JMP Charitable Management Services

The Who, What, When, Where and Why of Charitable Remainder Trusts

The Who, What, When, Where & Why of
Charitable Remainder Trusts

by J. Michael Pusey, CPA

The Who, What, When, Where & Why of Charitable Remainder Trusts
(Edition of June 30, 2001)

Copyright 1995-2001
J. Michael Pusey, CPA

Co-Author of
Tax-Planning Techniques for Individuals, 2nd Ed., AICPA (1980)

JMP Charitable Management Services
Trust Administration and Planned Gifts
606 N. Larchmont Blvd., Suite 210
Los Angeles, CA 90004
(310) 234-0878; (323) 469-4489, Fax: (323) 469-4965
E-mail: info@JMPCMS.com; Web Site: www.jmpcms.com

Diagram of Typical Charitable Remainder Trust

Donor or Beneficiary	Charity	Tax Collector
Appreciated Assets Donated to the Trust
Donor gets immediate income tax deduction measured from IRS actuarial tables. (not full value).	Receives nothing.	Less tax due to charitable income tax deduction.
Appreciated Assets Sold by the Trust
Donor avoids income tax on gain. Trust is usually exempt and pays no tax.	Receives nothing.	Less tax due to avoidance of capital gains tax.
Trust Invests in Diversified Portfolio
Beneficiary's income is higher because not depleted by gains tax. Value of income stream (annuity or percent of annual value) may also be enhanced by naming low-bracket beneficiary. May be possible to defer income to donor or other beneficiary.	Receives nothing.	Beneficiary is taxed on income reported by the trust that flows through to the beneficiary to the extent paid out. Trust is not taxed.
Donor or Beneficiary Dies and Trust Terminates
Estate tax avoided on assets in the trust. If trust continued past donor's death and spouse was successor beneficiary, still no estate tax. If trust continued past donor's death and children were successor beneficiaries, estate tax is reduced but not eliminated.	Trust assets go to charity. How much depends on earnings, rate of payout to beneficiary, appreciation, etc. but not reduced by capital gains tax or other tax on trust's earnings.	Less or no estate tax.

The Who, What, When, Where & Why of
Charitable Remainder Trusts

A friend and I were having lunch after having played a round of golf. The plan was that I pay the check, my golfing partner leave the tip, and we settle up in the car. As we approached the car, the restaurant door burst open, and out ran the waiter shouting, "Is my service no good? Where is my tip?" The waiter got his tip, and my golfing partner and I pledged to be more careful next time.

If we earn it, we want to keep it. This waiter is a prime example. The same holds true of our investment and entrepreneurial gains. If we put our hands to it and it prospers, we'd like to keep the gains in the family.

We're going to look at the ability of the charitable remainder trust (CRT) to enable us to keep more of our assets, or at least control more of the fruit of our labor and investment gains.

I've spent most of my professional career helping taxpayers wrestle with the U.S. government, states, localities and others over dividing up the American dream. I'm too experienced to ask the reader to believe the CRT is the miracle that makes all tax problems go away. But the CRT can be an extraordinarily powerful and flexible vehicle in the right circumstances. With this short writing we hope to enable to reader to begin to discern whether the CRT should fit into his or her financial and charitable planning.

The writing is basically narrative style, what I'd say to a prospective donor or husband and wife coming in for an extended office visit to explore whether the CRT is right for them. I'll try to be frank about both the advantages and drawbacks, and try to give the reader a balanced perspective from which he or she can begin to make decisions.

What is a Charitable Remainder Trust?

Basically, it is a trust that each year pays an annuity or a percentage of the trust's value to one or more noncharitable beneficiaries, then pays a qualified charity when the trust terminates. The trust is an individually-designed contract between the grantor (donor) and the trustee. The grantor controls the terms of the trust, within the parameters of what the IRS permits for a qualified CRT. The grantor names a beneficiary or beneficiaries that benefit from the trust, and names a trustee to make the decisions. The grantor can also be a beneficiary, and as a general rule, can also be trustee. So within the tax rules and laws governing trustees, the donor may maintain some control - and in many cases, control works better than direct ownership.

While it may be possible to include some investment guidelines in the trust instrument, in general, the trustee must have investment discretion. For example, the trustee can't be required to hold onto donated assets until the end of the trust. Usually, this isn't a problem because the idea is to sell appreciated assets within the tax-exempt CRT.

A husband and wife can generally use the same CRT if desired. The IRS has objected to multiple grantors using the same CRT, unless they are spouses.

There can be any number of noncharitable beneficiaries. The more the beneficiaries and the younger their ages, the less the income tax deduction unless the trust is for a term of years. But the size of the tax deduction is only one factor that gives value to the CRT.

