Charitable Remainder Trusts (CRT)

“Charitable Remainder Trusts,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Cynda Ottaway, ACTEC Fellow from Oklahoma City. What are the rules of Charitable Remainder Trusts? To answer that question, you will be hearing today from ACTEC Fellow, Matthew Brown, of Irvine, California. Welcome, Matt.

Well, thanks, Cynda. Charitable Remainder Trusts incentivize the combination of tax planning and philanthropy. While we will generally refer to these special trusts as CRTs during the podcast, there are several practical applications of the CRT. CRTs can be used to create a tax-deferred sale of business interests, appreciated securities or appreciated real estate. CRTs can also be used as an alternative to a stretch IRA [Individual Retirement Account] for inherited retirement accounts. In some instances, CRTs can be used to defer income until such time as the beneficiary moves from a high income tax state to a lower income tax state. Finally, CRTs can be used as an income tax efficient and gift tax efficient way to transfer an income stream that is payable to children or grandchildren over time. Now it’s important to note at the outset that CRT planning is not cost-free philanthropy. It is simply a way to more thoughtfully time when income is taxed while also increasing the extent to which the government subsidizes the taxpayer’s desired charitable giving.

But before jumping into the technical specifics, let’s go through a quick example. John and Susan Havealot are selling a piece of investment real estate. The real estate is worth $2 million and their basis in the real estate is $500,000. Therefore, if the Havealots sell their investment real estate, they’ll pay income tax on $1.5 million of gain, assuming a combined federal and state income tax rate of 33 percent, they will pay $500,000 in income taxes upon selling their investment real estate. If the Havealots instead used a CRT, they could sell their investment real estate free of current income tax, spread the cash flow and resulting tax liability over the remaining lifetimes and support their favorite charity or charities at the surviving spouse’s death.

In addition, depending on their ages and certain structural decisions at the time of the transaction, they will also receive an income tax deduction of at least $200,000 in exchange for their promise to give whatever is left in the CRT to their favorite charities upon the surviving spouse’s death. In other words, if the Havealots promise to give the leftovers to charity upon the surviving spouse’s death, the government will allow them to defer their income tax liability. In having used the CRT, they’ve sold their investment real estate free of current income tax, leaving them the full $2 million with which to generate a future income stream instead of just the $1.59 million they would have had after paying income taxes.

Split-Interest Trusts

A CRT is one type of Split-Interest Trust. This generally means that the interest in any asset going into the trust is being split into something other than the ownership of the entire asset. In the case of the CRT, the ownership of the gifted asset is split between an income interest and a remainder interest. Generally, the income interest provides an income stream for the lifetime of the non-charitable beneficiaries, the Havealots in our example above. Charities can also receive a portion of the income stream if the taxpayer desires. The remainder interest, whatever is left upon the death of the surviving Havealot in our example above, goes to one or more charities.

Charitable Remainder Annuity Trusts (CRAT) and Charitable Remainder Unitrusts (CRUT)

There are two types of CRTs, the Charitable Remainder Annuity Trusts or CRAT and the Charitable Remainder Unitrust or CRUT. The Charitable Remainder Annuity Trust or CRAT pays a fixed income stream to the taxpayer that is based on a taxpayer chosen percentage of the fair market value of the asset or assets gifted to the CRAT on the date of the initial gift. This payment does not change during the course of the CRAT, hence the description as an annuity. If the CRAT were funded with $1 million in assets and the taxpayers selected a 5 percent annuity payment, the CRAT would pay the taxpayer a fixed $50,000 per year for the duration of the CRAT. The CRAT payout rate must be a minimum of 5 percent and cannot exceed 50 percent. The payout rate is further limited to the maximum rate that will provide to charity, on an actuarial basis, at least 10 percent of the value of the assets initially transferred to the CRAT. Finally, the payout is yet further limited to the maximum rate that creates less than a 5 percent probability that the trust will leave nothing to charity. Practically speaking, this means the CRAT annuity payments can rarely exceed 15 percent. The taxpayer cannot make additional contributions to a CRAT, but the taxpayer can create and fund a new CRAT with similar or identical terms if desired.

The Charitable Remainder Unitrust or CRUT pays an income stream to the taxpayer that is based on a taxpayer chosen percentage of the fair market value of the CRUT-owned assets every year. The taxpayer has chosen to take distributions of a fixed percentage of a changing market value, the meaning of the term unitrust, this means that the taxpayer receives an income stream that fluctuates with the market value of the assets within the CRUT receiving larger distributions when CRUT investments grow and receiving smaller distributions when CRUT investments shrink. So, if a CRUT were funded with $1 million and the taxpayer selected a 5 percent payout, the unitrust payment for the first year would be $50,000 or 5 percent of $1 million. If at some point in the future the CRUT grew in value to $2 million, the unitrust payment for that year would be $100,000 or 5 percent of $2 million. Alternatively, if the CRUT dropped in value to $500,000, the unitrust payment for that year would be $25,000 or 5 percent of $500,000. The CRUT payout rate must be a minimum of 5 percent and cannot exceed 50 percent. The payout rate is further limited to the maximum rate that will provide to charity on an actuarial basis at least 10 percent of the value of the assets initially transferred to the CRUT.

