CHARITABLE REMAINDER TRUSTS: AN OVERVIEW

By MacKenzie Canter, III, ©1999
Member of VA, DC, MD and MO Bars
Copilevitz & Canter, LLC
1900 L Street, NW
Suite 215
Washington, D.C. 20036
202-861-0740
maccanter@aol.com

The charitable remainder trust ("CRT") is a creature of statute, specifically Internal Revenue Code ("IRC") §664. Born in 1969, it has evolved into the one of the most flexible tax and financial planning device available to taxpayers, both individual and corporate.

No charitable deduction is permitted for a charitable remainder in a "split interest" trust (other than a pooled income fund) unless the life or term interest is a fixed annuity or unitrust amount. See, IRC §664. This is true for both income tax purposes (§170(f)(2)(A)) and federal estate tax purposes (§2055(e)(2)).

The IRS issued published requirements for CRT instruments. The requirements are highly technical. In Rev. Procs. 89-20, 1989-1 C.B. 841; 89-21, 1989-1 C.B. 842; 90-30, 1990-1 C.B. 534; 90-31, 1990-1 C.B. 539; 90-32, 1990-1 C.B. 546; and 90-33, 1990-1 C.B. 551, the IRS provided sample "forms" for charitable remainder trusts, both unitrusts and annuity trusts⁽¹⁾.

While CRT's can be established by will, it is important to consider the advantages of establishing a CRT inter vivos, i.e. during lifetime. In addition to lowering (via exclusion) estate tax, the following additional benefits may be attained:

1. Current income tax deduction;

2. Avoidance of capital gains tax when converting low-yield appreciated assets to high-yield investments;

3. Accumulation of yield and capital gain tax-free;

4. Deferral of income until years when it may be taxed at a lower rate;

Setting up the CRT now makes tax sense. The estate tax effect is the same. An exclusion is equal to an deduction. For an individual in the 50% estate tax bracket, the savings derived from an testamentary charitable contribution is $50,000---but transferring $100,000 to a CRT also saves $50,000 in estate taxes.

However, the charitable contribution deduction resulting from a "lifetime" transfer to a CRT also will reduce current federal income taxes. As explained below, the income tax deduction is equal to the present value of the remainder interest which eventually will be distributed to the qualified IRC §501(c)(3) organizations designated in the CRT.

The Two Types of CRT's

There are two types of CRT's: the charitable remainder annuity trust ("CRAT") and the

charitable remainder unitrust ("CRUT"). Because of its flexibility and capacity to receive additional contributions, the CRUT is generally preferred to the CRAT.

The CRUT is available in four models:

1. Standard ("fixed payout") CRUT;

2. Net-income CRUT ("NICRUT");

3. Net-income with make-up provision CRUT ("NIMCRUT")

4. "Flip" CRUT, i.e., NICRUT or NIMCRUT which converts to a standard CRUT.

When real estate is used to fund the CRUT, the NIMCRUT and "flip" CRUT are preferred.

Elements common to CRAT and CRUT.

Any CRT (be it CRAT or CRUT) is a split-interest trust which must have at least one non-charitable income beneficiary and at least one "remainderman" or "remaindermen"⁽²⁾ whose interest is fully and irrevocably vested. The grantor may reserve the right to change the remainderman or remaindermen.

A CRT is charitable because the remainder interest will be disbursed when the trust closes to one or more "charities." Actually, "charities" is a misnomer. In this context, it means any organization qualified as charitable, educational, religious, etc. under IRC §§170 and 501(c)(3). (The "flip side" of §501(c)(3) is §170 which refers to charitable contribution deductions. The organization is exempt from tax under §501(c)(3). The taxpayer is entitled to a charitable contribution deduction to the organization under §170(c)(2).)

However, there is not an "exact fit" between §§501(c)(3) and 170(b)(1)(A)(i)-(vi). The reason is that within the genus of §501(c)(3) organizations, there are two species: "private foundations" and "publicly supported organizations." Of the approximately 600,000 §501(c)(3) organizations on file with the IRS, about 10% are private foundations.⁽³⁾ Complicating the statistic is the fact that churches, synagogues, mosques, temples, etc. are not required to apply for §501(c)(3) status. Some do. Most don't. Gifts to these types of religious organizations are deductible under IRC §170. (Note: not every "church" is recognized by the IRS as a "church" for §170 purposes. If in doubt, make sure the organization has received an IRS ruling.)

To maximize the tax deduction from a CRT, it is important to select "remainderman"-- or "remaindermen"-- which are "maximum deduction donees," i.e. not certain types of private foundations. The deduction may be limited to "cost basis," as opposed to "fair market value," if a private foundation is the donee.

As "remainderman" and "remaindermen" imply, there is no need to designate only one qualified organization as the recipient of the remainder interest. You must identify at least one, but may name as many as you want---and allocate the remainder between them in whatever shares you desire, i.e., 1% to Save the Whales, 99% to Save the Guppies.

The IRS held that a special power of appointment granted to the income beneficiary of a testamentary CRT to name qualified charitable remaindermen in place of those named by the trust instrument is not a power that violates the prohibition against a power to invade, alter, amend or revoke for the beneficial use of any person other than a qualified charitable organization. See, Rev. Rul. 76-7. The IRS also ruled that a donor can grant to the trustee, during the donor's lifetime, the power to name additional or alternative charitable remaindermen.

