Take-Away: This summer the IRS denied a charitable remainder trust’s application to tax-exempt status. While that sounds like a bad outcome, what is important to remember is that a charitable remainder trust’s tax incentive feature, the income tax deduction with regard to the charitable remainder interest, falls under a different section of the Tax Code, which means while the charitable remainder trust is not a tax exempt entity under IRC 501(c) (3), it still functions as a charity.

Background: An entity that seeks to be qualified as a tax-exempt entity must be operated exclusively for charitable purposes. [IRC 501(c) (3).] With a charitable remainder trust (CRT), only the CRT’s remainder interest is charitable. Therefore, a CRT cannot qualify as a tax-exempt entity because a substantial non-exempt purpose of the CRT was to benefit private, non-charitable recipients, i.e. the donor who retained a lifetime annuity interest in the CRT.

Split-Interest Trust: CRT’s are generally exempt from tax under IRC 664, which deals with what are called split-interest trusts, which refers to a private interest, either the annuity or unitrust benefit that is paid to individuals, and the charitable remainder interest. IRC 501(c) (3) is not generally applicable to a split-interest trust because of the individual’s private interest that is part of the CRT.

PLR 201935013 (June 5, 2019): In this PLR the IRS held that the CRT did not qualify as a tax-exempt organization because a substantial non-exempt purpose of the trust was to benefit private, non-charitable, individual beneficiaries. Apparently, the CRT mistakenly applied for tax-exempt status under IRC 501(c) (3) by filing Form 1023. This was not necessary because the CRT, if it met the applicable requirements under IRC 664, would qualify as a tax-exempt entity under its unique provisions. In short, by following the rules of IRC 664, and better yet, following the CRT suggested forms published by the IRS for CRATs and CRUTs, there is no need to take the additional step and file Form 1023 to have the CRT classified as a tax-exempt entity.

CRTs Going Forward: As indicated in prior missives, many more individuals may be taking a second-look at CRTs as part of their estate plans for a couple of reasons.

  • SECURE Act Surrogate: Existing stretch inherited IRAs generally have disappeared under the SECURE Act, to be replaced with a 10-year mandatory payout of the inherited IRA balance. If the IRA was made payable to a testamentary CRT and not to the individual IRA beneficiary, some of the benefits of the stretch inherited IRA can be replicated. The IRA paid directly to the CRT on the IRA owner’s death is taxable, but the CRT is a tax-exempt entity under IRC 664. As a result, the payment of the IRA’s ordinary income assets to the CRT is not an immediate taxable event. That said, when the CRT then makes distributions to the CRT individual lifetime beneficiary, they will all be taxed to the beneficiary as ordinary income, just like with the stretch The difference is that rather than receiving that ordinary income over the 10 years that follow the IRA owner’s death as required by the SECURE Act, the CRT’s lifetime beneficiary will take the distributions from the CRT over the CRT beneficiary’s lifetime, usually at the rate of 5% of the CRT assets each year.  The drawback to naming a CRT as the IRA beneficiary is that at least 10% of the actuarial present value of the IRA when it is distributed into the CRT must ultimately pass to the charity, which means that the IRA owner should have some philanthropic objectives in order to be remotely interested in making a testamentary CRT as beneficiary of their IRA and thus a large part of his/her estate plan.
  • QTIP Trust Alternative: Many individuals are in second marriages. One spouse may consider using a qualified terminable interest trust (QTIP) as part of their estate plan. The QTIP trust is used, in part, to provide for a surviving spouse, with the ability to control who will receive the interests held in the QTIP trust upon the surviving spouse’s subsequent death. Usually the remainder beneficiaries of the QTIP trust are the children from the deceased spouse who established and funded the QTIP. The drawback to using the QTIP trust is that the surviving spouse must be entitled to receive all of the income from the QTIP trust  for the balance of his/her lifetime. Thus, the surviving spouse is entitled to receive all of the QTIP trust’s income, even after the surviving spouse remarries. A remarried surviving spouse’s right to the QTIP trust’s income is, consequently, a major drawback to the spouse who considers creating a QTIP trust. If, instead, the deceased spouse left his/her assets to a testamentary CRT, a different result could occur. Again, the surviving spouse would receive the income from the CRT either as an annuity amount, or a unitrust amount, for his/her lifetime. However, unlike a conventional QTIP trust, a CRT can cause the surviving spouse CRT beneficiary to forfeit his/her interest in the CRT if they remarry. The CRT beneficiary’s remarriage is a qualified contingency, which can cause the beneficiary to lose their distribution rights under the CRT. [IRC 664(f) (3).]  The CRT can be established for the shorter of either the life beneficiary’s lifetime or 20 years. As such, if the CRT beneficiary-surviving spouse remarries, he/she forfeits his/her distribution rights in the CRT, and the settlor’s children then step into their step-parent’s shoes under the CRT and complete the maximum 20-year payout of the annuity or unitrust amount. Alternatively, if the individual who creates the CRT is philanthropically inclined, the remarriage of their surviving spouse CRT beneficiary could cause the CRT to terminate, thus accelerating the remainder interest in the CRT that is to be paid to the charity selected by the donor.

