Charitable Remainder Trusts

By Bart L. Fooden

A charitable remainder trust can accomplish several purposes. While the trust principal eventually goes to charity, its use can result in considerable savings in income, gift, and estate taxes.

The charitable remainder trust (CRT) is a very effective technique not only for satisfying an individual's charitable inclinations but also for providing a mechanism for the transfer of property from one generation to the next without incurring any gift or estate tax liability. The grantor of the CRT may also continue to receive payments from the trust after the property is transferred to the trust for a designated period, or a term covering an individual's lifetime, either the grantor's lifetime or the grantor's and the lifetime of any other designated individuals.

The most effective use of the CRT is to transfer highly appreciated long-term-capital-gain property to it, since the trust will not be subject to income tax on the capital gain if the property is sold. In addition to avoiding gift and estate taxes on the property transferred to the trust, no income tax is incurred on the appreciation of the property in the hands of the donor or after it is transferred to the trust. Additionally, these tax avoidance techniques may be accomplished without decreasing the amount of property eventually left to the heirs of the grantor of the CRT.

Advantages and Disadvantages

The principal advantages of a CRT are as follows:

* An income tax charitable deduction in the year in which the trust is funded.

* Avoidance of capital gains tax on the sale of appreciated property after it is transferred to the trust.

* No gift or estate tax is incurred on the value of the property either when the property is transferred to the trust or on the death of the grantor.

* An income interest may be retained and the grantor and others may receive periodic payments for the duration of
the trust.

The principal drawback of establishing a CRT is that the grantor gives up control of the property. The grantor has virtually no right to alter the provisions of the trust or to determine the fate of the property transferred to the trust.

How the CRT Works

An individual creates a trust for the benefit of a public charity, which is an organization qualified under IRC Sec. 501(c)(3). There is no estate or gift tax liability incurred when the trust is created and property is transferred by the grantor to the trust. The grantor retains an income interest in the trust and may continue to receive payments from the trust for a specified term of not more than 20 years or for the grantor's lifetime and the lifetimes of any successor beneficiaries designated in the original trust agreement. A charitable deduction for income tax purposes is allowed to the grantor for the present value of the remainder interest in the trust when the CRT is funded. The trust is not subject to tax on its income. However, the noncharitable beneficiaries will be subject to income tax on any money or property distributed to them. When the last surviving income beneficiary dies, or the trust term expires, the property is transferred to the charity pursuant to the terms of the trust.

Types of CRTs

There are two types of CRT: the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT). Depending on the individual's needs and goals, either type of CRT might be
appropriate.

A GRAT provides for payments of a fixed amount to the noncharitable beneficiary at least annually during the trust term. The annual fixed payment amount may not be less than five percent of
the initial fair market value of the trust principal.

A GRUT results in payments to the noncharitable income beneficiary at a fixed percentage of the annual fair market value of the trust property not lower than five percent. The trust property, therefore, must be revalued at the beginning of each year in which the trust is in existence to determine the amount of the payment to which the noncharitable beneficiary is entitled.

Payments. The CRAT provides for a fixed payment. The grantor will always know what the income from the trust will be regardless of what the trust income actually is or of any changes in the value of the trust principal. The CRUT provides for a payment based on the value of the trust property and may increase or decrease from year to year.

Subsequent Contributions. Once the CRAT is created and funded, no additional contributions may be made to the trust by the grantor. However, in a CRUT, additional contributions to the trust may be made if provided for in the trust
agreement.

Timing of Payments. The CRAT trustee must pay to the noncharitable beneficiary the annuity payment each year the trust is in existence. With a CRUT, payments to the noncharitable beneficiary may be deferred under an income exception provision. This presents tax and financial planning opportunities as explained further below.

Risk. The CRAT does not provide for any protection against inflation during the term of the trust since the payment is fixed in the initial year and does not change. However, there is no market risk assumed by the noncharitable CRAT beneficiary either. If the value of the trust property declines, the noncharitable beneficiary still receives the full annuity. The market risk is assumed by the charitable remainder beneficiary. On the other hand, the CRUT provides some measure of protection against inflation risk during the term of the trust, provided the value of the trust property increases at the rate of inflation. The noncharitable beneficiary does however, assume some measure of market risk under a CRUT scenario, since the annual payments are based upon an annual valuation of the trust property and any decline in the value of the trust property, temporary or otherwise, will result in a decrease in the unitrust payments.

