1.Lifetime Charitable Remainder Trusts
Charitable giving is usually accomplished through the use of the charitable remainder trust. The charitable remainder trust also generates numerous lifetime benefits for the donor, such as an income tax deduction and creation of income. There are two types of charitable remainder trusts, the Charitable Remainder Annuity Trust (“CRAT”) and the Charitable Remainder Unitrust (“CRUT”).
A CRAT is a trust which provides lifetime income benefits to a non-charitable income beneficiary for a term not to exceed 20 years or which is measured by the lifetime or lifetimes of the beneficiary or beneficiaries. Income payments are permanently fixed as a specified dollar amount or a percentage (at least 5%) of the initial value of the trust assets. The payment remains the same regardless of what happens to the value of trust corpus. Additionally, the provisions of the instrument creating the CRAT must prohibit future contributions to trust corpus.
A CRUT is similar to a CRAT except with respect to the amount of income payments. Under a CRUT, income payments are determined as a fixed percentage (again, at least 5%) of the net fair market value (“FMV”) of trust assets, redetermined annually. Thus, unlike the case with the CRAT, as the value of trust assets change, there is a corresponding change in the annual payments to the non-charitable income beneficiary or beneficiaries.
Under both a CRAT or a CRUT, at termination of the last non-charitable beneficiary’s income interest, all remaining trust assets must be distributed to a charitable organization described in Internal Revenue Code section 170(c) or must be retained by the trust for the use of such organization. For the donor to qualify for the full (50% of adjusted gross income) income tax charitable deduction, the charitable remainder beneficiary must also be an organization described in IRC section 170(b)(1)(A). If the organization does not so qualify, then the income tax charitable deduction is limited to between 20% and 30% of adjusted gross income.
Moreover, in order to qualify for any income tax charitable deduction, the donor must create the CRAT or CRUT in such a way that it meets the 10% test-at least 10% of the assets must pass to charity. A CRAT must also pass the “5% probability test.” Under this test, it must actuarially be determined that there is a more than 5% probability that there will be assets remaining in the trust for distribution for the benefit of the charitable beneficiary at termination of the trust.
In choosing between a CRAT or a CRUT, the potential donor should weigh the possible benefits and advantages of each. Under a CRAT, income payments are fixed at the establishment of the trust, and cannot vary. The charitable remainder beneficiary receives the benefit of appreciation in asset FMV and bears the risk of loss of asset depreciation. Establishment of a CRAT also entails the risk of the trustee selling depreciating trust assets in order to meet the income requirement. Additionally, it is generally more difficult for a CRAT to qualify for the 10% test. Finally, where charitable giving is a primary focus of the wealth replacement estate plan, a CRAT may provide a limitation to the donor’s wishes as a CRAT allows only one transfer of property at the trust’s inception to the trust.
CRUTs, on the other hand, are perceived as more difficult to administer than CRATs as they require annual revaluation of the trust assets. The income to the non-charitable income beneficiaries is also subject to fluctuation. If the trust is funded with appreciating assets, the beneficiary’s income is likely to increase. The reverse is also true, however, in the case of depreciating assets. A CRUT, unlike a CRAT, may provide for payments out of trust income only, minimizing the possibility of a force sale of trust assets to generate income.
A disadvantage common to both CRATs and CRUTs is that all charitable remainder trusts must be irrevocable if the trusts are to generate tax and related benefits. This fact, and its attendant inflexibility with respect to future estate planning, intensifies the need to resolve all planning issues worth some certainty before finalizing and executing a wealth replacement plan.
2.Formation on Death
Similarly either a CRAT or a CRUT can be formed upon death. The same rules apply with respect to income payments either being permanently fixed on the formation of the trust as a percentage of the initial value of the trust assets (CRAT) or a fixed percentage of the net fair market value of the trust assets re-determined annually (CRUT). If formation occurs on death no income tax deduction occurs, although the estate receives a deduction for the value of the asset or assets distributed to the charitable trust. Due to payment of income on death to children, there will be some estate tax due on the value of the income interest retained by the beneficiaries.
3.Common Uses of Charitable Remainder Trusts
A number of tax, financial and estate planning objectives can be accomplished through charitable planning. These include:
(a)Avoidance of state and federal income taxes. Transfer of appreciated property to a CRAT or CRUT, followed by the sale of that property by the trust, will not be subject to income tax, since the trust is a tax-exempt entity.
(b)Charitable contribution income tax deduction. The creator of the Charitable Remainder Trust during life can qualify for a charitable contribution deduction for the value of the charitable remainder interest which will ultimately pass to the charitable organization.
