A CREDO TAX PLANNING STRATEGY SOLUTION
CHARITABLE REMAINDER TRUST: Converting Highly Appreciated Assets Into a New Income Stream While Getting a Big Tax Break
As committing to a CRT is an irrevocable decision, consulting with a qualified estate planning lawyer and tax advisor is crucial in validating if a CRT would provide you with your expected results when it comes to the income tax consequences of the donation as well as the management of the CRT.
WHAT IS A CHARITABLE REMAINDER TRUST?
Unlike any other trust, a Charitable Remainder Trust involves non-charitable beneficiaries or what we call lead beneficiaries. The beneficiaries are usually the grantor or their spouse who then receives a fixed amount of income each year within a certain period of time or throughout their lives. But at the end of the trust term, the charity will receive the trust assets. Another term for charitable trusts is split trusts because the interest is split between the charitable and non-charitable beneficiaries.
With the conversion of your highly appreciated asset into a lifetime income, CRT helps you reduce your income taxes while you are still alive (or depending on the number of years you chose for the CRT), and lower your estate taxes when you die. When your asset is sold, you won’t need to pay for capital gains tax. You gain all these benefits plus the opportunity to donate to your favorite charity.
BENEFITS OF SETTING UP A CHARITABLE REMAINDER TRUST
Being a charitable trust, this means that any appreciated asset that is transferred to your CRT would not yield any capital gains tax. This means that you can diversify the assets that you invested while increasing your income without the need of paying any capital gains tax. For example, your contribution to the trust is $100,000 (assuming that you are in the top 39.6% income tax bracket). With this, you would have as much as $20,000 savings in capital gains tax (capital gains tax rate on assets that are held for more than a year is 20% for those in the top 39.6% income tax bracket).
A portion of your gift to the trust would entitle you to receive a charitable income tax deduction that is based on the market value of the property on the date that it gets transferred (regardless of the amount that it was originally bought) minus the current value of the income stream that you will receive (and / or your income beneficiaries) over the anticipated trust term. This deduction can be equal to or above 50% of your gift to the trust.
The income payments from a CRT are usually between 5% to 8%. So if your asset is generating 1% in dividends or interest prior to donating it to the trust, your investment income could be increased by the remainder trust for as much as tenfold).
Any kind of asset can be contributed to a trust (cash, stocks, bonds, real estate, closely-held stock, partnership interests, even antiques or valuable art). You have the option to receive either a variable income or a fixed annuity income. You may also add to your CRT whenever you want to (applicable for unitrusts only). The option to defer income is also possible (when the need arises such as retirement or if you want to grow your principal tax-free).
Your estate tax liability is reduced when you contribute your asset to a CRT (which matters a lot if you have a taxable estate).
When your trust term ends, you may decide to name multiple charities as beneficiaries (a percentage interest should be assigned to each). For those with multiple charitable interests, this matters a lot.
Some parts of your income may be treated as tax-free income or capital gains income for federal income tax purposes (which is taxable at 15% – 20% based on your tax bracket) depending on how the trust is invested. However, the interest and dividend income are taxed depending on your current tax bracket.
HOW DOES A CHARITABLE REMAINDER TRUST WORK?
The first step is to set up a CRT and transfer to it the asset that you want to donate to your chosen charity which is IRS-approved (the charity should have a tax-exempt status under the IRS). With the charity serving as the trustee of your trust, they would be the one to handle and invest the property to make it profitable (the trustee typically sells the asset and reinvests the proceeds in a diversified portfolio). They then pays you (or the person that you name as the beneficiary) a portion of the income earned by the trust property for a specified number of years (or your whole life). The payment period in the trust document is specified by you. At the end of the set CRT period (or at your death), the property would then go to the charity.
When your assets is sold, the trust itself won’t be taxable, making it possible to protect the full value of the appreciated asset and reinvest in a diversified portfolio. As a result, the capital gain taxes are distributed while the lead beneficiaries receive their annual payment and income tax deductions will be implemented.
TYPES OF CHARITABLE REMAINDER TRUST
The CRT allocated a fixed percentage of the trust assets to the income beneficiary (which is re-valued every year). Depending on the performance of the investment in the previous year, this method yields a variable income. Unitrust is preferable if your beneficiary has 10 to 15 years of life expectancy because of the possibility of growing the income as the assets grow over time. You also have the option of making additional gifts to this type of CRT.
This type of trust pays a fixed annuity income depending on the initial value of the trust. Older beneficiaries prefer this type for income security reasons as annuity trust payments do not change over time. Adding gifts to the trust is not allowed in this CRT type.
This special type of CRT offers you the option to defer or limit income payments until a future specified time (like your 60th birthday or when the time comes that you are able to sell an illiquid asset). At a specified future time, the trust “flips” and a standard unitrust amount commences. Trust assets accrue tax-free until the “flip” event, bringing in higher effective payouts.
CHARITABLE REMAINDER TRUST FAQs
When should you consider a Charitable Remainder Trust?
There’s a direct line as to when CRT will be useful for you. It works for any person who is charitably inclined and wants to bring variety to an appreciated portfolio with the addition of producing cash flow and instant income tax deduction. In the event that someone may need to sell a concentrated stock position, it may be dissuaded by the outcome of the capital gains tax. One remedy would be to transfer it and diversify inside a charitable remainder trust. Although it cannot avoid the income tax but may result in a deferred tax.
Will there be an income tax on the distribution of the payments? Who shoulders it?
The good thing about CRT is that it is safe from income tax. Once the asset is sold, the CRT and the donor don’t have to pay any income tax on the sale. On the other hand, once the donor receives the payments, that would be the time that it will be subject to income tax. To better understand this, we have outlined here the following rules:
The payments made can be taxed due to the ordinary income for the current year as well as the undistributed income for the previous years.
Next, the distribution of payment can also be considered as capital gains due to the extent of the capital gains for the current year and undistributed capital gains for the previous years.
The distribution can also be regarded as other income due to the extent of the other income of the present year and undistributed other income for the past years.
Excess amounts for the distribution from the said incomes are viewed as a non-taxable return of principal.
How long does a Charitable Remainder Trust last?
The charitable remainder trust can last up to the joint lives of the lead beneficiaries or a maximum of 20 years. For the charity, the actual value of the CRT should be 10% of the onset value which is figured out at the time of funding. Having a 10% base tests how young the lead beneficiaries would be because if it is too young, then the CRT will be unsuccessful in passing the required test percentage.
This “10% test” creates a floor as to how young the Lead Beneficiaries can be. If the Lead Beneficiaries are too young, the CRT will fail the 10% test. For a lifetime CRUT, the Lead Beneficiaries must be at least in their 40s and for a lifetime CRAT, the Lead Beneficiaries need to be at least in their mid-70s. The “10% test” depends on three factors:
CRT term or the life expectancies of the lead beneficiaries
Amount of payment per year
IRC 7520 rate which is 120% of the standard midterm rate