by retaining the CRT interest and waiting for future distributions;
  • Flexibility: The client may prefer a lump sum payment of cash in lieu of the future income stream from the CRT.
  • Simplification: There are costs and administrative expenses that are associated with maintaining a CRT, e.g. an annual income tax return must be filed by the CRT, which can be avoided if the CRT ceases to exist with a sale of its income interest.

CRT Rollover:  Suppose, however, that the income interest holder of the CRT does not want to cash out their interest in the CRT, but they would like to change some of the CRT’s terms. Examples:  to add beneficiaries to the CRT, like children or a new spouse; to slow down the current recognition of income which can be accomplished with a net income charitable unitrust (NiCRUT); to convert an underperforming Net Income Make-Up Unitrust (NimCRUT) to a conventional CRUT to increase annual distributions. These changes to the CRT can be accomplished with an CRT rollover. How that rollover is accomplished is by the client selling his/her income interest in the old CRT to a new CRT that is created by the same client, a new CRT with terms that better meet the client’s current objectives. A sale or rollover can usually be accomplished even if the CRT contains a spendthrift provision, as most CRT’s are self-settled, thus rendering the spendthrift provision unenforceable.

  • Rollover Example: A classic example of where a CRT rollover would be used is if the client marries after having created a CRT,  and the client wishes to add their new spouse as a contingent beneficiary of the CRT. A rollover of their interest in their old CRT to a new CRT with their spouse added as a lifetime beneficiary can effectively change the terms of the CRT. The same could be done if the client wanted to add a child as a contingent lifetime beneficiary of their CRT.
  • Assignment of Income: The irrevocable assignment of an old CRT income interest is sufficient to shift the taxability of the income interest to the new CRT (the assignee.) Because the new CRT is a tax exempt entity, no taxes are owed by the CRT, but distributions from the CRT will continue to be taxed to the client.

Retain Prior Income Tax Deduction: A client who either sells or rolls his/her interest in a CRT gets to retain the income tax deduction that was claimed when the CRT was originally created. The sale or rollover of the lead income interest in the CRT does not change the fact that the remainder in the CRT is still assigned to the charity, and it was the initial gift of the remainder interest to the charity that gave rise to the charitable income tax deduction.

Conclusion: The sale of the income interest or the rollover of that income interest into a new CRT is one way that client can effectively either terminate their CRT or change its terms, while retaining the income tax charitable deduction that they originally claimed when they initially transferred assets into the CRT. While the CRT can be formally terminated in a judicial proceeding, consideration needs to be given to these options short of a judicial termination, like a sale of the income interest to a third party or the charitable remainder holder, or a rollover of that income interest into a new CRT that better meets the client’s needs.