Considering CRTs

June 25, 2020

Reduce Estate Taxes and Create Lifetime Income

By Christine S. LeGrand, CPA

Charitable remainder trusts (CRT), created under IRC Sec. 664, have been a popular planning tool for individuals to reduce income, gift and estate taxes for many years. The reasons are clear: When a contribution is made to the trust, assets contributed are removed from the grantor’s estate and not subject to probate. Also, the donor receives an immediate charitable deduction from income when the trust is funded, based on the present value of assets that will eventually pass to the designated charities. 

The grantor, while living, still retains control of assets contributed to the CRT, as they are controlled by the trustee selected by the grantor, not the charity. Further, the donor retains the right to change both the trustee and the charity without losing any of the tax benefits.

A CRT is formed under state law like any other type of trust and California requires that charitable trusts file Form CT-1 with the California Attorney General within 30 days after any charitable interest in the trust becomes a present interest [California Govt. Code Sec. 12585(a)].

A CRT can be structured to provide an income stream to the grantor for a term of up to 20 years or for life with, as mentioned above, the remaining assets upon death passing to a charity. The income also can be paid to heirs over their lifetimes if the trust meets certain requirements; there are gift and estate tax considerations if someone other than the grantor receives the income stream. 

There are two types of CRTs to consider: charitable remainder annuity trusts (CRAT) and charitable remainder unitrusts (CRUT). The primary difference between them is that a CRAT pays a fixed sum each period based on the initial fair market value of the trust assets, while a CRUT pays a fixed percentage of the trust’s assets each period based on the fluctuating value 
of the assets. 

Both types require a distribution to the beneficiary at least annually once the payout term starts; additionally, a CRUT requires an annual valuation. Also, both require that the remainder interest to charity not be less than 10 percent of the initial fair market value of the contributed assets. 

When deciding between the two, a CRAT may be more suitable for an individual who prefers to receive a fixed income amount each year. Regardless of the trust’s performance, the CRAT’s income distribution will not change. A CRAT also might be a better option if assets contributed to the trust are difficult to value, such as with private company stock or with certain types of real estate.

In contrast, as a CRUT requires the assets be valued each year, the amount of annual income generated will fluctuate annually based on the investment performance and yearly asset value of the trust. If the assets are expected to increase and the grantor would like to benefit from this situation and receive an increasing income stream, a CRUT may be a more suitable choice.

Preservation of Value of Highly Appreciated Assets
CRTs are not subject to federal or state income tax unless they incur unrelated business taxable income (UBTI), which is income the trust would earn if it carried on a trade or business. 

Individuals holding highly appreciated assets (stocks) or non-publicly traded assets (real estate, private business interests or private company stock—except S corp stock or mortgaged real estate) can donate these assets to a CRT at their full fair market value with no capital gains tax and without the future sale of these assets generating income tax within the trust. 

For example, assume an individual owns publicly traded stock with a basis of $100,000 that appreciated over time to $1 million. If the individual sells the stock, there would be a capital gain of $900,000, which would generate high capital gains tax. Taking into account the combined U.S. and California 37 percent capital gains tax rate for federal and state, $333,000 in capital gains taxes would be due. 

However, if the stock is contributed to a CRT, the trust could sell the stock without owing any capital gains tax. Additionally, the grantor would receive an income stream based on the full $1 million amount received from the sale, rather than on the $775,000 after tax amount. The capital gains taxes are deferred on the sale of the stock until that specific income is distributed to the non-charitable beneficiaries, so the grantor would pay capital gains tax in future years if those proceeds were also distributed in the future. If the CRUT is not generating enough taxable income to equal the annuity, individuals would be subject to capital gains taxation as a result of this income being distributed.

An additional point is that if the CRT generated UBTI, under IRC Sec. 664(c), it would be subject to excise tax on this income, which is equal to the amount of UBTI (essentially equaling a 100 percent tax). As income from partnerships or limited liability companies can generate UBTI if the entity conducts a trade or business, CRTs should avoid investing in pass-through entities. Another concern to be aware of is that under IRC Sec. 514, income produced by assets acquired with borrowed funds also will create UBTI.

With respect to gift tax issues, if the grantor to the CRT is also the beneficiary of the non-charitable interest, that grantor does not make a taxable gift to the trust. However, if an individual other than the grantor is the designated beneficiary, a taxable gift will be made and so will have gift tax consequences.

