ESTATE PLANNING: Charitable Planning

Charitable Remainder Annuity Trust (CRAT) and
Charitable Remainder Unitrust (CRUT)

by: John B. Palley, Attorney

INTRODUCTION

Is it possible for your client to get a current income tax deduction, avoid the capitals gain tax on the transfer of highly appreciated property, increase their cash flow, lower their estate taxes, leave their progeny with more money, provide a lasting legacy to a deserving charity, and create a life insurance need? Since Congress introduced the “life income contract” in 1969, all this is possible. The only change of any significance since 1969 is the name, it is now called the “charitable remainder trust (or CRT).”

Although in existence for many years, the CRT did not gain ready acceptance by financial planners until the Tax Reform act of 1986. The act changed nothing of CRTs themselves. Rather it defined many accepted “tax shelters” as abusive, causing financial planners to quickly seek alternative investment vehicles for their clients to increase their wealth.

At one time CRTs were thought to be just for the very rich making very large donations. Although these people still use CRTs, they also can be beneficial to people wishing to give money, from a smaller estate. There are law firms, accountants and other financial advisors with the knowledge and expertise to execute a CRT and make it economically feasible when donating small amounts of money.

Understanding the basics of CRTs can be crucial to the insurance professional, as these can be great sales opportunity. I write this article to you, the life professional, and hope that is both understanble, yet technical enough to get you the understanding you need when faced with this as a sales opportunity!

 

WHAT IS A CRT?

A CRT is legally described as a “split interest trust.” Although this term may sound like complicated legalese, it shouldn’t. Most property is actually made up of two interests, both an income interest and a remainder interest. These two interests, although in existence, are usually held together. The income interest may be thought of as the right to the useful enjoyment of the property (interest, rents, etc.) for a period of time. This period may be measured in terms of years or as a life or joint lives. The remainder interest is that which remains when the income interest expires. For example a deceased husband may leave a residence to his wife for her life (a “life estate”). The husband’s will may then provide for the house to go to his daughter upon the wife’s death (the remainder interest).

The concept of split ownership is combined with the many charitable tax rules to make powerful estate and financial planning tools. With a CRT one interest belongs to the donor, who can choose to take a life income stream from the trust. The other interest is to the charity, who will get the entire value of the gifted asset when your client dies.

There are two types of CRTs, one of which must be chosen upon the establishment of the Trust. The two types are a Charitable Remainder Annuity Trust (CRAT) or a Charitable Remainder Unitrust (CRUT). Regardless of which is selected the trust can last for a term of years (not exceeding twenty years) or can be measured by a life or lives (which may exceed twenty years). The type and length of time selected will affect the amount of the current income tax deduction. That is the longer the income payments are to be made and the more they are to made for, the less the remainder value will be. Thus, the less the deduction will be for your client.

A CRAT pays a predetermined sum of money (not less than 5% of the initial fair market value) to the income beneficiary, at least annually, for the term provided for in the trust document. The payout cannot be changed from the initial stated sum, and for this reason additional contributions can not be made to the trust.

A CRUT is a trust from which a fixed percentage (not less than 5% of the fair market value, valued annually) is to be paid to the income beneficiary, at least annually, for the term provided for in the trust document. Since the CRUT payout can fluctuate, annual contributions are allowed to increase the amount in the trust, and thus get subsequent income tax deductions.

One of the few risks of employing a CRT is early death by grantor and spouse, because all the money in the trust goes to charity at the second death. This is where life insurance can come into play. Many people hedge the risk of early death with life insurance, placed in an irreovcable trust. Either first to die or second to die policies can be used to replace the risk, and usually by using only a small fraction of the annual payout from the CRT. Part of the extra income that will be earned by the CRT through income deferral can be used to pay the premiums on such policies. This is something that every person executing a CRT should be made aware of, as it not only has the potential for great sales, but also can be an integral part of a complete estate plan.

