Table of Contents:
What is a Charitable Remainder Trust?
There are two broad types of charitable trusts, charitable lead trusts, which are discussed in a separate article, and charitable remainder trusts which this article will focus on. Charitable remainder trusts (CRTs) are vehicles primarily used by charitably minded individuals looking to avoid estate and income taxes. CRTs are best suited for those with a large estate who are looking to make a substantial charitable gift.
How It Works
A charitable remainder trust is an irrevocable split interest trust; meaning the beneficiary interest (the people who will benefit from the trust assets) is split between two or more parties. The donor contributes assets to the trust, takes an income tax deduction for the donation, receives annual income from the contributed asset for a certain period of time, and at the end of the time period the remainder goes to charity.
Mr. Havealot wants to make a $500,000 donation in 2020 to his alma mater but is concerned he will not have enough income to live on for the rest of his life. Mr. Havealot decides to set up a charitable remainder trust and contribute the $500,000 to the trust. The trust is written so that Mr. Havealot will receive 5% of $500,000 ($25,000) annually for the rest of his life. At his death, the remaining assets in the trust go to charity however, Mr. Havealot will take a charitable contribution deduction in 2020 for the present value of the remainder interest that passes to charity at his death. The $500,000 is also immediately removed from Mr. Havealot’s estate.
Two Main Types (CRATs vs. CRUTS)
There are two main types of charitable remainder trusts. Mr. Havealot above used a charitable remainder annuity trust (CRAT) as his annual income payment was a fixed percentage of the initial contribution or in his case, $25,000 annually. Alternatively, Mr. Havealot could have established a charitable remainder unitrust and the annual income payment would have been a percentage of the fair market value of the property in the trust re-determined annually.
CRAT vs. CRUT Comparison
|Annual Income||Fixed % of initial contribution||% of FMV re-determined annually|
|Subsequent Contributions||Only one initial contribution to the trust is allowed||Subsequent contributions to the trust are allowed|
|Administrative Costs||Less expensive than CRUT. No annual valuation needed.||More expenses than CRAT. Annual valuation of property needed.|
|Flexibility||Less flexible||More flexible|
Capital Gain Assets
Charitable remainder trusts are not taxable entities and will never pay income tax (apart from any unrelated business taxable income). This tax-exempt feature enables taxpayers to contribute highly appreciated property and defer or potentially eliminate the tax on the capital gain on sale. The trust can sell the asset and the gain is never taxable to the trust. As annual distributions are made the distribution carries any taxable income to the beneficiary.
Mr. Havealot has stock worth $1 million that he purchased for $200,000 years ago. If Mr. Havealot contributes the stock to a CRT, the CRT can sell the stock without triggering a tax bill on the gain. The full $1 million can be reinvested inside the trust without any tax drag. The annual income distributions will be taxable income to the beneficiary but the tax on the large $800,000 gain will be deferred for many years and ultimately eliminated at the end of the payout period.
Retirement plans can also be a great asset to consider contributing to a charitable remainder trust at death. There are multiple benefits to funding a CRT with a retirement plan at death including reducing estate taxes, reducing income taxes to the beneficiary, and providing a means of spreading the heir’s required minimum distributions over an extended period of time. This planning opportunity has gained even more appeal with the recent passing of the SECURE Act on December 20, 2019. The SECURE Act replaced the ability to stretch required minimum distributions over the lifetime of many beneficiaries with a 10-year complete distribution window of inherited retirement accounts. A CRT would extend this window from 10 years to a maximum fixed period of 20 years or the lifetime of the beneficiary.
Mr. Havealot has a $1 million qualified retirement plan. If Mr. Havealot leaves the plan directly to his son, Junior Havealot, it is included in Mr. Havealot’s estate and subject to the 40% estate tax. On top of the estate tax, Junior will have to distribute the account within 10 years exposing the entire account balance to tax in a short 10-year window. Alternatively, if Mr. Havealot were to leave the retirement plan to a CRT with annual income payments to Junior over his lifetime. Mr. Havealot will be allowed a charitable deduction for estate tax purposes and Junior will receive income over his lifetime, spreading out the tax impact of the distributions.
Draw Backs of Charitable Remainder Trusts
The primary drawback to a charitable remainder trust is the current interest rate environment. The IRS requires that at least 10% of the initial fair market value of the property placed into the charitable remainder trust must go to charity at the end of the payout period. In addition, the trust must ensure every year that there is never less than a 5% chance that the trust will run out of assets before the end of the payout period. These rules are based on the “7520 rate” which represents the IRS’s projected growth of the assets. The trusts must be written so that the term and amount of the payout to the beneficiary are not so great that the trust violates these minimum requirements. In today’s depressed interest rate environment, the 7520 rate is so low that the payout rate and term are limited, and the charitable deduction is so low relative to the initial contribution that charitable remainder trusts lose their appeal. Below is a depiction of a CRAT funded in August of 2007 when the 7520 rate was 6.2% compared to December of 2019 when the 7520 rate is 2%. The result of the low 7520 rate is the charitable tax deduction was $253,270 smaller with no change to the contribution to the trust.
Charitable Remainder Annuity Trust
|August 2007||December 2019|
|FMV of Trust||$1,000,000||$1,000,000|
|Term of Payout||20 Years||20 Years|
|Charitable Deduction for Remainder Interest||$435,700||$182,430|
In addition to low interest rates, charitable remainder trusts also add complexity and professional fees to the taxpayer’s life. For many the complexity that comes with setting up a CRT and the on-going administrative burden outweigh the benefits.
Charitable trust planning is an important consideration for charitably minded taxpayer’s with significant estates. Charitable remainder trusts provide an income stream to the non-charitable beneficiary and leave the remaining assets of the trust to charity at the end of the payout period. While the current low interest rate environment has left charitable remainder trusts largely ineffective, charitable lead trusts remain a viable planning opportunity as taxpayer’s look to maximize the financial benefits of their charitable intentions.