Many clients seek guidance from professional advisors regarding retirement, investments, tax planning and charitable giving. These clients are often concerned with maintaining their standard of living and looking for a way to support their favorite charitable organizations. Life income gifts are a great solution for clients who desire a steady source of income for the duration of their lives, while also providing a legacy for charity.
Due to substantial tax law changes, now is a great time to suggest charitable solutions for clients. Part one of this article series discussed charitable gift annuities. Part two of this article series will provide an overview of charitable remainder trusts. This two-part article series will provide a few illustrations of the gift models and practical pointers to help guide a client toward the gift model that will best fulfill his or her philanthropic goals.
Charitable Remainder Trusts
A charitable remainder trust (CRT) is a split-interest gift, which offers life income options to clients. With a CRT, the trust makes payments to the trust beneficiary during the trust term. The remainder of the trust goes to charity at the end of the trust term.
A charitable remainder trust will be structured as either a unitrust or an annuity trust. Both trust types generate a charitable income tax deduction based on the present value of the remainder interest. Trust documents must be drafted by an attorney and can be costly due to the complexity of the drafting and clauses desired by the client. Clients may find this to be an excellent way to obtain liquidity and bypass capital gain.
General Charitable Remainder Trust Rules
Charitable remainder trusts provide flexibility in the payout term and payout amounts. Cash or appreciated property may be contributed to fund the trust. If appreciated property is contributed, the CRT can sell the property tax free and invest the proceeds. CRTs may pay out for the life or lives of the income beneficiaries, a term of years up to 20 years or for a life plus a term of years. CRTs can be created for more than one measuring life with payments for the joint or successive lives of the beneficiaries.
A CRT's payout rate must be at least 5% and cannot exceed 50% of the trust's value. The payout percentage will be stated in the trust document. Once a CRT is created, it must start making payments according to the trust's stated payment frequency.
At the time of creation, a CRT must have a minimum charitable remainder interest equal to 10% of its initial principal or it will not qualify as a charitable remainder trust. This 10% minimum deduction test factors in the Sec. 7520 applicable federal rate in calculating the present value of the remainder interest to charity.
CRTs must adhere to the Sec. 4941 private foundation self-dealing rules. Sec. 4947(a)(2). The creator of the trust is prohibited from personal use of an asset once it is transferred to the CRT. For example, if a personal residence is donated to a CRT, the donor cannot remain living in the home or rent the home from the CRT.
Transactions between the CRT and "disqualified persons" are prohibited as self-dealing and will incur penalty assessments. Disqualified person definitions are found in Sec. 4946. A non-exhaustive list of disqualified persons is as follows: the donor, lineal descendants of the donor, the trustee of the CRT and spouses of any disqualified person.
A CRT will be administered by its trustee who will be responsible for managing trust investments, making payments to beneficiaries and proper trust accounting. The Form 1041 Schedule K-1 must be issued to income beneficiaries of the trust each year. It is crucial that the trustee is competent and receives qualified counsel on these issues.
While the donor may act as trustee, caution should be exercised to avoid running afoul of the self-dealing rules. For this reason, a donor might select a third party trustee. A CRT can be administered by a corporate trustee, such as a bank or financial company or by a charity. A charity's willingness to serve as trustee may depend on its size. A small organization may decline the role if its expertise and manpower is limited. A private trustee service is also an option.
A trustee must act for the benefit of the remainder beneficiaries and the income beneficiaries of the trust. The trustee has a fiduciary duty not to jeopardize the remainder interest and should have an understanding of prudent investor principles. Since many states issue guidelines for trust investments, the trustee may have a duty to diversify the CRT investments.
Federal law prohibits the trustee from jeopardizing the trust's investments. This is determined on an investment-by-investment basis. Certain investments, such as trading securities on the margin, trading in commodities futures, purchases of puts, calls, straddles or warrants and selling short are more closely scrutinized.
CRTs generally are tax-exempt trusts and do not pay tax on capital gain or income produced within the trust. There are, however, certain circumstances that can cause the CRT to be taxed. CRTs are subject to tax on all unrelated business income (UBI). The transfer of an active business or debt encumbered property may trigger UBI.