Factors to Consider. Whether a grantor should choose a unitrust or an annuity trust is a decision that should be arrived at after careful consideration of all the factors involved and evaluation of the grantor's goals by the grantor and financial advisor.

Generally, the longer the expected term of the trust, based on the life expectancies of the noncharitable beneficiaries, the greater the advantages of the unitrust due to the ongoing inflation risk associated with the CRAT. However, a conservative client may wish to ignore such risk for the guarantee of a fixed payment amount.

If hard-to-value property, such as real estate, artwork, or nonpublicly traded securities, is used to fund the trust, or will be held by the trust during its term, the CRAT might be preferable to the CRUT since the property held in the CRUT must be revalued each year.

Pooled Income Fund. Another type of CRT is a pooled income fund, in which a group of individuals pool their contributions in a common trust and each receives a fixed percentage of the trust's net income for a predetermined period. Pooled income funds are normally established and administered by the charitable organizations themselves and are likely to be more restrictive than CRATs or CRUTs. For example, a pooled income fund established by a charitable organization may accept only contributions of cash and certain securities. In addition, the power the grantor may have to change the charitable remainder beneficiary under a CRAT or CRUT is forfeited.

Since different rules apply to pooled income funds and to CRATs and CRUTs and since not all the planning opportunities available to grantors of CRATS and CRUTS may be available to contributors to pooled income funds, the remainder of this discussion will focus on CRUTs and CRATs.

The Charitable Deduction

As previously mentioned, the grantor of the CRT is allowed a charitable deduction for income tax purposes in the year in which the trust is funded. The amount of the deduction is the present value of the remainder interest in the trust (see Table 1). The actual amount of the deduction is dependent on the term of the trust, the amount of the annuity payout or percentage of unitrust payout, the applicable Federal interest rate (AFR) in effect at the time the trust is funded, and the type of property contributed to the charity via the trust. If non-cash property is contributed to the trust, the deduction is limited to 30% of adjusted gross income in the year of contribution.

As the trust term may continue for a long time if it covers one or more person's lifetimes, the initial deduction for the present value of the remainder interest may be quite small. Considering the reduced value of the contribution, the charitable deduction for property gifted to a CRT is not the primary motivation for entering into such a transaction.

Income Taxation

The CRT is a tax-exempt entity under IRC Sec. 664(c). The distributed net income of the trust is taxable to the grantor or to such person designated by the grantor to be the noncharitable income beneficiary of the trust. Capital gains, which are allocable to the trust corpus, are not subject to income tax at the trust level. This includes the appreciation on property contributed to the trust, even if such appreciation occurred prior to the transfer of the property to the trust. The special tax on a transfer of an appreciated asset to a trust that is sold within two years (IRC Sec. 663) will not apply to a CRT. Even if the unitrust or annuity payment exceeds the net income of the trust, the invasion of principal to pay the required amount to the noncharitable beneficiary will not have any adverse tax consequences. However, a distribution by a trust in a year in which the payments exceed the cumulative undistributed net income of the trust and the trust has cumulative undistributed capital gains, will cause a portion of the gain to be taxed to the noncharitable beneficiary. The cumulative undistributed capital gain must be exhausted before any portion of a distribution to a noncharitable beneficiary is considered a return of principal or corpus.

Estate and Gift Taxes

As stated earlier, there is no estate or gift tax due on the value of property transferred to the trust or on the value of the property in the trust on the grantor's death subsequent to the creation of an inter vivos trust. This is due to the fact that the corpus of the trust is held primarily for the benefit of the charitable remainder beneficiary, and therefore no transfer tax is incurred on the value of such corpus. A gift or estate tax will be incurred if someone other than the grantor or the grantor's wife is named as the noncharitable income beneficiary. The amount of the taxable transfer is computed on the present value of the income interest given to such individual at the time such person's right to receive the payments becomes fixed. However, the avoidance of virtually all estate and gift tax liability on the value of the property transferred to a CRT is one of the principal advantages of creating such a trust.

