Take-Away: As we near the end of the calendar year, it is a pretty good guess that there will be a lot of discussions with regard to charitable giving, and charitable remainder trusts (CRTs) in particular. With the run- up in the stock market this year, many investors are sitting on appreciated stock portfolios who will be interested in using charitable gifts to reduce their income tax bill for the year, or to diversify those portfolios without incurring capital gains taxes. Moreover,  with the impetus of promised income tax reform, many taxpayers may begin to worry about some type of income ‘cap’ Congress may place on charitable income tax deductions in the coming years. Consequently,  there may be more attention given to charitable giving, and CRTs in particular, this year than in prior years.

Background: A CRT is a planned gift. It enables a taxpayer to make gifts now that would ordinarily be made by a will or a trust. The donor retains a life income interest in the CRT, and receives current income tax savings in the form of a charitable income tax deduction, based on the present value of the remainder interest in the CRT that is assured to the charity. There are also capital gains savings because CRT is a ‘mini-charity’ which as a general rule (but there are always some exceptions) pays no income taxes. Thus, if the donor transfers highly appreciated stock into the CRT and the CRT trustee (normally the donor) sells the stock, there is no capital gain recognized on the sale of the appreciated stock held inside the CRT. The entire sales proceeds remain in the CRT to be reinvested by the CRT trustee, the income from which will be distributed to the donor for his/her lifetime. When annual distributions are made from the CRT to the donor-beneficiary, some of those distributions will be taxed as ordinary income, some as capital gains, and some will be treated as a tax-free return of capital to the donor. IRC 664.

  • Beneficiaries: As a general rule the lifetime interest (set up either as a specific dollar amount, called a charitable remainder annuity trust, or CRAT, or set up as a unitrust, paying a specific percent of the value of the CRT assets each year, called a charitable remainder unitrust, or CRUT) is payable to one or more non-charitable beneficiaries. The remainder interest in the CRT is payable to a tax exempt entity when the non-charitable beneficiaries die.
  • Tax Deductions: If the CRT is funded with marketable securities the donor can take a charitable income tax deduction up to 50% of the donor’s adjusted gross income for the year. If closely held securities are the subject of the charitable gift, the deduction is limited to 30% of the donor’s adjusted gross income for the year. Any unused charitable deduction caused by these income limitations can be carried over for the next five calendar years.
  • CRT Forms: While there can be some ‘free-lancing’ in the form that a CRT takes, it makes sense to follow the ‘safe harbor’ specimen form documents that the IRS published about 15 years ago. For CRUTs see Revenue Procedure(s) 2005-52, 53, 54, and 55. For CRATs see Revenue Procedure(s) 2003-53, 54, 55, and 56.

Charitable Giving with an Eye on Tax Reform:

  • Rates: For many taxpayers, charitable income tax deductions are more valuable this year, if the top income tax rate drops from 39.6% to 35% next year as has been discussed.
  • Standard Deduction: For many taxpayers who are not at the highest marginal income tax brackets, tax reform measures that double the standard deduction also make charitable gifts this year more valuable. While there is the potential for fewer income tax brackets, more impactful is the proposal to double the amount of the standard deduction (along with the elimination of the personal exemption) which makes a charitable gift this year more valuable when itemizing deductions than in future years when more taxpayers may decide to not itemize their deductions.
  • Elimination of other Deductions: If the deduction for state and local income taxes, and property taxes disappear, taxpayers will be more likely to use the enlarged standard deduction than itemize their tax deductions where the charitable income tax deduction (along with home mortgage interest payments) appear to be the last income tax deductions ‘standing’ with the promised tax reform.
  • Elimination of the AMT: If the alternative minimum tax disappears as has been proposed, there will be less incentive to make deductible charitable gifts in future years to avoid that irritating tax.

Accelerate Charitable Giving: If these proposed tax law changes take place as a part of tax reform (or simplification),  then it may be wise to accelerate charitable giving into 2017.

  • Charitable gifts this calendar year will reduce taxable income from higher marginal income tax brackets,  so a charitable income tax deduction could be more impactful this year.
  • With the ‘run-up’ in the stock market the built-in gains in stock portfolios might better be harvested now;  the gift of appreciated stock directly to charities or to a charitable remainder trust,  should be seriously considered. Generally the taxpayer is entitled to the fair market value income tax deduction at the time of the gift of appreciated stock; capital gains can be reduced, deferred or possibly eliminated; the consequence is that more wealth can be donated to the charity than liquidating the appreciated securities, paying the gain tax (20% federal + 4.25% to the state + perhaps the net investment income surtax of 3.8%, or a total of about 28%), and then donating the net sales proceeds.
  • Consider maximizing the charitable gifts this year, in anticipation of exploiting the charitable income tax deduction carry-forward into future calendar years. If charitable deduction cannot be fully used this year due to taxable income limits, the excess amount of the charitable deduction can be carried over for up to five additional calendar years to off-set taxable income in those future years. This carry forward option may be prove to be valuable for those taxpayers who worry about the possible disappearance of the federal income tax deduction for state income, sales and property taxes paid.
  • While not as beneficial as the gift of appreciated marketable securities to a charity, this might be the year where clients over the age of 70 ½ exploit the Qualified Charitable Distribution from their IRA- up to $100,000 per taxpayer. This transfer does not result in a charitable income tax deduction, but the amount gifted is applied towards the taxpayer’s required minimum distribution (i.e. taxable income) obligation for the calendar year. Thus, the gift reduces the taxpayer’s gross income, possibly into a lower marginal income tax bracket,  and it also  reduces the amount of income taxes that are owed. This charitable gift-distribution can also positively impact those high income earners who might have many of their existing exemptions and deductions phased out due to their higher reported adjusted gross income for the year, i.e. the Pease amendments take a portion of some deductions away when AGI is too high.