If a CRT has UBI, it must pay an excise tax on the income generated. UBI triggers an excise tax of 100%, meaning all income generated from the unrelated business will be paid to the IRS.
While CRTs are generally tax-exempt trusts, the income beneficiary of the trust may be taxed on income received from the trust. The tax characterization of distributions from the CRT is governed by a four-tier accounting system. All of the ordinary income accumulated in the trust must be paid out before the trust pays out capital gain, tax-free income or return of principal. The categorization of the distribution is determined by the funding asset and the type of investments the trust holds. The trustee will be responsible for sending out an end-of-year tax statement with information to the income beneficiary.
A CRT can be structured as a charitable remainder unitrust (CRUT) or a charitable remainder annuity trust (CRAT). A CRUT offers a fixed percentage based on the value of the trust and must be revalued each year. A CRAT pays out a fixed dollar amount based on a percentage of the trust's initial value. The practical difference is that the dollar value of the CRUT payout will fluctuate year-to-year depending on the growth and earnings inside the trust, while the CRAT payout will pay an identical amount every year regardless of the value of the trust corpus.
Charitable Remainder Unitrusts
The CRUT payment amount is based on the annual valuation multiplied by the payout percentage. The annual valuation can provide benefits if the CRUT investments are growing. There is also risk, as CRUT payments may decrease if the principal shrinks due to underperforming investments or fluctuations in the market. CRUT administration costs may also reduce the principal of the trust and result in a lower payment amount.
There are four different ways to structure CRUT payouts. In addition to the standard unitrust, which simply pays the fixed unitrust percentage, a CRUT can be formed as a Net Income Plus Make-up Unitrust (NIMCRUT), Net Income Only Unitrust (NICRUT) or Flip Unitrust (FLIP CRUT).
NIMCRUTs and NICRUTs pay out the lesser of the trust's net income or the payout percentage specified in the trust document. A NIMCRUT is able to make-up payments to the beneficiary in a later payment. If the net income exceeds the payout percentage, a NIMCRUT will pay the standard percentage payment plus make-up amounts for previous payment periods where there was a deficit between the payout percentage and the net income amount actually paid. The accounting for a NIMCRUT is highly technical as the trustee must track any deficit and any applicable make-up payments to ensure overpayments are not made. While a NIMCRUT allows for make-up payments, a NICRUT does not. The NICRUT simply pays the lesser of the trust percentage or the net income generated by the trust.
NIMCRUT and NICRUT structures provide income control. This protects the trust principal and allows for a robust remainder to charity. The trust can be invested in non-income producing growth assets, which will allow the principal to grow. The income beneficiary may enjoy larger payouts as the trust corpus is able to grow and provide make-up payments. This also allows for the deferral of income payments. If at any time in the future, the client is in need of income, the trustee can adjust the investments to income producing assets. The income payments would then increase as the net income of the trust increases. Clients interested in protecting trust principal for the charitable gift and who desire income control, may want to choose a NIMCRUT or NICRUT structure.
A FLIP CRUT is another option to consider for those clients who would like to receive a charitable deduction today, while postponing large payments from the trust until a future date. A FLIP CRUT is structured as a NIMCRUT until a specified "trigger event" occurs. The event may be a marriage, divorce, death, birth, specific date or the sale of unmarketable assets. On January 1, following the triggering event, the trust will become a standard payout CRUT. Any make-up amounts accumulated before the triggering event will be forgone, as the standard payout will be paid.
A FLIP CRUT may be a great option to hedge against risk when the client plans to fund the trust with an illiquid asset, such as real estate. This ensures that the trust will not be required to make payments until the trust has the liquidity to make payments.