(c)Providing income stream to creator. The avoidance of capital gains tax, together with the creation of the trust, will result in a cash flow to the creator which might not otherwise be available. Many individuals own principal residences which have greatly appreciated in value over time. These properties can be transferred to a CRAT or CRUT, sold by the trust, and the proceeds used to provide the creator with income. If a CRAT or CRUT is formed on death, the beneficiaries will receive the income stream.
This income would be substantially higher than that produced by the property itself as a rental unit, and would be higher than if the property were sold by the creator and subject to capital gains tax. The additional income or portion of the proceeds can also be used to provide the creator of the trust with a smaller home or more suitable to the creator’s needs.
(d)Removal of the property from the creator’s taxable estate. The net amount which the creator can pass to subsequent generations can be passed tax free and represent a substantial increase over situations where the property is sold in a traditional transaction.
(e)Benefits to charity. Since the charitable organization is entitled to the remainder interest in trust assets, the charity may ensure itself of a substantial future flow of contributions. However, the charitable benefits to be obtained are not an essential concern often of the creator of the CRAT or CRUT. To avoid the abuses described below, and to minimize the possibility of attack of any charitable transaction by the IRS, the planner should pay careful attention and ensure that only clients with bona fide charitable intentions are creating Charitable Remainder Trusts.
4.Tax Consequences of Charitable Remainder Trusts
(a)Income Tax.
A contribution to a Charitable Remainder Trust will result in an income tax charitable deduction for the creator who donates property to the trust during his or her lifetime. On death no income tax deduction is received. The deduction is based upon the present value, at the time of creation of the trust, of the remainder interest passing to the charity. The present value of the charity’s income or remainder interest is determined using the Internal Revenue Service actuarial and life expectancy tables.
The deduction is thus a function of both the duration of the non-charitable income interest and the selected percentage of trust assets to be distributed annually. The charitable deduction amount will normally be smaller in the case of a CRUT, since the IRS tables assumes further that the amounts are ultimately distributed to non-charitable beneficiaries in a CRUT. This results in a smaller portion of the gift going to the charity at the end of the CRUT term. The CRAT therefore produces a larger charitable contribution deduction.
Moreover, there is no capital gain recognized by the creator with respect to transfers of appreciated assets to a charitable remainder trust during life or upon death. Further, a subsequent sale by the trust of appreciated property will generally not result in recognition of capital gain by the creator or the trust unless all or part of that gain is distributed to the creator.
However, the creator may recognize capital gain in the event the property transferred to the trust is subject to a mortgage. In such cases, the transfer is treated as a bargain sale and the creator recognizes gains to the extent of the debt relief. For this reason, it is generally not a good idea to transfer mortgaged property to a CRAT or to a CRUT.
Income earned by the trust entity is not taxable to the trust, as it is considered a tax exempt entity. However, income payments to non-taxable beneficiaries do constitute taxable income to those beneficiaries in the year in which paid.
The trust may also be subject to tax in limited situations where it earns income that is characterized as unrelated business taxable income, or it is subject to the debt financed income rules. Moreover, a Charitable Remainder Trust may be treated as a private foundation if the charitable deduction exceeds 60% of the initial fair market value of trust assets.
(b)Gift Tax.
A transfer of property to a charitable trust during life constitutes a reportable gift. Thus, a gift tax return is required to be filed on or before April 15 of the year after the close of the calendar year in which the transfer is made. However, normally, no gift tax will be due, since the income “gift” will be made to the creator and the remainder interest goes to a charitable beneficiary resulting in an offsetting charitable deduction. No annual exclusion is given for the gift of any non-charitable income interests after the grantor’s interest to the charity [even if it is under $12,000, because section 2503(b) of the IRC requires a gift of a present interest].
Income payments to third parties may constitute taxable gifts. Of course, there is no gift tax attributed to the income interest if it is retained by the creator of the trust. Any income interest paid to a third party, other than the creator’s spouse, is a reportable transfer for gift tax purposes, and will result in a gift tax due if the value of that interest exceeds more than $12,000 per year as allowed under the annual exclusion under IRC section 2503(b).
(c)Estate Tax.
If a creator establishes a Charitable Remainder Trust in his or her lifetime and retains the lifetime income interest therein, the entire value of the trust will be includable in the creator’s estate under IRC section 2036(a). However, the creator will also receive an offsetting estate tax charitable deduction for the entire value of the property transferred to the charitable organization remainder beneficiary. The result is no estate tax.
However, if the trust is formed upon death and if the beneficiary is a non-charitable income beneficiary, some inclusion of the trust fair market value in the creator’s gross estate is likely. This will be offset by an estate tax charitable deduction under IRC section 2055 in the amount of the value of the remaining interest passing to charity.
