By Cowles Liipfert

Creating CRTs

Charitable Remainder Trusts can be useful tools to avoid or to postpone capital gains tax on the sale of appreciated assets, for someone who wants to make a charitable gift after the termination of the trust.  A person (the trust “grantor”) creates a trust which pays a stream of distributions each year to one or more beneficiaries (the “income beneficiary”) for life or for a term of years, after which the trust terminates and the remaining trust assets are distributed to a tax-exempt organization or organizations (the “remainder beneficiary”). Since the remainder beneficiary is a charitable organization, any capital gains which are retained in the trust are not subject to capital gains tax.   

There are two types of charitable remainder trusts, called  Charitable Remainder Annuity Trusts or CRATs and Charitable Remainder Unitrusts or CRUTs.  A CRAT pays fixed distributions to the income beneficiary based on the original value of the trust assets, whereas a CRUT adjusts the distributions each year to reflect any increases or decreases in the value of the trust assets.

Example: $1,000,000 in assets are transferred to a charitable remainder annuity trust, or CRAT. The Grantor is to receive 5% of that value, or $50,000, per year, until the trust terminates. The income beneficiary frequently is a married couple and the trust term may be for their joint lifetimes and for the lifetime of the survivor.  If the trust is funded with appreciated assets, no capital gains tax will be payable upon the sale of those assets.  If the assets are worth $1,000,000 at the time of the gift and if they are sold for that amount, assuming that they were originally acquired for $100,000, the trust would not pay income tax on the $900,000 capital gain when the assets are sold.  In addition to avoiding capital gains tax at that time, the grantor gets a charitable deduction on his or her income tax return for the value of the charitable remainder interest, calculated by Treasury actuarial tables applicable when the contribution to the trust is made.  When the trust terminates – often after the death of the second spouse to die, the remaining trust assets are paid to a tax-exempt organization or organizations (the “charitable remainder beneficiary”) as set forth in the trust agreement.

A charitable remainder “unitrust” or CRUT is similar to an annuity trust, except that the distributions are adjusted annually, to reflect any increase or decrease in the value of the trust assets.  If a 5% Unitrust was originally funded with $1,000,000 in assets, but grows in value to $1,100,000, the unitrust distributions for the following year would be 5% of the new value, or $55,000. This is different from a CRAT or annuity trust, for which the distributions would remain the same, even if the value of the trust assets increases or decreases.

Please note that the distributions from a CRT to the income beneficiary are taxable, to the extent that (a) the trust has taxable income, including capital gains, and/or (b) the trust had , in previous years, taxable income which has not been distributed to the income beneficiary.  The trust cannot avoid income tax by investing in tax-free bonds until all taxable income has first been distributed, which makes this strategy impractical.

The general rule is that a CRAT or CRUT is required to distribute at least 5% annually, but there are exceptions for certain types of unitrusts.  For example a “net income” CRUT (sometimes called a NICRUT) is not required to distribute more than its net income, and a “net income” CRUT with makeup provisions” (sometimes called a NIMCRUT) may make up income arrearages from past years (i.e., from years in which the trust was allowed to distribute less than the unitrust percentage), until the excess distributions have caught up with those arrearages. Thus a 5% NIMCRUT which earns only 1% in a given year would distribute only 1% currently and would accrue a 4% arrearage, which may be distributed only from excess income in subsequent years, i.e., income in excess of the 5% unitrust percentage.  If 7% income is earned in a subsequent calendar year, the 2% overage for that year in excess of 5% may be distributed to the income beneficiary as a make-up distribution.

There are certain types of investments which enable the trustee to have some control over the realization of taxable income of a trust, in which case the trustee may minimize taxable income in one year and maximize taxable income in another year.

Exiting CRTs

Occasionally someone creates a CRT which he or she later desires to exit. Circumstances can change over time, and sometimes there is an unanticipated major life event, which causes a change of mind.  The trust itself is irrevocable, but there are alternatives which permit an income beneficiary of a CRT to obtain a more suitable result.

