A lifetime gift to a charitable remainder trust (CRT) can produce impressive tax and nontax results. A gift to a CRT qualifies for current income and gift tax charitable deductions although the charity will not have the beneficial use of the property until the noncharitable interests expire. In the meantime, the donor or other noncharitable beneficiaries will receive payments from the trust. Transferring highly appreciated assets to a CRT is particularly attractive - especially for donors who have some charitable interests. Under a recent change in the law, a trust qualifies as a CRT only if the charitable remainder is worth at least 10 percent of the total value of the trust at the time it is created.

A CRT is a form of irrevocable trust from which a fixed amount or a fixed percentage of the value of the trust is distributed annually to one or more individuals for life or for a term of 20 years or less. At the end of the term for which payments are made, either the property is retained in trust for the exclusive benefit of charities or it is distributed to the charities named in the trust or later designated by the trustor.

Main Advantages of CRTs

The principal advantages of a CRT are: First, the gift qualifies for charitable income and gift tax deductions for the value of the remainder interest given to charity. Second, because a CRT is exempt from federal income taxes, the trustee can sell appreciated assets at no tax cost and reinvest the proceeds in a more diversified portfolio. Third, a CRT can be designed to defer distributions and provide later benefits similar to those of a tax-exempt retirement plan. Alternatively, the trustor can use the distributions from the CRT, which often exceed the income previously generated by the assets, to achieve other important estate planning goals such as funding contributions to an irrevocable life insurance trust (ILIT). The latter approach is sometimes called a "wealth replacement plan." Although the creator of a CRT can serve as trustee, it is often better to have another person act as such. A charity that is designated as the remainderman of a CRT is often glad to act as trustee, which appeals to some clients.

Types of CRTs

A CRT can take the form of a charitable remainder annuity trust (CRAT), which provides for an annual payment to a noncharitable beneficiary of a fixed amount of at least 5 percent of the original value of the property transferred to the trust. Because the amount of the annual payout is fixed at the time the CRAT is created, no additions can be made to it. The other, more commonly used form of CRT, is the charitable remainder unitrust (CRUT), which must each year pay out to a noncharitable beneficiary a fixed percentage of at least 5 percent of the annually determined fair market value of the trust assets. Thus, the amount of payments from a CRUT will vary from year to year. A special exception applicable to CRUTs allows the annual payment to be varied in either of two ways: One, the payments can be limited to the net income of the CRUT in the years that it does not exceed the specified annual percentage (NICRUT). Two, the payment can be limited to net income, but with "make-up" (NIMCRUT), which provides for payment to a noncharitable beneficiary of only the income in years it does not exceed the specified percentage amount, and the amount plus a make-up payment out of the net income for the current year to the extent the current income exceeds the required percentage payment. Some clients establish NIMCRUTs in order to defer receiving distributions until a later time - perhaps after they retire from full-time activity.

Income Tax Tier System

For income tax purposes, the distributions from a CRT are taxed according to a tier system: In order of priority, distributions are treated as following:

• first as ordinary income, to the extent of the CRT's ordinary income for the current and all prior years;
• then as capital gain, to the extent of the CRT's capital gains for the current and all prior years;
• next, as other income (e.g., tax-exempt) for the current and all prior years; and
• finally, as a return of principal.

CRAT Example: Donor (D), aged 55, transfers $1,000,000 worth of XYZ, Inc. stock that has a basis of $10,000 to a CRAT from which D is entitled to receive an annual distribution of $50,000 for life. When D dies, the property will be distributed to qualified charities designated by D in the CRAT. The trust calls for the required minimum 5 percent payout and appropriately designates a charitable remainderman. Based on a 4.2 percent interest rate prescribed by the IRS (the applicable rate, which changes monthly, has fluctuated between 1.8% and 8% since 2000), D is entitled to charitable income and gift tax deductions of $284,565 for the gift of the remainder interest to charity. The CRAT could provide for a higher annual payout to D, but that would reduce the amount of the charitable deduction. (Note: The income tax deduction is limited to the amount allowed under IRC § 170 - usually no more than 30 percent of adjusted gross income, with a carryover allowed for up to 5 years.)

