In a previous blog post, we discussed how charitable lead trusts (CLTs) could be used to gain a large tax deduction, offset other capital gains, and fund philanthropic interests. However, that is just one side of the charitable trust world; charitable remainder trusts (CRTs) represent the other.
A CLT allows the grantor to transfer assets into trust for a term of years, pay a charity an annual amount, and then take the assets back after the term is up. The value of the charitable tax deduction is equal to the present value of the payments going to the charity. With a CRT, the grantor is doing the opposite. Money is placed inside of the trust, and the grantor (or other designated beneficiary) gets the annual payments. Then, when the trust is done, the money goes to the charity.
Benefits of a CRT
There are many benefits to a CRT, the first of which is cashflow for the income beneficiary. There are two types of CRTs: charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs). The main difference between the two is that CRUTs define the distribution as a percentage of the value of the assets every year, and CRATs value the assets on setup, and maintain that payment throughout the distribution phase.
The second benefit is the massive up-front tax deduction they offer. Since the charity gets the money after the income beneficiary, that deduction is calculated using the present value of the lump sum presumed to be left over. Like the CLT, the applicable federal rate (AFR) is used as an assumed rate of return. This means that the higher the AFR, the greater the deduction, since more is assumed to go to charity.
Duration of Income Flow
How long the income will flow to the beneficiary is the other big factor for determining the deduction. CRTs can be defined by a number of years and can run for the lifetime of the income beneficiary. Because most of us don’t know when we’re going to die, the IRS has mortality tables that estimates when the gift will likely go to charity. Should you beat the IRS estimate, you don’t have to give back any of the benefit. If there are joint beneficiaries, you must use the younger one’s life expectancy.
Capital Gains Not Immediately Taxable
The third benefit of a CRT is that any capital gains recognized inside the CRT are not immediately taxable to the grantor. This means that a person can contribute highly appreciated stock and the gain inside will not show up on their tax return when the gain is realized. Instead, the gain is tracked on the tax return in a deferred capital gains account. When money is distributed from the trust, the recipient will first pay the tax on any current income (e.g., interest and dividends), then current capital gains, and then the rest of the cash received will be attributed to the long-term deferred stock account. Only after the deferred gains account is exhausted will the beneficiary will receive return of capital.
Money Given to Charity
Finally, the money eventually goes to charity. Grantors use CRTs because they have a cause or organization that they believe in. In a CLT, the grantor, or a person of the grantor’s choosing, will get the property back in the end. With a CRT, the assets are ultimately relinquished.
Complexity of CRTs
With many more variations than the CLT offers, CRTs carry additional complexity. The different types of CRTs can lead a taxpayer down the proverbial rabbit hole. They can also lead to onerous accounting and tax prep bills for the unwary, which is what makes CRTs the Mr. Hyde of the charitable trust duo.
For instance, the CRT can make up income that does not get distributed. This is often referred to as a NIMCRUT. Envision a scenario where a person funds the CRUT with a piece of real estate that they aren’t yet willing to sell, but isn’t collecting rent. The CRUT can’t pay the required distribution, so the phantom distribution is tracked. Then, once there is actual income, the trust makes up the prior amounts that should have been distributed.
It’s important to note that taxpayers cannot use stock options to directly fund CRTs. A transfer of ISOs to a charitable trust is considered a disqualifying disposition. If transferred before two years since grant date or one year since exercise, it will result in ordinary income on the person’s tax return. That being said, any shares that are owned outright (RSA or RSU, or previously exercised options that qualify) can be used to fund a CRT. If you want to use pre-IPO stock, you should check with HR for transfer restrictions.
Whether it’s a CRT or CLT, charitable trusts are complex tools that require an attorney, a CPA, and a financial advisor who has an expertise in charitable planning. For ongoing information from our financial experts about your financial options, subscribe to our blog.