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The Retirement and Estate Planning Benefits of Charitable Remainder Trusts

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The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13.61 million.

For individuals that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the estate and gift tax. One method that may potentially be utilized to plan for the estate and gift tax are private annuities. This article discusses how charitable remainder trusts may be utilized to avoid the estate and gift tax.

This article discusses how a charitable remainder trust (“CRT”) works. In the case of a CRT, a donor transfers property to a trust, and then one or more noncharitable beneficiaries receive a specified amount each year from the trust for a term. At the end of the term, the charity gets the remaining trust assets. The advantages of a CRT include: 1) an income tax charitable deduction on transfer of property to the trust; 2) tax-free sale of appreciated property by the trust; 3) tax-free accumulation of income inside the trust; and 4) deferral of income taxation to the individual beneficiary until the income or gain is actually received by the beneficiary. Disadvantages include 1) tying up the property transferred to the trust; 2) application of certain private foundation rules to the trust; and 3) primarily, permanent loss of the property to the family (except to the extent of the annuity or unitrust payments).

Types of Charitable Remainder Trusts

Charitable Remainder Annuity Trusts

A charitable remainder annuity trust (“CRAT”) pays the noncharitable beneficiaries an annuity of a specific dollar amount, which may be stated in the trust’s governing instrument as such or as a percentage of the initial value of the trust.

Charitable Remainder Unitrusts

All charitable unitrusts (“CRUTs”) require an annual payout to the noncharitable beneficiary, which is wholly or partially based on a percentage of the value of the trust determined annually (i.e., a noncharitable percentage). A fixed percentage CRUT pays the individual beneficiary an annual amount equal to the noncharitable percentage.

Income Exception Trusts

NIOCRUT: Net income only CRUT. A net income only charitable remainder unitrust (“NIOCRUT”) provides that the unitrust amount payable to the individual beneficiary in any year will be limited to the lesser of: 1) the noncharitable percentage or 2) the net income of the trust in the year, as determined for trust accounting purposes.

NIMCRUT: Net income makeup CRUT. If the trust contains the NIOCRUT definition of the unitrust amount, but also contains a provision saying that a shortfall in the noncharitable percentage amount in any year can be made up from income earned in excess of the noncharitable percentage amount in a subsequent year, it is known as a net income with make up charitable remainder unitrust (“NIMCRUT”).

FLIPCRUT: Flip Unitrust

A “flip unitrust” (“FLIPCRUT”) is a unitrust that begins as a NIMCRUT or NIOCRUT and, after a trigger event, flips to a fixed-percentage CRUT. The governing instrument of a FLIPCRUT provides that, on a permissible triggering event, the FLIPCRUT will convert to the fixed percentage method for calculating the unitrust amount. The income tax regulations include a number of examples of permissible and impermissible triggering events. See Treas. Reg. Section 1.664-3(a)(1)(i)(e). For example, permissible triggering events with respect to any individual include marriage, divorce, or birth of a child. See Treas. Reg. Section 1.664-3(a)(1)(i)(d). The CRT’s sale of an unmarketable asset, such as real estate, is also a permissible triggering event. Examples of impermissible triggering events include the sale of marketable assets and a request from the unitrust recipient or the unitrust recipient’s financial advisor that the trust convert to the fixed percentage method. See Treas. Reg. Section 1.664-3(a)(1)(i)(e). “Unmarketable assets” are assets other than cash, cash equivalents, or assets that can be readily sold or exchanged for cash or cash equivalents. For example, “unmarketable assets” include real estate, closely held stock, and unregistered securities for which there is no available exemption permitting public sale.

The conversion to the fixed percentage method must occur at the beginning of the taxable year that immediately follows the taxable year in which the triggering date or event occurs. Any make-up amount in a NIMCRUT is forfeited when the trust converts to the fixed percentage method. The only type of permissible conversion is from an income-exception CRUT to a fixed-percentage CRUT. Thus, a CRAT cannot convert to a CRUT without losing its status as a CRT. Similarly, a CRUT using the fixed percentage method cannot convert to an income exception method without losing its status as a CRT.

Structure and Operation of Trust

Certain documentary and operational requirements and choices apply.

Governing Instrument

The trust instrument is required to contain some provisions, permitted to contain others, and prohibited from containing others. Detailed requirements and rules for CRTs exist under Internal Revenue Code and its regulations.

Annual Payout

In all cases, the annuity annuity amount payable from a CRAT must be at least 5 percent and not more than 50 percent of the initial value of the trust assets, and the noncharitable percentage of a CRUT must be at least 5 percent of the annual value of the trust assets.

Trust Term

The trust can be (1) a term of years (not exceeding 20 years); (2) a term measured by the life or lives of the designated recipients (who must be in being at the creation of the trust); or (3) a term defined as the shorter of a term of years (not exceeding 20 years) or the life or lives of the designated recipients. At the end of the term, the CRT’s remaining assets pass to charity or continue in trust for charity.

Income Tax Deduction to Donor

Amount of Deduction

If the donor transfers real property or intangible property (e.g., stocks, bonds, cash, etc) to a CRT, the donor is entitled to an income tax charitable deduction in the year of transfer equal to the actuarially determined value of the charity’s remainder interest in the trust. If tangible personal property is donated to a CRT, the charitable deduction is allowed when the property is sold to an unrelated party (that is, a party who is not a related person within the meaning of Internal Revenue Code Section 267(b) or Internal Revenue Code Section 707(b)) or the noncharitable period ends, whichever comes first. See IRC Section 170(a)(3).

