Exploring the Charitable Remainder Trust in the Time of COVID-19by
This article is to help offer tax professionals a planning perspective with respect to charitable remainder trusts (CRTs) and offer a “big picture,” rather than the many details of implementing such trusts.
As we are well into the coronavirus pandemic, there are hopeful signs from the standpoint of health and finances, yet increased concerns for family financial security. Tax planners should generally be considering whether CRTs can play a role in advising clients in our new environment.
CRTs – An Overview
Just to review, the charitable remainder trust (CRT) is a unique type of trust that has its own IRC section of tax rules. The CRT is a trust under state law but the trust instrument is designed to meet the requirements of Section 664 and its regulations.
Barring unrelated business income within the trust, the CRT that meets the requirements of Section 664 has an exempt status. This presumes its actual operations, not just its design, are consistent with the rules. Its exemption doesn’t depend on applying for IRS exemption as a charity.
CRTs are almost always funded with appreciated long-term capital gains property because the gain goes untaxed when realized within the trust. There are characterization rules here that determine the nature of distributions from the trust.
These rules presume the income most likely to yield tax to beneficiary is distributed first. Dividends and other ordinary income realized within the trust are distributed prior to long-term capital gains (IRC Section 664(b)).
A charitable remainder trust comes in two basic varieties – the charitable remainder unit trust (a CRUT) and the charitable remainder annuity trust (a CRAT). Both types of trusts have required payout rates of not less than 5 percent or more than 50 percent. When reading about CRTs, the term “income” is often used to describe what is either an annuity or unit trust interest.
The CRUT pays a percentage of the annual valuation of the trust, whereas a CRAT pays a percentage of the up-front valuation. Only the CRUT is permitted to receive additional contributions. Such contributions can yield future deductions, looking to the actuarial valuations at such later date.
A CRUT can contain an income limitation that curtails the payout. This provision may be drafted with or without make-up. The CRUT with make-up can have the effect of restoring benefit to the income beneficiary despite payouts being initially limited by the trust’s income limitation feature. Adding an income limitation feature potentially hurts the income beneficiary but it does not increase the charitable deduction.
The payout rate is one of the key factors affecting the actuarial calculations. Those calculations measure the upfront charitable income tax deduction. If the payout rate is too high, it can also affect whether the actuarial value of the remainder interest is high enough.
The actuarial value of the charity’s remainder interest must be at least 10 percent, then the remainder interest can be split among qualifying charities. A qualified trust is generally wholly exempt from tax, even if the value of the income stream that benefits individuals is as much as 90 percent.
Again, it is important to remember the exempt status of the trust flows from meeting the requirements of Section 664. This doesn’t require having an up-front ruling from the IRS, which means a CRT can be set up quickly if that’s the need.
What’s more, as long as it is a qualified charity, it is possible to designate a qualified charity without initially naming one or name the charity at a later date even if it’s a designated family member that does so.
A good first step in familiarizing yourself with the details would be to review the IRS model agreements for such trusts. (For sample agreements that meet IRS requirements for unit trusts, see generally Rev. Procs. 2005-52 through 2005-59,2005-2 C.B. 326, 339, 353, 367, 383, 392, 402 and 412 For sample agreements for annuity trusts, see generally Rev. Procs. 2003-53 through 2003-60, 2003-2 C.B. 230, 236, 242, 249, 257, 262, 268 and 274).
From an estate planning perspective, the CRT is generally designed to achieve an estate tax charitable deduction. Assets flow to charity upon termination of the trust and this typically achieves an estate tax deduction equal to the entire value of the trust. It is also possible that estate tax aspects become more complex, depending on the trust’s design and such features as successor income beneficiaries.
Design Perspectives in our Evolving 2020 Environment
CRTs are encouraged in our tax rules by allowing an up-front partial deduction. The deduction is the actuarial value of the remainder interest. Note that including the charity in the income stream is generally not a good idea because it doesn’t increase the income tax deduction.
CRTs tend to be major gifts, as such, they are more likely to yield significant deductions albeit subject to percentage of income limitations. In general, the federal liberalization of the percentage of income limitations with the CARES Act doesn’t focus on encouraging gifts to CRTs. Its focus is primarily on encouraging cash gifts (See generally the Description of the Tax Provisions of Public Law 116-136, The Coronavirus Aid, Relief, and Economic Security (CARES) Act, prepared by the Staff of the Joint Committee on Taxation, April 23, 2020., p. 23-26).
The percentage of income limitations are a consideration but there is also the prospect of carryover should these limitations be encountered. It is important to consider understanding the grantor’s projected deduction within the overall tax picture.
Another important consideration is the payout rate and its impact of increasing the family’s income stream with an element of enhanced security. The CRT balances this goal with benefitting the charity.
Also consider that the younger the beneficiary, the less the income tax deduction. Increasing the number of income beneficiaries also reduces the income tax deduction.
CRTs for a term of years should be considered if that is consistent with family needs. The deduction may be significantly increased by introducing a term of years approach. However, the element of income security to the family (donor and/or children) is usually enhanced with lifetime interests.
CRTs may also be an avenue to the grantor’s converting an appreciated, more volatile asset into more stable investments, usually dividend yielding or interest-bearing in nature. CRTs may help the owner reach different investments without gains tax, which may well appeal given the volatility, so far, of 2020.
High payout CRTs might still avoid most gain realization in 2020. For example, a taxpayer’s goal might be to maximize write-off elections to create a net operating loss (NOL) carryback, which may be helped by shifting a large capital gain to a tax-exempt CRT.
The recent CARES Act significantly liberalized the NOL rules, primarily focusing on allowing carrybacks. CRTs can enter into the math here in that they can shelter within the exempt trust gains that might otherwise eliminate or reduce the net operating loss. NOLs arising in particular years may, if carried forward, offset only 80 percent of income. CRTs can be an important element in various aspects of NOL planning.
Charitable remainder trusts have tax benefits that are intended to encourage their use. This old tool continues to be an important planning avenue in our new environment, particularly when retaining some element of benefit may be important to family security.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...