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A CREDO TAX PLANNING STRATEGY SOLUTION

CHARITABLE REMAINDER TRUST: Converting Highly Appreciated Assets Into a New Income Stream While Getting a Big Tax Break

This whitepaper is designed to guide you through how CLTs blend philanthropic generosity with strategic tax planning, establishing themselves as a preferred option for donors keen on reducing inheritance tax impacts for their heirs. As a form of split-interest trust, the CLT offers a unique allocation of benefits between charitable organizations and personal beneficiaries, balancing altruistic objectives with financial prudence. This aims to provide you with detailed insights into how CLTs operate, their benefits in terms of tax efficiency and charitable giving, and their role in effective estate planning.

Optimize your philanthropic and tax strategies with a Charitable Remainder Trust (CRT). This tool is not only a means to make significant charitable donations but also offers substantial tax advantages for you and your heirs. A CRT allows the conversion of high-value assets, like real estate or stocks, into a steady stream of income, potentially increasing your yearly returns manifold without incurring capital gains tax.

Given that establishing a CRT is an irreversible action, it’s essential to seek guidance from a qualified estate planning attorney and tax advisor. They play a pivotal role in determining whether a CRT aligns with your financial goals, particularly regarding the income tax implications of your donation and the effective management of the CRT. This SEO-optimized approach ensures that you make informed decisions, leveraging CRTs for both charitable impact and personal financial benefit.

WHAT IS A CHARITABLE REMAINDER TRUST?

A Charitable Remainder Trust (CRT) stands out among trusts for its unique structure involving non-charitable, or ‘lead’, beneficiaries – typically the grantor or their spouse. These beneficiaries receive a fixed annual income for a specified period or for their lifetime. Upon the trust’s termination, the remaining assets are bequeathed to a designated charity. Often referred to as a ‘split trust’, the CRT divides interests between charitable and non-charitable beneficiaries.

Converting high-value assets into a life-long income stream, a CRT offers multiple tax advantages. It not only reduces your income taxes during the trust’s term or your lifetime but also diminishes estate taxes upon your passing. The sale of assets within the CRT incurs no capital gains tax, enhancing your financial benefits.

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?

Initiating your philanthropic journey begins with establishing a Charitable Remainder Trust (CRT) and transferring your chosen asset to it, ensuring the selected charity is IRS-approved with tax-exempt status. Once the trust is set up, the charity, acting as the trustee, takes on the responsibility of managing and investing the asset. This often involves selling the asset and reinvesting the proceeds into a diversified portfolio to generate income.

As the trustor, you specify the income beneficiary – which can be yourself or someone else – and determine the payment period, whether for a set number of years or for life. During this period, the beneficiary receives a portion of the trust’s income. Upon the conclusion of the CRT term or the trustor’s death, the remaining assets are transferred to the charity.

A key advantage of a CRT is the tax efficiency it offers when the asset is sold. The trust itself is not subject to tax, thereby preserving the full value of the appreciated asset for reinvestment. This setup defers capital gains taxes while providing annual income to the lead beneficiaries, along with potential income tax deductions. This guide highlights how a CRT not only supports your chosen charity but also maximizes the financial benefits of your philanthropic actions.

TYPES OF CHARITABLE REMAINDER TRUST

UNITRUST

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.

ANNUITY TRUST

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.

FLIP UNITRUST

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

How frequent are distributions made?

Usually, the distributions are done yearly or by quarters.  But, they can also do weekly, monthly or semi-yearly.

How are the amounts for distributions established?

It is set by the IRS that the distribution amount should be set at at least 5% (but not be more than 50% of the assets).  The distributions can be different because it will be based on the CRT term and the lead beneficiaries’ life expectancy.  The schedule of distribution, as well as the amounts differ per the type of CRT used.

1. CRAT (Charitable Remainder Annuity Trust) gives out the same amount yearly even if the value of the trust decreases or increases.

