Charitable remainder trusts (“CRTs”) are irrevocable, split-interest trusts that are ideal for certain philanthropic clients, and these trusts are increasingly popular now that real estate prices are soaring. This article will be the first in a two-part installment discussing CRTs: this segment will cover general principles applicable to all or most CRTs, and the next segment will review many of the most popular types of CRTs, and explore their distinguishing characteristics.
What Is a CRT?
CRTs are specifically authorized by the Internal Revenue Code, and allow one or more noncharitable beneficiaries (which may include the grantor) to receive payments for a specified term, and distribute the remaining assets to one or more qualified charitable organizations at the end of the term. In the year the trust is funded, the donor receives a charitable deduction for the present value of the remainder interest that will eventually pass to charity.
Common Planning Considerations
If a client ultimately intends to sell the asset to be contributed to a CRT (e.g., the client holds appreciated real estate and is ready to sell), transferring the asset to a CRT and then having the trust sell it allows the client to
(1) achieve an income tax deduction and (2) defer (or possibly avoid) capital gains tax.
The client receives the charitable deduction from ordinary income in the year that the trust is created. Because the capital asset is held by the CRT and not the donor, the CRT (not the donor) will realize the capital gain when the asset is sold. Because the trust itself is tax-exempt, tax on the capital gain realized on the sale of a CRT’s asset is deferred until that income is distributed (see above)—as a consequence, the donor may pay tax on that capital gain in future years.
CRTs are obviously most appealing to clients who are already charitably inclined; they involve irrevocable transfers of property with only a stream of income coming back to the grantor. These trusts are especially worth considering in high earning years, when the donor holds appreciated property and is motivated to sell, when there is a need or desire to diversify a concentrated position in the donor’s portfolio, or when an IPO or an M&A transaction is contemplated.
A CRT can have a fixed term of up to 20 years, or may be created for the life of one or more individual income beneficiaries, depending on their ages. Any qualified charity may be used as the charitable remainder beneficiary, and the donor may designate one or more charities to receive the remainder interest. Additionally, the donor may retain the right to change the designated charitable beneficiary, provided that the new designee is also a qualifying charitable organization. The value of the remainder interest at the time the CRT is created must be at least 10 percent of the initial fair market value of the property contributed, and the payout to the noncharitable beneficiary must be at least 5 percent.
If the trust is created during the donor’s life, the donor receives an income tax deduction in the year it is created. If the trust is created at the donor’s death, the donor receives an estate tax deduction that is not subject to any percentage limitations.
How Does the Tax Work?
- Taxation of Gift or Bequest
If the grantor is not the beneficiary of the noncharitable interest, the grantor makes a taxable gift (or bequest) of the value of that noncharitable interest in the year the CRT is created.
Taxation of CRTs
CRTs themselves are not subject to federal or state income tax unless they have unrelated business taxable income. Noncharitable beneficiaries, however, may be subject to income tax on the distributions they receive.
Taxation of Distributions
The Internal Revenue Code establishes an order for making distributions from a CRT, using four separate categories of income and principal. Distributions are taxed first as ordinary income to the extent of the ordinary income from the current year plus undistributed income accumulated from prior years. If the current-year distribution exceeds the current year’s ordinary income and all accumulated but undistributed ordinary income, the excess will be taxed as capital gain, to the extent of the trust’s current-year capital gain and all prior years’ undistributed capital gain. Only after all current and undistributed taxable income is distributed are tax-exempt or tax-free distributions made.