One of the greatest challenges and opportunities with proactive tax planning is timing. At its best, effective tax planning pairs eligible deductions against taxable income. Enter the charitable remainder trust.

Charitable remainder trusts are incredibly powerful planning tools. When you execute a large transaction inside of a CRT, like the sale of a concentrated stock position or an M&A transaction, you can take a one-time transaction and spread it out over a fixed term or even the lifetime of the beneficiary. Unlike many trusts, CRTs primarily impact income tax planning rather than estate planning.

A charitable remainder trust is a split-interest trust in which the income beneficiary is a person and the remainder beneficiary is a charitable organization. They are statutory trusts governed by Sec. 664. They can be either a charitable remainder annuity trust (CRAT) with a fixed annual payment or a charitable remainder unitrust (CRUT) with a percentage payout based on the trust’s value. The latter is more common because it allows the income beneficiary to participate in the growth of the trust assets.

In a CRUT, the trust must distribute at least 5 percent annually, while preserving 10 percent of the present value of the assets for charity. The two variables that allow planners to thread the needle between these goals are the actuarial tables governing these types of trusts and the 7520 rate, which is equivalent to 120 percent of the midterm AFR. Therefore, the ages of the potential beneficiaries and the current interest rate environment play a large role in determining the feasibility of the trust in any given scenario.

Once inside a trust, the assets grow tax-free. The annual distribution (determined as either a fixed annuity or as a unitrust percentage) pulls taxable income out to the beneficiary through a Form K-1. In this way, CRTs operate similarly to a supercharged traditional IRA, where income accumulates tax-free inside the account, but becomes taxable when it is distributed. One unique feature of CRTs is that distributions are taxed under a tiered system that treats the highest-taxed income as coming out first. Payments are drawn first from ordinary income, then capital gains, then tax-exempt income, and finally from the trust’s corpus.

It’s this predictability that enhances the tax planning benefits of CRTs. It is easier to plan against predictable distribution amounts; long-term tax loss harvesting strategies can be more effective over a multi-year period than trying to time them all against a single transaction; and there is potential for tax rate arbitrage if your tax rate in future years falls in more modest tax brackets, or if you change residency from a high tax state to a low tax state.

Pitfalls to avoid when planning with CRTs include Unrelated Business Income Tax (UBIT) and mortality risk. UBIT is generally relevant for nonprofit organizations, but it also applies to CRTs, and the consequences are severe. A CRT that earns unrelated business taxable income faces a punitive 100 percent federal excise tax on that income, plus any applicable state tax. Therefore, you want to be careful to avoid investments that generate UBIT, or debt encumbrance inside the trust, because that will also be classified as UBIT.

For mortality risk, the grantor must understand that once they pass, the charity receives the balance of the trust. Taxpayers should avoid putting more assets into a CRUT than their heirs will need to sustain themselves. Some of this risk can be offset with life insurance.

Taxpayers who are planning around large transactions (whether it be an M&A transaction or a concentrated single stock position) should consider whether a CRT can be a useful tool to help manage the tax consequences of the sale. They can provide much needed time horizon and predictability to help taxpayers manage and minimize the tax liability.