By: John Pitlosh
By: John Pitlosh CFP®, MST
Would you give more money to a charity if:
You could get a deduction for simply pledging assets to your favorite charity after you die?
You could receive an annuity income stream from the assets that you pledge to your favorite charity?
You could pledge and sell highly appreciated assets without immediately paying taxes, and then reinvest the proceeds to produce a larger or more stable income stream?
One of the largest hurdles preventing charitably minded people from making significant gifts to their favorite charity is the uncertainty of their own long term finances. A Charitable Remainder Trust (CRT) affords people the opportunity to give assets to their favorite charity in a manner and timeline that doesn’t undermine their own retirement objectives. A CRT is an irrevocable trust that overcomes the anxiety of making a large gift by splitting the interest of the trust assets between an upfront non-charitable beneficiary who receives an annual income stream from the trust for a certain number of years followed by the eventual qualified charity that receives the remaining interest in the trust once the term for the non-charitable beneficiary has run its course.
A funded CRT must payout income at least annually to a non-charitable beneficiary; however, the amount of annual income that is paid out depends on the type of CRT that is created. There are two primary types of CRT’s: a Charitable Remainder Annuity Trust (CRAT) and a Charitable Remainder Unitrust (CRUT). The primary difference between the two trusts involves how the annual payout is determined. A CRAT will pay out a fixed dollar amount every year based on the initial percentage that was selected when the trust was initially funded. For example, a 10% CRAT funded with $100,000 will pay out $10,000 every year regardless of the trust balance in the future. On the other hand, a CRUT determines its payout based on the value of the trust assets at the beginning of each year; so if the CRUT’s assets increase or decrease for the given year, so will the payout for that specific year. If an individual is looking for a more conservative approach to pulling out money, then they would favor the CRAT structure as the income will be the same amount every year. If an individual is looking to grow the income stream into the future then the CRUT structure makes the most sense because revaluing the payout will take into account future growth, which helps the annuity keep up with inflation.
Sizing up the Deduction:
Because the non-charitable beneficiary is receiving an income stream upfront, the donor will not receive a full charitable deduction for funding the CRT. Instead, the donor will receive a deduction based on the present value of what is expected to be left behind after the annuity income has run its course. The value of the charity’s remaining interest in the trust is determined by a calculation using specific actuarial factors. Besides the type of CRT that is being used, there are other key factors influencing the size of the deduction including:
- The term of the annuity stream – The longer the annuity stream is likely to benefit a non-charitable beneficiary, the lower the projected deduction will be. The donor has the option of choosing a single life expectancy, joint life expectancy, or specifying a number of years, but that term cannot exceed 20 years.
- The size of the annual annuity payout – Whether the annuity stream is based on the initial valuation (CRAT) or an annual revaluation of the trust assets (CRUT), the higher the percentage payout is to the non-charitable beneficiary, the more it will reduce the size of the charitable deduction. In order to qualify for the deduction, there are regulations stating the annual payout must be between 5% and 50%.
- IRC Section 7520 rate – The 7520 rate is essentially 120% of the federal mid-term rate. This rate is put out monthly by the IRS, and it is used to value charitable interests in trusts like charitable remainder trusts. The only thing someone considering a CRT needs to understand is that the higher the 7520 rate is, the larger the deduction will be if all other factors are equal. As a result, if a donor is trying to maximize their income stream or deduction, they will get more out of the CRT if interest rates are high.
Unlike deductions for outright charitable gifts, CRT gifts do not require the donor to obtain a corroborating written acknowledgement of the contribution by the donee organization. In addition, the donor may reserve the right to change the remainder beneficiary, but that right must be restricted to only “qualified charities” (described in IRC Section 170(c)).
One of the key planning features of a CRT is its general exemption from income tax. Because there is no immediate recognition of gain on the sale of the appreciated property inside the CRT, it is common practice for a CRT to be funded with highly appreciated property. This gives the donor the opportunity to defer the recognition of gain and diversify the investments into something more appropriate for generating income. When a distribution by a CRT is made to the non-charitable beneficiary, the beneficiary receiving the distribution must characterize the distribution for tax purposes under a special regime applicable only to CRTs. In general, distributions are characterized based upon a four tier system that filters distributions in the order of highest rate of tax are deemed to be distributed first.
In a world where nest eggs are on the mend and tax rates are on the rise, a CRT can be a useful tool for charitably minded individuals looking for a way to give to their favorite charity without sinking their own retirement. While there are a lot of benefits associated with using a CRT to give to charity, the donor needs to recognize that their pledge is irrevocable and that they will lose all rights to the residual interest in the property once they fund the trust. That said, a well thought out and well executed charitable remainder trust can provide the cake for years to come for both you and your charity.