Payments

Payments must be made at least annually. There is no limitation on the maximum percentage that may be returned by the trust to the noncharitable beneficiaries. The payment may exceed the net income of the trust, so that a portion of the principal can be distributed annually to the noncharitable beneficiary. This will not disqualify the trust from qualifying as a CRT under IRC Sec. 664 or affect the tax advantages realized by the grantor of the trust. However, as previously mentioned, if the trust has undistributed capital gains, a portion of the gain may be taxed to the noncharitable beneficiary. Therefore, if one of the principal objectives of using a CRT is the avoidance of capital gain on appreciated property, this benefit will be reduced or nullified if the payout rate to the noncharitable beneficiary is too high.

One of the primary benefits of the CRT, as compared to other types of trusts without a qualified charitable remainder beneficiary, is that the grantor can reserve the right to receive payments from the trust for life. In noncharitable trusts such as grantor retained income trusts (GRITs), grantor retained annuity trusts (GRATs), and grantor retained unitrusts (GRUTs), the period for which the payments may be reserved by the grantor must be for a term determined without reference to the grantor's lifetime. If it is, the trust principal will be includable in the grantor's estate. Additionally, if the grantor dies before the retained interest expires, some portion of the trust corpus is includable in the grantor's estate. Therefore, the CRT is the only vehicle that guarantees no portion of the trust corpus is includable in the grantor's estate and the grantor will not outlive the retained interest.

There are certain techniques that may be used in connection with the payment of distributions to beneficiaries of CRUTs. The trust may limit the annual payment to the net income of the trust if it is less than the unitrust fixed percentage amount. Additionally, the trust can provide that any amounts not paid due to the income exception provision can be paid in later years when net income exceeds the fixed percentage payment (a makeup provision).

Strategies for Maximizing Benefits

Life Insurance. At the beginning, it was noted that one of the primary benefits of the CRT was the ability to transfer property from one generation to the next without payment of estate tax. However, when the trust term ends, the principal of the trust is distributed to the designated charitable organization. The grantor can replace the value of the asset transferred to the trust by using a portion of the trust payments or the initial income tax savings from the charitable deduction to purchase life insurance. If the life insurance is owned by an irrevocable trust or by the child of the insured, the life insurance proceeds will not be subject to estate tax on the death of the insured. If the CRT provides for payments to the grantor and another individual for their lifetimes, second-to-die life insurance, with lower premiums, could be utilized to replace the asset on the second death. If a highly appreciated asset is used to fund the CRT and life insurance is used to replace the asset, the heirs of the donor may come out better than if no gift to charity were made, due to the combined income and estate tax savings (Table 2).

Alternative to Qualified Retirement Plans. Small business owners are often averse to setting up and using qualified plans because the nondiscrimination rules require such plans cover other employees as well as the business owner. In addition, the recordkeeping and reporting requirements for qualified plans can be overly burdensome. If an individual has a qualified plan funded to the extent that distributions (or accumulations at death) may be subject to the 15% excess distributions (accumulations) excise tax, or has a defined benefit plan which is fully funded or overfunded, additional contributions to the qualified plans may not be advisable or possible. In these situations, the CRT can be used as a nonqualified plan alternative.

The business owner can use the CRT as a nonqualified plan by transferring cash or other property to the trust and receiving annuity payments in return. If the donor to a CRUT wishes to defer receiving any payments from the trust until a later time, such as when he or she actually retires, this can be done by using the income exception provision (described earlier) in the trust agreement and having the trust hold only non-income producing assets. At the
time the donor wishes to commence receiving payments, the non-income providing assets in the trust can
be converted to income producing
assets with no income tax ramifications if the non-income providing assets have appreciated.

The trust agreement may also contain a makeup provision so that the noncharitable beneficiary can receive unitrust payments for years in which there was no income if trust income exceeds the amount payable under the fixed percentage. This enables the income beneficiary to defer the receipt and recognition of income until such time as he or she may be in a lower marginal tax bracket.

