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Charitable Gifting Strategies II: Split Interest Trusts

By: Investor Solutions

By: Investor Solutions, Inc.

Our first installment on charitable gifting strategies covered the easiest, most basic method of gifting — outright lifetime gifts. This article will give a basic overview of charitable remainder trusts.

The Charitable Remainder Trust (CRT) is one of the most efficient estate planning tools available to anyone holding appreciated assets with low basis like stocks or real estate. Because of the charitable nature of CRT’s, funding this trust with appreciated assets allows the donor to sell the assets without incurring a capital gain.

There are two sets of beneficiaries: income beneficiaries (ie. you and your spouse) and the charities that you choose to name in the trust. Income beneficiaries receive a set income during lifetime and the charities receive the residual principal of the trust at your (or spouse’s) death. Depending on how the trust is set up, the payments will continue for a fixed period of time, or until the death of the beneficiary.

The IRS requires that all CRT’s distribute at least 5% of the trust’s fair market value every year. Income beneficiaries not needing the income during a given year can defer the income through a “make up provision”. High distribution percentages to the income beneficiary will depreciate the principal left for the charity. Therefore, the charitable income tax deduction will be smaller too.

There are two types of CRT’s: charitable remainder annuity trusts and charitable remainder unitrusts. A charitable remainder annuity trust (CRAT) provides a fixed dollar amount with each payment to the beneficiary. This amount corresponds to a percentage of the original investment paid out annually. The amount paid annually to the beneficiary of a charitable remainder unitrust (CRUT) is a fixed percentage of the fair market value of the assets, as determined each year

As a result of the Taxpayer Relief Act of 1997, the trust will not qualify as a CRAT if the annuity for any year is greater than 50 percent of the initial fair market value of the trusts assets or as a CRUT if the percentage of assets required to be distributed at least annually is greater than 50 percent. Any trust that fails this 50-percent rule will be treated as a complex trust and, accordingly, all its income will be taxed to its beneficiaries or to the trust.

Asset transfers into a CRT are considered completed gifts and may reduce the estate tax bill by as much as 55%. Gifts to charities can be unlimited and are not constrained by the $11,000 annual exclusion. CRTs, because they benefit a charity, also qualify you for an income tax deduction that is equal the present value of the remainder interest to the charity.

Who may be the trustee? Anyone. The donor, the income beneficiary, and the charity all can be the trustee. So, too, of course, can a third-party, such as a bank or trust company. There is no restriction against the donor (or grantor) serving as the trustee and the income beneficiary. And although the trust is irrevocable, the donors may change the charitable beneficiaries at any time.

Since the CRT will eliminate any testamentary disposition of property to the donor’s heirs, it may be desirable to replace the value of the asset contributed. The use of an irrevocable life insurance trust in conjunction with a charitable remainder trust could replace the asset’s value for the heirs.

Charitable remainder trusts provide investors an efficient way to transfer appreciated property, benefit from the charitable income tax deduction, and reduce estate taxes while still reaping the benefits of the underlying assets for income purposes. Next up, charitable lead trusts.

Want to make sure your IRA money gets disbursed exactly as you had hoped after you die? How would you feel if an unplanned recipient, like your spouse’s future husband, inherited your hard-earned dollars? It would be enough to make you turn in your grave!

The fate of your IRA after your death rests squarely on the beneficiary designation you assigned during life. No will or estate-planning document can negate the beneficiary designation that you’ve assigned. Naming a Trust as beneficiary of your IRA is an excellent way to control the disposition of your IRA assets.

Let’s face it, the days of “Leave it to Beaver” are over. With the divorce rate in the U.S. hovering at 50%, today’s families are more mixed than ever, increasing the need for careful planning. If you get divorced, then remarry, how can you be sure that your kids from the first marriage don’t get cut out?

No doubt the IRA owner will want to provide for his current spouse. But, just naming those children as contingent beneficiaries won’t cut it. Listing the spouse as primary beneficiary gives her the power to rollover the husband’s IRA and start her own, cutting the kids out of the inheritance. Or, she can deplete the whole account during her life, also leaving the children with nothing. In a case like this, a trust is the most effective way to avoid these planning disasters; ensuring both your kids and your spouse will get the financial provisions you wanted them to have.

