So, do you have a desire to gift or bequeath money to your favorite charitable organization, but are concerned that either (i) you will need the income generated by the property during your retirement or (ii) you will need the assets to from part of a bequest to your spouse or children. Is this an irreconcilable dilemma?
Good news! There are several "tried and true" methods by which you can often accomplish both, through the use of a Charitable Remainder Trust ("CRT") or Charitable Lead Trust ("CLT"); and to make it even more appealing, you will be entitled to an income or estate tax charitable deduction. Further, with CRTs, you can often accomplish your retirement income goals better than you could without the CRT, while still providing a significant benefit to the charitable organizations of your choice.
This summary will focus only on CRTs, and we'll look at CLTs another time.
I. Charitable Remainder Trusts – overview
Let's first go through a quick review of CRTs. There are two basic types of CRTs: a Charitable Remainder Unitrust (CRUT) and a Charitable Remainder Annuity Trust (CRAT). Each pays an amount of income to you and/or your spouse (or an individual of your choosing) for your life or lives or a fixed period up to 20 years. With a CRAT, you receive a fixed income from the trust each year, which is a fixed percentage of the initial fair market value of the assets. Thus, regardless of any increase or decrease in the value of the assets, you receive the same payment each year. A CRUT also provides a stream of income based on a fixed percentage, but the percentage payout is computed on the fair market value of the assets each year. Unlike the CRAT, your annual income under a CRUT may increase or decrease based on the trust's asset values each year. Furthermore, CRUTs allow additional property contributions that can increase both the charitable deduction and your annual income. As such, a CRAT provides more stability (through a fixed dollar payment), but a CRUT may provide greater income as and if the assets appreciate in value (since the payment is based on annual asset value).
One of the most significant advantages of CRTs has yet to be fully addressed – DIVERSIFICATION WITHOUT IMMEDIATE TAX CONSEQUENCES. This is the reason CRTs are particularly favored by those who own low basis stock or real estate. Let's look at one example.
H&W are both age 63. Assume the current Applicable Federal Rate ("AFR") is 2.6%. H anticipates retirement in the near future, and wishes to benefit a charity in his estate planning, but is concerned that he may not have enough income to comfortably live during retirement if he gifts assets now. H owns, among other assets, $700,000 of stock, with a basis of $100,000. If H sells this stock, there is a capital gain of $600,000, resulting in a long term capital gain tax liability of approximately $120,000, leaving only $580,000 to invest. However, if H places this stock in a 20 year term CRUT, the CRUT can diversify the portfolio without paying capital gains tax. H & W could, for example, retain an 11% annual payout on these facts, which would result in over $77,000 per year in income in the first year, gradually declining to about $40,000 in the last year, assuming growth at 5% and trust income at 3%. (Note that if instead the trust were a CRAT, growth would be irrelevant, since the annual payment is a fixed dollar amount). This income would be paid first through any income the trust earned, then through distributions of trust principal, if needed. It would also entitle H&W to an immediate $70,000 charitable deduction, which could be carried over up to five years. From a pure economic standpoint, and assuming the assets grew at 5% and earned 3% income each year, the charity would eventually receive $357,000. At the same time, over the course of 20 years, H & W would have received over $1,150,000 in income!
Under a Charitable Remainder Trust, your percentage payment is based upon a number of factors, including: age, whether for one life or joint lives, whether paid annually, quarterly or monthly, the current federal interest rates and the amount contributed. The higher the payout, the less the charitable deduction.
The benefit of the charitable deduction provided by a CRT is significant in and of itself. The amount that may be deducted in any given year is generally up to 50% of an individual's Adjusted Gross Income ("AGI"). Any amount not used may be carried forward for up to 5 years. Additionally, if the trust is created through testamentary bequest, a charitable deduction is available to the estate.
II. Legal Requirements of CRTs
CRTs are subject to strict rules promulgated by the Internal Revenue Service ("IRS"). The following is not intended to address these rules in detail, but rather, to provide an overview of the more significant rules. CRTs must be irrevocable and unamendable, except for the reserved right to change the charitable beneficiary. A CRT can be created in life, or through testamentary provisions in a Will. Contributions of encumbered property are generally prohibited. As to CRTs, additional property may be contributed to a CRUT, while a CRAT must expressly prohibit the same. Additionally, a CRT is not subject to income tax on earnings at the trust level in most instances.
There are numerous other legal requirements and "traps for the unwary." As such, consultation with your tax professional is strongly advised.
In summary, charitable trusts are a way to "have your cake and eat it too." Depending upon your goals and needs for retirement, you can not only accomplish your charitable goals, but provide retirement income or provide for loved ones, in as good (or better) a manner as could be done through outright ownership. These trusts can also serve to defer or avoid the capital gains tax on the sale of appreciated assets, relieving you of both the burden of the tax and the burden of inclusion of these assets in your taxable estate. Furthermore, with the new capital gains rate structure, this can be an even more significant advantage for assets that have significant gains which have been held for less than 18 months.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.