The ability to name any number of beneficiaries or younger beneficiaries as lifetime recipients is severely limited by a rule which says that the charitable value must be at least 10%. This 10% rule precludes naming a young child as lifetime beneficiary of a CRT since the actuarial value of the child's interest will be more than 90%. The charity's interest is less than 10% because payable in the distant future. The IRS has not ruled on the issue, but it may be possible to tailor the trust's term so that the noncharitable interest is exactly 90% (or 89.9%)

The value of the income stream is often more important than the charitable deduction. If the trust is a "long-distance runner," then there is more value to the family because of the longer period that the "enhanced" income stream has to run. We discuss below the circumstances in which a CRT can enhance the income stream that would otherwise be available if the asset were simply sold.

Of course, the longer the life of the trust, the longer the charity has to wait to get its gift. It is in the nature of the CRT that one has to think a lot about trade-offs. Designing the trust to enhance value to the donor and his or her family means less value to the charity.

The CRT comes in two basic varieties, the annuity trust (charitable remainder annuity trust or CRAT) and unitrust (charitable remainder unitrust or CRUT). The annuity trust pays a percentage (no less than 5% or more than 50%) of the value of the assets funding the trust. This amount is fixed up front and stays the same throughout the term of the trust. It has no inflation hedge, but the certainty of the amount to be paid may appeal to older beneficiaries.

The unitrust pays a percentage (no less than 5% or more than 50%) of the annual value of the trust. This has a bit of inflation hedge if the value of the trust increases, but the unitrust is a bit more difficult to administer because it requires annual calculations of value. Unlike the annuity trust, the unitrust can receive additional contributions after the initial funding. This open-ended feature makes unitrusts more flexible than annuity trusts. Also, the unitrust can limit the required payment to the trust's income, which, as we discuss below, may entail an element of tax deferral to the beneficiary.

So when we say the CRT pays out "income," technically, it must pay either an annuity or unitrust amount (percentage of annual value, sometimes limited to income if the trust so provides). If a trust instrument said pay the trust's income to my family and later pay the assets to charity, it would not pass IRS inspection because it didn't pay either an annuity or unitrust amount. If the trust fails to qualify for any reason, it fails for income, gift and estate tax purposes.

The CRT isn't limited to paying income; the grantor can set a high payout rate that can be expected to exceed income. On the other hand, if the payout is so high that the value of the trust decreases over time, the unitrust payment will also decrease, since the unitrust amount paid the beneficiary is a percentage of value. In many respects, the design parameters for a CRT are extremely flexible but one has to judge such matters as selecting a payout percentage from the perspective of long-term goals.

The CRT can't admix these concepts, that is, function one year as an annuity trust and the next year as a unitrust.

With either a CRAT or CRUT, payments come from the trust not the charity. The charity's financial ups and downs are normally irrelevant to the financial health of the trust, unless the trust happens to make loans to the charity. Nor will the IRS allow the charity to guarantee payments from the rust.

With either a CRAT or CRUT, the income payments from the trust are prorated in the initial and final years. The beneficiary gets 1/365th of the annuity or unitrust amount if the trust is funded on December 31. A full year's payments begin in the following year in a quarterly, semi-annual or other periodic fashion as designated by the trust. It is not uncommon for a CRT to be funded in late December because the income tax charitable deduction arises in full upon funding the trust, but in general plan such trusts well in advance of December. IRS regulations sometimes require payment of the annuity or unitrust amount by December 31, and in other cases permit the trust to make the annual distribution by (usually) April 15 of the following year. The payout requirements can be difficult or impossible to satisfy if the trust is funded on December 31. Because there is no restriction on the number of CRTs a donor may establish, an individual may consider transferring certain assets to an annuity trust and other assets to a unitrust, or use multiple trusts with different specific provisions, such as different payout rates.

The term of the trust can be for a life or lives, or a term. If a term, it cannot exceed 20 years. There is no minimum term. For example, a CRT might be set up at the beginning of a child's college years and terminate at projected graduation time.

Successor or concurrent beneficiaries are permitted. For example, the beneficiaries can be X, then Y, then Z. The beneficiaries might be X, Y and Z who share 1/3 of the annuity or unitrust amount with survivorship rights to the other beneficiaries. Term and lifetime designations can be combined but subject to IRS limitations.

There are any number of IRS requirements that have to be satisfied. For example, the CRT has to be a trust under local law and can't be a foreign trust.

The CRT must function exclusively as a CRT. For example, it can't take a portion of what should go to charity and provide for funeral expenses at the beneficiary's death. The distribution at the end of the trust must go entirely to a qualified charity. A CRT can't flow its assets into another CRT.

