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

7-Jan-20

SECURE Act – The Charitable Remainder Trust ‘Workaround’

Take-Away: With the SECURE Act’s elimination of the stretch distribution rules for most retirement account beneficiaries, more attention may now be devoted to the use of charitable remainder unitrust as a substitute for an existing conduit see-through trust. A charitable remainder unitrust can work reasonably well as an alternative to a stretch see-through, but not for all beneficiaries.

Background: Why a charitable remainder unitrust might serve as a replacement for a conduit see-through trust is because of the technical rules that apply to a charitable remainder trust. A charitable remainder trust, either the annuity version (a CRAT) or the unitrust version (a CRUT), is required to distribute a percentage of the trust assets to one or more individual beneficiaries for life or for a term of up to twenty (20) years. When the trust ends, the balance of the trust assets are distributed to a charity.

Stretch Substitute: It is IRC 664 that requires a distribution for the life of the individual beneficiary that makes a charitable remainder trust a viable alternative to the SECURE Act’s elimination of the lifetime stretch distribution rule for most retirement account beneficiaries. To that extent, the use of a charitable remainder unitrust as the designated beneficiary of a retirement account has gained renewed interest since the CRUT requires lifetime distributions to its individual beneficiary.

Benefits and Limitations: As noted, a CRUT can be used as a substitute for a conduit see-through trust with many comparable features. However, there are also limitations to a CRUT that have to be addressed which, in the end, may not result in a CRUT being named as the designated beneficiary of a retirement account on the account owner’s death.

  • CRUT is Tax Exempt: A charitable remainder trust is a tax-exempt entity. [IRC 664.] Consequently, a CRUT can receive a lump-sum distribution from the decedent’s retirement account without any adverse income tax consequences.
  • CRUT’s Lifetime Duration: A charitable remainder trust is required to distribute a percentage of its assets to one or more individual beneficiaries either (i) for the beneficiary’s life or (ii) a term or up to 20 years. As such, distributions of the former retirement account assets through the CRUT will be distributed to the individual beneficiary for his/her lifetime. Thus, a charitable remainder trust will function much like the ‘old’ stretch distribution rules making distributions for the beneficiary’s lifetime.
  • Required Annual Distributions: The annual distribution from the charitable remainder trust must be at least 5% and not more than 50% of the charitable trust’s assets. The payment can be a fixed amount, based on the value of the charitable remainder trust at its inception (a charitable annuity trust, or CRAT) or the payments may vary from year to year based on the value of the charitable remainder trust’s assets at the end of each year (a charitable remainder unitrust, or CRUT.)
  • Charitable Remainder Unitrust Favored: Since the unitrust’s payments are adjusted each year based on the value of the charitable trust’s end-of-year assets, a CRUT provides inflation protection for the lifetime individual beneficiary; an annuity would not provide any inflation protection to the individual beneficiary. In short, the payments from the CRUT are adjusted annually so that the CRUT will never be exhausted during the individual beneficiary’s lifetime. Most retirement account owners who contemplate the use of a charitable remainder trust as a stretch distribution substitute will opt for the unitrust version, in order to obtain that inflation protection and to avoid the trust being exhausted before the individual beneficiary’s death.
  • 10% Charitable Remainder Rule: The primary difficulty with naming a charitable remainder trust as the beneficiary of a retirement account is that the Tax Code requires that the actuarial value of the charity’s remainder interest must be worth at least 10% of the value of the trust’s assets as of the inception of the trust. This 10% remainder rule limits the duration of a CRUT, or more accurately, the age of the lifetime beneficiary of the charitable remainder trust. Moreover, this 10% remainder interest limitation is further exacerbated by the currently very low interest rates under IRC 7520 that is used to value the charity’s remainder interest in the charitable trust, also restricting who may be the lifetime individual beneficiary of the charitable trust.
    • Comparative Example- #1: The IRC 7520 interest rate 20 years ago was 8.2%. Using that interest rate, a 5% annual distribution charitable remainder unitrust could make lifetime distributions to an individual beneficiary who was at the time of the trust’s creation age 22. Now, for January 2020, the IRC 7520 interest rate is 2%. Using that low 2% interest rate to value actuarially the charity’s minimum 10% remainder value limits the charitable remainder trust to an individual lifetime beneficiary who must be at least age 27 years if the annual distributions are to be made over that individual beneficiary’s lifetime. In short, the lower the interest rate used to value the charity’s 10% minimum remainder interest in the charitable trust, the older the lifetime individual beneficiary of that trust must be.
    • 5% Distribution Example- #2: If the charitable remainder unitrust was established not to provide lifetime distributions to the individual beneficiary, but instead to make annual distributions only for a period of 20 years [twice the duration of the new SECURE Act’s required 10-year distribution rule,] the CRUT could have as its highest permissible annual distribution rate at 11.093% of the charitable trust’s assets, regardless of the individual beneficiary’s age. Trading a lifetime payout to the beneficiary for a 20-year certain duration of the charitable trust can often achieve the settlor’s objectives; the ‘numbers’ just have to be run as to what works best.
  • Taxation of CRUT Distributions: All of the retirement account that is paid to the charitable remainder trust is characterized as ordinary income. As noted, since the charitable remainder trust is a tax-exempt entity [IRC 664], the entire lump-sum distribution of the retirement account balance to the trustee of the charitable remainder trust is without immediate income taxation. When the distributions are then made from the charitable remainder trust to the individual beneficiary of that trust, those distributions will all be taxed as ordinary income to the individual beneficiary. Accordingly, this is no different than if the retirement account was made payable to the individual beneficiary, who began to take required minimum distributions under the ‘old’ stretch distribution rules, or the individual retirement account beneficiary who must empty the inherited retirement account on the tenth anniversary date of death the retirement account owner under the SECURE Act’s 10-year distribution rule. The government still gets its tax revenues using the charitable trust, but only over the individual’s life expectancy. After all of that former-retirement account ordinary income is distributed to the individual lifetime beneficiary, future distributions to that individual lifetime beneficiary from the charitable trust will carry out ordinary income, capital gains, and tax-free income depending on the character of the income that is earned by the charitable remainder trust’s investments.

