Charitable Trusts

Who should consider a Charitable Remainder Trust?

  1. If you want to or must sell a capital asset, such as real estate or stock, and will incur a large capital gain and so pay a large amount of income tax;

  2. You have already named or are considering naming your favorite charity(ies) to  receive a significant amount under your living trust or will; or

  3. You have no children and do not know to whom to give your estate.

What is a Charitable Remainder Trust ?

It is a trust you set up typically during life to which you transfer an asset or assets.  You retain the right to receive back from the trust a payout equal to a set percentage of the trust value or set dollar amount each year.  You typically will receive the percentage or amount each year for the rest of your life.

What are the benefits of  a Charitable Remainder Trust?

The Charitable Remainder Trust (“CRT”) has the following general benefits:

  1. Your appreciated asset can be sold, and you pay no income tax on the capital gain.  You, therefore, have the whole amount working for you the rest of your life without income taxes having been taken out of the principal in the first place.  In particular, you can rid yourself of a burdensome asset, such as an apartment building, without being taxed on capital gain.

  2. Often the cash flow is higher from the investments in the CRT than you were receiving before the transfer to and sale by the CRT.

  3. You receive an income tax deduction, which reduces your income taxes.

  4. The CRT generally effectively escapes estate tax after you are gone.

  5. You select the trustee of the CRT.  With careful planning, you may even name yourself as the trustee of the CRT.  Between your having a good CPA and a good financial planner, you then should have no trouble in administering the CRT.

  6. You have the satisfaction of benefiting a needy cause.  Also, if you wish to disclose your creation of the CRT, the charity would surely publicize your generosity.

What is the potential downside of a CRT?

The only real downside of a CRT is that it is irrevocable.  Other than receiving the annual payout, you cannot get the principal back.  In addition, when you are gone the assets go to the charity(ies) you have named, instead of to your heirs, such as your children.  Therefore, it is important to be very careful in setting up the CRT, and you should not put all your assets in to a CRT.

However, if you create a CRT and live past a certain point, your family will be better off.  This results because you will have saved up and invested so much more because of your extra cash flow from the CRT that such cash invested will far exceed the amount your heirs would have received if you had sold the asset.  Furthermore, if you are concerned about an early death, you can protect your heirs through life insurance paid for out of your extra cash flow from the CRT as discussed below.

With a CRT, am I giving the Asset to the charity now?

No.  The charity has nothing to do with the CRT until you pass away.  The one exception is if you choose the charity as the trustee of the CRT to administer it for you.

What are my options on the payout amount?

There are two basic types of charitable remainder trusts:  the charitable remainder unitrust (“unitrust”) and the charitable remainder annuity trust (“annuity trust”).  The annuity trust must pay you, at least annually, a fixed dollar amount equal to at least 5% of the original fair market value of the assets you contributed to the CRT.  The annuity trust payments remains the same despite the CRT’s asset values going up or down in the future.  For example, if you were to put $300,000 in an 8 percent annuity trust, it would pay you a fixed $24,000 per year (before taxes).

The more popular of the two types is the unitrust.  It instead pays you a fixed percentage, at least 5%, of the fair market value of the trust assets.  That value is in turn recomputed each year.  Therefore, although the annual payout percentage remains fixed, the actual payout per year varies with the trust ‘s total asset value.  the unitrust is more popular because the payment rises with any inflation in the value of the unitrust’s assets.  For example, if you were to put in $300,000 in an 8% unitrust, it would pay you $24,000 the first year.  If the assets had gone up to $350,000 by the beginning of the second year, the unitrust would pay you $28,000 the second year (8% of 350,000).

Another variation of the unitrust is a version that only pays you the ordinary income the CRT receives from its investments.  Therefore, the unitrust could invest in growth stocks early on and pay you little income you may want to do so if you are working now and in a high tax bracket.  Later when you retire and are in a lower tax bracket, the CRT (remember you can be the trustee) can then shift the assets from the growth stocks to high ordinary income investments, such as bonds and deeds of trust.  With the CRT having grown in value over the years, your annual income would be higher than if you had not postponed the income.

