Extremely useful in estate planning, charitable remainder trusts (CRTs) provide for specified distributions at least annually to one or more beneficiaries for life or for a term of years, with an irrevocable remainder interest passing to a designated charity. The grantor receives these benefits: an immediate income and gift tax deduction for the value of the charitable remainder interest; a continuing yearly income stream; eventual estate tax savings; immediate capital gains tax relief; the avoidance of probate (with respect to gifted property); and an ultimate charitable gift.
Only charities meeting the requirements of IRC Sec. 170(c), which includes religious organizations, public charities, educational institutions, and libraries, may be the recipient of a charitable remainder interest. Tax-exempt status under IRC Sec. 501(c)(3) can be sought for a private foundation to remain in existence after the last income stream beneficiary has received his last payment.
The IRS has issued safe harbor trust agreements which can serve as the starting point for drafting a CRT. Sample agreements modified to comport with local law and practice, to define legal relationships, or to pass property by bequest, will be considered “substantially similar” to IRS sample forms. Failure to come within the safe harbor does not necessarily mean that a trust is disqualified as a CRT; only that there is no assurance that the trust shall qualify. Regardless of the trust agreement used, all CRTs must meet all statutory requirements and file yearly income tax returns.
Although the grantor himself may serve as sole trustee, this may entail risk. Under IRC Sec. 674, the retention by the grantor of certain powers, such as the power to allocate income among income stream beneficiaries, would result in the loss of the trust’s tax-favored status. This risk can be lessened if the approval or consent of an independent co-trustee is required for all decisions made by the grantor which affect beneficial enjoyment of the trust property.
Transferring property to a CRT results in an immediate charitable income tax deduction based on the present value of charitable remainder interest gifted. This, in turn, is a function of the age of the grantor at trust creation and the income stream provided by the trust. Thus, an older grantor retaining a small income stream for his life only would be entitled to a larger deduction than would a younger grantor retaining a larger income stream over joint lives.
[The amount of the charitable deduction allowed in a given year may be limited by the “contribution base,” which is a function of the type of charity, the type of property contributed, and the grantor’s AGI. However, the result of this limitation would not result in a permanent loss of the deduction, but would require the grantor to amortize the deduction over five years.]
The CRT may provide an income stream for the life of the grantor, the joint lives of the grantor and spouse, for other beneficiaries for a period of years not to exceed 20 years, or for a combination of a life term and a term of years. The trustee may also be given the power to allocate or “sprinkle” income among income stream beneficiaries, as he deems appropriate.
Between 5 and 50 percent of the yearly trust income must be distributed. At trust termination, the remainder interest — which must constitute at least 10 percent of the initial fair market value of all property placed in the trust — must pass to the designated charity. The loss to the grantor’s heirs of their legacy may be minimized if the donor purchases term life insurance, whose premiums could be funded by the income tax savings generated by the CRT.
IRC Sec. 664(c) provides: “[a] charitable remainder annuity trust … shall for any taxable year, not be subject to any tax imposed by this subtitle.” Thus, one of the most attractive features of the CRT lies in its ability to neutralize the capital gains tax on appreciated property. Highly appreciated property can be contributed and then sold by the trust with no capital gains tax. The entire proceeds can then be used to provide an income stream to the grantor or other beneficiaries.
The tax-exempt nature of the trust will also cause the trust assets to appreciate quickly. Furthermore, if the trust sells appreciated property and then invests in tax-exempt securities, the noncharitable beneficiaries’ yearly annuity will also be tax-exempt. The result of these favorable tax rules may be that the granter could enjoy a higher rate of return by utilizing a CRT than he would by selling the property himself and then paying capital gains tax. As noted, the tax savings so generated may be more than sufficient to purchase a life insurance policy whose proceeds at death could equal or exceed the value of the property the grantor’s heirs would inherit but for the CRT.
Encumbered property should generally not be contributed to a CRT, since taxable gain will result to the extent debt exceeds basis. In addition, CRT income is taxable in any year in which the trust has any unrelated business taxable income (UBTI). Since rental real estate subject to acquisition indebtedness is by definition UBTI, encumbered rental real estate should not be contributed.
Two transfer tax issues warrant careful consideration: first, the trust must not provide the grantor with any retained interest (i.e., “incidents of ownership”) which would cause inclusion in his gross estate. Second, if the grantor executes a trust which provides an income stream to his children, he will be making a taxable gift. By comparison, an income stream provided to the grantor himself results in no taxable gift; and one to the grantor’s spouse, though taxable gift, is shielded by the unlimited marital deduction.
All beneficiaries receiving an income stream must report their income. The character of distributions to noncharitable beneficiaries is determined by the character of that income to the trust. Each payment therefore constitutes ordinary income, capital gain, tax-exempt income, or a return of principal. Since a trust may have various types of income in a given year, the regulations provide ordering rules to determine the characterization of particular distributions.
CRTs are comprised of two types: the annuity trust and the unitrust, differentiated primarily by the determination of yearly income stream. The income stream of the annuity trust is a fixed dollar amount or percentage of the trust at inception. This remains constant over the life of the trust. Conversely, the income stream of a unitrust is a fixed percentage of the fair market value of the trust each year. The property constituting the unitrust will thus require a yearly appraisal, and the income stream will vary. Only the unitrust is permitted to be funded with additional property in later years.
The grantor is treated as making a taxable gift of the present value of the noncharitable annuity at trust inception. When a married donor creates a joint and survivor CRT, the grantor will also receive a gift tax marital deduction. Thus, no gift tax liability will arise from the transfer. Although the value of the trust will eventually be included in the donor’s gross estate under IRC Sec. 2036, the estate may claim a marital deduction for the surviving spouse’s annuity interest, and a charitable deduction for the remainder interest. Thus, the entire trust will escape estate tax in the donor’s estate. Since the surviving spouse never possesses more than a life estate in the trust property, no estate tax will be imposed on the surviving spouse’s estate.
If other beneficiaries, such as children, will ultimately receive income streams, this contingent interest would cause the gift to the grantor’s spouse to constitute a “terminable interest,” rendering the marital deduction unavailable. The grantor may deem the loss of the marital deduction to be less important than providing guaranteed payments to his children. If, however, the loss of the marital deduction would unduly complicate the grantor’s estate planning, another option exists: income tax savings generated from the charitable deduction could be used to purchase a joint and survivor life insurance policy. If placed in an irrevocable life insurance trust, this “wealth replacement trust” would serve as substitute for the interest which passes to the charity rather than the grantor’s children, and would be excluded from the grantor’s gross estate.
The CRT can also serve as a quasi-retirement plan, deferring income to the grantor. To accomplish this, the yearly annuity to the grantor would be fixed at the lesser of (a) the income earned or (b) a fixed percentage of the net fair market value of trust assets. This formula will not violate Code provisions if the “deficiency,” i.e., the difference between the fixed percentage of the value of assets, and the income earned, is made up in later years. A “deficiency” can be created by causing the CRT to invest in low current-yield assets, such as low dividend stock, or vacant real property.