2. (Charitable Remainder Unitrust) gives out a specified percentage of the trust value yearly.  Each year, the amount will be computed. If the CRUT’s rate of return is more than the fixed percentage, the beneficiaries will likely receive larger payments.  Ifthe rate of return is smaller, then there would also be smaller payments.

3. NIMCRUT (Net Income with Makeup CRUT) can be the net income or the fixed percentage of the year. If it is below the fixed percentage, the payments can be recovered in the future years once the income exceeds the fixed percentage.  Those who have illiquid assets like artwork and collectibles can benefit from NIMCRUT.  While the assets are under the NIMCRUT, there will be no income distribution attained but once it is sold, there will be so much more to cover up for the years that there is no income.

4. Flip CRUT is a type of plan that allows individuals to gain cash flow for future needs. This changes from a NIMCRUT to a normal CRUT once there is a need for cash.  The cash can be attained once the donor reaches a certain age or once the pension is terminated due to the grantor’s passing.  That is why in the 3rd year, transferring to a normal CRUT would yield a cash flow to recover the lost income due.

Is the donor subject to a charitable deduction?

The answer is yes.  The donor receives an income tax deduction instantly and is equivalent to the current value of the predicted remainder interest that is passed on to the charity.  The allowed income tax deduction is limited to 60% of the adjusted gross income for the year if the donor gifted cash to the CRT together with their chosen charity or if the donor let the fund itself be the charitable remainder beneficiary.  If the donor chose a property, it can be limited to only 30% of the adjusted gross income.  The property will be classified as short-term or long-term capital gain property and the kind of charity can also suggest a different percentage.  Although the percentage is limited, the donor is still able to carry over unused deductions from any year.

What are the rules when it comes to the chosen charity? Can the choice of charity be changed if needed?’

The charity should be an organization which is described by the Internal Revenue Code section 170 (c) like a religious organization, private foundation, public charity, or a donor advised fund.  As the grantor, you have the power to change the choice of charity throughout your life.  But, to prevent the risk of being taxable, it is recommended to give that decision to an independent trustee.  Those who are likely to change their choice of charity may opt-in making the donor-advised funds be the charitable beneficiary.  This would able them to change the charity without the help of an independent trustee.  Choosing a private foundation as the charity is okay but the deduction will be lesser.

Who are likely to be the trustees?

It is usually the grantors or their spouses that act as the trustee, but their family members can also be one.  In the event that the grantor would need to change the charity, they can choose an independent trustee.

Will there be a gift tax in setting up the CRT?

There will be no gift tax.  But as they say, there’s always an exception.  In the case that someone receives the payment (not the grantor nor the spouse), it can mean that someone received it as a taxable gift.  What the grantor can do is to use his or her unified credit to offset the gift tax due with regard to the amount passed on to the grantor.  The charities will always be free of gift tax so you don’t have to worry about any passed-on tax.

Is the Charitable Remainder Trust included in my estate?

Once the assets have been gifted to a CRT, those are already removed from his or her estates.  Also, the remainder passed onto the charity is not included in the donor’s taxable estate.  For as long as the donor and her spouse are the lead beneficiaries, the estate tax wouldn’t be a problem.

But, let’s say the donor decided that the lead beneficiary be his children, there can be an estate tax possibility.  A donor who is worried about his or her premature death and sets up a CRT so that his or her children will be the ones to receive the payments if she passed away.  This will also have the donor the authority to cancel the payments in his or her will.  The right to revoke allows the donor to prevent any gift tax.  If the donor fails to revoke the payments before he passes, the charitable remainder trust would be included in the donor’s estate.

CONSULT WITH CREDO

Are you excited about setting up your own Charitable Remainder Trust? Our team at Credo will help you in establishing this legal entity as you get the best advice on the most efficient trust and payout options. We’ll also help you customize your goals and needs as a donor.  Together, let’s explore how you can make the most out of CRT and if it’s the right strategy for you!

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