Take-Away: A charitable remainder trust(CRT) must be irrevocable if it is to provide the income and estate tax benefits that are intended by its settlor. But sometimes life takes sudden turns, and the CRT does not work as well as originally intended. While the CRT must be irrevocable and it is somewhat inflexible, the beneficiaries of the CRT are not necessarily stuck with the CRT as it was originally drafted.

Example: Assume a CFO of a Russell 2000 company, Herb, retires at age 60 years. Herb owned a considerable position in his former employer due to several stock options that he exercised during and shortly after his retirement. In order to diversify his wealth, Herb transferred all of his appreciated Russell 2000 stock into a charitable remainder unitrust (CRUT) which was set up to pay 7% of its assets annually to Herb and his wife, Wendy, or the survivor of the two of them for life. Since the CRUT is a ‘charity’, it sold all of the Russell 2000 stock, and reinvested 100% of the sales proceeds in a more balanced blue-chip investment portfolio held by the CRUT. Each year Herb and Wendy receive 7% of the CRUT assets. The CRUT was used to defer recognition of capital gains taxes on the sale of the Russell 2000 stock (charities don’t pay capital gains as a general rule) so that 100% of the sale proceeds, not a net amount after capital gains taxes were paid, is available to be re-invested and against which the 7% unitrust annual distribution is calculated. Note, too, the Herb and Wendy were able to take a charitable income tax deduction of 10% of the value of the Russell 2000 stock that was transferred to the CRUT when it was established.  But now, 15 years later, Herb and Wendy are 75 years old. Their CRUT holds $1,500,000 of assets. But, 15 years later, Herb has a serious health condition that is consuming a lot of their wealth, and thus there is a need for more liquidity than what the 7% annual unitrust distribution provides to them. The CRUT no longer aligns with Herb and Wendy’s needs, and they are now interested in their ability to gain access to more funds in a lump sum from the CRUT.

Tax Background: There are usually several good reasons to establish a CRT, not the least of which is benefiting a charity at the end of the CRT income/unitrust interest term. In addition, an immediate charitable income tax deduction is available for the gift of the remainder interest to the charity. [IRC 170.] The gift of the remainder interest is also not taxable for federal gift tax purposes. [IRC 2522.] As noted earlier, since the CRT is treated as a ‘charity’ for tax reporting purposes, the CRT can sell appreciated assets without having to pay a capital gain tax; the gain does not disappear, it is reported and a tax is paid as the CRT income/unitrust recipient receives annual distributions from the CRT over the recipient’s lifetime. The income or unitrust interest retained in the CRT by the donors is treated as a capital asset. [Rev. Ruling 72-243 C.B. 233; See also Private Letter Ruling 200152018 (September 26, 2001.)] The transfer of that retained income or unitrust interest by the lifetime beneficiaries, if irrevocable, is treated as an assignment of an equitable interest in the CRUT, which is sufficient to shift the taxability of the income interest to the assignee of that interest. [Blair v. Commissioner, 300 U.S. (1937)]

Exit Strategy: Herb and Wendy, who are no longer enchanted with the 7% annual distributions from their CRUT look for options to exit their CRUT. A few follow:

  • Contribute the Unitrust Interest to Charity: The CRUT could be terminated with a gift by Herb and Wendy of their unitrust interest in the CRUT to the charitable remainder beneficiary. However, this is not a viable option since Herb and Wendy need access to more wealth, not less. But in situations where the donors are financially well off and they begin to resent having to pay income taxes on their annual unitrust distribution when it no longer enhances their lifestyle, giving the unitrust interest to the charitable remainder beneficiary is one quick way to exit a CRT. Note if that if they gave their unitrust interest to the charitable remainder beneficiary, Herb and Wendy would be able to claim an additional income tax charitable deduction for that gift.
  • Judicial Termination of the CRUT: The CRUT could be terminated in a trust termination proceeding in the probate court. The CRUT would be divided on a pro-rata basis between the unitrust beneficiaries, Herb and Wendy, and the designated charitable remainder beneficiary. The value of Herb and Wendy’s unitrust interest would be calculated following IRS procedures and tables and the value of their interest would be determined using the prevailing IRC 7520 interest rate. [Note that if Herb and Wendy’s interest is valued at more than what the prevailing IRC 7520 interest rate dictates, they will be treated as violating the self-dealing prohibitions of IRC 4941, and they will be subject to penalties if that overpayment is not promptly corrected by them. It is also possible from them to incur an excise tax (penalty) of 200% of the overpayment amount if it is not readily addressed once they are alerted by the IRS.] As such the CRUT could be terminated with part of the CRUT corpus paid to Herb and Wendy, and the balance paid to the remainder charity that they named in their CRUT. Note that the Michigan Attorney General-Charitable Trust Division would become involved in that formal charitable trust termination proceeding in the probate court.
  • Sale: Apparently there is now a ‘cottage industry’ in the US where third-party buyers will purchase an income or unitrust interest in a CRT. Unlike the IRS’s approach which uses the static formula that applies the prevailing IRC 7520 interest rate for the pro rata valuation calculation using IRS life expectancy tables, a third-party buyer will look at other factors, like the anticipation of future investment returns that might be experienced by the CRUT assets, which might produce a price that is paid that is higher than a pro rata calculation following the IRS’s commutation approach. Also, since the CRUT will continue on after the sale of the unitrust interest, since the sale simply redirects the unitrust payment to the third-party buyer, there is no need to terminate the CRUT in probate court, and the Attorney General can continue to sleep at his desk in Lansing.

Return to the Example:

  • Contribution: Herb and Wendy, who need access to funds now, will not contribute their unitrust interest in the CRUT to the remainder charity. While it would be nice to get an additional income tax charitable deduction, and avoid the annual costs that are incurred to administer the CRUT, giving their interest in the CRUT does not immediately provide to Herb and Wendy access to more funds.  Thus, the gift of their unitrust interest is not really an option.
  • Termination: If Herb and Wendy decide to terminate the CRUT with a pro-rata distribution of the CRUT’s assets, using the current IRC 7520 rate would provide to them a distribution of about $930,000 if the CRUT’s corpus is now worth $1,500,000, less probate court fees and legal fees that are incurred to file the court petition to terminate the CRUT. Depending upon the urgency of Herb and Wendy’s need to access their share of the corpus, they will have to wait for the probate court to authorize the termination of their trust, which could take a few months which may be longer than they are willing to wait.
  • Sale: One national organization that facilitates the sale of income interests in CRTs, Sterling Foundation Management- [which is the source of this example], could facilitate the sale of Herb and Wendy’s 7% unitrust interest in the CRUT to a third-party buyer for $1.06 million net of Sterling’s fees. Such a facilitated sale could result in the receipt of the sale proceeds in a couple of weeks if Herb and Wendy needed quick access to the sales proceeds.

Conclusion: Often with the passage of time a ‘disconnect’ evolves between the original goals of the settlors of a CRT and their current cash-flow needs. While their CRT may be irrevocable there are still a couple of options that the settlors can consider to exit their CRT if it no longer works as they had intended.