5.Proper Drafting
Creation of charitable trusts and trust instruments has been recently limited by IRS pronouncement. Under these published notices, the IRS has provided taxpayers with sample forms for various types of charitable remainder trusts. IRS has provided further that if the provisions of charitable remainder trust documents are substantially similar to those in one of the samples provided, the creator is assured that the IRS will recognize the trust as meeting all the requirements under IRC section 664. For this reason, it is strongly suggested that any trust documents establishing the charitable remainder trust closely follow the suggested language.
6.Choosing Property
With respect to choosing property for funding trusts, there are few, if any, legal restrictions (except those discussed below and elsewhere in this memorandum), regarding which assets can properly be used to fund the charitable trust. A Trustee should always exercise due care and diligence when considering whether to accept certain gifts. There are a number of reasons why some properties should be excluded from consideration. These types of properties include:
(a)Property likely to generate unrelated business taxable income (“UBTI”) or unrelated debt financed income. This type of income may produce adverse tax consequences to the trust, including loss of tax-exempt status. For example, a gift of a partnership interest in an operating partnership whose income’s UBTI were to subject the trust to a 100% excise tax under IRS section 664(c)(2). This income must be reported to the income beneficiary as well resulting in further tax.
(b)Encumbered property transferred to a CRAT or CRUT, where the creator is the trustee, may give rise to a charge of self dealing or bargain sale by the IRS. This may call into question the entire validity of the charitable trust scheme and the charitable deduction and other tax benefits taken thereby. Also, if the creator remains personally liable for debts secured by an encumbrance, the trust may not qualify as a CRAT or CRUT.
(c)Careful consideration should be given to inclusion of real property in a charitable trust during life. The trust in such cases may be saddled with landowner liability and toxic issues. Liabilities from remediation could exceed the value of the property. Also, inclusion of real property in a trust also raises liquidity and income production problems.
(d)Tax exempt securities can be used to initially fund a trust, but a later purchase with proceeds of sale of taxable property would be disastrous for the creator. In Revenue Ruling 60-30, the IRS ruled that a scheme whereby appreciated property was transferred to a trust, sold by the trust, and the proceeds reinvested in municipal bonds, was a sham transaction and subjected the creator to taxes and penalties.
(e)S Corporation Stock. A charitable remainder trust cannot be a qualified stockholder. This would impair the status of the corporation as an S Corporation.
(f)Property without an established fair market value can result in a charge of self dealing if the creator is the trustee with power to value the income for allocation in other purposes.
7.Trustee and Powers
The planner should also give careful consideration to the powers of administration granted to the trustee of the charitable remainder trust and to the choice of the trustee itself. Again, the powers should be carefully drafted to avoid any charges of self dealing. For example, the IRS has ruled that a sprinkling trust, which sprinkles the income amongst a variety of charitable beneficiaries where the creator is serving as trustee, will not qualify as a charitable remainder trust. Any trust which provides for compensation to the creator/trustee also might raise a charge of self dealing.
Care should also be taken to ensure that things are done properly when the charitable remainder beneficiary wishes to serve as trustee. Again, the self dealing can arise when the charity is deemed under the domination of the non-charitable donor. Caution must also be exercised to determine if the charitable beneficiary is capable under state law or under its own charter to serve as a fiduciary with respect to the trust. IRS has taken the position, however, that the creator can serve as trustee.
8.Pitfalls of Trustee Duties and Liabilities
(a)Failure to Make Distributions.
A CRT is required to make distributions at least annually. The trust agreement may specify that distributions occur more frequently with quarterly distributions typically being the most common frequency. In general, the required distribution(s) for a given year must be made by the filing of the trust’s tax return for that year, including extensions. Where payment of the distribution is delayed (for example, due to a lack of ready cash), filing of the return should be delayed until the payment is made. The due date for filing the return can be extended from April 15 to October 15.
In Atkinson v. Commissioner, the tax court denied the Trustor’s estate an estate tax deduction because the trustee was unable to demonstrate to the satisfaction of the court that the required distributions had been made. The court held that the trust was not a qualified CRT because it had failed to operate as a CRT from inception merely because distributions were not made. Even though the estate tax deduction was denied, the property in the CRT could not be used to pay the estate tax as the trust assets passed to charity under state law.
(b)Failure to Make Property Distributions.
CRT’s payouts, and the distribution frequency may vary from trust to trust. The proper administration of a CRT requires an understanding of the annuity payout format in contrast to the unitrust payout format. In addition, a unitrust may further limit the trust payout to the trust’s fiduciary accounting income (FAI). Failure to make proper distributions may result in a determination that the trust has engaged in self-dealing and/or a determination that the CRT is not a qualified CRT. As discussed in Atkinson above, strict adherence to the rules are required.