Specifically, a Qualified Terminable Interest Property Trust (QTIP) is a good choice if you want to support your surviving spouse but you want control over investments and disposition of assets. The surviving spouse must be the only beneficiary of the trust during your lifetime. The trust must distribute all income to the spouse and the spouse cannot invade the principal. This ensures that your children (or other beneficiary) can get the remainder. An advantage to this method is that it allows estate taxes to be deferred until the death of the second spouse while giving you, the owner, control over final disposition.

Using a trust as IRA beneficiary may also be a good way to minimize estate taxes. Someone holding substantial assets in an IRA can also use an irrevocable bypass trust to take advantage of the uniform credit ($1 million in 2003). If you leave property to someone in the form of a bypass trust, that property will not be subject to estate taxes when that person dies. A bypass trust is particularly useful for spouses who plan their estates together. By leaving property to each other in bypass trust form, they can guarantee that the property will only be taxed once between the two of them. For instance, $1 million of the IRA can fund the bypass trust (ie. for the children) and the balance can go to directly to the spouse (unlimited marital deduction), thus eliminating any estate tax.

Naming a trust as IRA beneficiary is imperative if your heir is a minor. In a situation like this, the IRA owner can leave the management duties to a trustee. The trustee would also be responsible for annual distributions of the required minimum distributions. And the child is, therefore, unable to invade the IRA but is still adequately provided for.

Finally, if you intend for your IRA to go to an adult who may be vulnerable to lawsuits (ie. a daughter who is a doctor), it would be appropriate to list a trust as beneficiary. Assigning an independent trustee for the trust affords a measure of protection from creditors, since the adult heir has no direct control of the IRA assets.

How This Effects RMD

It used to be that naming a trust as beneficiary had a negative effect on required minimum distributions (RMD). Because a trust is a nonliving entity, the life expectancy of a trust is zero. This forced RMD’s to be larger and quicker. Not good if you’re trying to defer taxes.

But a legislative change in 1997 has allowed the IRA to “look right through” the trust and use the life expectancy of the trust’s oldest primary beneficiary to determine minimum distributions. This change effectively made the distribution pattern of the IRA longer for the account owner. Contingent beneficiaries are ignored for purposes of determining the distribution period.

There are certain technical requirements for the “look through” to be valid:

  • Trust must be valid under state law
  • Copy of trust must be given to trustee
  • Trust must become irrevocable at your death
  • All beneficiaries must be identifiable
  • The beneficiaries are individuals (not organizations)

If, however, the primary beneficiary of the trust (say, the spouse) disclaims the trust assets to the younger contingent beneficiaries (the children), the law allows the longer life expectancy of the younger beneficiary to be used when the IRA owner dies before his RBD.

Some Disadvantages

If your primary objective is to defer income taxes as long as possible, naming a trust as IRA beneficiary is a bad idea. A stretch IRA (also known as legacy IRA or multi-generational IRA) uses the strategy of naming a younger IRA beneficiary in order to extend your IRA’s tax-deferred growth as far into the future as possible. However, where the spouse is an income beneficiary of the trust, it is not possible to achieve continual deferral of the IRA over the lives of the children who may be listed as contingent beneficiaries.

For married individuals, naming a trust as beneficiary means that your spouse cannot automatically rollover the IRA into his/her name at your death. This is a tremendous disadvantage if your objective is to defer the income taxes as long as possible. Remember that a rollover is a big perk for the spouse, because a new distribution pattern can be established.

Also, funding a trust with IRA money means a transfer of pre-tax dollars. For instance, if you bequeath $1 million of your IRA into the trust, it’s really $1 million less taxes owed on the IRA.

IRA’s are often people’s biggest asset. While it may not seem like a significant decision when you are younger or still working, your choice of beneficiary for your IRA can have a huge impact on your tax bill, your heirs, your distributions….your intended plans.

Naming a trust as beneficiary of your IRA may be an effective way to control the disposition of your assets and minimize taxes. But, it’s not a solution for everyone.

Nobody said that planning for your death was a fun job! Estate planning is a very complex process. You’ve worked a lifetime for the assets you own. The only way to make sure that your loved ones are cared for in the way you intended after your death is to get some professional help. Consult with a qualified estate-planning attorney to set up a plan that makes sense for you! Because after you’re dead, it will be too late.