Charitable Remainder Trusts

Estate Planning isn’t just about the taxes.

Those who are charitably inclined but concerned about having sufficient income to meet their needs may find that a charitable remainder trust (CRT) is the answer. A CRT allows donors to support a favorite charity while potentially boosting their cash flow, shrinking the size of their taxable estate, and reducing or deferring income taxes.

A fresh look at charitable remainder trusts

In today’s uncertain economic environment, even those with philanthropic intentions may be reluctant to pull the trigger on charitable gifts. What if you make a substantial donation to charity and then run into cash-flow problems down the road? The soft economy, volatile stock market and unsettled tax laws are enough to make anyone a bit leery of giving assets away today. Yet many charities are also facing financial challenges and need support from their donors more than ever.

If you’re charitably inclined but concerned about having sufficient income to meet your needs, a charitable remainder trust (CRT) may be the answer.

Charitable Remainder Trust Basics

A CRT allows you to support a favorite charity while potentially boosting your cash flow, shrinking the size of your taxable estate, reducing or deferring income taxes, and providing investment planning advantages.

How does a CRT work? You contribute stock or other assets to an irrevocable trust that provides you — and, if you desire, your spouse — with an income stream for life or for a term of up to 20 years. (You can name a noncharitable beneficiary other than yourself or your spouse, but there may be gift tax implications.) At the end of the trust term, the remaining trust assets are distributed to one or more charities you’ve selected.

When you fund the trust, you’re entitled to claim a charitable income tax deduction equal to the present value of the remainder interest (subject to applicable limits on charitable deductions). Your annual payouts from the trust can be based on a fixed percentage of the trust’s initial value — known as a charitable remainder annuity trust (CRAT). Or they can be based on a fixed percentage of the trust’s value recalculated annually — known as a charitable remainder unitrust (CRUT).

Generally, CRUTs are preferable for two reasons. First, the annual revaluation of the trust assets allows payouts to increase if the trust assets grow, which can allow your income stream to keep up with inflation. Second, donors can make additional contributions to CRUTs, but not to CRATs.

The fixed percentage — called the unitrust amount — can range from 5% to 50%. A higher rate increases the income stream, but it also reduces the value of the remainder interest and, therefore, the charitable deduction. Also, to pass muster with the IRS, the present value of the remainder interest must be at least 10% of the initial value of the trust assets.

The determination of whether the remainder interest meets the 10% requirement is made at the time the assets are transferred — it’s an actuarial calculation based on the terms of the trust. If the ultimate distribution to charity is less than 10% of the amount transferred, there is no adverse tax impact related to the contribution.

Investment advantages

CRTs facilitate tax-efficient investment strategies. To manage investment risk, diversification is critical. Ordinarily, to diversify your portfolio, you liquidate more concentrated holdings and reallocate the proceeds to a broader range of investments. But rebalancing your portfolio often generates taxable income. By contributing assets to a tax-exempt CRT, however, you’re essentially free to reallocate the assets to achieve your investment objectives without undue concern about immediate tax consequences.

A CRT is particularly effective for selling highly appreciated assets that would otherwise generate substantial immediate capital gains. Instead of selling those assets outright, you contribute them to a CRT. The trustee then sells them, unburdened by capital gains taxes, and reinvests the proceeds in more diversified assets that provide greater returns.

Annual payouts from a CRT are taxable — generally as a combination of ordinary income, capital gains and tax-exempt income (if any), and tax-free return of principal. But because you pay tax only as you receive the annual payouts, you can defer much of the tax on a large capital gain for a potentially significant period of time (depending on the trust’s term).

CRTs offer a great deal of flexibility — they can even provide retirement planning advantages. (See the sidebar “Controlling the flow of income.”)

Handle with care

CRTs require careful planning and solid investment guidance to ensure that they meet your needs. But properly structured and funded, they can provide substantial benefits. Discuss your options with your advisor before taking action.

Sidebar: Controlling the flow of income

A charitable remainder trust (CRT) gives you the ability to control the income flow to suit your needs, which can be helpful in retirement planning. By designing a charitable remainder unitrust (CRUT) with a “net income with makeup” feature — known as a NIMCRUT — you can reduce or even eliminate payouts early in the trust term and enjoy larger payouts in later years when you’re retired or otherwise need an income boost.

Here’s how it works. Each year, a NIMCRUT distributes the lesser of the unitrust amount (say, 5%) or the trust’s net income. The trustee can invest the trust assets in growth investments that produce little or no income, allowing the trust to grow tax-free and deferring distributions to later years. The deferred payouts accumulate in a “makeup account.”

When you’re ready to begin receiving an income, the trustee shifts the assets into income-producing investments. You can use the funds in the makeup account to increase your distributions beyond the unitrust amount (up to the amount of net income).

One disadvantage of a NIMCRUT is that, even with careful planning and quality investment advice, there’s a risk that it will underperform and fail to provide you with income when you need it. A less risky alternative (albeit with less upside potential) is a FLIP-CRUT.

It’s a NIMCRUT that converts into an ordinary CRUT on a specified date or at some predetermined event, such as retirement, marriage, divorce, birth of a child or death. This ensures that, when the time comes, a fixed percentage of the trust assets will be distributed regardless of the trust’s income.

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