Estate Planning Begins with Charity
February 15, 2008Charitable Reminder Trusts, a Win-Win Tax Planning Technique
The charitable remainder trust (CRT) is a viable tax planning tool, especially when paired with the often used irrevocable life insurance trust. The taxpayer's constant quest to increase cash flow, reduce income, gift, and estate taxes, and transfer assets to future generations has led to a renewed interest in the CRT. For those persons with appreciated, non-income-producing property and some inclination toward charitable giving, the CRT may be just the answer for accomplishing their philanthropic goals while receiving substantial tax benefits.
What is a Charitable Remainder Trust?
Basically, a CRT is a trust in which the noncharitable beneficiary, who must be alive at the time of the trust's creation, has an income interest either for life or for some other specified term (not to exceed twenty years) and the remainder upon the termination of the beneficiary's interest goes to charity. Even though property is being put in trust, the grantor can retain enormous control over the property (or its proceeds) because the grantor may choose to be the trustee, thereby having power to direct how the gifted property is invested, as well as being able to reserve the right to change the charities that will receive the property at the termination of the trust. Due to the fact that a charitable contribution is being made, the grantor of the trust may also have several tax benefits at his or her disposal. In order to fully comprehend the potential tax implications with respect to the CRT, one must first understand the fundamentals in creating this estate planning device.
There are two types of trusts that may be used to create a CRT, an annuity trust and a unitrust. The charitable remainder annuity trust (CRAT), as defined in I.R.S. Code § 664(d)(1), is a trust in which annual payments in a fixed dollar amount of not less than 5 percent of the initial trust value are made to at least one noncharitable beneficiary. I.R.S. Code § 664(d)(2) defines the charitable remainder unitrust (CRUT) as a trust from which annual payments of a fixed percentage of not less than 5 percent of the annual fair market value of the trust are made to one or more noncharitable beneficiaries.
The CRUT is generally a more flexible trust vehicle. Unlike the CRAT, the CRUT is valued annually, which enables subsequent contributions. Additionally, the CRUT may also have provisions giving the noncharitable beneficiary the option to receive the actual income produced by the trust if such income is less than the specified percentage annual payment amount. Consequently, when the lesser income amount is taken in lieu of the percentage payment amount, the difference between the two may be distributed at a later time, when there is sufficient trust income, in what is commonly referred to as a catch-up payment. The versatility of the CRUT makes it the more likely candidate for estate planning purposes, and thus will be the type of trust primarily focused on in this article.
Tax Benefits
CRUTs are normally exempt from income tax, except in cases of unrelated business taxable income. The tax-exempt status makes the CRUT an attractive transferee of low-basis, non- or low-income-producing, highly appreciated property . By transferring such property to a CRUT, the grantor may escape costly capital gains tax while still preserving an income flow from the property. It must be noted, however, that although the grantor may not pay any capital gains tax on the transfer of the property to the CRUT and the property's sale thereafter, the grantor, if a beneficiary of the trust, will most likely have some taxable income at a later time with respect to annual distributions made by the trust to the trust beneficiary.
For example, Mr. Smith owns a piece of land that he purchased for $100,000 and that is now valued at $1 million. Mr. Smith desires to sell this property, but by selling it outright he would have to pay capital gains tax on $900,000. If, instead, Mr. Smith transferred the property to a CRUT, which then sold the property, neither Mr. Smith nor the CRUT would pay an immediate capital gains tax on the transaction. Clearly, the lower the basis, the greater the value, and the higher the capital gains rate, the more significant the benefit is to the taxpayer.
Now, if the CRUT invests the proceeds from the sale of the property in securities producing $10,000 of annual dividend income and distributes $50,000 (5 percent of the CRUT's current value) to the grantor, the grantor will have $10,000 of ordinary income and $40,000 of long term capital gain income. The grantor's capital gain is a recognition over a long period of time of the undistributed capital gains realized but not recognized by the CRUT upon the sale of the appreciated property. Obviously such tax liabilities may be avoided altogether by having the trust invest in non-income-producing investments, but usually the need for cash flow from the trust is more important than full tax exemption.
In addition to the up front capital gains tax savings, the trust grantor will receive a charitable income tax deduction for the year in which the gift to the CRUT is made. The charitable deduction is based upon the present value of the charitable remainder interest, which is determined by many variables, including, but not limited to, the age of the noncharitable beneficiary, if payments are to be made for life to the CRUT noncharitable beneficiary, or the term of years of the trust, if payments are to be made according to such specified term; the annual percentage payout to the noncharitable beneficiary; and the amount contributed to the CRUT. All of this information is calculated in accordance with IRS actuarial tables to ascertain the current value of the remainder interest in question.
