Tansey Estate Planning

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Charitable Remainder Trust

A Charitable Remainder Trust (“CRT”) is a Split-Interest Trust developed under the tax rules in which: (1) an Annuity Interest or Unitrust interest is paid to a non-charitable Beneficiary during the Income Period; and (2) at the end of the Income Period, the remaining property in the trust is transferred to a charitable beneficiary or a series of charitable beneficiaries. A CRT is the mirror of a Charitable Lead Trust.

The Income Period could be measured in two ways: (1) it could be measured in a Term of Years with a maximum amount twenty years; or it could be measured for a lifetime or series of lifetimes. However, the Income Period cannot combine a Term of Years and a measuring lifetime.

If the Settlor desires, the Settlor may reserve right to change the Charitable Remainder Beneficiary during the Income Period.

The value of the taxable gift is the present value of the required payments during the Income Period. There are three factors that the IRS uses to determine of those payments: (1) the length of the Income Period (or the actuarial projection of the length of the Income Period based upon the non-charitable Beneficiary’s age; (2) the percentage rate chosen by the Settlor to be paid to the non-charitable Beneficiary each year during the Income Period; and (3) AFR at the time money or other assets are contributed to the CRT. The first two factors are in the Settlor’s total control, and the AFR is set by the IRS each month (based on interest-rate market conditions). A shorter Income Period and/or a lower percentage rate during the Income Period makes it easier to reduce the amount deemed to be a taxable gift. On the other hand, a higher AFR makes it easier to reduce the amount deemed to be a taxable gift.

A Charitable Remainder Annuity Trust (“CRAT”) pays the charity an Annuity Amount during the income period, which is based on upon a percentage of property contributed to the CRAT. A CRAT would be used if the Settlor does not want to take a risk with the underlying assets of the CRAT decreasing in value, because the Annuity Amount does not vary, even if the underlying value of the CRAT’s assets change. Also, the Settlor may not make additional contributions to a CRAT

Most Settlors create Charitable Remainder Unitrusts (“CRUT”) where it pays a Unitrust Amount during the Income Period, because the Settlor wants to share in any increase of the value of the CRUT’s assets during the Income Period. The Unitrust Amount is adjusted each year to a fixed percentage of the trust’s property. For example, the Settlor creates an CRUT which provides that he or she will receive a Unitrust amount equal to 5% of the fair market value of the trust. The Settlor funds the trust with $100,000, and the Beneficiary will receive $5,000 in the first year. If in the second year, the CRUT’s assets are valued at $110,000, the Beneficiary will receive the Unitrust Amount equal to $5,500. Unfortunately the Beneficiary would have to take the risk of the CRUT’s assets decreasing. If, in the prior example, the CRUT’s assets were valued at $95,000, the Beneficiary would be paid $4,750. This type of CRUT is also called a standard or straight pay unitrust (“S-CRUT”).

There is another way to measure the Unitrust Amount. The Settlor can limit the payment to the non-charitable Beneficiary during the income period to the lessor of a fixed percentage or the CRUT’s income. The non-charitable Beneficiary must also receive any amounts in excess of the amount calculated by reference to the fixed percentage, to the extent the aggregate amounts paid in prior years was less than the aggregate amounts so calculated. This type of CRUT is called a Net Income plus Make-up Unitrust (“NIM-CRUT”). For example, the Settlor creates a NIM-CRUT which provides that non-charitable Beneficiary is to receive a Unitrust Amount equal to 5% of the net fair market value of the trust, as valued annually, or actual trust income, which is lower. In any later years the trustee is required to pay the excess income to the beneficiary to make up deficiencies of prior years (if any). The Settlor funds the trust with $100,000. The following table shows how the NIM-CRUT works.

FMV of Trust 5% of Assets Trust Income Payment Shortfall
Year 1: $100,000 $5,000 $4,000 $4,000 $1,000
Year 2: $110,000 $5,500 $4,000 $4,000 $2,500
Year 3: $120,000 $6,000 $9,000 $8,500 $0
Year 4: $120,000 $6,000 $5,500 $5,500 $500

The NIM-CRUT is used when assets initially do not generate income, but are expected to generate income in the future. Also a CRUT could be drafted to change from a NIM-CRUT to an S-CRUT upon a certain event, such as a sale of a hard-to-value asset.

Unlike most other Trusts, CRTs are tax-exempt entities. The CRT is exempt from income taxation as long as there is not any unrelated business taxable income. This includes long-term capital gains taxes. Many Settlors will donate highly appreciated property to a CRT in order to avoid capital gains taxes. The growth of assets in the CRT grow income tax free in the same manner as an IRA or a Qualified Plan. Additionally, the Settlor is allowed a current income tax deduction for the actuarial value of the Remainder Interest distributed to the charity after the Income Period.

The rules for CRTs are quite complex. The following are a few of the more important rules that must be followed: at the creation of the CRT, the actuarial value of the Remainder Interest must be 10%; the percentage paid annually to the non-charitable Beneficiary must range from a minimum of 5% to a maximum of 50%; the CRT cannot be funded with debt-encumbered property or there will be unrelated business taxable income with dire income tax consequences; and CRTs are subject to the Private Foundation rules, which extract heavy penalties if violated.

The non-charitable Beneficiary has special income tax rules for income received during the income period. It is “worst in—first out” taxation. The income is taxed in the following order: (1) ordinary income; (2) short-term capital gains; (3) long-term capital gains or qualified dividends; and (4) a return of principal. The Trustee must be careful in selecting investments, so the payments to the non-charitable beneficiary can be as tax efficient as possible.

The CRT makes a Taxable Payment to a Non-Taxable Beneficiary. As stated earlier, the CRT can be used to avoid capital gains taxes on highly appreciated property. In many cases, the value of the Remainder Interest distributed to charity can be replaced by a life insurance payment in an Irrevocable Life Insurance Trust (“ILIT”). This type of ILIT is sometimes called a “Wealth Replacement Trust.”