 

BENEFITS OF A CRT

There are many advantages to donating money to a worthy charity, through a charitable remainder trust, in addition to the great feeling one gets when giving. These include: tax free asset conversion, current tax deduction, as well as gift and estate tax savings.

Tax free asset conversion means you can use a CRT to sell highly appreciated assets free from the erosion of capital gains or ordinary income tax and then provide the lifetime recipients with an income stream. The lifetime payments can be used to fund a completely different form of investment, thus enabling a person to diversify their holdings, again without paying capital gains taxes.

Like all charitable contributions, gifts to CRTs can provide the donor with a current income tax deduction. This deduction can be used to offset all forms of income, under the normal deduction rules.

In addition to providing a significant increase in current income, another increasingly common use of CRTs is to use them to provide retirement or other deferred income. Unlike qualified plans, the tedious approval, reporting and non-discrimination rules are not of concern. Further, there are no excise tax penalties for excess distributions if the Unitrust is selected.

The CRT can provide that a deficiency in income be made up in later years when the CRT’s income exceeds the fixed percentage. This is known as a “makeup” feature, and is an integral part in using a CRT as a retirement plan. With a Unitrust, the grantor can give some every year, getting a deduction for each contribution. The money can be invested in zero coupon bonds, growth securities, or real estate until retirement. At that time the trustee can move the investments into income producing assets for the retirement years. Through the use of the CRT you get the opportunity for the tax deferral of income, plus a current tax deduction!

 

CRT IN ACTION

Actual numbers are probably the best way to demonstrate the advantages of a CRT. Let’s assume you are fifty years old, in a relatively high income tax bracket, and have an asset with a fair market value of $100,000, a basis of only $10,000, and not producing any income. If your choices are to sell the asset today or put it into a CRT, which benefits you the most?

By selling it today, you will have $90,000 subject to the capital gains tax of 28%, thus reducing your actual investment to $74,800. You can invest this $74,800 for life at 8%, giving you approximately $175,000 of income during your normal life expectancy, thus leaving you with an estate of approximately $250,000. It is not as hard as it once was to get into the 50% estate tax bracket, thus leaving your heirs with $125,000 from your old $100,000 asset.

By putting this money into a Charitable Remainder Trust, you will end up benefiting your heirs more, and will give money to a worthy charity. Our $100,000 asset can be put into the trust, and sold. There will be no capital gains tax, as it is a qualified charity selling the asset, and thus not subject to income taxes. You thus have $100,000 to invest, again at 8%. In addition to this you can invest the money saved by the charitable deduction. The deduction will not be for the full $100,000, but will be for the present value of the future gift. Let’s assume for our purposes this deduction will equal $16,500, thus freeing up an extra $6,400 to invest ($16,500 X 39% Tax Bracket). The CRT can now invest $106,400, at the stated 8%, making payments to you for your life. This will give you cash flows totaling approximately $275,000. Assuming again a 50% estate tax bracket, your heirs get $137,500, plus the charity you chose gets $100,000. The only loser in the deal is the government!

A common investment vehicle used in conjunction with the CRT is an ILIT, or Irrevocable Life Insurance Trust. This can increase the amount of money passing to your heirs, as you can give the annual payments from the CRT to the ILIT. The ILIT buys life insurance on your life. This insurance builds income tax free, and assuming the ILIT is set up properly, will pass the entire proceeds of the life insurance policy estate and gift tax free to your heirs.

CONCLUSION

Although a relatively common technique, this is not something for the inexperienced to handle. A highly qualified attorney is needed, as any straying from the established guidelines can have severe negative effects. In addition to possible negative effects if the CRT is not drafted properly, it is an irrevocable trust. Which means once established, the grantor can not unwind the transaction.

If properly drafted and administered, a Charitable Remainder Trust can provide an opportunity to benefit a deserving charity, such as Sonoma State, as well as the grantor and the grantor’s heirs. The IRS has explicitly provided for CRTs as an acceptable planning technique, even issuing prototypical trusts in the Internal Revenue Procedures.