Donor Resource | Charitable Remainder Trusts Explained

*A contributed post from a friend of the Foundation, estate planning attorney, Richard L. Ferris of Carrell Blanton Ferris & Associates, PLC:

Any gift you donate to a tax-exempt organization is not only a positive contribution to your community, but also a powerful tax planning tool under both the Income Tax and Estate Tax subtitles of the Internal Revenue Code. Both of these taxes provide for a Charitable Deduction.  The Charitable Remainder Trust is one of our most versatile Estate Tax Planning tools. This irrevocable trust is exempt from income tax and is usually created during the donor’s lifetime. It also has a significant place as a testamentary tool when created through a Revocable Living Trust or Will at an individual’s death. A Charitable Remainder Trust (CRT) not only has important Estate Tax benefits, but welcome Income Tax benefits as well.

How the Charitable Remainder Trust (CRT) Works:
A Charitable Remainder Trust pays an income stream to you (and your spouse), with the principal or remainder passing to a charity at a stated event or point in time. This income interest is subject to Income Tax payable by you–the donor. The income interest of the CRT is calculated based on a percentage of the fair market value of the trust assets. This income interest must be payable to you for either your life or joint lives at the creation of the CRT or for a specific period of years. The term of years may not exceed 20 years. At either the death of the last income beneficiary or at the expiration of the term of years, the remaining principal is payable to a charity or charities chosen by you. This gift to charity generates an Income Tax Charitable Deduction for you. The calculation for this deduction is quite complex; however, the concept is relatively simple. You will receive an Income Tax Charitable Deduction now for the present value of the remainder interest received by a charity or charities at the specified time in the future.

There are two basic types of Charitable Remainder Trusts. The first is a Charitable Remainder Annuity Trust (CRAT) and the other is a Charitable Remainder Unitrust (CRUT). The CRAT requires that the income interest be a guaranteed sum certain paid to the non-charitable beneficiary(ies) on at least an annual basis. The annuity amount paid to the income beneficiary is determined at the inception of the trust. In the trust agreement, the Trustmaker selects the value of the annuity. The guaranteed sum certain is determined by applying the annuity percentage (which may not be less than five percent or greater than fifty percent) to the value of the trust corpus at the inception of the CRAT. This calculation determines the fixed amount of the annual annuity required to be paid to the income beneficiary each year for the life of the trust. This amount will always remain constant. The CRAT is a favorite for those clients who desire to receive a constant income stream, similar to the interest payments from bonds. This consistent income stream, however, is not adjustable to take into consideration inflation or other market factors.

Charitable Unitrust or Annuity Trust?
Because of its additional flexibility, the Charitable Remainder Unitrust (CRUT) is a more popular tool
than the Charitable Remainder Annuity Trust (CRAT). A CRUT requires that a fixed percentage, which must be between five percent and fifty percent, of trust principal be paid to the noncharitable beneficiary at least on an annual basis. However, in the CRUT, the Trustee recalculates the percentage each year instead of only one at the inception of the trust as with the CRAT. The Unitrust percentage is a constant percentage applied to the value of the trust corpus on a specific date, usually the first business day of the trust’s tax year, in order to determine the Unitrust amount for that particular year’s  distribution to the named income beneficiary(ies). The CRUT, with its annual recalculations of the amount of the income stream, allows for a changing income payout from the CRUT. A client is able to vary the CRUT’s income stream to meet differing needs by varying the type of investments held by the trust. For example, an investment in growth securities would allow for an increase in trust principal. With the annual recalculation based on the size of the principal, the client can achieve an increase in the income payable to him. This flexibility can provide numerous choices for a client and may even allow the client to choose when to recognize income from the CRUT.

Inter Vivos or Testamentary CRT?
A CRT may be best used in an inter vivos setting, that is, during a donor’s lifetime. The advantages to this strategy are numerous:

(1) Income Stream for Life. A CRT is usually created in order to pay income to the donor for their and/or their spouses’ lifetime. Many times the annuity amount or the Unitrust amount represents another pension to the client.