The amount of the income tax deduction is ordinarily determined using the actuarial tables found in the income tax regulations. The factors determining the amount of the charitable deduction will generally be: (1) the length of the noncharitable term; (2) the amount of the noncharitable payment; and (3) the applicable 7520 rate. (The 7520 rate is 120 percent of the applicable federal midterm rate, rounded to the nearest two tenths of one percent). However, with respect to the amount of the noncharitabe payment, the value of the charitable remainder of a NIMCRUT and NIOCRUT is calculated in the same manner as that of a CRUT.

Income Taxation of CRT

A CRT is exempt from income tax unless it has any unrelated business taxable income in any year. If it does, all of the CRT’s income for that year is fully taxed under the complex trust rules, except that the CRT rules still apply to the characterization of trust distributions.

Deferral or Avoidance of Capital Gains Tax on Sale of Appreciated Property

The most common time to consider a transfer of property to a CRT is when the prospective donor is contemplating a sale of highly appreciated property. In lieu of selling the property and paying tax on the gain recognized, the donor can transfer the property to a cRT and let the CRT sell it. In order for the donor to avoid being taxed on the property’s appreciation when the sale occurs, the transfer to the CRT must occur before the donor acquires a right to the income from a specific sale of the property. Thus, a donor can make a transfer of appreciated property to a CRT, the CRT can then sell the property, and the CRT will realize the gain attribution to the property’s appreciation. This sale does not generate a tax for the donor or other noncharitable beneficiary, nor does it generate a tax for the CRT, because the CRT is tax-exempt. Taxable gain from the sale of the property however will be recognized by the noncharitable beneficiary as that beneficiary receives trust distributions of the gain during that noncharitable term.

Use of NIMCRUT AS RETIREMENT PLAN

A NIMCRUT is sometimes used as a substitute for a retirement plan. The idea is that the trustee in growth-producing assets during the donor’s working years, makes few or no distributions, and accumulates gains tax-free. Then, when the donor retires, the trustee will invest in income-producing properties to fund the donor’s retirement, and will use the makeup provision to make larger distributions than would have been possible with a fixed-percentage CRUT. Below, please see Illustration 1 which demonstrates how a NIMCRUT can be used as a retirement plan.

Illustration 1.

Donor transfers low basis land to NIMCRUT with 8 percent payout. Trustee sells land and invests proceeds in growth stocks that pay low or no dividends. Donor retires at age 65. Trustee sells stocks and reinvests in high-yielding bonds. Donor begins receiving an 8 percent annual payout. He can also receive any excess trust income to make up for the previous years in which he did not receive his full 8 percent payout.

One practical difficulty with using a NIMCRUT as a retirement plan is that it does not work well unless the trust’s investments meet certain performance expectations. For example, in the above illustration, the market for the CRT’s stocks may be down when the owner is 65 years old, and liquidating the stocks at that time might be equivalent to a so-called fire sale. In order to plan for this issue, various plans have evolved to fund the NIMCRUT with assets that by their nature, grow in value for a while and then start generating trust accounting income.

Investment in Deferred Annuities

A deferred annuity earns money for a time, and begins to make payments to the annuitant after the deferral period. The NIMCRUT is drafted to provide that the inside buildup of the annuity value is treated as trust accounting income only when annuity payments are made to the CRT; in order to be effective, such a provision must be valid under state law. Normally, a deferred annuity’s inside buildup would be taxable on an annual basis to a trust owner. See IRC Section 72(u). However, the income inside the annuity contract held by a NIMCRUT builds up tax-free, despite Internal Revenue Code Section 72(u), because the NIMCRUT itself is not taxable. Consequently, the NIMCRUT may not need to distribute anything to an individual beneficiary until the trustee actually takes distributions from the annuity, as there will be no trust accounting income until that time. When the donor retires, the NIMCRUT can make withdrawals from the annuity and distribute them to the donor.

Gift Tax

If the noncharitable beneficiary is anyone other than the donor and/or his U.S. citizen spouse, the creation of the CRT will normally result in a taxable gift of the value of the noncharitable beneficiary’s interest. However, retention of a testamentary power to revoke the interest will avoid a completed gift to the beneficiary whose interest is subject to revocation until the right to revoke expires, or, if earlier, the noncharitable beneficiary receives payment from the trust.

Estate Tax

On the donor’s death, any noncharitable beneficiary’s interest (to the extent that it extends beyond the donor’s life) will be included in the donor’s estate pursuant to the rules on revocable or amendable interests.

Asset Replacement Plan

A typical plan involving a CRT is as follows. Establish a CRT, claim the available income tax charitable deduction, and use the income tax savings to acquire life insurance in an irrevocable life insurance trust for the benefit of the family, thus replacing part or all of the assets passing to charity from the CRT. If the CRT qualifies for a marital deduction or if the CRT terminates at the donor’s death, zero estate tax will be paid with respect to the life insurance or the CRT assets. However, estate tax will be assessed on any unconsumed distributions from the CRT. Under certain circumstances, an asset replacement plan can be an effective estate planning tool. Below, please see Illustration 2 which demonstrates how a replacement plan can be an effective tool for estate planning.

Illustration 2.

Donor has assets of $100,000,000. He dies. Estate tax is $40,000,000. His children receive the after-tax amount of $60,000,000. Suppose, instead, that Donor establishes a CRT, transfers the $100,000,000 to it, claims an income tax charitable deduction, and uses income tax savings to fund an irrevocable life insurance trust, which purchases a $100,000,000 life insurance policy on Donor. He dies the next day. Charity will receive $100,000,000, and children will receive $100,000,000.

Conclusion

A CRT is a legal entity that allows donors to donate assets to charity while still receiving income for themselves or a named beneficiary. CRTs can be a valuable retirement and estate planning tool. Donors can even receive a valuable charitable deduction for the contribution to the CRT. CRTs should be a consideration in any complex estate tax plan.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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