Notwithstanding, in the 1997 Tax Act, Congress added another limitation.  The present value of the remainder interest that will eventually go to charity must at least equal 10 percent value of the charitable trust assets.  When we plan a charitable trust for you we will make sure we consider such limitation.

What will determine my income tax deduction?

If you set up a CRT, you will almost surely receive a deduction on your federal and state income tax returns.  The deduction equals the fair market value of the charitable remainder interest.  The valuation of the remainder to charity is made at the time the trust is established and is equal to the actuarially determined present value of assets that are likely to go to charity at the termination of the trust, and the payout percentage you decide to receive from the CRT.

Therefore, the older you are or the lower the CRT payout percentage is the higher the resulting value of the charitable remainder interest, and so the higher is the income tax deduction.  For example, if a 65 year old person puts $300,000 into an 8 percent unitrust the income tax deduction would be about $101,211, and so with a 34.7% tax bracket saves $35,120 in income taxes.

However, this deduction has the same limitations as regular charitable deductions.  For example, the deduction you can take in one year arising out of contribution of appreciated property is limited to 30% of your adjusted gross income.  Any excess deduction, however, may be carried forward to the following five years.

Does the CRT itself pay income tax?

The most important attribute of the CRT for most donors is that it pays no tax on its income.  In particular, and most importantly, it pays no income tax on capital gains from the sale of an asset.  For example, you would transfer an appreciated asset to the CRT, usually an asset that is throwing off a small return.  The CRT would sell the asset pay no income tax on the sale, and reinvest all the proceeds in higher paying investments.  Moreover, just as the CRT incurs no income tax liability on the gain realized from the sale of the appreciated property, you would pay no income tax on such gain.

How am I taxed on the annual distributions from the CRT?

Although the CRT is not taxed on its earnings, you are taxed on the distributions you receive from the CRT.   Such taxation is somewhat of a flow-through of the income received by, but not taxed to, the CRT.  These distributions would be taxable as follows:

–      First , as ordinary income,

–     Second, as capital gain,

–      Third, as other income (such as tax exempt income, and

–     Last, as a tax-free distribution of CRT principal.

The amount of these items is the amount for the current year plus any such amounts that the CRT has not previously distributed to you.

How about the estate tax?

The next major aspect of the CRT is estate and gift taxation.   In fact, charitable estate planning often focuses in this area.  If you and your spouse are the only beneficiaries of the CRT, the value of the CRT assets is effectively excluded from your estate for estate tax purposes, and so escapes estate tax.

On the other hand, if the CRT itself provides benefits for any other individuals, such as your children, then the result may differ somewhat and so should be considered in the analysis.

How may it pay to give it away?

May we take the example of some stock you purchased several years ago for $30,000 that is now worth $300,000.  If you sell the stock you will have $270,000 in capital gain.  Your federal and state income taxes on a $270,000 gain would be, let us say 34.7%.  You, thus, would pay $93,690 in income taxes on the sale, and this would leave you with only $206,310.  If you then invested the $206,310 and received a 9 percent return, you would receive $18,568 in income each year – $12,125 after taxes.

On the other hand, if you put the stock in a CRT that pays an 8 percent return, with the CRT itself earning 9 percent on its investments, you would receive $24,000 in the first year – $15,672 after taxes.  This is $3,547 more in after tax dollars than if you had sold the $300,000 asset.

What about my heirs though?

When you (and your spouse) are gone, the CRT assets go then to the charity(ies) you have named and not to your heirs.  You may not like that, and your heirs especially may not like that.  However, there are two alternative ways to solve the problem, so it will actually “pay to give away”:

The first way is for you to invest outside the CRT your tax savings from the income tax deduction.  Under the example above, the IRS rules provide that $35,120 in taxes is saved on a $300,000 CRT.  You would also then personally save and invest the extra cash flow you receive because of having the CRT as opposed to a sale by you.  In other words, you would still spend the $12,125 per year you would have had after taxes if you had sold the $300,000 asset and paid the income tax on the capital gain.