Example 1: FLIP CRUT
Charitable Remainder Annuity Trusts
Michael, 80, and Brenda, 78, want to fund a gift to benefit their favorite charity and receive income as well. Michael and Brenda own an undeveloped plot of land and currently have a buyer waiting in the wings to purchase the land. They originally paid $25,000 for the land, but it has appreciated to $175,000 in value. Based on Michael and Brenda's goals, Emma, the charity's planned giving officer, suggests a FLIP CRUT. The trust will start as a NIMCRUT and will pay out the lesser of trust income or the unitrust percentage. The sale of the lot will be the "triggering event." After the lot is sold, the trust will make payments based on the unitrust percentage. As there is a buyer waiting in the wings, the property is expected to sell quickly. Michael and Brenda deed the property to the trustee of the FLIP CRUT. As predicted, the property sells within a few months. On January 1 following the sale, the unitrust starts making payments at the standard 5% payout rate. Michael and Brenda will receive the benefit of a charitable income tax deduction of $98,812 in the year of the gift. Once the trust begins making payments, Michael and Brenda will receive an annual payment of approximately $8,750 in the first year. The subsequent payments will be based on the annual valuation multiplied by a payout percentage of 5%. The charity will receive a generous legacy gift.
A charitable remainder annuity trust (CRAT) offers fixed payments based on the payout percentage multiplied by the initial trust principal. Unlike a CRUT, the exact dollar amount of the CRAT payment will remain the same for the duration of the trust. Therefore, the principal of the trust will be depleted if the trust's payouts outpace the trust's investments. Administration costs can cut into the principal as well. If the CRATs principal is completely depleted, no further income payments will be made and the trust will terminate.
In Rev. Rul. 77-374, the Service addressed the concern of depletion and implemented what is known as the 5% probability of exhaustion test. The 5% probability test requires that the trust have a less than 5% probability of exhaustion before the life expectancy of the beneficiary. If the trust fails this test, the charitable deduction will be denied, unless the trust is reformed under Sec. 2055(e). This test is used to protect the charity's remainder interest and is unique to life income CRATs.
During a period of time with low interest rates, it became increasingly difficult to create CRATs that met the 5% probability test requirements. In Rev. Proc. 2016-42, the Service instituted an alternative to the 5% probability test by creating the 10% early termination qualified contingency test. Pursuant to this test, a CRAT that fails the 5% probability test at creation will not lose its charitable deduction so long as the trust document contains the precise qualified contingency language. The language provides that if the trust corpus declines to 10% of the initial trust corpus (with discounting at the initial applicable federal rate), the annuity trust will terminate and the corpus must be distributed to the specified charities. The language necessary to adopt the 10% termination test can be found in Rev. Proc. 2016-42.
If the 10% termination test is employed, it can cause the CRAT to terminate more quickly than the donor anticipates. As such, the 10% termination test should be used with caution. Donors may be disappointed if the trust ceases to make payments. The 10% termination test is not meant as an easy alternative, but as a means to secure a charity's remainder from the trust.
Example 4: CRAT
Melinda, age 74, is looking to increase her liquidity in her retirement years. She is considering funding a gift with $150,000 worth of tech stock. The tech stock is paying a 2% dividend each year. Melinda explains to Dominique, the gift planner at her alma mater, that she is looking for a fixed income payment to supplement her retirement years. Dominique suggests that a CRAT might provide her the liquidity she desires. Melinda is pleased to learn that with a CRAT she can increase her liquidity, bypass the capital gain on the stock, leave a substantial gift to her alma mater and receive a charitable income tax deduction. Her basis in the stock is $70,000 and she would like a 6% payout. The 6% fixed payout passes the 5% probability of exhaustion test and the CRAT qualifies for a charitable deduction of $70,490. Melinda will receive an annual payment of $9,000, which is a much needed increase over her previous income from the dividends. Melinda is thrilled that she is able to leave a legacy gift to her alma mater.
This two-part article series reviewed both CGAs and CRTs. Through CGAs and CRTs, clients can obtain income for life and meet their philanthropic goals. Charitable gift options differ and professional advisors should be aware of the unique benefits of each gift model. Charitable remainder trusts are a great option to provide future support for a charity, while also offering income payments for the life or lives of the beneficiaries.
By understanding various gift models, advisors can help meet the needs and lifestyle goals of their clients. A CRT can be a great gift vehicle for appreciated property. CRUTs offer different payment structures, which allows for flexibility in meeting the client's desires. CRATs offer fixed income payments, which can provide peace of mind for clients. Charitable remainder trusts are a wonderful solution to provide financial security, income tax savings and meet the client's philanthropic goals.