Jeannine and Robert Dell have been retired for almost 10 years and now are very active as volunteers for various charities. This brings a great deal of joy to their lives. Robert spends two days a week building homes for the poor through Habitat for Humanity. He is also a member of the board for the Special Olympics. Jeannine is very active in the American Cancer Society as chairperson for the Special Events committee. Both of the Dells are active in their church.
Even though the Dells have a sizable stock portfolio, the income from their investments is not sufficient to allow them to contribute money to their favorite charities while maintaining their lifestyle. They were unwilling to sell any of their stocks to make charitable donations partly because they dread the idea of paying capital gains tax. So, in their estate plan they included a charitable bequest to be paid at the second death. This will allow them to benefit their charities, but they were still concerned about having enough assets to both provide for their children and satisfy their charitable intent.
When they learned a charitable remainder trust would help them sell their highly appreciated assets without capital gains tax, provide them with a much greater income, save taxes and create a lasting charitable legacy, they were ecstatic! They were even happier to learn that, with the addition of a wealth replacement trust, they could do everything without reducing the estate they planned to leave to their children.
As incredible as it may sound, it is possible to benefit yourself, your family and society at large. This synergy can be created through the use of a charitable remainder trust (CRT). A CRT is an irrevocable trust that receives gifts of property—usually appreciated stock, appreciated real estate—or other assets, such as artwork. The donor of the property typically designates him- or herself as the trustee. The donor and spouse generally are the income beneficiaries of the CRT for their lifetimes. This allows the donor-beneficiary to retain control of, and receive income from, contributed assets. Once transferred into the CRT, the assets are free from the claims of creditors. Upon the death of the income beneficiaries, any assets left in the CRT are distributed to one or more charities.
Individuals have long used CRTs to avoid capital gains taxes on the sale of highly appreciated assets. The flexibility of a CRT, however, can help you accomplish a wide variety of personal and financial goals. Properly structured, a CRT can protect your profits and gains, increase your income while reducing income taxes and estate taxes, eliminate property management headaches, diversify your investments, lower your financial risk, increase amounts left to your heirs, help you direct your social capital and make a lasting difference in your community.
Setting Up a CRT
There are two main steps in creating a CRT. First, work with a knowledgeable attorney to establish a CRT that will qualify under the Internal Revenue Code as a charitable trust that is exempt from taxation. Second, give one or more assets, such as highly appreciated stocks and/or real estate, to the trust. This transfer creates an immediate income tax deduction that you can use in the current tax year. If you cannot use all of the allowable deduction immediately, you can carry the deduction forward for five additional years. The total amount of the allowable deduction depends on the interest payout you have selected (usually between 5 and 12 percent), the government discount rate at the time of the transfer, and the term of the trust. This can be for one or multiple lives or for a term certain of no more than 20 years, but is usually the life expectancy of you and, if married, your spouse. Also, the amount you can deduct is limited to a percentage of your adjustable gross income (AGI). For example, if you contribute appreciated property to your CRT and have named one or more public charities as the remainder beneficiary, your deduction is limited to 30 percent of your AGI for that year.
After transferring your appreciated property to the CRT, you, as trustee, would typically sell the property (taking care to avoid any prearranged agreements) and reinvest the proceeds—perhaps in a variety of assets to obtain the benefits of diversification. Selling the contributed asset is often recommended for two reasons:
- Highly appreciated property, such as stocks, typically provides very little income.
- You avoid all capital gains tax when you sell the appreciated asset in the trust because of the tax-exempt status of the CRT.
This strategy allows you to reinvest the full amount of the sale proceeds rather than the net amount after tax, as would be the case if the property were sold without the CRT. The ability to reinvest the full value of the contributed assets into higher-yielding investments may increase your cash flow substantially.
When the trust is first established, you select the percentage of payout. This must be done carefully because once you choose the percentage it cannot be changed. The percentage selected must be at least 5 percent of the value of the assets in the trust. The actual dollar amount paid to you will be the value of the assets in the trust, as revalued each year, multiplied by your chosen payout percentage.