The trustee of the CRAT could, without incurring any tax liability, sell the XYZ, Inc. stock immediately after it is transferred to the trust. The trustee could invest the proceeds in tax-exempt bonds or in other advantageous ways. Distributions to D would be taxed according to the tier system described above. Under it, so long as the CRAT does not have any ordinary income, the distributions would be taxed as capital gain to the extent of the trust's capital gain for the current year and for prior years. Thus, if the CRAT had no ordinary income, distributions of up to $990,000 (the gain on the sale of the XYZ, Inc. stock) would be taxed at capital gain rates.

Wealth Replacement Plan

The creator of a CRT, such as D in the foregoing example, could use part of the distributions received from a CRT to make gifts to support the purchase of a life insurance policy by his adult children or an irrevocable life insurance trust. If properly planned, the proceeds of the insurance policy acquired by the children of the trust would not be subject to the estate tax on D's death.

CRUTs

A CRUT must require an annual payout to the noncharitable beneficiaries of a fixed percentage of at least 5 percent of the annually determined net fair market value of the property. Thus, the amount of the annual payment made from a unitrust will vary from year to year according to the value of the trust corpus. Unlike a CRAT, property may be added to a CRUT if the trust instrument contains provisions that require appropriate adjustments in the amount of the payout. As indicated above, a CRUT may provide that distributions be limited to the annual income of the trust. If the income is less than the required payout, the trust may be structured as a NIMCRUT (i.e., it requires that the deficit in current payments be made up in later years when the income of the trust exceeds the amount of the required payout). Importantly, for purposes of making distributions, the IRS allows the trustee of a NIMCRUT to treat a reasonable portion of the post-contribution appreciation in value of its assets as income. Accordingly, a carefully drafted and administered NIMCRUT can be used to defer distributions until the trustor retires, or is in a lower tax bracket - when the trustee will change investment strategy to produce income that can be distributed to the trustor.

CRUT Example: Just as in the CRAT example, Donor (D), aged 55, transfers $1,000,000 worth of XYZ, Inc. stock that has a basis of $10,000 to a NIMCRUT from which D was entitled to receive an annual distribution equal to 5 percent of the value of the trust. Accordingly, in the first year D was entitled to receive $50,000. The trust authorized the trustee to treat a reasonable amount of the post-contribution appreciation in value as income. Based upon a 4.2 percent interest rate, the charitable remainder has a value of $328,360, which D could deduct for federal income tax purposes subject to the limits of IRC § 170. The trustee retained the XYZ, Inc. stock throughout this year, during which the trust had no income. Accordingly, no distribution was made to D this year. As no distribution was made this year, the NIMCRUT had a distribution deficiency of $50,000, which it could make up in later years if the income is sufficient to support both a current payment and a make-up distribution. If the value of the trust property increases to $1.5 million next year, D would be entitled to a distribution of $75,000. Again, if the trust has no income, no distribution would be made to D in that year. Later, the trustee could sell the XYZ, Inc. stock and treat part of the post-contribution gain in its value as income - which should be enough to support current and makeup distributions. As the NIMCRUT had no ordinary income, the distributions would be taxed to D entirely as capital gain. If the trust property increased in value to $2 million in 2006, D would be entitled to a distribution of $100,000 apart from any amount that was distributable as a make-up for deficiencies in earlier years.

Lifetime CRT v. Testamentary Gift

In some respects a lifetime gift of property to a CRT is preferable to a testamentary gift to charity. From a tax point of view a lifetime CRT is better - the donor gets a present income tax deduction for the value of the charitable remainder. A lifetime gift can also encourage other donors to make gifts to the trustor's favorite charities. Finally, a lifetime gift allows a charity to express its appreciation directly to the trustor during his or her lifetime - when it counts most.

© 2011 Perkins Coie LLP