Why Triple Tax Benefits Are Not For Everyone

Few tax strategies provide as many benefits as charitable remainder trusts. The trusts generate a current income tax deduction, remove assets from the estate, shelter asset appreciation from capital gains taxes, and provide income for life or a period of years.

Yet, CRTs are a paradox. On the one hand, they seem underused. Many people sell appreciated assets and pay capital gains taxes rather than set up CRTs. On the other hand, a survey of those who did set up CRTs found that most are unhappy. Either the taxpayers were inappropriate candidates for a CRT or the trusts were set up improperly.

Let’s take a look at what CRTs can offer, who is a good candidate for a CRT, and how to avoid the potential traps in a CRT.

A CRT should be considered by someone who has one or more valuable, highly appreciated assets and is looking to sell them at a minimum tax cost. The candidate also should be charitably inclined and have sufficient other assets to leave for loved ones.

Suppose Max Profits owns stocks worth about $3,000,000 with a tax basis of $250,000. If he sells the shares, the tax bill would be $412,500. After taxes he would have $2,587,000.

An alternative is for Max to set up a CRT. He donates the stock to the trust. The trust terms (which are determined by Max within some limits set by the tax law) say that the trust will pay Max and his wife Rosie income for the rest of their lives. Then, the remainder of the trust property will go to charities designated by Max.

After contributing the stock to the trust, Max is entitled to a charitable contribution tax deduction. He does not deduct the full value of the stock. Instead, he deducts the present value of the amount the charity is estimated to receive at the end of the trust term. That value is determined by current interest rates, the ages of the trust’s beneficiaries, the income payout formula, and annuity tables issued by the IRS. The older Max and Rosie are, the greater the tax deduction. The longer the income will be paid, the lower the tax deduction.

Once the stock is in the trust, it is out of Max’s estate. Max owes no capital gains taxes on the appreciation in the stock, because he is transferring the stock to a charitable trust. The trust can sell the stock, also without incurring taxes. The trust then can set up a more diversified portfolio or one that produces more income than the stock did. The trust then makes regular payments to Max and Rosie for life.

Max sets up the formula that determines the income payments. He could set up a charitable remainder annuity trust, which pays a fixed dollar amount each year. Or he could create a charitable remainder unitrust (CRUT), which pays a percentage of the trust’s value each year.

Max has some flexibility when determining the amount of the payouts under either trust. The present value calculation must indicate that the charity will receive at least 10% of the original trust value. Max also should keep in mind that the higher the income payments, the lower the tax deduction will be.

The advantage of the unitrust is that income has the potential to increase as the trust’s value increases. That gives Max and Rosie inflation protection. The income also could decline if the trust’s value declines. While that is not good in the short term, it does make it less likely that the trust will be spent down.

The income payout formula can change, which can be good in some situations.

For example, there is a flip unitrust. In the early years of the trust, it pays only whatever net income it earns. If there is no income, there are no payments to Max and Rosie. (The portfolio can be structured to yield little or no income.) After some triggering event, either a point in time or the sale of assets held by the trust, payments under a different formula begin. This provision is helpful if Max contributed illiquid assets to the trust or Max is too young to begin taking income payments.

A CRUT also can have net income with makeup provisions. When the net income for the year is less than the percentage payout, Max receives only the net income. But the trust tracks the amount of the shortfall in a deficiency account. In the future when income exceeds the percentage payout, Max receives the excess until the deficiency is eliminated. This is called a NIMCRUT.

Despite all these advantages, the CRT is not for every situation or property owner. Here are some ways a CRT can go wrong.

Wrong donated assets. A CRT is best-funded with highly appreciated assets to shelter the capital gains taxes. It also can be good for illiquid assets, especially those that generate little or no income. Some types of real estate and private company stock are good examples. The CRT should not be funded with cash, assets with little appreciation, or assets that already are distributing high income to the owner.

Some advisors encourage CRT grantors to have the trust purchase an annuity or illiquid assets. These usually are not appropriate for a CRT. Highly volatile investments also might not be appropriate if the grantor wants regular and dependable income from the trust. Insurance products that convert capital gains into ordinary income probably are not appropriate for a CRT.

Wrong payout formula. Unitrust payouts usually are in the 5% to 7% range. The 7% or higher payout is aggressive. The trust probably won’t earn enough income to make the payout, and in today’s markets might not appreciate at that rate or higher over time. A 4% to 5% payout is best for most CRTs. Otherwise, the annual payouts reduce the principal, and that causes the payouts to decline over time.

Wrong beneficiary. The choice of income beneficiary determines how long the trust will last, and that affects the amount of the tax deduction. Naming a young beneficiary or co-beneficiary reduces the tax deduction. In addition, naming someone other than the donor and his or her spouse as beneficiary results in a gift and possibly gift taxes.

If it is desired to benefit a young person, it might be possible for the grantor to name himself or herself as beneficiary, but name the younger person as successor beneficiary while retaining the right to revoke that designation in the will. That means there is not a completed, taxable gift when the trust is created.

Wrong owned assets. A charitable trust cannot own certain assets without causing problems. Debt financing causes at least part of the trust’s income to be taxed. Real estate with a mortgage, margin in investment accounts, and interests in partnerships that use debt are examples. A charitable trust also cannot participate in a trade or business. Under IRS regulations, this means it cannot own master limited partnerships, oil and gas partnerships, and Canadian energy trusts, among other assets.

Wrong grantor. It costs money to set up a CRT, and there are continuing costs to manage the trust and file tax returns. Someone who does not want to incur those costs should not set up a CRT. The CRT also has limited annual payouts. A CRT grantor cannot receive additional payouts if there are cash needs. There need to be other assets available to pay for life’s surprises or the desires of the grantor, or the grantor is better off not using a CRT. The CRT also cannot make loans to the grantor or anyone related to the grantor.

The grantor also must have a charitable intent, since the trust remainder will go to charity and not to heirs. The front-end tax benefits could be used to buy life insurance to leave an inheritance for the heirs. But the grantor must be aware that a significant part of the trust will go to a charity.

A CRT can provide multiple benefits for the right property owner. It also is fraught with potential pitfalls. A CRT should be customized to a particular situation, and the property owner needs to work with advisors who know the details of the CRT rules.