(c)Failure to Understand and Property Account for Trust Activity Under the Four-Tier System.
While a CRT is exempt from federal income tax, distributions to the beneficiaries are not exempt. In order to properly determine the tax character of trust distributions, a trustee must maintain tax accounting records according to the four-tier accounting system applicable only to CRTs. Because the four-tier accounting rules apply only to CRTs, they are not generally understood by many accountants and corporate trustees unless they specialize in the administration of CRTs. Therefore, the charity or individual choosing to serve as trustee must exercise care in selecting a qualified accountant and, if necessary, a trust administrator or corporate co-trustee to ensure the proper maintenance of tax accounting records.
(d)Failure to Prepare Proper Tax Filings.
As a split-interest charitable trust, a CRT has a unique set of filing requirements. These requirements differ significantly from those imposed on private (noncharitable) trusts. A CRT is generally required to file Form 5227, Split-Interest Trust Information Return, and Form 1041-A, Trust Accumulation of Charitable Amounts. In addition, a CRT trustee may be required to file Form 8282, Donee Information Return, Form 4720, Return of Certain Excise Taxes, and/or issue form 1099-MISC to various service providers. These returns are very complex and it is imperative that an accountant be engaged to ensure proper completion. For example, the charitable deduction is disallowed if an appraisal is not attached in the year of the gift. Further, failure to prepare and file the appropriate forms could cause the IRS to impose penalties. Such penalties, unless abated, may be chargeable to the trustee.
(e)Failure to Properly Determine the Fiduciary Accounting Income of the Trust.
In the case of a net-income-with-makeup charitable remainder unitrust (NIMCRUT), a trustee is responsible for allocating each cash receipt and disbursement to either income or principal. The result of this allocation is the trust’s fiduciary accounting income (FAI). The trustee is guided in this task by the terms of the trust agreement and the California principal and income statute. Because the standard used to compute fiduciary accounting income is not governed by generally accepted accounting principals (GAAP) or federal income tax law, the computation of FAI is a specialized task and Trustor should seek assistance on these allocations.
(f)Failure to Prepare an Accounting to Trust Beneficiaries.
Under California law, a trustee is required to account to the trust’s beneficiaries. While the Trustors’ are living, they may be able to avoid this but providing an accounting offers a Trustee greater protection. Failure to provide an accounting may open the trustee to liability that could have been avoided with an accounting.
9.Compliance Pitfalls.
(a)Failure to Understand and Apply the Private Foundation Rules Under Chapter 42.
A CRT is subject to the private foundation rules found at IRC §§4941-4946. These include the prohibitions against self-dealing (§4941) and taxable expenditures, such as payments for lobbying (§4945). In addition, the governing document may include the prohibitions against excess business holdings (§4943) and jeopardizing investments (§4944). These rules are complicated, and violating them will subject the trustee, and in some cases, a third party, to excise penalty taxes.
(b)Failure to Stay Abreast of Changing Laws and Regulations.
The environment in which CRTs are created and administered continues to evolve with statutory and regulatory changes occurring with an increasing frequency. It is important to stay abreast of changes in the law. Failure to keep up with these changes can subject the unwary to adverse tax consequences and potential liability from trust beneficiaries.
(c)Failure to Observe the Proper Investment Standard.
Under the California Uniform Prudent Investor Act, a trustee (or the trustee’s delegate) is charged with investing and managing trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill and caution.
In order to meet this standard, the trustee (or the trustee’s delegate) must examine the trust agreement, understand why the trust was created and how its terms achieve the purpose for its creation, and understand the needs of the trust’s beneficiaries.
In addition, the trustee is required to consider each investment decision in the context of the portfolio as a whole and as part of an overall investment strategy. This investment strategy should be based on risk and return objectives that are suitable to the purposes, terms and circumstances.
Among the key responsibilities of a trustee is the management and supervision of the investment of the trust’s corpus. Under the Prudent Investor Act, a trustee is permitted to delegate the investment management function. The trustee must exercise reasonable care, skill and caution, however, in selecting the investment firm to whom the investment management function is delegated. The periodic review of investment performance and an annual review of investment objectives are important steps in exercising appropriate oversight of the investment function.
One of the basic tenets of Modern Portfolio Theory is the creation of a diversified portfolio that balances the expected reward for the assumption of a given level of risk. Where a trust has multiple classes of beneficiaries (such as income beneficiaries and remainder beneficiaries in the case of a CRT), the risk profiles of all beneficiaries must be taken into account in order to create a composite risk profile for the trust. This risk profile then allows the investment manager to select an appropriate target rate of return and complementary asset allocation. The key point is that the risk profile of one class of beneficiary cannot be considered while ignoring the risk profile of other trust beneficiaries.