Planning Considerations: Certain assumptions have to be made with regard to a CRUT’s distribution rate, including the investment returns within the unitrust, and the individual beneficiary’s after-tax return on distributions from the unitrust. The biggest problem is that there is no way to know what the IRC 7520 rate will be when the retirement account owner dies and the charitable remainder trust is to receive the balance of the decedent’s retirement account.

  • Formula Unitrust: With this uncertainty, if a CRUT is to be named as the designated beneficiary of a retirement account, a formula is often used.
    • Example: The trustee of this ABC charitable remainder unitrust that is established on my death shall annually distribute to the individual beneficiary of that unitrust the highest permissible rate, in other words, the rate that results in the actuarial value of the charity’s remainder interest being 10.0%.
  • Creative Planning-10th-Year Distribution + CRUT+ Family Foundation: Consider exploiting the SECURE Act’s 10-year distribution rule, to delay any distribution from the decedent’s retirement account until the 10th anniversary of his/her death. Then have the charitable remainder trust as the designated beneficiary of that account. The trustee receives the balance of the retirement account, (after ten years of additional tax-deferred growth) and only then begins to make distributions from the charitable remainder trust. The trustee would then begin to make 5% annual distributions to its named beneficiary, either for the beneficiary’s lifetime, or for 20 years. Perhaps the decedent’s spouse is the first individual beneficiary of a 20-year CRUT, and the decedent’s child is the second individual beneficiary of the 20-year CRUT who will benefit if the spouse does not live the entire 20 years. After 20 years the balance of the CRUT’s assets are distributed to the family foundation to be managed by the child or the decedent’s grandchildren.
  • Charitable Remainder Beneficiary: The retirement account owner can specify the CRUT remainder beneficiary. Alternatively, the CRUT instrument can permit the individual lifetime beneficiary to select the charitable remainder beneficiary.
  • 5% ‘Fail Safe:’ The other option to a formula based percentage amount is simply to specify in the CRUT a minimum 5% annual distribution to the individual lifetime beneficiary.
  • Expected CRUT Duration: The minimum 5% charitable unitrust distribution rate will generally work better if the CRUT is expected to last a long time, such as a charitable trust that is established for a child or grandchild with a long life expectancy ahead of them. If the CRUT is not expected to last for a long time, using the maximum unitrust distribution rate that will satisfy the 10% remainder limitation may work better.
  • Reality Check: With the current low IRC 7520 interest rates, the highest annual distribution rate that will satisfy the 10% remainder rule a CRUT established for the beneficiary’s lifetime will often not be much higher than 5%, so it may not make much difference whether the CRUT annual distribution rate is 5% or the highest permissible distribution rate calculated using a formula. As noted above, with the 2% IRC 7520 interest rate for January 2020, the individual lifetime beneficiary has to be at least 27 years old in order for a 5% unitrust to satisfy the 10% charitable remainder valuation rule. That low-interest rate coupled with the 10% remainder value limitation could rule out many potential beneficiaries of the CRUT.
  • Disabled Beneficiaries: Since a CRUT is less flexible than an accumulation see-through trust because annual distributions must be made from the CRUT, the charitable trust probably would not work well for a disabled trust beneficiary who has special needs and who may receive governmental benefits based upon their available resources, of which the annual distribution from the CRUT would be one.
  • Beneficiary’s Creditors: Similarly, withholding distributions by the trustee is not permitted under a CRUT. Mandatory annual distributions that will cause those required distributions to be vulnerable to the lifetime individual beneficiary’s creditors or divorcing spouses.
  • Beneficiary’s Budgetary Needs: Because annual distributions must be made outright from the CRUT to the individual lifetime beneficiary, a CRUT will work best for a beneficiary who will likely need substantial periodic distributions for their support, and who will be more likely to spend those distributions than save them.
  • Partial CRUT Funding: A retirement account owner probably will not use a CRUT for their entire retirement account unless the individual lifetime beneficiary has other money or inheritances available to cover their nonrecurring financial needs. Thus, part of the retirement account could be payable directly to the beneficiary, subject to the SECURE Act’s 10-year distribution rule, with the balance of the retirement account payable to a CRUT which will make distributions for the rest of the beneficiary’s lifetime.
  • Administrative Expenses: A CRUT functions much like the accumulation see-through trust in that there are administrative costs associated with each trust’s administration including fiduciary fees, investment management fees, and annual income tax returns to be filed.

Conclusion: The use of a CRUT may be a viable option for an individual who previously had made their retirement account payable to a conduit see-through trust. The principal drawback to using the CRUT for distributions to the individual lifetime beneficiary is the required minimum 10% remainder ultimately that must pass to a charity, when the account owner may not be charitably inclined. In addition, there exists the possible limitation on who the beneficiary of the CRUT may be in light of the valuation principles used to value the charity’s 10% remainder interest, which may deprive a younger individual of becoming the lifetime beneficiary of the CRUT. Stacking the SECURE Act’s 10th year distribution obligation on top of the lifetime (or 20 year) distribution requirement of a CRUT present some interesting planning solutions to consider for very large inherited retirement accounts.