Converting the Yield. An individual whose financial goal is to maximize current income may hold appreciated property (such as real property, growth stocks, artwork, and other collectibles) that yields no income or a very low rate of return. If the owner were to sell this property to reinvest in higher income producing assets, the value of the property would be reduced by the income taxes due on the appreciation, thereby reducing the potential income. As an alternative, the individual could create a CRT and transfer the appreciated low yielding property to the trust. The trust could sell the property and reinvest in higher yielding assets at no tax cost, paying the net income to the donor. This technique enables the individual to realize a higher current income, since the value of the principal assets are not reduced by income taxes.

Transferring Highly Appreciated Assets to Family Members. The CRT is the only vehicle in which the full value of appreciated property can be transferred from one generation to the next without paying any gift, estate, or income tax on capital gains. If property is transferred by gift or by using another type of grantor retained trust, estate and gift taxes may be avoided, but the remainder beneficiary will assume the donor's cost basis. If the recipient thereafter sells the property, a tax on the capital gain will be due. Therefore, the CRT should be used to shelter the gain on very highly appreciated assets for maximum benefit. If the trust is a unitrust, the income exception provision may be utilized to ensure that no portion of the capital gain realized by the trust is attributed back and taxed to the noncharitable beneficiary.

Investing in Tax-Free Securities. The trustee may invest the trust assets in tax-exempt securities to produce tax-free annuity or unitrust payments. However, if the trust has undistributed ordinary income or capital gains, these will be deemed to be distributed in full prior to the distribution of any tax-exempt income under the distribution rules of IRC Sec. 664(b).

Other Considerations

There are several mandatory provisions of the Internal Revenue Code and regulations pertaining to the creation and operation of CRTs. There are also several restrictions that apply to these types
of trusts.

The grantor should choose an independent trustee for the CRT. Although many of the acts engaged in by the trustee are purely ministerial as provided by the trust agreement, there may be some power the trustee may hold that would potentially cause the grantor to be the owner of the trust if he or she
were trustee.

The grantor may reserve the right
to change the charitable remainder
beneficiary (but not any noncharitable beneficiaries) to another qualified charity at any time during the term of
the trust.

IRC Sec. 664 exempts CRTs from income tax, unless the trust has unrelated business taxable income within the meaning of IRC Sec. 512. If the trust does have unrelated business taxable income, the trust is not exempt from tax for that year and all income, including capital gains, will be subject to tax. For this reason, mortgaged property is not recommended to be used as a contribution to the trust. Under certain circumstances, the holding of mortgaged property will cause the trust to have debt financed income, which constitutes unrelated business taxable income, and the trust will lose its tax exemption. In addition, if the amount of the mortgage exceeds the donor's basis in the property, the donor will recognize a gain on the transfer of the mortgaged property to the trust. Finally, under certain conditions, the assumption of the mortgage by the trust may be considered an act of self dealing under the private
foundation rules to which the CRT is subject and trigger an excise tax on
the prohibited transaction under IRC
Sec. 4941.

If property other than long-term-capital-gain property is gifted to the trust, the initial charitable deduction may be limited to the present value of the donor's basis rather than the fair market value. Also, the donor should be aware of the limitations on gifts of taxable personal property and gifts of future interests in property to charity.

The IRS has indicated in Notice 94-78 that it will not recognize a CRT in which a donor contributes appreciated property to a trust that sells the property and returns a substantial amount of cash to the grantor without the recognition of capital gain. In the situation described in the IRS notice, 80% of the value of the principal of the trust was returned to the grantor in the first year, prior to the realization of the capital gain on the property in the second year. Where a CRT is used for tax evasion for the benefit of the individual who created it,
such transactions will be subject to IRS scrutiny and potential disqualification of the trust. *

Bart L. Fooden, CPA, CFP, is a partner in the New York City firm of Bard & Glassman and a member of the board of directors and chairman of
the Planned Giving Committee for
the Make-a-Wish Foundation of Metro New York, Inc.

Assuming an individual leaves appreciated property to a child and the marginal combined Federal and state transfer tax rate on the individual's estate is 50%, the child will only end up with $500,000 of property after payment of estate tax.

Value of property bequeathed to child $1,000,000

Estate tax at 50% 500,000

Value of property inherited by child $ 500,000

If the property is gifted to the child, the tax effect is greater since the child could incur a capital gain if the property is sold. There is no step-up in basis on property gifted.