Therefore, under the example above you would save a minimum of $3,547 in extra cash each year.  With the assumptions above, these amounts you invest outside of the CRT would compound and grow to $278,614 at the end of a 65-year old’s life expectancy.  This is $72,304 more than the mere $206, 310 as you would have had left for your heirs if you had sold and then spent the same $12,125 per year in cash.

However, the risk in the first alternative is you may pass away before the end of your life expectancy.  If you die early, you will not have had time to save and invest the extra cash flow, and so it will not have grown to equal the $206,310 from a straight sale.

This then leads to the second alternative.  The tool makes sure that your heirs receive at least as much as or more than what they would have received if you had not transferred the property to the CRT.  Instead of investing tax savings and the $3,547 in extra cash flow each year yourself, you would instead give such amounts to the trustee of yet another trust, a life insurance trust – many times called a “wealth replacement trust”.  The trustee of the insurance trust, usually a child or sibling of yours, would take out a life insurance policy on your life.  The trustee uses the cash from the tax savings and the extra cash flow from the CRT each year to pay insurance premiums.  Typically, those amounts will buy a life insurance policy that pays as much or even more when you are gone (the $278, 614 under our example).

On your death the policy proceeds are paid to the insurance trust and then distributed to the insurance trust beneficiaries.  There are then two great tax advantages of the insurance.  First, proceeds are free from income tax.  Second, and even more dramatically, the proceeds go to your heirs free from the estate tax. This happens because the life insurance trust, and not you, owns the policy.   Therefore, the life insurance trust can transfer a substantial amount (life insurance proceeds) to your heirs without being subject to estate tax.

The result is even more spectacular when you consider what would have happened to the $206,310 left after a sale by you, without the CRT.  That amount would be taxed by the estate tax.  Therefore, your heirs would have been left with only $121,723 after estate tax ($206,310 minus $84,587, assuming $1,000,000 in other assets), compared to at least $278,614 in that case of a CRT with a life insurance trust.

Please note that if you find you are uninsurable, the odds are still good with the first alternative that your heirs will be at least as well off as in a sale.

The combined effect of the above is you receive the same income as if you had sold the asset, and your heirs receive at least as much or probably more when you are gone.   It may pay to give away.

May my heirs receive the payout after I am gone?

Yes, but it is not as advantageous.  Naming your heirs to receive the payout after you are gone for their lives creates some gift tax and estate tax problems and decreases the income tax deduction.  It is generally better to protect the heirs through the insurance trust described above.  In addition, the 10 percent charitable remainder value requirement from the 1997 Tax Act may hinder forming a trust for children.   Notwithstanding, we will consider all option if you have us prepare a formal plan for you.

What assets most often trigger the need for a CRT?

Those that have appreciated quite a bit since you acquired them.  They typically include stocks, bonds, mutual funds, and real estate.  Real estate is particularly popular because a CRT is the only way to sell real estate and get out of the burden of having to continue to manage it without paying taxes on capital gains.  The best real properties for a CRT are those with little or no debt on them.

Who can be the Trustee of the CRT?

The choices include the following:

–    you, with careful planning and administration,

–    a child, close family member, friend, or trusted advisor of yours,

–    the charity, in many cases, or

–    a trust company.

The trustee invests the CRT assets, distributes the payout to you, files the annual tax returns for the CRT, and in general runs the CRT.  The trustee has full power to change the CRT assets.

May I retain some control?

As just stated, you may retain control if you serve as the trustee.  In addition, you may have the power to change the trustee any time.  You may retain the power to change the charity who receives the CRT assets when you are gone.

Conclusion

The CRT is a “win-win” tool for all involved.  Most importantly, you win by avoiding income tax on the gain from the sale of the property, avoiding estate tax on the property, receiving a larger cash flow from the CRT, and receiving an income tax deduction.  You heirs win in that they either most likely or surely (your choice) will receive at least the same inheritance as if you had not done the CRT.   The charity wins when the CRT is ultimately distributed.  Society in general is benefited by the work of the charity.  Everyone wins.

How Can I Find Out More?

To learn more about charitable remainder trusts, or if you would like a free consultation to learn if a charitable remainder trust is right for you, please do not hesitate to contact us at (805) 482-2282, or e-mail us at  KGS@Staker.com


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