Reduce Income Taxes with a Charitable Deduction
IRC Sec. 2055(a) provides for a partial tax deduction to the donor based on the value of assets, which will eventually pass to a charitable beneficiary. If the CRT is created upon the death of the donor, the donor’s estate receives the estate tax deduction. For the CRT to qualify for a charitable deduction the value of the remainder interest to pass to charity must be at least 10 percent of the initial fair market value of the property contributed. The payout amount to the non-charitable beneficiary must be at least 5 percent.

The tax deduction is calculated differently whether the trust is a CRAT or a CRUT. For a CRAT, reg. 1.664-2(c) provide the rules for calculating the tax deduction. Typically, the present value of the annual income payments is calculated and subtracted from the value of the property transferred to the trust to determine the remainder interest. IRS Pub. 1457 provides procedures on calculating the present value of these payments and IRC Sec. 7520 and regs. secs. 20.7520-2(b) provide guidance on the interest rate to apply to the remainder interest to determine the charitable contribution deduction.

For CRUTs, as the income stream fluctuates based on changes in the value of the contributed property, the tax deduction is calculated differently. Regs. secs. 1.664-4 provide a methodology for calculating the remainder interest. Generally, the charitable tax deduction is determined by the trust’s payout rate, the annuitant’s age and the term of the trust. From these, the present-value factor to apply to the contributed property is calculated. IRS Pub. 1458 provides present-value factors in calculating remainder interest.

The charitable deduction for contributions of cash can generally be up to 100 percent of adjusted gross income and up to 30 percent of AGI if capital gain property is contributed. If the grantor isn’t able to take the full deduction in the first year, it can be carried forward for up to five years. 

Distributions to Non-charitable Beneficiaries Are Taxable
CRTs can be structured to defer the payment stream to a later date, most often to the individual’s retirement period. However, once the annuity payout period stated in the trust documents begins, CRTs will be required to distribute a portion of income or principal each year and the non-charitable beneficiaries receiving this annuity stream will owe tax on this income. 

Under IRC Sec. 664(b), the character of this income is categorized into four tiers that must be distributed in the following order:
  • Ordinary income (including current year and accumulated) and qualified dividends; 
  • Capital gains; 
  • Other tax-exempt income; and 
  • Return of principal. 

With both CRATs and CRUTs, the IRS requires that the payout rate each year cannot be less than 5 percent or greater than 50 percent of the initial fair market value of the trust’s assets.

Life Insurance and CRTs
A concern for an individual setting up a CRT is the risk of death occurring shortly after creating the trust. Upon death, the balance of the trust’s assets would immediately pass to the designated charitable beneficiary without the individual or heirs having received any substantial payout of income. However, the purchase of life insurance either outside of the trust or through an irrevocable life insurance trust removes this risk. 

For example, if the grantor of the trust died prematurely and purchased a $1 million life insurance policy, the individual’s heirs would receive $1 million in insurance proceeds and the charitable beneficiary would receive the balance of assets in the CRT. These life insurance proceeds would be exempt from income or estate tax.

Combining a CRT with a Donor-advised Fund
Combining a CRT with a donor-advised fund can add flexibility to charitable giving because it’s easier for the donor to adjust the grant amount or to change the charitable beneficiaries. These types of adjustments can be made at a significantly lower cost than amending the CRT, which in some circumstances may be prohibited or would most likely result in substantial additional legal fees through a trust amendment.

CRTs are Irrevocable and Have Significant Administrative Duties
Once a CRT is established, it’s difficult to revoke or change the stated fixed or asset percentage payouts to the non-charitable beneficiaries as established in the trust document. CRUTs have an added risk: If the value of the underlying assets drops considerably, the annuity stream from those assets also will decrease. 

Additionally, administering the trust can be a complex task and often the trustee is a trust company or bank, which adds another layer of expense. Administration involves handling the accounting, investment decisions, distributions and government reporting. The preparation and filing of federal and state trust tax returns are complicated and expensive.

So When Is a CRT a Good Choice?
Even though there can be some significant costs in setting up charitable remainder trusts, they can be very appealing to individuals who consider philanthropic giving an important part of their estate plan and for those who hold appreciated property which requires disposal. These planning vehicles have been popular for families who wish to increase income in retirement, save on taxes, facilitate charitable payments and offer a charitable deduction options to their estate plans.
Christine S. LeGrand, CPA is senior tax consultant and a member of CalCPA’s Estate Planning Committee.

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