Unlike with the CRAT, the taxpayer can make additional contributions to a CRUT. In the example above, I noted the Havealots would receive a deduction of at least $200,000 based on a $2 million gift. This is due to the 10 percent remainder requirement which requires the charity or charities must be projected to receive, on an actuarial basis, at least 10 percent of the value of the initial gift to the CRT. The value of the remainder interest for income tax deduction purposes is based on two factors. First, the anticipated length of the CRT and second, the assumed growth rate, also known as the Section 7520 Rate, which is published monthly by the IRS. The lower Section 7520 Rate provides a lesser charitable deduction because it assumes the money in the CRT will not grow as fast and there will therefore be less left for the charity when the income interest ends.

A higher Section 7520 Rate provides a greater charitable deduction because it assumes the money in the CRT will grow more quickly, leaving more for the charity when the income interest ends. The taxpayer can choose to use a Section 7520 Rate of the month in which the CRT is funded or for the two months prior to funding when calculating their income tax deduction. The income interest can last for one or more lifetimes, for a fixed term that does not exceed 20 years, or for a combination of one or more lifetimes in a minimum fixed term. A longer term results in a smaller charitable deduction and a shorter term results in a larger charitable deduction. If a CRT lasts for the lifetime of a young person or across multiple lifetimes, the deduction will be less than if the CRT lasts for the lifetime of a single person who is age 80. Instead of listing a bunch of additional rules, I’ll now transition into a list of questions that clients often ask when considering a CRT.

Charitable Remainder Trusts (CRT) FAQs

Question 1:  Do I have to set aside the money that is expected to go to charity?

Answer:  No. All of the money stays in a single trust for the benefit of the income beneficiaries until the income interest ends; the charitable deduction is based on a hypothetical growth rate and hypothetical income interest term based on actuarial life expectancies. In the case of a CRT with the term measured by the lifetimes of the income beneficiaries, if the income beneficiaries die before reaching life expectancy, the charity will receive more than expected; if the income beneficiaries die after reaching life expectancy, the charity will receive less than expected.

Question 2:  What if the trust runs out of money or leaves less to charity due to poor investment performance? Do I lose my charitable deduction?

Answer:  The upfront deduction is based on hypothetical trust performance. The actual value of what goes to charity at the end of the income interest term does not affect the deduction. It is possible that the trustee of the trust could face liability if the loss in value is due to financial mismanagement, but there should be no impact on the upfront deduction.

Question 3:  I’m considering a CRT in which the income interest lasts only for my lifetime. What if I die early?

Answer:  It is possible to provide that the income stream must last a minimum of 20 years and that helps reduce the negative financial consequences of an early death. Alternatively, some taxpayers choose to purchase life insurance as a hedge against the financial risk of early death. If life insurance is an important component of the plan, it’s important to determine whether the taxpayer is insurable before assets are transferred to the CRT.

Question 4:  Can my children be the charity?

Answer:  It often feels like children are charity, but they do not qualify. CRTs only work with a bona fide charity.

Question 5:  Can I name more than one charity?

Answer:  You can name as many charities as you like.

Question 6:  What if my favorite charity changes?

Answer:  You can reserve the right to change the charity or charities at any time.

Question 7:   My family has a private foundation. Can it be the named charity?

Answer: A private foundation can be a charitable remainder beneficiary, but the mere ability within the trust instrument to name a private foundation as a charitable remainder beneficiary means the taxpayer may have reduced income tax deduction benefits upfront and may also be subject to certain investment limitations inside of the CRT that would not otherwise apply.

Question 8:  Can I be the trustee of my own CRT?

Answer:  It is absolutely acceptable for the creator of a CRT to serve as trustee, but sometimes the charities that benefit from the CRT will serve at a reduced cost or perhaps the taxpayer would like to avoid the administrative burdens of serving as trustee and will choose to appoint a professional trustee instead.

Question 9:  I don’t need the income for my CRT until I retire. Is there any way to delay when those payments start?

Answer:  With CRUTs, but not with CRATs, it is possible to impose an income limitation on the CRUT such that it will only distribute its required unitrust payment when there is fiduciary accounting income within the CRUT. There are a variety of creative planning structures that can maximize the flexibility of income distributions using this concept, but those are outside the scope of this podcast.

Question 10:  I’m selling S Corporation’s stock. Can I contribute the stock to a CRT?

Answer:  Such a contribution is technically possible, but a CRT is not a qualified S corporation shareholder. So, such a contribution would terminate the corporation’s S election and the corporation will be taxed as a C corporation going forward. It is possible for the S corporation itself to form a corporate level CRT, which can last no longer than 20 years since corporations are not individuals and therefore not eligible for lifetime payouts.

Question 11:  If I need extra cash flow, can I borrow from my CRT?

Answer:  Borrowing from a CRT violates the private foundation rule against self-dealing and will result in excise taxes, which are effectively a penalty for violating the self-dealing rules.

Question 12:  I want to use a CRT with indebted real estate. Is this a problem?

Answer:  Debt is generally a problem with CRTs, but a gift of an indebted asset may work if the debt is nonrecourse, the CRT will not assume the debt but only take the assets subject to the debt and the contributing taxpayer has owned the asset at least five years and the asset has not been refinanced in the last five years (the so-called 5 and 5 exception).

Question 13:  Can I contribute retirement plan assets to a CRT?

Answer:  This is often a good planning concept because it can be a tax efficient way to spread retirement income over an extended time period, but it only works for gifts of retirement plans upon the plan participant’s death. Such a gift during life would be deemed distribution of the retirement plan participant, subjecting the participant to income tax on the distribution followed by a cash contribution to the CRT.

In conclusion, CRTs can be a very effective tool for taxpayers planning to sell appreciated assets in a manner that allows them to defer income taxes while maximizing the tax efficiency of their charitable giving.

Thank you, Matt, for educating us on Charitable Remainder Trusts.

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