A CRT must have an least one non-charitable income beneficiary and must pay at least a 5% annual return, either a 5% annuity in the case of a CRAT or an annual payout equal to 5% of the value of the CRUT's assets. As a result of the 1997 Tax Act,⁽⁴⁾ the law provides that a trust cannot be a qualified CRAT if the annuity for any year is greater than 50 percent of the initial fair market value of the trust's assets or be a qualified CRUT if the percentage of assets that are required to be distributed at least annually is greater than 50 percent. Any trust that fails this 50-percent rule will be treated as a complex trust and, accordingly, all its income will be taxed to its beneficiaries or to the trust.

Moreover, the 1997 Tax Act requires that the value of the charitable remainder with respect to any transfer to a qualified charitable remainder annuity trust or charitable remainder unitrust be at least 10 percent of the net fair market value of such property transferred in trust on the date of contribution to the trust. (See, discussion below.)

Who may be the trustee? Anyone. The donor, the income beneficiary, and the charity all can be the trustee. So, too, of course, can a third-party, such as a bank or trust company. There is no restriction against the donor (sometimes called "grantor") serving as the trustee and the income beneficiary. The reason why this is allowed is the trust instrument, to qualify under IRC §664, must irrevocably dedicate the remainder interest to one or more qualified §501(c)(3) organizations.

State law standards (applicable to fiduciaries of all trusts) preclude the trustee from unduly favoring, e.g., by selection of high-yield but risky investments, the income beneficiary at the expense of the remainderman. It is also possible, in extreme cases, that the IRS could invoke the "self-dealing" rules applicable to private foundations to strip the CRT of its tax-exempt status. on the basis of "self-dealing."

It is possible (depending on state law) to provide that post-contribution capital gains will be treated as "income" for CRT accounting purposes. See, Treas. Reg. §664-3(a).

A CRT may be established for either a fixed term of years, up to 20, or for the life (or lives) of individuals who must be alive at the time the CRT is formed. It is possible to use a combination of a fixed term plus a life or lives, so long as the fixed term sets the "outside" date. For example, "to my son for life and then to my daughter for the shorter of her life or a term of years not to exceed 20 years." Note that the "measuring life" (or lives) must be those of the income beneficiaries. It is not possible to have a third party serve as the "measuring life." For example, "income to be paid to my wife for so long as Madonna shall live" will not qualify.

In extreme factual circumstances, such as imminent death of a taxpayer, the IRS has demonstrated recently its position that the government tables are to be ignored when their use distorts reality.⁽⁵⁾

It is possible to nominate a "non-natural" person, e.g., corporation, trust, or LLC, as the income beneficiary, but in such case a term of years must be used.

A 1984 amendment to IRC §664 provided that any "qualified" contingency which accelerates the charitable remainder is permitted. A qualified contingency is a provision which provides that upon the occurrence of a contingency the income payments will terminate not later than when the payments would otherwise have terminated. A CRT providing for payment of income to X for life or until X's remarriage will qualify, even if the value of the contingency is unascertainable.

The qualified contingency will not increase the value of the remainder for charitable deduction purposes, even though it clearly favors the charity by making it more likely the corpus will be disbursed to the charity sooner than the normal end of the income stream. Even if the contingency is capable of being quantified, this is still the case. The contingency can be "remote" without disqualifying the trust. For example, a CRT providing for payment of an income to X for life or, if earlier, the date on which the Chicago Cubs win the World Series qualifies.

Is it possible to have more than one income beneficiary? Yes, but all lives must be "in being" at the time the trust is formed.⁽⁶⁾

Exempt From Capital Gains Tax.

CRT's are tax-exempt pursuant to IRC §664(c), except to the extent they have "unrelated business income," as defined in IRC §513⁽⁷⁾.

This means that a CRT does not incur capital gains tax when it sells low-basis property and reinvests in higher-yield forms of investment. This also means that a CRT can accumulate surplus income tax-free. In other words, if a CRT has income in excess of what is needed to make the annual payment to the non-charitable income beneficiary, the surplus is not subject to tax. It remains available (retaining the character of ordinary income) for distribution in later years.

This is particularly important to a CRUT with a "net income/make-up" feature. This enables the CRUT to serve as a "wealth accumulation" vehicle. This combination of "zero capital gains" and "tax-free accumulation of income" makes it possible to use the CRUT as a flexible "income shifting" vehicle, i.e., from years when the need for income is low to years when the need is expected to be more pressing. This is not possible with a CRAT which pays a fixed, certain sum annually.

Example

Distributions Are Taxed When Received by Income Beneficiary

How are the non-charitable income beneficiaries taxed? Unlike grantor trusts, which utilize a "pro rata" (proportional) system of tax, the income from a CRT is taxed to the recipient on a "tier" system. First, to the extent the CRT has generated ordinary income, this is distributed to the beneficiary. Second, to the extent of undistributed capital gains, these are distributed. Third, if there is "other income" e.g., "tax-exempt income," this is next distributed. Finally, if there is return of principal, this is distributed. (In contrast, income from grantor trusts is treated as proportionately distributed, i.e, within each installment there are "blended" layers of ordinary income, capital gain, etc.)