Let us suppose that the spouse of the trust grantor unexpectedly dies and later the grantor remarries and wants to make the new spouse an income beneficiary. Since the original trust was irrevocable, it cannot be changed to substitute the new spouse as a replacement beneficiary.  In that case the grantor may want to exit the original trust in a manner permitted by law and to enter into a new trust agreement under which the new spouse is an income  beneficiary.

There are several alternative methods for exiting an existing charitable remainder trust:

1. Temination of a CRT.  One option is for the trustee simply to terminate the trust, in which case the trust assets must be divided between the charitable beneficiary and the income beneficiary strictly according to Treasury actuarial tables, following procedures established by the IRS. Care must be taken to avoid “self-dealing” under Code Section 4941, which could subject the trust to severe penalties.

• Sale of income interest.  Another option would be for the income beneficiary to sell the income interest in the trust to a third-party buyer. An important benefit from this alternative is that it frequently results in getting more money to the income beneficiary than would be received in a straightforward trust termination.  Please note that the income interest in a CRT is considered a capital asset for income tax purposes, and if the sale of that capital asset results in a higher price than the actuarial value of that asset under the Treasury actuarial tables, there would be a taxable capital gain for the income beneficiary.

The original CRT would continue to exist under this alternative, under the same terms and conditions, but with a different income beneficiary – but please be aware that if the original term of the trust was measured by the life of the original income beneficiary, there would be no change in the term of the trust and the original income beneficiary’s life would continue to be the measure for the remaining term of the trust. 

The proceeds received by the income beneficiary from the sale of the income interest could be contributed to a new charitable remainder trust if the Grantor so desired, with income tax benefits applicable to a new CRT, but the new trust would be scaled down in size as compared to the original trust unless additional assets were added to the new trust.  The new trust could have different beneficiaries than the original trust, such as a spouse by a second marriage or other family members.     

• CRT Rollover.  A third option could be a charitable remainder trust “rollover,” where the income beneficiary rolls over his or her income interest to a new CRT.  Initially, the new CRT would have no assets other than the right to receive unitrust distributions from the old trust, which would continue to exist.  However, an important benefit of this alternative is that the income interest from the old trust can be sold by the new CRT to a third-party buyer, and if the sale price is higher than its actuarial value under the Treasury tables, there will be no capital gains tax on the sale of that income interest, as long as the gain is retained by the trust.  The proceeds of sale could be invested by the new CRT differently than the assets of the old trust, which investment strategy may be more appropriate for the new trust.  The income beneficiary from the old trust would be the grantor of the new CRT and would get income tax benefits applicable upon the creation of a new CRT.  New beneficiaries could be named for the new trust.   

The original CRT would continue to exist and the charitable beneficiary would still receive the remainder distribution on termination of the trust under the original terms of the trust.  Please note that if remaining term of the old trust was based on the measuring life of the original income beneficiary, that same person’s life would continue to be the measuring term for the old trust, even if that person is no longer receiving the unitrust distributions from the old CRT.

• Distribution to charitable beneficiary.  Lastly, an income beneficiary who no longer needs or wants the income distributions from the CRT may want to terminate his or her trust by giving the income interest to a charitable remainder beneficiary.  If that is done, then the charitable remainder beneficiary would own both the income interest and the remainder interest, and the trust could be terminated.  A beneficiary who gives his or her income interest to a charitable organization will get a charitable deduction for giving that income interest to charity, based on the value of the income interest under the Treasury actuarial tables at the time the trust is terminated.

Charitable remainder trusts often last for one or more decades.  Although the original reasons for creating the trust were presumably valid at the time the trust was created, circumstances can change over time.  Whatever the reason for the exiting a CRT, the procedure is complicated and in some states may even require court action.  You need to consult with an experienced professional to discuss your situation and to determine the best option available for you.