(2) Shelters Capital Gains on Highly Appreciated Assets. A client may contribute highly appreciated stock to the CRT and, as a Qualified §501(c)(3) Tax Exempt Organization, it sells the stock. The CRT does not pay any Income Tax on the capital gains from the sale of the highly appreciated asset. In this situation a client has taken an unproductive asset that was not producing any income for him and exchanges it for a highly productive asset.

(3) Income Tax Charitable Deduction. The client receives an Income Tax Charitable Deduction for the present value of the gift of the remainder interest going to charity at some point in the future. Many times these charitable deductions are quite sizable and exceed the limitations on the amount a taxpayer can deduct in any one year. However, these deductions can be carried over for five years; giving a  taxpayer a total of six years in which to claim the full deduction.

(4) Estate Tax Savings. The contribution of an asset to a CRT, in effect, removes that asset from the donor’s estate as a result of an Estate Tax Charitable Deduction.

Even though an inter vivos CRT has many advantages, it does have one drawback for some individuals. Since the family asset contributed to the CRT is eventually transferred to a charity, then the donor’s children do not receive the full value of their parent’s estate. The solution to this concern is for the donor to utilize a portion of the income stream, as well as the savings from the Income Tax Deduction, to purchase a second-to-die life insurance policy in the amount of the asset contributed to the CRT. This life insurance policy should be held in an Irrevocable Life Insurance Trust (ILIT) which not only removes the proceeds of this policy from the parent’s estate, but the proceeds are received into the ILIT both Income Tax and Estate Tax free. The children would be the beneficiaries of the ILIT, thereby receiving not only the full benefit of their parent’s estate, but also allowing the parents to protect their children’s inheritance from a failed marriage, financial mismanagement or creditor. This cost effective, high-leverage strategy is called a Wealth Replacement Trust.

The CRT may also be used as a testamentary trust, effective after the donor’s death. Used in this way, a CRT can meet very specific needs. For example, it can provide an income stream to a spouse, sibling or other family member for their life with the remaining balance of the CRT payable to the donor’s favorite charity or to their Private Family Foundation. Another specific use of a Testamentary Charitable Remainder Trust (TCRT) is as the beneficiary of a donor’s Qualified Retirement Plan (QRP – i.e. Individual Retirement Accounts, 401(k) Accounts and 403(b) Accounts). This is a tool used for substantial QRPs as a method of reducing the Estate and Income Tax burden on an estate. Since the TCRT is a Qualified §501(c)(3) Tax Exempt Organization, it will not pay the Income Tax due on distributions from the QRP. The donor’s spouse or children would usually be named the income beneficiaries of the TCRT, allowing them to receive income from the QRP through the TCRT for their lives. The donor’s Estate would then receive an Estate Tax Charitable Deduction  for the present value of the remainder interest going to charity after the death of the last living income beneficiary.

Summary
The Charitable Remainder Trust is a remarkable planning tool that provides benefits either during lifetime or after death. There are both Income and Estate Tax advantages, as well as non-tax benefits. For example, a non-tax benefit of the CRT is the ability to take an appreciating asset that produces little or no income for the family and convert that asset into an income stream for the donor’s lifetime.

A Testamentary CRT may provide income to a spouse or relative for their life in order to supplement their lifestyle, while still obtaining an Estate Tax Charitable Deduction for the donor’s estate. The Charitable Remainder Unitrust has a great deal of flexibility in granting you options as to the amount of the income and when it is to be received from the CRUT. The CRT is an excellent tool for the client who wants to provide income security for family on the road to charitable giving.

*This article is intended for general information purposes only and does not constitute legal or tax advice.  You should consult your attorney or qualified tax advisor regarding your situation.  This is part of a series of contributed articles from local estate planning professionals serving the Tri-Cities area of Virginia, and John Randolph Foundation does not endorse these professionals nor do we receive any compensation or incentives for referrals.

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This post was written by AJ James