Those wishing to sell and diversify highly appreciated assets (stocks, real estate) and those who have lots of taxable income should consider a charitable remainder trust (“CRT”) to minimize income tax on capital gains as well as gift and estate tax.
Because the CRT is not income-taxed, the sale of such assets does not create income tax on the capital gains. The capital gains will be taxable to the grantor (or the grantor’s spouse) only as distributions are made as part of the annual distribution. In addition, the grantor receives a charitable deduction against current income that can be carried forward for up to five years. And the asset is out of the estate of the grantor for estate tax purposes.
What are CRTs?
In a CRT, assets are transferred to an irrevocable trust for the benefit of a noncharitable beneficiary who receives an amount from the trust for a certain period and for one or more qualified charities that receive the assets remaining in the trust. If all the requirements are met, the grantor receives a current income and gift tax deduction for the value of the charitable remainder interest and pays gift tax on the present value of the noncharitable interest going to someone other than the grantor.
- Transferred assets. The assets transferred to a CRT must qualify for a charitable deduction.
- Noncharitable interest. Typically, the noncharitable beneficiary is the grantor or the grantor and the grantor’s spouse. But the noncharitable beneficiary can be another family member, such as a child, sibling, niece, or nephew. The gift to the spouse qualifies as a marital deduction, and the gift to another member of the family is a taxable gift that may be excluded by the annual exclusion ($14,000 per year) or applied against the federal exclusion (currently $5,340,000).
- Amount received by noncharitable interest. There are two types of CRTs and several variations on these two types.
- The charitable remainder annuity trust, or CRAT, must distribute to the noncharitable beneficiary a fixed amount or a fixed percentage at least annually. The annual distribution cannot be less than 5 percent or more than 50 percent of the initial net fair market value of the assets transferred originally to the CRAT.
- The charitable remainder unitrust, or CRUT, distributes to the noncharitable beneficiary at least annually a set percentage of the annual valuation of the trust assets. The annual distribution must be not less than 5 percent or more than 50 percent of the annual fair market value of the trust assets. A popular variation of the CRUT is NIMCRUT, which distributes to the noncharitable beneficiary at least an amount equal to the lesser of the unitrust amount or the current trust income and allows for a make-up in future years for any deficiency between the income and the fixed percentage.
- Term of CRT. The noncharitable beneficiary’s interest may be for a term of up to 20 years or the life or the lives of one or more persons. Typically, the two lives are for a husband and wife, in which event the annuity or unitrust amount continues for the life of the surviving spouse. It is also common for a grantor to establish a CRAT or CRUT for other family members, such as older siblings or children.
- Qualified charitable beneficiary. The charitable remainder beneficiaries must be qualified as charities to which contributions would be deductible for income tax purposes.
- Amount received by charities. The remainder amount going to charity must be at least 10 percent of the net fair market value of the property contributed to the trust. This requirement will preclude the creation of a CRT for a young noncharitable beneficiary.
Advantages of CRTs.
- Tax deduction. The grantor receives both income tax and gift tax deductions for the value of the remainder interest in a CRT.
- Reduction in estate tax. If the transferred asset is an appreciating asset, the estate of the donor is reduced by the asset’s value.
- Annual payout. A CRT is exempt from federal and state income tax. Transferring appreciated property into such a trust converts appreciated property into an annual payout based on the entire value of the property, undiminished by federal or state income taxes.
- Flexibility. The grantor has the right to amend the trust to change the charitable remainder beneficiaries and to change the amount or percentage of the remainder that is distributed to them.
Disadvantages of CRTs.
- Gift tax. The grantor is treated as making a taxable gift to the noncharitable beneficiary. If the noncharitable beneficiary is the grantor’s spouse, the gift will qualify as a marital deduction. If the noncharitable beneficiary is someone else, it may qualify for the annual exclusion in whole or in part; if only in part, then a gift may be allocated against the federal exemption.
- Adherence to formalities. To get the benefits of the tax deductions afforded to the grantor by creating a CRT, attention must be paid to the formalities of the trust:
- The trust must be a written instrument that meets all the statutory requirements;
- Each CRT must have its own taxpayer identification number; and
- The trustee of each CRT must file an annual information return with the IRS.
- Sale of highly appreciated stock. The grantor transfers $500,000 of low-basis publicly traded stock into a 7 percent CRUT. The grantor and the grantor’s spouse (age 65 and 64, respectively) are the noncharitable beneficiaries for their lives, and the remainder interest is a qualified charity. At the adoption of the CRUT, the grantor’s charitable deduction is $108,980. The trustee of the CRUT sells the stock and reinvests, providing a stable income stream for the grantor and the grantor’s spouse for life. The sale and reinvestment of the low-basis stock does not trigger income tax on the capital gains, as discussed above.
- Remainder to family foundation. The grantor transfers $1,000,000 of low-basis real estate into a 5 percent CRAT, retaining the income interest as the noncharitable beneficiary for 14 years, with the remainder at termination going to a family foundation. Upon adoption, the grantor has a charitable deduction of $367,239. The trustee of the CRAT sells the real estate and reinvests in other appreciating assets. The sale of the real estate does not trigger income tax on the capital gains as discussed above.
Related Files: Estate Planning Advisor - Fall 2014