Many people wish to save income taxes today, and create a stream of retirement income in the future.
The FLIP trust, especially the FLIP-CRUT (charitable remainder unitrust), is a venerable way to accomplish both goals.
The FLIP-CRUT strategy begins with a charitable remainder trust (CRT).
An individual (known as the grantor) executes a trust agreement creating a charitable remainder trust – and transfers money or property to the CRT.
The trustee will invest this principal. In most cases, the grantor (or the grantor and his or her spouse) also is the primary income beneficiary of the trust.
But the grantor can name someone else as income beneficiary, such as the grantor’s adult children.
For this discussion, I assume the grantor and their spouse are the income beneficiaries. The trustee will make annual income payments to the income beneficiaries.
I also am going to assume the annual payments will be made to the income beneficiaries for the rest of their lives. The grantor further could choose to have the income payments made for a period of years, or for the life of only one income beneficiary.
After the payments to the income beneficiary terminate, the property left in the trust, known as the trust remainder, is transferred to one or more charities that were named by the grantor in the trust agreement.
There are two ways the distributions from the charitable remainder trust to the income beneficiaries can be calculated.
The trustee could be directed to pay a fixed annual amount to the income beneficiary, known as a charitable remainder annuity trust or CRAT.
The downside of the CRAT is the income beneficiary doesn’t have inflation protection. The income payments lose purchasing power to inflation over the years.
The alternative is that the trustee can be directed to pay the income beneficiary a fixed percentage of the charitable remainder trust’s current value each year, known as a charitable remainder unitrust, or CRUT.
The unitrust gives the income beneficiary rising income over time if the charitable remainder trust’s investments generate positive returns that exceed the annual income distributions.
But if the trust’s investments don’t do well, the income distributions will decline. For either type of trust, the income payments will end if the charitable remainder trust runs out of money.
There are several advantages to either version of the charitable remainder trust. In fact, it has been called the triple tax benefit trust.
The grantor receives an income tax deduction for the present value of the amount the charity is estimated to receive in the future.
Though the charity won’t receive the money until the future, perhaps decades in the future, the grantor receives the tax deduction in the year the property is transferred to the trust.
The amount of the tax deduction depends on the age of the grantor (or years income payments will be made), current interest rates and the value of the property transferred to the trust.
The charitable remainder trust is a great way to convert appreciated investments into a stream of income without incurring capital gains taxes.
When you transfer appreciated investments to a charitable remainder trust, you owe no capital gains taxes on the appreciation that occurred while you held the property.
Plus, the fair market value on the date of the transfer is used to determine your income tax deduction.
Since the CRT is a charitable trust, it doesn’t pay taxes when it sells the property and reinvests the proceeds in a diversified portfolio. The entire value of your contribution is reinvested to generate future income for you.
A CRT can help you avoid capital gains taxes on stocks, bonds, mutual funds, real estate, and more, plus generate a current income tax deduction.
In addition, the assets in the CRT aren’t included in your estate for either the estate tax or probate. When your estate might be taxable, the CRT is a good way to avoid estate taxes on the property while retaining a stream of income from it.
Another advantage of the CRT is the trustee can provide professional management of the trust assets.
In fact, many large charities, including many universities, will provide free investment management and administration of a CRT when they will receive a minimum portion of the trust remainder.
Now, let’s look at how a couple of key provisions can add benefits to the CRT. The standard CRT begins distributions to the income beneficiary soon after the trust is created and funded. But that doesn’t have to be the case.
You can set up the trust so that it distributes each year no more than the net income of the trust, known as an NI trust.
An NI trust can be a good idea when the initial property transferred to the trust is not readily marketable, such as real estate, a small business, or artwork. The trustee won’t be forced to sell assets in a hurry to have cash to make mandated annual distribution to the income beneficiary.
An NI trust also can be a good idea when the grantor wants an income tax deduction today but does not want or need the income from the trust for a few years.
The grantor might not be retiring yet or might have other sources of income that will continue for a while.
The trustee can invest the trust assets to generate little or no current income.
Instead, the trust is invested for appreciation and capital gains. But the grantor will want higher income distributions at some point.
That’s why the grantor will put a flip provision in the CRT agreement and make it a FLIP CRT.
The flip provision simply states that at a particular point in time, the NI CRT will switch to a standard CRT. The change can occur on a particular date, such as when the income beneficiary reaches a certain age, or after a qualifying event.
Then, the trustee begins making distributions of either a fixed annual amount (in the case of a CRAT) or a percentage of the trust’s value (in the case of a CRUT). The income beneficiary begins receiving a steady stream of retirement income.
For the flip provision to be valid, the triggering event must be outside the control of any person, including the trust grantor, trustee, noncharitable beneficiary, or contributor or assets to the trust.
Permissible triggering events include a specific date, the sale of nonmarketable assets (but not liquid assets), a non-charitable beneficiary attaining a certain age, and the marriage, divorce, or death of a non-charitable beneficiary. Another variation is the NIM CRT, or net income with make up CRT.
You start with an NI provision, so the CRT doesn’t make distributions unless there is net income for the year.
The NIM provision says that when distributions in earlier years were lower than the specified annuity amount or percentage of the trust because of the NI provision, the unpaid distributions can be made up in any year when the trust has a lot of income.
The trustee can distribute more than the specified annuity amount or percentage of the trust value in such a year to the extent needed to make up distributions that weren’t made in the earlier years and to the extent there is net investment income for the year.
Let’s say, for example, that “Max Profits” sets up a CRUT in which the trustee is directed to make annual distributions equal to the lesser of 5% of the trust value or its net income. The trust assets are worth $1 million. In the first year, the trust has $500 of net investment income.
The $500 is distributed to Max. That distribution is $49,500 less than the 5% of trust assets that would have been distributed, if not for the NI provision.
In the second year, the trust has $75,000 of net investment income and still has a $1 million value. The trustee can distribute the $50,000 of regular distributions (5% of $1 million) plus $25,000.
The additional $25,000 is a make-up distribution for part of the distribution that wasn’t made the first year because of the net income limit.
Keep in mind that when a CRT has both a flip provision and a NIM provision, the NIM provision applies only before the flip is effective. Once the flip occurs, any make up payments remaining from the prior years are forfeited.
Going forward, the trustee can distribute only the annual annuity amount or the specified percentage of the trust assets.
When you want a current income tax deduction and future stream of income, consider one of the versions of the charitable remainder trust.
It is particularly valuable when you have an appreciated asset that you’d like to convert into a stream of income without paying capital gains taxes.