With volatile economic times threatening, flexibility in all aspects of financial affairs, including charitable giving, is more desirable than ever. While there is an increased need for charitable donations, there are also fewer resources among potential donors. One charitable giving vehicle that has grown popular over the past ten years because of its efficiencies is the charitable remainder trust.A CRT can provide a new income stream for the donor and a benefit to charity — a classic win-win situation. CRTs should continue to have viability for present-day donors, especially those who maximize the flexibility that the rules allow. In pushing CRTs to their legal limit, however, taxpayers also must heed restrictions that, if not followed, can result in disastrous tax consequences.
Those who are in need of an income stream and hold highly appreciated assets may find a CRT a good fit. A CRT can provide a guaranteed income stream to the grantor, as well as an upfront charitable income tax deduction that frees up current cash, a way to avoid capital gains tax on appreciated assets, and a solution to paying any estate tax on the property.
There are two kinds of CRTs: charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). An annuity trust pays a fixed amount each year. A unitrust pays a fixed percentage of assets per year. A CRT must be one or the other; it cannot be a hybrid and qualify.
In general, both CRATs and CRUTs must pass minimum and maximum payout requirements. A fixed percentage (not less than 5 percent or more than 50 percent) of the net fair market value of a charitable remainder trust’s assets must be paid annually to one or more named beneficiaries (typically, the donor or a family member) for a definite term of not more than 20 years or for the beneficiary’s life. In addition, both must pass a minimum remainder interest requirement: The remainder interest that is transferred to a qualifying charity at the end of the income payment period must be at least 10 percent of the fair market value of the initial trust property.
In addition, no payments other than the fixed income stream can be made from the trust to any person other than a qualifying charity. This no-other-payment rule, in fact, is one of the traps frequently triggered by innocent behavior. Transferring debt-encumbered property on which the trustee must “pay another” in paying down the debt may create a grantor trust situation if the donor has remained personally liable on the debt. Another similar trap that the Internal Revenue Service has set aside temporarily is the impact of a grantor spouse’s state law right of election against the property upon the grantor’s death.
Still another trap in dealing with the general requirements for a CRT is caused by how the rules interact. Specifically, payment of administrative fees should be made from trust principal only. If the trustee’s fees in whole or part are charged against the fixed percentage, the CRT amount is not a fixed percentage even if, after deduction of the trustee’s fees, the amount payable is not less than the minimum CRT amount.
While a CRT must be irrevocable, certain changes may take place without violating either that restriction or all the other fixed requirements set out in the Tax Code. These permissible changes can enhance the overall value of the CRT to the grantor who would otherwise be fearful of being locked into one course despite changed circumstances.
* The income stream. A unitrust by nature has a variable dollar payout each year, since it provides a payout that is a fixed percentage of the trust’s assets, which are revalued at least once a year. An annuity trust, on the other hand, distributes a fixed payment that does not change from year to year.
* Beneficiary’s income increases if the assets in a unitrust continue to appreciate. Since a unitrust’s term generally covers a sufficient number of years to virtually guarantee net appreciation due to general inflation, the unitrust isn’t as much of a bet on future stability as a straight annuity trust.
The unitrust may also allow the trustee to pay less than the fixed income percentage if actual income for the year is less than the required payout, and to pay more to compensate for an underpayment in a prior year.
* Payout methods. The trust agreement of a charitable remainder unitrust must provide for payment of a fixed percentage. However, the trust may also include an income-only or an income-only-with-makeup provision (also called a NIMCRUT). Both provisions effectively limit distributions from the trust to trust income other than capital gains, and prevent distributions of trust corpus.
The unitrust amount paid each year must be based on the net fair market value of the trust assets for that year, taking into account all assets and liabilities, regardless of whether these items are used to determine the trust’s income. Several private letter rulings have held that if the unitrust is a NIMCRUT, and capital gains are to be treated as income, rather than an addition to principal, the unpaid unitrust amounts are to be treated as a liability of the trust. The deemed liability will then reduce the fair market value of the trust’s assets and result in a decrease in the amount of the unitrust amount that the income beneficiary or beneficiaries are to be paid.
Another technique that is especially useful in rapidly changing economic circumstances is to set a date for the payout computation more than once a year. Selecting a minimum of two valuation dates guards against fluctuations in the markets that could result in an unfair over- or under-valuation of the trust’s assets. The only restriction is that the same valuation date or dates and valuation methods are used each year. If the governing instrument does not specify the valuation date or dates, the trustee must select a date or dates and indicate his selection on the first return that the trust must file.
* Alternative payout provision. A unitrust can also provide that it will begin by using one of the alternative payout provisions, then change to paying out a fixed percentage (within a so-called flip unitrust). Flip unitrusts permit donors to fund a unitrust with low- or no-income assets that nevertheless provide the income beneficiary with regular income payments based on the total return available from the value of the assets.
The use of alternative payout provisions must not be discretionary with the trustee. Permissible triggering events include marriage, divorce, death, birth of a child or sale of an unmarketable asset such as real estate. The trust instrument must provide for this one-time-only conversion.
Proposed regulations also provide that capital gain attributable to appreciation in the value of a unitrust asset after the date it was contributed to or purchased by the trust may be allocated to income under local law and the terms of the governing instrument, but not pursuant to a discretionary power granted the trustee.
* Additions. While no property may be added to an annuity trust after the initial transfer, the initial unititrust amount may be added to each year. This ability not to be required to make a full commitment of assets up front to receive the best terms is of considerable advantage to those not entirely comfortable with how their personal wealth will survive the current recession.
* CRT divisions. The IRS last month provided taxpayers with guidelines on how a division of a CRT into two or more separate and equal trusts may take place tax-free and not affect CRT qualification. Revenue Ruling 2008-41 uses two factual situations in which either a CRAT or a CRUT was divided into separate trusts.
In Situation No. 1, the trust was divided, pro rata, into as many separate and equal trusts as necessary to provide a separate trust for each recipient living at the time of the division. In Situation No. 2, the trust was divided into two separate trusts pursuant to a divorce. In both situations, each of the separate trusts had similar governing provisions to the original trust and the same recipients and beneficiaries, collectively, as the original trust. In Situation No. 1, each recipient and remainder beneficiary had the same beneficial interest both before and after the division.
Result in Situation No. 1: The IRS explained that a transfer from a deceased recipient’s separate trust to a surviving recipient’s separate trust would not be treated as a transferred remainder interest in violation of the CRT rules under Code Sec. 664(d) and would not be treated as a prohibited additional contribution to a CRAT.
Result in Situation No. 2: Crucial was the fact that, following the division of the trust, the total annuity amount or unitrust percentage remained the same as it was under the terms of the original trust, except that the survivorship right to the annuity or unitrust payment was relinquished. Again, the IRS ruled that the division of the trust into separate trusts did not cause the trust or any of the separate trusts to fail to qualify as a CRT.
A charitable remainder trust offers unique benefits. For some, it provides a stream of income where there was none before, in return for giving away to a worthwhile cause an asset that they may not be using but that would extract a high tax cost to sell. For others, it allows them to start giving away part of their estate while getting a large upfront tax deduction and a check each month that they otherwise would not be receiving.
Against the backdrop of a recession, however, these same individuals are more likely to want to hedge their bets as much as possible on how their generosity will affect their financial future. While the trust terms must follow certain parameters and be irrevocable, as we point out, there is flexibility within those restrictions to accommodate certain unforeseen circumstances, especially in the unitrust environment.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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