The CRT must be irrevocable. CRTs are quite flexible in the planning stage, but very inflexible once they're set up. The trust can't be invaded for family emergencies! This is a major drawback, the inflexibility of the CRT once it is funded.

In rare cases, a "nonqualified" CRT is set up which can be invaded if the grantor needs funds out of the trust. But you forego tax benefits and don't have an exempt trust.

If the reader forgets some of the terms used, note that there is a "Glossary" at the end. Also keep in mind that our purpose is to lay out ideas for the prospective donor to ask questions about. We don't cover every possible exception. Don't expect to become a tax or estate planning expert in the hour or so it may take to read this short writing.

Weighing the Financial Aspects and the Intangibles

Before we proceed with a more detailed discussion of the economics of the CRT, I'm going to ask the reader to think realistically about what he or she owns. Rather than thinking of stocks as stocks of a certain value and land as having a certain value, think of the assets in terms of what's left after taxes. What's really left after the capital gains tax? What's really left after the estate tax? Think of the asset in terms of what it can do for you and your family after taxes. Think of taxes as a "chasm" or gulf that stands between the value of the asset and what it can really do for you and your family.

Sometimes, the family's assets have to be thought of as puzzles that have to be taken apart and a new image constructed to show a prettier (after-tax) picture.

Think of your principal assets in terms of risk, such as whether too much family wealth is concentrated in one asset or asset type.

I'm also going to encourage the reader to value the ability to achieve something worthwhile by means of a CRT. As the name indicates, the assets of a charitable remainder trust go to charity when the trust terminates. The designated beneficiary gets paid first, and the charity's interest normally only comes in at the end. The charity gets the "remainder" when the trust has run its course. It is not prohibited for the charity to also share in the annuity or unitrust payment, but the income tax deduction is not increased.

I'm going to remind the reader that this "remainder" is valuable in its own right. The ability to personally allocate assets to help, say, blind children, should be something of value to you. The remainder interest in a CRT is sometimes thought of as "social capital," assets that are in a sense still on the grantor's "balance sheet" insofar as what he or she accomplished in life. We use this term "accomplished in life" even though the assets of the CRT may pass to charity after your death, or the beneficiary's death. If you cannot say that passing the remainder of the trust to charity has value to you, then the CRT may not be for you.

On the other hand, it is possible that the financial pluses of the CRT will outdistance the minuses even for the person with little or no donative motive.

The Financial "Race" / Measuring the Pluses and Minuses

The biggest minus of the CRT, from a purely financial standpoint, is that there is a charitable element. Assets pass to charity rather than go back to the donor or the donor's family. We said that it was possible that the donor or donor's family would even be better off for having set up a CRT. How can this be true given the very obvious cost of the transfer to charity?

Enhanced Income Due to Absence of Capital Gains Tax

The principal reason that the financial benefits may even exceed the charitable sacrifice is that the CRT itself is usually tax exempt. For this reason, the stream of payments that come out of the CRT to the beneficiary are enhanced. The income tax "hit" that would arise if appreciated property is sold outside the CRT is avoided.

If there is a large, unrealized capital gain that basically impedes the ability to divest out of one particular investment, the CRT can "unlock" the potential of such gain with the result that a diversified portfolio of investments can be selected without capital gains tax.

"Ties go the Treasury" is an expression that I sometimes use to describe the tendency of the government to write rules with a somewhat self-serving bent. If you envision two runners approaching the tape that marks the end of a race, and the race is close, and these two runners are the citizen and the government, the government basically wins. If it is a photo finish, normally you don't even have to look at the photo. As a general rule, Congress writes rules that resolve close issues in its own favor.

A major exception to that general tendency is the fact that CRTs are generally tax exempt. In the whole of the Internal Revenue Code, it is a major plus for the taxpayer, one of the few really major "players" in helping the charitably-minded citizen when it comes to keeping what you've accumulated.

In 1969, when the Congress re-wrote the rules governing charitable remainder trusts, trusts that by their nature have both noncharitable and charitable elements, it decided to allow this "quasi" charitable vehicle to be exempt, just like the charity that gets the "remainder" at the end of the trust. It is not an unreasonable rule, one obviously geared toward encouraging major gifts to the charitable sector. One could argue it is a perfectly rational rule because the assets ultimately pass to charity. But the tax-exempt status of the trust also helps the noncharitable beneficiary, and in this author's view, this was an historic exception to the general rule that "Ties go to the Treasury."

In analyzing the decision to transfer to a CRT, one basically compares the following alternatives...

End of Booklet Excerpts

J. Michael Pusey
606 N. Larchmont Bl., Suite 210
Los Angeles, CA 90004

Phone: (310) 479-8140
Fax : (323) 469-4965
Email: info@JMPCMS.com
Web Site: www.jmpcms.com