Take-Away: A couple of months ago a charitable remainder trust (CRUT) was suggested as a beneficiary of an IRA as an alternative to the loss of the ‘stretch’ IRA. Another option is to direct the decedent’s IRA to a charity in exchange for a testamentary charitable gift annuity (CGA) which may have more appeal to some IRA owners for several reasons.

Background: The distribution changes caused by the SECURE Act will not be reviewed (yet again, thank God!) Suffice it to say that with a 10 year maximum distribution period for most IRA beneficiaries, a substantial amount of an inherited IRA will now go to pay accelerated income taxes, arguably at marginally higher federal income tax rates.

CRUT Planning Option: One planning option previously covered was to name a testamentary charitable remainder unitrust (CRUT) as the designated beneficiary of the decedent’s IRA. The distribution of the IRA to the CRUT would not be taxed, as the CRUT is a charitable entity. Distributions from the CRUT to its individual beneficiary would be over the beneficiary’s lifetime, the CRUT functioning, in effect, as a surrogate for the stretch IRA that the SECURE Act eliminated for most beneficiaries. Distributions to the CRUT beneficiary will still be taxed as ordinary income, but the distributions will be over the beneficiary’s longer lifetime.

Drawback to CRUTs as IRA Beneficiary: While naming a CRUT might be a good option to replace the loss of the stretch IRA, it comes with its own set of limitations.

Charitable Intent Lacking: Some IRA owners are simply not charitably inclined, so they will not be receptive to naming a charitable remainder unitrust as the beneficiary of their IRA, even though the CRUT can function well to shelter the trust assets from the beneficiary’s creditors;

Mimium Charitable Remainder Interest: 10% of the present value of the IRA paid to the CRUT must be allocated to the charitable remainder interest. [IRC 514(c).]In addition, the CRUT has a mandatory 5% annual distribution obligation to its individual beneficiary; no ‘hold back’ in distributions are permitted;

Young Beneficiary Precluded: The impact of these two ‘rules’ (10% of initial bequest is earmarked ultimately for charity; minimum 5% annual distribution to beneficiary) often results in a testamentary CRUT not able to be established for a younger individual CRUT beneficiary (younger than 60 years old) since the 5% annual distributions will mean that less than  10% of the original amount will ultimately be available for the charity, which in turn means that the CRUT will ‘fail’ to meet the Tax Code’s requirement, and thus not be treated as a tax exempt ‘charity.’

Need for a Trustee: Some charities will not agree to serve as the CRUT trustee if the amount transferred to the CRUT is not large enough. The same with professional trustees.

Example: Deceased IRA owner directs the transfer of his $1.0 million IRA to a CRUT, with his child as the CRUT beneficiary. The CRUT’s investments earn 5% a year. Distributions are made from the CRUT to the child of 5% each year. Therefore, at the child’s death, $1.0 million will be transferred from the CRUT to the charity. That charitable gift may be too much for the IRA owner to accept.

Charitable Gift Annuity Option: Assuming that the IRA owner is somewhat charitably inclined, consider having the IRA owner make his/her IRA payable to a charity to fund a charitable gift annuity (CGA) for the IRA owner’s intended beneficiary. Some reasons follow:

Ascertainable: To qualify, the transfer as a CGA the annuity must be ascertainable, which means that either the beneficiary designation form or a charitable gift agreement must include: (i) the amount of the annuity; (ii) how often payments will be made; and (iii) whether payments are to be made at the benginning or end of the payment period.

Agreement with Charity:  Usually the CGA agreement or beneficiary designation will refer to the annuity being paid at the American Council on Gift Annuities maximum recommended rate, at the annuitant’s nearest age, made as of the decedent’s death. See www.acga-web.org.

Flexibility: Because the 10% actuarial remainder rule of IRC 514(c)(5) also applies to CGA’s, the agreement/ beneficiary designation should also include language that authorizes a reduction in the annuity amount to the extent necessary to accommodate that 10% to charity ‘remainder’ rule.

Example: A current one-life immediate annuity rate will result in a charitable deduction of more than 10% if the IRC 7520 rate is 1.8% or higher, whatever the annuity payment frequency. Normally most charities will not enter into a CGA if the annuitant is under the age of 60.

