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A Matter of Trust

CRTs provide an ideal mechanism for transferring highly appreciated assets in an estate.

By Richard A. Dulisse, CLU, MSFS, LUTCF

Successful individuals are seeking tax-favored methods of receiving income and distributing property. These clients frequently hold assets that have greatly appreciated in value beyond their original price. Their sale, for the purpose of realizing additional income or diversifying an investment portfolio, can unwittingly result in costly capital gains taxes. The charitable remainder trust (CRT) can remedy this situation. The transfer of highly appreciated property to a CRT offers the grantor/donor the opportunity to:

  • maximize current income
  • avoid capital-gains taxation
  • minimize estate taxation

When established simultaneously with the sale of life insurance, the charitable remainder trust can also maximize property left to one's heirs.

The difference between the annuity trust and the unitrust lies in the calculation of the annual payout to the income beneficiary.

The CRT begins with the premise that property can be divided into two interests: an income interest and a remainder interest. Utilizing a CRT enables the donor to name a beneficiary who will receive income from it for his or her lifetime, or a period of no longer than twenty years. At the end of the income period, the remaining trust principal is given to a qualified charity. Despite recent tax-law changes, the CRT remains the only planning device that allows the donor to retain the income earned from donated property for himself or another non-charitable beneficiary, and immediately take an income-tax deduction for the remainder value of the property given to charity.

There are two types of privately created CRTs: the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT). Both must be established in accordance with IRS guidelines.

A CRAT is designed to pay a fixed amount of money to a named beneficiary each year. The amount of the payout, which is established at the trust's inception and based upon the original value of the assets used to fund the trust, may be expressed as either a fixed percentage of this value or a fixed dollar amount. In either case, the specified payout must be equal to at least 5 percent of the initial value of the assets transferred to the trust and remains constant. Some other rules regarding the CRAT are:

  • The pay-out rate cannot exceed 50 percent of the initial fair-market value of assets placed into the trust.
  • The remainder value passing to the charity must be guaranteed to be at least 10 percent of the property's initial fair-market value.
  • Once created, no additional payments can be made to the CRAT.

A CRAT is useful when the grantor/donor seeks a stable and predictable income from the trust, and the dollar value of the assets transferred to the trust will retain a consistent value.

The difference between the annuity trust and the unitrust lies in the calculation of the annual payout to the income beneficiary. While the CRAT payout is based solely on the initial valuation, the unitrust requires valuation of the trust assets annually. The standard unitrust annual payout is based upon a set percentage of this updated valuation process. The percentage of payout, which is fixed at inception, must be at least 5 percent and no more than 50 percent for post-June 18, 1997 transfers.

However, in contrast to a CRAT, a CRUT may permit additional contributions as long as this provision is spelled out in the original trust document. A CRUT can provide a hedge against inflation and is ideally suited for assets that are expected to increase in value. As the value of the assets appreciate, the income stream rises due to the unitrust annual valuation feature. Once again, as with CRATs, CRUTs must guarantee that the remainder interest passing to the charity be at least 10 percent of the trust property's initial fair-market value.

Tax consequences
CRTs provide an ideal mechanism for transferring highly appreciated assets in a person's estate without incurring realized capital gains income taxation.

In addition, gift taxation can be avoided for two reasons: First the remainder value of the property given to a charity is deductible for gift-tax purposes. And second, as long as the donor or his spouse has retained the income interest from the CRT, it is not deemed to be a gift.

CRTs are normally structured to avoid estate taxation. When the donor establishes a trust during life but retains an income interest, the reversion into the estate of the remainder interest is offset by the estate-tax charitable deduction and thus no estate tax is incurred.

Income taxation of CRTs falls into two categories. First is the issue of calculating the income-tax deduction of the donor's charitable contribution. Second, there is the issue of how distributions from the trust are to be reported and taxed to the income beneficiary of the trust.

Charitable contribution deduction
Property transferred into a CRT is a charitable gift that qualifies the donor for a current income tax deduction equal to the present value of the remainder interest transferred to the charity. The remainder interest is actuarially determined based on mortality factors, interest assumptions and the total value of the property transferred. Once the donor's contribution has been calculated, as represented by the remainder interest, the actual amount of the tax deduction in any year will depend on the applicable limitation rules. As per the Taxpayer Relief Act of 1997, the actual deduction for gifts of long-term capital gain property to a CRT is limited to 30 percent of gross income.

For example: John Smith, age 50, establishes a CRAT funded with $100,000. Annual payments are $5,000. His legal and accounting advisors determine the Applicable Federal Rate (published monthly) is 10.6 percent. Based upon IRS tables corresponding to the annuitant's age and the AFR, John's advisors determine the present value of the annuity to be $43,040. This amount is then subtracted from the $100,000 transferred to the trust, leaving the present value of charitable remainder interest at $56,960. The 30 percent charitable deduction limitation rules are applied to this amount.

Taxation of trust distributions
The CRT can be thought of as a tax conduit that is not usually taxed. The IRS, however, sets up a four-tiered system for determining the taxation of distributions received by trust beneficiaries.

The first tier of income paid out from the CRT is treated as ordinary income, to the extent that the trust has current ordinary income or unpaid accumulated ordinary income from previous years. Once the ordinary income has been paid out, then distributions begin from the second tier. This consists of capital gains from both current and previous years. If all ordinary income and capital gains have been exhausted, distributions begin from the third tier that consists of other income--namely tax-exempt income. The fourth and final tier consists of distributions that are treated as nontaxable returns of principal.

One thing that makes the CRT so exciting is that since the trust itself is tax exempt, the sale of appreciated assets within it does not create an immediate tax liability per se to the donor or the trust. The tax impact to the donor is spread out over many years within the structure of the four-tier tax system.

Wealth replacement trust
CRTs serve the income, gift and estate-tax objectives of the donor. After the death of the income beneficiary, however, the charity becomes the sole owner of the CRT principal. Thus, the donor's estate has been stripped of these assets, which will inadvertently result in the donor's heirs being disinherited to the extent of the assets transferred. A wealth replacement trust (WRT) provides a dollar equivalent to what was given away for the benefit of the donor's family.

A WRT is an irrevocable trust established during the donor's lifetime, and is funded with life insurance that is equal in value to the capital gain type property that went into the CRT. To avoid any inclusion in the donor's estate, the policy is owned from inception by the trust. Assuming that the donor is the sole income beneficiary of the CRT, at the same time that assets are removed from the benefit of his or her heirs, the life insurance proceeds flow into the WRT to replace the lost wealth. Since the proceeds have been held by an irrevocable life insurance trust, they pass to the donor's heirs free of estate taxation.

Wealth replacement insurance, in combination with a CRT, can be used in a variety of sales situations. Together, they create a win-win situation for all parties. The charity gets an eventual donation, the donor gets an immediate tax deduction (which if too large, can be carried forward for five years) that can help pay the life insurance premiums for the WRT. The donor gets a reliable stream of income and the pride of helping a worthy cause. The heirs get the equivalent value of the property given away from the WRT that is funded with permanent life insurance.

Be sure to consult with your advanced underwriting department or proper legal and tax advisors for proper counsel and guidance before recommending a CRT.

Richard A. Dulisse is an LUTC author and editor working for the American College in Bryn Mawr, Pa. His email address is


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