CRT Traps: Several traps can exist with gifts of stock to a CRT, even with an innocent enough looking CRT instrument when using the IRA’s specimen form, either in the drafting of the CRT or in the CRT’s administration. Examples follow-

  • Timely Payments: If the annual payment required to be made to the lifetime beneficiary by the CRT trustee is late, the CRT is void from its inception. This results in the loss of the charitable income tax deduction and the trust’s possible exposure to adverse capital gains taxes. See Estate of Atkinson v. Commissioner, 115 Tax Court 26, 32 (2000) affirmed, 209 F.3d 1290 (11th 2002);
  • Failure to Diversify: Sometimes a closely held business interest will be transferred to the CRT. The business owner names himself as CRT trustee. The business owner, aka trustee, inserts a provision in the CRT document that says something like “the trustee shall expressly have the power to retain, without liability for loss or depreciation resulting from such retention, original property, real or personal, received from the grantor from any source, although it may represent a disproportionate part of the trust corpus’, meaning non-diversification of investments is authorized. [This type of CRT is often called a ‘flip NICRUT’ where income only is distributed to the lifetime CRT beneficiary, and when a future event occurs, e.g. the sale of the business, the CRT then ‘flips’ to the fixed percentage distribution to the lifetime beneficiary each year.]The owner-trustee does not diversify the closely held business interest held in the CRT, or is slow to do so, and the business’ value drops. Several courts have held that the trustee of a CRT cannot escape liability for not diversifying the assets held in the CRT, despite the presence of any non-diversification authorization provision in the trust, treating the trustee as having ignored the interests of the charitable remainder beneficiary in doing so. See Wood v U.S. Bank, 828 N.E. 2d 1072 (2005) and Fifth Third Bank v Firstar Bank, N.A. (Ct. App Oh., 2006-Ohio-4506 (2006 WL 2520392006). While the Uniform Principal and Income Act [Section 1(b)] acknowledges a clause that permits non-diversification of trust investments by the trustee, the clause must be carefully drafted to ensure that it does not appear to be just an ordinary boilerplate provision that permits retention of assets by the trustee with no obligation to diversity those transferred assets. Courts generally want to see diversification of trust assets, despite what the UPIA permits.  Therefore,  a clear, stand-alone, retention/ non-diversification provision should be used in a CRT  that contains explicit instructions to retain concentrated investments, together with express permission given to the trustee to avoid the diversification that is otherwise strongly recommended by the Uniform Principal and Income Act. See Smith v. First Community Bancshares, Inc. 212 W. V 809 (2015).
  • Not Following the Technical Rules: True story. Husband died leaving millions to a CRUT. The CRUT was structured to make annual payments to husband’s widow for her lifetime, and upon her death annual payments were to then be paid to husband’s brother if he was still living, and thereafter to a tax exempt entity after both individuals’ deaths. Widow was around age 60 when the CRT was created and husband’s brother was in his 80’s and not in good health. Consequently, the chances of the brother surviving the widow were very slim. The problem was that the brother’s presence as a successor beneficiary disqualified the widow’s interest in the CRUT from the federal estate tax marital deduction. The tax code provides: “If the surviving spouse of the decedent is the only beneficiary of a qualified charitable remainder trust who is not a charitable beneficiary…(paragraph (1) shall not apply to any interest in such trust which passes or has passed from the decedent to such surviving spouse.” IRC 2056(b)(8)(A) By inserting husband’s brother as a successor CRT beneficiary, husband forfeited the marital deduction for federal estate tax purposes. See Technical Advice Memorandum, 873004. This is an example where the technical CRT rules that deal must be closely followed. The tax attributes from the use of a CRT, both income tax and possibly federal estate tax, are extremely beneficial, but to gain them the IRS’s rules must be closely followed with little or no deviation. This is one area of the tax law where ‘substantial compliance’ with the tax code will provide no relief when mistakes are made.

Conclusion: With  stunning stock market performance this year coupled with the promise of tax reform or simplification, we should be talking to our clients about end-of-year charitable giving, and the possible tax benefits of a CRT. This is particularly the case if the client, with a substantial amount of appreciation in their stock portfolio, want to diversify those investments, but the client does not want to incur a capital gain tax as the price paid for that diversification. Not only are their tax savings to be gained by funding a CRT this year, it is important to remember that the CRT can provide protection from creditor claims if structured as a Michigan Qualified Dispositions in Trust (aka an asset protection trust) and also position a successor trustee to manage the assets if the donor-trustee is no longer capable of making investment decisions.