Advantages of CGA over a CRUT: Some obvious, and one not-so-obvious, reasons why a CGA should be considered over a CRUT.

Smaller amount attractive: While a charity might not agree to serve as trustee of CRUT unless the amount of the IRA transferred is substantial, a CGA might be more attractive to a charity as there is no need to establish and administer a separate trust;

Deferral: As noted above, with a CRUT there must be at least a 5% distribution made each year to the CRUT beneficiary- no delays, no hold backs, no ‘invasions of principal’ to meet the beneficiary’s needs.  A CGA can be deferred for a period of time. Example: If the proposed annuitant is under age 60 at the time the IRA owner dies, the agreement with the charity could expressly provide to defer the payment of any annuity amounts to the specified annuitant until the annuitant is age 65;

Graduated Payments: The CRUT must pay at least 5% each year. That 5% distribution obligation is fixed and cannot be changed. A CGA can be structured to permit graduated annuity amounts, so long as the actuarial value of the ‘step’ annuity is determinable as of the date of the IRA owner’s death; with that amount being determinable, a federal estate tax charitable deduction will still be available for the actuarial value of the charity’s remainder interest;

Flexible: Flexible CGAs are permitted. [Private Letter Ruling 200742010.] Thus, the named annuitant can opt to take the annuity or to defer taking the annuity. There will be no constructive receipt claim by the IRS until the payments are actually received (even though the annuitant has the right to request that payments begin.) With the CRUT, the beneficiary must begin taking the 5% annual distributions, all of which will be taxed as ordinary income.

Possible Big CGA Benefit: Distributions from inherited IRAs are classified as income in respect of a decedent (IRD.) Thus, distributions from the inherited IRA will be taxed to the beneficiary of that IRA. A CRUT is classified as a charity, which means that a lump sum distribution from an inherited IRA to the CRUT will not be taxed. However, the Tax Code makes it clear that distributions from a CRUT to its individual beneficiary will be classified as ordinary income to the extent that the CRUT received IRD. [IRC 691(a)(3) provides that IRD is ‘tier one’ income, meaning ordinary income until all of the IRA has been distributed to the beneficiary.] In short, naming the CRUT as beneficiary of the inherited IRA may help to stretch the period over which taxable distributions are received by the CRUT beneficiary, but income taxes cannot be avoided.

Tax-Free Distributions? With a CGA, the IRA is paid directly to the charity. Again, it is not a taxable distribution from the IRA due to the identity of the named beneficiary- a tax exempt charity. As such, the charity owns all of the IRA assets distributed to it. By virtue of the preexisting charitable gift agreement entered into between the charity and the IRA owner prior to his/her death, the charity has agreed to pay the named annuitant an annuity for the annuitant’s lifetime, using the charity’s own assets.

Consequently, it is possible that if a CGA is funded with an IRA’s assets, a portion of the IRD may be treated as an investment by the charity that is returned income tax-free to the named annuitant. Restated, it is possible that the IRD taint that comes from an IRA distribution is washed since the IRA assets flow through the tax exempt charity to the annuitant. The IRS came close to, but did not formally make this finding, in an earlier Private Letter Ruling [PLR 2002300.18.]

Technical point. Normally gain is recognized immediately when a donor, who is not the annuitant, transfers appreciated assets to charity for a CGA that benefits another individual (the true annuitant.) But IRC 1011(b) applies only if an income tax deduction was allowable under IRC 170, which is not the case with a testamentary charitable gift annuity.

Thus, one possible interpretation is that if a testamentary charitable gift annuity is funded with a decedent’s IRA, rather than IRD being used, it is more like cash that is used to make the annuity payments, which in turn means that most CGA distributions to the annuitant will be treated as tax-free principal and not taxable income.

Conclusion: As we learn more about the implications of the SECURE Act to retirement plan distributions, probably more strategies will come to mind. Using a testamentary charitable gift annuity is one strategy that may make some sense for some charitably inclined IRA owners whose intended beneficiaries might enjoy tax-free income in their retirement years.