Key learning over a career of estate planning: almost everyone should consider a charitable remainder trust as part of their estate plan. In creating well defined rules, Congress created highly useful planning opportunities:
In 1969 Congress passed legislation meant to reform an area of abuse – where one creates what I like to call a split interest trust – one that benefits a private individual and then the remainder passes to charity or one that benefits a charity and then the remainder passes to a private individual. Congress believed that in reality, the taxpayer often overstated the benefit accruing to the charity and understated the benefit to the private individual, so it made up a new rule. What follows is an oversimplification to give you the main idea.
The new rule was that to create a split interest gift, you have to fit within well-defined requirements, the most widely used one of which is the charitable remainder trust.
A charitable remainder trust benefits one or more people by providing that they will receive a defined distribution, most typically a % of the value of the trust computed as of the beginning of each year. The % must be at least 5%. There is no averaging – each year is computed based only on its beginning market value. Another requirement added a few years ago is that the present value of the charity’s benefit must be at least 10% of the value of the trust when it is created. The charitable remainder trust may run for the life of one or more people or for a term of up to 20 years. Instead of a 5% or greater payout (charitable remainder unitrust or “CRUT” for short), it is also permissible to lock in a flat, never-changing dollar amount to be paid each year (charitable remainder annuity trust or “CRAT” for short), The rest of this section discusses the charitable remainder unitrust.
If the charitable remainder unitrust distributing the minimum of 5% can be invested to earn a total return exceeding 5%, after all expenses, then it will gradually grow, and the recipient will receive a greater distribution each year. If the investments decline in value, so would the distribution the next year, and so forth, making the trust self-adjusting.
Here are the two economic anomalies of charitable remainder trusts:
- Even though nothing is paid to the charity until after the lifetime beneficiary has died, you (the person creating the CRUT) still receive an immediate income deduction for that part of the total value of the property contributed to the CRUT equal to the present value of the charity’s right to eventually receive the remainder. The anomaly is there is no charitable benefit until after the lifetime recipient dies, but the deduction is obtained immediately.
- Even though nothing is paid to the charity until after the lifetime beneficiary has died, the income of the CRUT itself is, with certain exceptions, reported and tracked but not subject itself to income tax. As distributions are made to the lifetime recipient, they are treated as income according to the income inside the trust, starting first with ordinary income, ultimately capital gains and so forth. The anomaly is that although the present value of the non-charitable interest in the CRUT could be well more than half (up to 90%) of the total value, NONE of the income inside the CRUT is ordinarily taxed at the CRUT level – only the distributions to the lifetime recipient.
These anomalies are the “gimmick” aspect of the CRUT that makes it especially attractive, after considering taxes.
We could almost fill a small book on its own about the uses and strategies of charitable remainder trusts and related trusts, but here are a few key ideas.
Starting a CRUT During Lifetime
One key use of a charitable remainder unitrust is to transfer property to it during your lifetime and reserve the right to the 5% distribution until you (and your spouse) have died, with the remainder passing to the charity(ies) you designate.
- You often can be your own initial trustee (designating a back-up for when you die), if you prefer.
- Sometimes you will transfer to it an investment where you anticipate that the investment be sold by the CRUT after the contribution (as a separate, independent transaction), avoiding tax on the gain and deferring gain at the CRUT level (only the distributions from the CRUT are taxed).
- If you are planning to leave a large part of your estate to charity when you die, starting with a CRUT during your lifetime gives you the ability to transfer a portion of your estate to a trust to pay you 5% for life and harvest an income tax deduction for the present value of the charity’s remainder interest, something you are planning to do anyway.
- You can add a special provision giving you the right to change your mind which charities are to receive the remainder when you die and in what proportions. I have clients who have done this and revise the beneficiary designation each time they change their main estate plan.
Starting a CRUT at Death
When you follow this approach, your will or trust contains the CRUT provisions in it, and you inherently retain the right to change your mind.
- One use might be to put part of an adult child’s inheritance in a CRUT as the ultimate safety net, since the amount to be distributed is fixed (5% – or whatever % you select – no more, no less), and a third party charity exists to block any invasion of principal.
- Another use might be where you are, say, 75 years old and want to make a generous gift to a contemporary such as a friend or sibling, and a good portion of the rest of your estate will pass to charity. Instead of leaving the money outright to your contemporary, you leave it to a CRUT to pay the beneficiary a lovely stream of payments for life, and then the remainder (hopefully more than what was there when you died) passed to the charity you designate. You even receive a charitable deduction from estate taxes for the present value of the charity’s remainder interest.
- CRUTS have a kissing cousin – the charitable gift annuity. A CRUT is always a free-standing trust, and the lifetime beneficiary can only look to the CRUT for payment. Some larger charities offer a charitable gift annuity, where there is no separate trust and the donor pays a certain amount to a charity and receives a contractual right to an annuity for life. Here the charity is acting just like a life insurance company (and is typically regulated by the state), but the annuity is typically less than what an insurance company would pay (the difference being the charitable component for which a deduction is obtained when the charitable gift annuity is created. Because the donors will be a general (unsecured) creditor of the charity, depending on its full faith and credit for the their receipt of the annuity in their retirement years, they should look into the financial condition of the charity.
- Typically, smaller amounts are involved in setting up a charitable gift annuity, less than what would be needed for a CRUT to make sense. It is not unusual for a retiree to purchase more than one charitable gift annuity from the same charity over the years.
- Example: John, age 75, is thinking about leaving $200,000 to each of three cousins, and the rest of his estate passes to a charity which he deeply loves and wants to benefit as much as possible. Instead he leaves $600,000 to a CRUT to pay 5% to the three cousins (all of whom happen to be his age) for life, remainder to his charity. He can change his will , but if this plan is in force at his death and he died in March, 2012, the estate tax deduction for the plan would be about $260,000. The cousins are stunned by the generous gift. After they have all died, the charity receives whatever the $600,000 has grown to, money it would never otherwise have seen.
- Example: A married couple has $3 million in assets and a son, age 50. They have helped him over the years. The cycle of help seems to repeat. He has been employed but is currently “looking.” The existing wills leave everything to him in trust until he reached certain ages, all of which he has now passed. From the $3 million he stands to inherit they carve out $1 million and provide in their wills for a CRUT of that amount to pay him 5% for life, remainder to a charity. They can always change their mind before they die. When they die, the trust cannot be invaded, and the charity is there to defend its interest. If the investments in the CRUT do well, the distribution will gradually grow, we hope keeping pace with inflation. The result is the ultimate safety net for part of the son’s inheritance, giving the parents peace of mind.
© 2014 by Stephen J. Smith
creator, The Family Vision Experience™