Once the deductible amount with respect to the charitable gift is determined, it is then necessary to calculate how much of that deductible amount the grantor can actually use for the present tax year. Under I.R.S. Code § 170(b)(1)(A), a charitable income tax deduction of up to, but not exceeding, 50 percent of the grantor's contribution base for the taxable year for a cash contribution to a public charity is allowed. Cash contributions to nonpublic charities are deductible up to 30 percent of the grantor's contribution base. Gifts of capital gain property are deductible as follows: up to 30 percent of the grantor's contribution base for public charity donations and up to 20 percent of the grantor's contribution base for nonpublic charity donations. The contribution base for most individuals is his or her adjusted gross income, although there are some other possible adjustments as described in I.R.S. Code § 170(b)(1)(F). Any deductible contribution amounts exceeding the above deduction limitations for the tax year in question may be carried forward as deductions in the next five succeeding tax years.
Lastly, with respect to conceivable tax benefits, the value of the remainder interest going to charity is constructively excluded from the value of a grantor's estate, because the estate of a CRUT's grantor receives an estate tax deduction for its gift of the remainder interest to charity. In effect, due to the income interest that a grantor retains during the life of the CRUT, the corpus of the trust will be included in that beneficiary's estate for federal estate tax purposes in accordance with I.R.S. Code § 2036(a). However, under I.R.S. Code § 2055(a), the estate of a noncharitable beneficiary will also receive a corresponding estate tax charitable contribution deduction, thereby canceling any estate tax effects.
An important tax consideration to keep in mind while structuring a CRUT is that any parties who are named as non-charitable beneficiaries, other than the grantor or the grantor's spouse, will be deemed to have received a gift for gift tax purposes, and, therefore, the grantor may be subject to gift tax liability. Also, with regard to both estate and gift tax considerations, a corresponding deduction may not be available for the contribution of a remainder interest in trust where the probability that the designated charity will not receive any trust corpus exceeds 5 percent.
Use of Irrevocable Life Insurance Trusts
An irrevocable life insurance trust may be used in conjunction with a CRUT to replace the value of the property placed in the CRUT for subsequent generations. Such an insurance policy may be purchased by the insurance trust on the life of the grantor or the joint lives of the grantor and the grantor's spouse for the benefit of the grantor's children or heirs. The premiums for the policy can be paid for out of the annual income paid to the grantor by the CRUT. For example, if the aforementioned Mr. Smith were to use part of his approximately $50,000 income to pay the annual premiums for a $1million individual life insurance policy owned by an insurance trust, he could guarantee that his heirs would receive at least the value of the property he initially transferred to the CRUT.
The estate planning strategy in using this combination of CRUT and insurance trust is that the grantor and his or her estate obtains the tax benefits associated with the use of the CRUT, as explained above, while the insurance trust beneficiary receives the insurance proceeds free from inheritance and estate taxes. If properly planned, the gifts by the grantor to the insurance trust of the insurance premiums each year can also be free of gift taxes. This can be accomplished by the grantor's taking full advantage of the $10,000 annual gift tax exclusion for annual gifts to donees, plus the applicable credit amount, if necessary. The gifts to the insurance trust must be characterized as present interests to the beneficiaries of the insurance trust in order to qualify for the $10,000-per-year-per-donee gift tax exclusion. To achieve this characterization, a Crummey withdrawal right, subject to certain restrictions, must be given to the beneficiary of the insurance trust for a limited period of time after each gift is made to the insurance trust. By following this structure both the CRUT and the insurance trust act as effective estate planning vehicles to transfer wealth from the grantor's estate to future generations with significant tax advantages, while at the same time enabling the grantor to fulfill his or her charitable inclinations.
Conclusion
Although the CRUT is an effective tax and estate planning technique, it is important to emphasize that it is not useful for everyone. Depending on various factors such as the type of property one wishes to transfer, including its basis and current value; the age of the grantor and/or other noncharitable beneficiary; and the percentage of income flow specified during the term of the trust, one may or may not receive enough of a tax incentive to make the entire transaction worthwhile. In light of these considerations, it is strongly recommended that anyone contemplating using a CRUT first compile the relevant financial data and consult an attorney, accountant, other financial adviser and/or charitable organization that can effectively use available computer software program(s) to calculate the various potential tax benefits. Once armed with this valuable information, one can truly determine, based upon needs and goals, whether a CRUT will produce the desired win-win results.
1. It must be noted that encumbered property in which the grantor remains personally liable on the debt cannot be transferred to a CRT unless the encumbrance is removed or the grantor is released from personal liability for the debt.
2.Procedures and tables set forth in Treasury Regulation § 1.6644(b)(2) and tables F and U(1) in IRS Publication 1458 (1989).
3.See Treasury Regulation §§ 20.2055-2(b)(1), 25.2522-3(b)(1); Revenue Ruling 70-452, 1970-2 C.B. 199.