Charitable Gift Annuity Alternative: What motivates many individuals these days is the fear of out-living their retirement assets. As such, a lot of interest is now given to annuities, which the annuitant cannot outlive. Consequently, for those individuals who are inclined to support their favorite charities, they now looking closely at a charitable gift annuity (CGA.) A CGA functions much like a split-interest gift to a CRT. However, a CGA is not technically a deferred gift. A CGA is a bargain-sale transaction in which the individual transfers cash or other assets to a charity in return for the charity’s promise to make annuity payments to one or two individuals for their lifetimes. As such, a CGA provides fixed income during retirement years in an environment of low interest rates. As noted, though, only two lives are entitled to receive the CGA payment. With a CRT, more than two lives are permitted to receive either the CRT annuity or unitrust distribution if the 20-year option is selected. Moreover, usually the CGA distribution is calculated with the charity receiving somewhere between 30% to 40% of the initial value of the asset that is transferred to the charity in exchange for the annuity payments. With a CRT, while there are several ‘tests’ to be passed, e.g. the minimum amount of the charity’s remainder interest in the CRT must be at least 10%, with a CRAT it is probable that the annuity amount paid to the lifetime beneficiary will be larger than with the CGA. Example: A 70-year-old single individual contributes $25,000 to a charity in exchange for a single-life CGA. The donor receives a $9,318 charitable deduction, and will receive an annual annuity payment of $1,400 (of which $985 is a tax-free return of principal.) This means the CGA’s rate of return to the donor is about 5.6%.

“Bunching” a Charitable Deduction:  Much has been said about the impact of the 2017 Tax Acts doubled standard deduction affecting charitable giving. Many charitable gifts effectively are no longer tax deductible because the donor uses the standard deduction to report and pay income taxes. Hence, the strategy of bunching large gifts into a single tax year, in order to have the income tax deductions exceed the standard deduction amount ($12,000 for individuals, $24,000 for married individuals) in a single tax year. If a CRT is funded with the donor’s appreciated assets, the value of the remainder interest given to the charity is currently income tax deductible. If the charitable deduction of the gifted CRT remainder interest exceeds the donor’s standard deduction amount in the year the CRT is funded, funding a CRT has the effect of bunching a large charitable income tax deduction into a single income tax year. Example: Donors, age 65 and 64, transfer $250,000 of appreciated assets to a charitable remainder unitrust (CRUT.) Using January 2020’s IRC 7520 rate to value the gift of the remainder interest to the CRUT’s charity [2.0%], the value of that tax deductible charitable remainder interest will be $25,000, and the donors’ quarterly distribution from the CRUT will be 10.964% of the CRUT’s assets. The $25,000 charitable deduction amount, when added to their state and local tax deduction [the SALT limit is $10,000 a year] will be sufficient to permit the donors to itemize their income taxes for this year when the CRUT is funded.

Conclusion: Charitable remainder trusts have been overlooked for several years as a basic estate planning tool. With the SECURE Act, they should now receive renewed attention, either to receive IRAs on the owner’s death to replicate the lost stretch IRA or as a means to bunching a large charitable gift into a single income tax year to circumvent the standard deduction limitation on non-itemized charitable gifts.