This blog explores the basics of charitable remainder trusts, including how they work and their tax advantages.
A charitable remainder trust or CRT begins when a donor transfers assets into the trust. The trust makes specific distributions, at least annually, to one or more non-charitable beneficiaries for the beneficiaries’ lives or for a specific number of years. The grantor – along with the grantor’s spouse – can be and often is the beneficiary. At the end of the term, the assets remaining in the trust go to one or more charities. Those charities are called the remainder beneficiaries.
I. Benefits of Charitable Remainder Trusts
CRTs offer several benefits. First and foremost, CRTs enable donors to accomplish their goals of charitable giving. Indeed, CRTs work best for folks with charitable intentions and motivations. CRTs also offer immense tax benefits. The donor can obtain a significant income tax deduction in the year when the donor transfers funds into the CRT, and the deduction may carry forward for up to five additional years. Donors with highly appreciated property can defer or avoid capital gains tax by contributing that property to a CRT. The CRT can then sell the property without realizing a capital gain and reinvest proceeds from the sale. In this way, CRTs enable donors to accomplish diversification that the large capital gains tax would otherwise discourage. Contributions to a CRT can avoid gift taxes in some circumstances. With a CRT, donors can provide cash flow for themselves or other beneficiaries for up to 20 years or for life. This can be an especially powerful retirement planning tool, enabling donors to obtain an income tax deduction in their high earning years and an income stream in later years.
II. Requirements for Charitable Remainder Trusts
The tax benefits of CRTs come with many rules established by the IRS and tax courts.
The annual payout to the noncharitable beneficiaries must be a minimum of 5% and a maximum of 50% of the trust’s value. The trust’s term or duration – that is, the period during which payments are made to the noncharitable beneficiary – cannot be more than 20 years or the lives of the noncharitable beneficiaries. At the end of the term, the remainder interest going to the charity must be equal to or greater than 10% of the value of the property originally contributed to the trust. No deduction will be allowed if there is more than a 5% probability that payments will exhaust trust assets before the term’s end.
III. Types of Charitable Remainder Trusts
Two main variations of CRT meet these requirements. The Charitable Remainder Annuity Trust or CRAT pays a fixed dollar amount based on a fixed percentage of the trust’s initial value to the noncharitable beneficiaries at least annually. The Charitable Remainder Unitrust or CRUT pays a variable amount to the noncharitable beneficiaries, which is a percentage of the net fair market value of the CRUT as valued annually. Unlike a CRAT, a CRUT’s assets must be appraised or valued every year, and additional assets can be added to a CRUT. The CRUT comes in several variations, including the Standard CRUT or S-CRUT, NI-CRUT, NIM-CRUT, and FLIP-CRUT. I address these distinctions in another video.
IV. Tax Advantages
When planned carefully, CRTs have immense tax advantages.
CRTs are excellent vehicles for planning with highly appreciated assets because they mitigate capital gains taxes. This works as follows.
The donor transfers a highly appreciated asset into the CRT. The CRT sells the asset without realizing any capital gain. The CRT does not have to pay either capital gains tax or the net investment income tax. Therefore 100% of the proceeds of the sale remain for reinvestment by the CRT, which can diversify its portfolio with the new investments. The distributions paid to the noncharitable beneficiaries may be subject to the capital gains tax at the beneficiaries’ tax rates. However, these taxable distributions will be distributed over many years rather than all at once.
Upon funding the CRT, the donor obtains an income tax charitable deduction. The deduction can carry forward for up to five years. Technically, the amount of the deduction is the present value of the remainder interest that will pass to charity at the end of the term. Numerous factors go into determining this amount, including:
- The value of the property contributed to the trust. Unless it’s cash or marketable securities or mutual funds with a ready valuation, the property must be appraised.
- The type of property contributed to the trust. For example, the CRT may be funded with cash, appreciated property, long-term gain property, or ordinary income property.
- The donor’s AGI or Adjusted Gross Income.
- The term or the age of the noncharitable beneficiary or beneficiaries. A longer term or a younger beneficiary lowers the income tax deduction.
- The amounts distributed to those beneficiaries. Higher payouts to noncharitable beneficiaries lower the deduction.
- The type of charitable beneficiary. The donor receives a higher deduction for a public charity than for a private foundation.
- The Section 7520 rate in the month of the gift or one of the previous two months. This is the IRS’ determination of applicable interest rates. A higher Section 7520 Rate means a larger deduction.
Determining the deduction amount is complicated. Charitable planners like me use specialized software for the calculations.
A transfer to a CRT qualifies for the unlimited gift tax charitable deduction to the extent of the present value of the remainder interest that will go to the charitable remainder beneficiary. A CRT has no gift tax consequence if the donor or the donor’s US citizen spouse are the only noncharitable beneficiaries of the trust. However, there are gift tax consequences where the noncharitable beneficiary is not the donor or the donor’s spouse. The future interest gift to the non-spouse recipient is subject to the gift tax if the donor’s lifetime gifts go over the unified exemption amount.
Unlike other types of trusts, a CRT is exempt from federal income taxes. The assets in the CRT can grow tax-free, to the advantage of the charitable and noncharitable beneficiaries. There is one exception to this rule. The IRS taxes any unrelated trade or business income at 100%. This excise tax would apply, for example, if a CRT started a company, opened a retail store, or engaged in any business. Otherwise, the noncharitable beneficiaries must pay taxes at their own tax rate on distributions they receive. The IRS considers distributions in four tiers, each of which has different tax consequences. Tier 1: Ordinary income for the current year and undistributed income from previous years is taxable when distributed to the noncharitable beneficiaries. Tier 2: Capital gains for the current year and undistributed capital gains from previous years are taxable as well. Tier 3: Other income for the current year and undistributed income from past years may be tax-exempt. Tier 4: Corpus is not taxable because the IRS treats it as a return of the principal transferred into the CRT. The trustee should rely on experienced experts to calculate these taxes, since they are extremely complex. The trustee provides a K-1 to the beneficiaries, who then report the income on their tax returns.
V. The Charity Will Prepare My CRT for Free!
Many larger charities will prepare CRTs, serve as trustee, and prepare CRT tax returns free of charge for their donors. Why not take advantage of these services?
After all, if you hire professionals – including attorneys, tax preparers, and professional trustees – to establish and maintain your CRT, the fees will add up because the work is intensive. You can allow the charity to create and maintain your CRT for you but be aware of the tradeoffs. First, the charity may require a higher value remainder interest than you might otherwise leave to the charity. Second, the charity may require a higher contribution than you might otherwise give to the charity at the beginning. Most significantly, the charity will not allow you to change the charitable beneficiary. Sometimes charities change course or start to support initiatives with which the donor’s disagree. For this reason, many donors desire to retain the ability to change the charitable beneficiaries of the CRT. A donor who allows the charity to establish the CRT will lose the ability to change the remainder charitable beneficiary. That beneficiary will receive your money even if it starts doing things that are completely contrary to your values.
If you would like to discuss your options for charitable planning, contact us for a consultation.