It might seem that selecting a higher percentage would produce a better financial result; however, this is not necessarily the case. A lower percentage creates a larger tax deduction, which puts money in your pocket immediately. Additionally, any earnings of the trust above the selected payout percentage accumulate tax-free and are added to the principal. Over time, a lower percentage payout can often produce more total income.
You can also select the charities that will benefit from the trust. You can name any number of charities when establishing your CRT and change them at any time. You may even choose your own family foundation or a donor-advised fund of a public charity (such as a community foundation) along with or in place of other charities.
Upon the death of the last income beneficiary, trust assets are distributed to the selected charities. Assuming the CRT is properly structured, no estate tax will be due.
Types of CRTs
There are three main types of CRTs:
1) Charitable Remainder Unitrust
In a charitable remainder unitrust (CRUT), distributions are based on a percentage of the value of the trust assets (the percentage chosen at inception). Each year, the value of the trust’s assets is re-determined and as the value of the assets fluctuate, so do the annual unitrust payments. This approach provides some protection against inflation, but it also presents some risk because the annual payments will be less than expected if the trust’s assets lose value.
2) Charitable Remainder Annuity Trust
In a charitable remainder annuity trust (CRAT), the amount of the payout is fixed. The payout selected must be between 5 and 50 percent of the amount contributed and there is no need to revalue the assets in the trust (as in the case of a CRUT) each year. If the income of the CRAT is less than the annual payout, the balance of the mandatory distribution is taken from principal.
3) Net Income with Makeup Charitable Remainder Unitrust
For those who do not need immediate income from the appreciated assets they contribute, a special type of CRUT is available. This variation of the standard CRUT is known as a net income with makeup charitable remainder unitrust (NIMCRUT). With a NIMCRUT, each year the trust pays to the donor the lesser of the unitrust amount specified in the trust document or all the trust’s income for the year. When the trust’s income is less than the unitrust amount, the trustee creates a “makeup account” for the amounts that remain unpaid each year based on the percent chosen times the trust value. This account accumulates (an accounting notation) until the trust’s actual income exceeds the chosen percentage payout, at which time the beneficiary receives the additional income. This arrangement continues as long as there is an accumulation in the makeup account.
To minimize the trust’s income (while it is not needed), the trustee invests the proceeds from the sale of contributed assets into non-income-producing investments such as zero-coupon bonds, variable annuities, growth stocks or raw land. Since these assets do not usually produce income, there is no annual payout and no income tax. When the donor desires the income, the trustee sells the investments and purchases income-producing assets such as bonds.
NIMCRUTs are commonly used for retirement planning. A person could make annual deposits of cash or other assets (i.e., appreciated assets) of any amount to a NIMCRUT and let the assets appreciate tax-free until retirement. When the donor retires, the trust’s investments would be repositioned to generate income. This arrangement avoids the restrictive Employee Retirement Income Security Act (ERISA) rules on qualified plans and enables the donor to retire at any age and start taking the income without penalty. Furthermore, there is no restriction on the amount that can be set aside, yearly or otherwise, when using this plan as a retirement strategy and it can even generate a small annual deduction based on a percentage of amounts contributed each year.
Taxation
The grantor of a CRT is entitled to a deduction for assets that are contributed to the trust. The amount of the deduction is based on several factors: the term of the trust; the ages of the income beneficiaries if the payout is for life; the applicable federal rate at the time the assets are transferred to the trust; and the payout rate chosen by the grantor. Depending on these factors, the deduction can range from 10 to 60 percent of the value of the contributed asset or more.
Assets contributed to a CRT and subsequently sold will avoid tax on any gain that is realized. Losses, however, are not deductible. The income generated by a CRT is free from taxation while it is in the trust. When distributions are made, the amounts paid out are taxed on the basis of their makeup and a four-tiered accounting system that calls for ordinary income first, capital gains second, tax-free income third and return of principal last.
