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If you wish to leave a charitable legacy while generating income during your lifetime, a charitable remainder trust (CRT) may be a viable solution. In addition to an income stream, CRTs offer an up-front charitable income tax deduction, as well as a vehicle for disposing of appreciated assets without immediate taxation on the gain. Plus, unlike certain other strategies, CRTs become more attractive as interest rates rise. In the current environment, that makes them particularly effective.

How do CRTs work?

A CRT is an irrevocable trust to which you contribute stock or other assets. The trust pays you (or your spouse or other beneficiaries) income for life or for a term of up to 20 years, then distributes the remaining assets to one or more charities. When you fund the trust, you’re entitled to a charitable income tax deduction (subject to applicable limits) equal to the present value of the charitable beneficiaries’ remainder interest.

There are two types of CRTs, each with its own pros and cons:

  • A charitable remainder annuity trust (CRAT) pays out a fixed percentage (ranging from 5% to 50%) of the trust’s initial value and doesn’t allow additional contributions once it’s funded.
  • A charitable remainder unitrust (CRUT) pays out a fixed percentage (ranging from 5% to 50%) of the trust’s value, recalculated annually, and allows additional contributions.

CRATs offer the advantage of uniform payouts, regardless of fluctuations in the trust’s value. CRUTs, on the other hand, allow payouts to keep pace with inflation because they increase as the trust’s value increases. And, as noted, CRUTs allow you to make additional contributions. One potential disadvantage of a CRUT is that payouts shrink if the trust’s value declines.

What are the benefits of contributing appreciated property?

A CRT enables you to dispose of highly appreciated assets without triggering an immediate capital gains tax bill. Suppose, for example, that you own $1 million worth of publicly traded stock with a $400,000 tax basis. If you were to sell the stock, you’d owe capital gains tax. The tax could be as high as $120,000 if you’re at the 20% rate.

Keep in mind that you’d likely incur an additional $22,800 of net investment income tax on the gain and, depending on where you live, there may also be state and local tax to consider. If, instead, you contribute the stock to a CRT, the trustee can sell it tax-free (a CRT is a tax-exempt entity) and reinvest the proceeds.

This is a significant benefit, but it doesn’t mean that capital gains tax is eliminated (contrary to what some CRT promoters might have you believe). Rather, income earned by the trust is taxable to you or your beneficiaries as it’s paid out.

CRT can’t be used to eliminate capital gains

Every year, the IRS warns taxpayers of its “Dirty Dozen” tax scams they should avoid. This year, the first scam on its list was “Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain.” In this scam, a taxpayer transfers appreciated property to a CRAT and improperly claims that they qualify for a step-up in basis to fair market value, essentially erasing the gain. The CRAT sells the assets and uses the proceeds to purchase a single premium immediate annuity (SPIA). The beneficiary reports a small portion of the annuity from the trust as income from the SPIA, incorrectly treating the remainder as tax-free return of principal.

The proper treatment is to report payments from the CRAT as a combination of ordinary income from the SPIA and capital gain from the sale of appreciated assets, until both types of income have been exhausted.

For tax purposes, the IRS treats each payout as coming first from ordinary income (up to the trust’s current and accumulated ordinary income), followed by capital gains, tax exempt income and tax-free return of principal. (See “CRT can’t be used to eliminate capital gains” above.)

Why do CRTs work better when interest rates are high?

To ensure that a CRT is a legitimate charitable giving vehicle, IRS guidelines require that the present value of the charitable beneficiaries’ remainder interest be at least 10% of the trust assets’ value when contributed. Calculating the remainder interest’s present value is complicated, but it generally involves estimating the present value of annual payouts from the trust and subtracting that amount from the value of the contributed assets.

The computation is affected by several factors, including the length of the trust term (or the beneficiaries’ ages, if payouts are made for life), the size of annual payouts and an IRS prescribed Section 7520 rate. If you need to increase the value of the remainder interest to meet the 10% threshold, you may be able to do so by shortening the trust term or reducing the payout percentage.

In addition, the higher the Sec. 7520 rate at the time of the contribution, the lower the present value of the payouts and, therefore, the larger the remainder interest. In recent years, however, rock-bottom interest rates made it difficult, if not impossible, for many CRTs to qualify. As interest rates rise, it becomes easier to meet the 10% threshold and to increase annual payouts or the trust term without disqualifying the trust.

Now may be the time for a CRT

If you’ve been exploring options for satisfying your charitable goals while generating an income stream for yourself and your family, now may be an ideal time for a CRT. The Sec. 7520 rate has increased steadily over the last several months, and will likely continue to rise, enhancing the effectiveness of CRTs as a financial planning tool.

 

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Disclaimer: The THK Legal Blog is for informational purposes only and should not be relied upon as legal advice. In no case does the published material constitute an exhaustive legal study, and applicability to a particular situation depends upon an investigation of specific facts. You should consult an attorney for advice regarding your individual situation. All THK blogs are considered advertising material by the Indiana Bar Association.