Wealth Replacement Trust
After you irrevocably place assets in the CRT, your heirs are effectively disinherited from receiving that property. Thus, a wealth replacement trust (WRT) is in order. A WRT is an irrevocable life insurance trust created to benefit your heirs. The grantor of the WRT funds the trust with a portion of the additional cash flow generated from the CRT and/or the tax savings generated by the charitable income tax deduction. After the grantor contributes funds to the WRT, the trustee purchases life insurance on the grantor to replace the wealth represented by the assets given to the CRT. In many cases, this strategy generates a larger inheritance for the grantor’s heirs than they would have received if the assets transferred to the CRT had remained in the estate and been subjected to estate taxes. In some cases, the income tax savings alone are enough to cover the cost of an insurance policy that replaces the full value of the assets. This means that the children will end up with more than they would have received otherwise and the IRS effectively pays the cost in the form of tax savings.
Estate Protection
In a recent estate planning case, a woman complained about the amount of estate taxes that would be due on her $22 million estate, which was made up primarily of one stock she had inherited from her father. The stock had gone up in value substantially in recent months. In fact, the woman remarked that her $10 million in stock value had increased nearly 22 percent in the prior two months (to $12.2 million). Her basis in this stock was very low, so she hesitated to sell any of the stock because of the income taxes that would be due. She transferred shares representing just the increase in the stock over the previous two months ($2.2 million worth) into a CRUT with a 10 percent ($220,000) payout. By doing this, the woman would avoid capital gains taxes on the sale of the stock and have enough income from the trust, after income taxes, to purchase a $6 million insurance policy that could be used to pay the estate tax on her entire large estate. Her decision to adopt the strategy was made easy when we discussed the many charitable causes she could help. In addition, by arranging to fund a family foundation with the proceeds of her CRT at her death, she could designate her grandchildren and future generations of her family as trustees—to run the foundation and carry on her charitable legacy, possibly for decades.
Through the use of charitable planning, the woman was able to use the recent appreciation in her stock to offset the estate taxes on her entire estate. In addition to the fact that her children will inherit her total estate intact, she received a current income tax deduction that generated sizable tax savings which she used to provide additional gifts to the current charitable causes important to her (see Figure 17-2).
Shortly after she completed the plan, the market value of her stock dropped over 35 percent from its high when she made the transfer and received her deduction. Thus, 35 percent of the stock value that created the funds to pay her estate taxes and create the charitable legacy would have disappeared had she procrastinated.
Private Family Foundation
With a CRT, you have unlimited choices regarding the charity (or charities) you name as the beneficiary and, if the trust is designed with you as trustee, you can change the beneficiary at any time. One option is to name a private foundation as the charitable beneficiary. A private foundation is a legal entity that qualifies under the Internal Revenue Code as a charity. Assets donated to the foundation (directly by you while you are alive and/or from your estate or CRT at your death) can accumulate and be disbursed (5 percent minimum per year) to other qualified charities in accordance with your wishes as outlined in the foundation documents. By creating a private foundation, you can direct your social capital long after you are gone and, if you desire, can include family members in the process. A private family foundation can focus on the interests of your children along whatever charitable lines you choose, keep future generations of your family together by uniting them at least annually for trust decision making and raise the standing of your descendants within their respective communities. Also, your children are entitled to be paid for their work in serving as trustees of the foundation.
Although a private foundation offers several benefits, it also has drawbacks. These include excise taxes on the net investment income of the foundation, burdensome recordkeeping and reporting requirements, a limitation on the amount of your deductions and other restrictions.
Donor-Advised Account
An excellent alternative to the private foundation is a donor-advised account of a community foundation or some other public charity. Donor-advised accounts operate much like private foundations: family members are able to direct the income and principal of the account, but they do so under the guidance of a host public charity or community foundation. This arrangement provides many of the benefits offered by a private foundation but costs substantially less to set up and administer. For most donors who want their families involved in their philanthropy, this alternative makes the most sense.
