Recently, a client, whom I will call Mr. Jones, contacted me to prepare his estate plan. Of all Mr. Jones’s assets, one asset in particular caught my attention. Mr. Jones owned an undeveloped parcel of land in a desirable location which he acquired a number of years ago for $50,000 and was now worth about $350,000.
In probing further into Mr. Jones’s intentions with respect to his appreciated parcel, I learned that he had no immediate plans for the parcel – he wasn’t planning on developing the land nor was he inclined to immediately sell the land. However, the land did play a role in Mr. Jones’s retirement planning. At some time before his retirement (anticipated in about ten years), Mr. Jones planned on selling the parcel and investing the proceeds in an income producing asset. The income generated would supplement Mr. Jones’s other retirement income.
At this point in the discussion, I explained to Mr. Jones the substantial capital gain that would result from the sale of his parcel of land. In fact, had Mr. Jones sold the parcel of land, his federal tax liability, on the sale alone, would be about $84,000. And this figure does not take into account the tax liability associated with any future appreciation.
It appeared that the only way for Mr. Jones to avoid this capital gain would be for him to own the parcel of land until his death. At that time, Mr. Jones’s heirs would receive the asset with a stepped-up basis, allowing them to sell the parcel without having to pay a capital gains tax.
Since holding the parcel until his death was inconsistent with Mr. Jones’s retirement planning, we discussed another method of avoiding the capital gains tax. I explained to Mr. Jones that there is a way for the parcel of land to be sold without triggering the capital gain. Furthermore, it would be possible for the sale proceeds to be reinvested in income producing assets, thereby achieving Mr. Jones’s retirement income plan. This method that I was suggesting was a charitable gift of the parcel. Actually, I was suggesting a charitable remainder trust.
At this point, Mr. Jones informed me that although he considered himself a generous person, it was essential that any planning take into account his needs first then those needs of his children. This is when I explained to Mr. Jones how a charitable remainder trust could provide a current benefit to him and a testamentary benefit to both a charity of his choice and his children.
Charitable Remainder Trust
A charitable remainder trust, or “CRT,” is a trust established by an individual to provide someone of his or her choosing (usually him or herself or a family member) with current income, followed by a gift of property to a charity of his or her choice. Typically, an appreciated asset is transferred to a CRT, which sells the asset and invests the sale proceeds. Some or all of the investment income is distributed to the income beneficiary and the property remaining, after the income interest terminates, is distributed to a charity.
So long as the tax rules applicable to CRTs are complied with, which will be discussed below, the trust itself will be tax exempt. Therefore, the trust will not recognize a capital gain when it sells the donated asset. This provides a tremendous benefit to someone who, like Mr. Jones, is relying on the investment income generated by his donated property and would like the full sale proceeds of his asset, not diminished by a capital gains tax, reinvested.
Two Types of Charitable Remainder Trusts
The Internal Revenue Code (the “Tax Code”) recognizes two types of CRTs – the annuity trust and the unitrust. Actually, both trusts are very similar. The primary distinction between the annuity trust and the unitrust is that the annuity trust must pay the income beneficiary, at least annually, a fixed sum based upon the value of the property when it was contributed to the trust. The unitrust, on the other hand, must pay the income beneficiary, at least annually, a fixed percentage of the trust’s assets, re-valued annually.
Specific Requirements of Charitable Remainder Trusts
Like other trusts, the interests in a CRT are divided into an income interest and a remainder interest. With a CRT, the donor names a non-charitable person or entity as the income beneficiary and the charity of his or her choice as the remainder beneficiary.
The Tax Code sets forth many specific requirements for a trust to qualify as a CRT. One such requirement is the minimum distribution rule. A charitable remainder annuity trust must distribute, to the income beneficiary, at least five percent of the value of the contributed assets. For the unitrust, at least five percent of the property’s value, re-valued annually, must be distributed.
The unitrust, however, can limit its distribution to the actual income that it earns in a given year. This provision makes the unitrust more attractive for the donor who wants to defer his income interest. For example, a donor could contribute stock in a closely held business to a unitrust. The donor, to the extent he controls when, and if, the corporation pays dividends, will be able to control the income earned by the trust. When the donor desires income from the unitrust, the corporation could declare a dividend or the trust could sell the stock and invest the sale proceeds in an income producing asset.
Another requirement for CRTs concerns the term of the income interest. The income interest can continue for the life of an individual who is alive when the trust is established, or for a term of up to 20 years. The Treasury Regulations provide several examples of the different permissible combinations of life and term income interests. If properly structured, the CRT can name multiple or successive income beneficiaries. For example, the income interest could last for the joint lives of a husband and wife.
A CRT, once established, must be irrevocable. The grantor, however, can reserve the right to change the charitable beneficiary. In fact, the trust should have some flexibility to accommodate a situation where the named charitable beneficiary is either no longer in existence or is not a qualified charitable entity when the remainder interest is to be distributed.
Income Tax Implications of the CRT
The individual making a charitable gift through a CRT will be entitled to an income tax deduction for making a charitable contribution. The amount of this contribution, and thus the income tax deduction, is determined under IRS tables and is based upon several factors, including the donor’s age or the term of the income interest, and the stated amount or percentage of the income interest.
While the CRT is considered a tax exempt entity, and will generally not recognize taxable income or capital gains, its distributions are generally taxable to the income beneficiary. The following ordering rules determine the taxation of distributions from a CRT: (i) distributions are considered taxable ordinary income to the extent the trust has current income or undistributed income from prior years; (ii) distributions are then considered capital gains to the extent the trust has capital gains in the current year or undistributed capital gains from prior years; (iii) distributions are next considered tax exempt income to the extent the trust has current tax exempt income or undistributed tax exempt income from prior years; and (iv) any additional amount distributed is considered a tax-free return of the donor’s contribution.
Gift Tax Implications of the CRT
In a typical CRT, the donor will name him or herself as the income beneficiary. This structure does not result in a taxable gift.
Where the donor names another income beneficiary, a taxable gift may have been made. If that other income beneficiary is the donor’s spouse, the gift will generally qualify for the marital deduction and no gift tax will result. However, except for some limited exceptions, the donor’s spouse must be the sole income beneficiary to qualify for the marital deduction.
Alternatively, if the named income beneficiary is not the donor’s spouse, a taxable gift has been made. If the income beneficiary has an immediate right to enjoy the trust income, the taxable gift is subject to the donor’s annual exclusion and is only subject to gift tax if the value of the income interest exceeds $10,000, or $20,000 when the donor’s spouse joins in the gift.
Estate Tax Implications of the CRT
The estate tax implications of a CRT will depend on the specific terms of the trust. If the donor retains the income interest for his or her life, and there is no surviving income beneficiary, then the remainder interest is includible in the donor’s estate. The amount that is includible in the donor’s taxable estate, however, will be offset by a charitable deduction.
If the donor has given the income interest to another person, although there may be a gift tax due for this gift, the income interest is generally not included in the donor’s taxable estate. However, if the donor has retained the right to revoke the income interest, the income interest will be includible in the donor’s taxable estate and the estate tax charitable deduction will be reduced by the value of the income interest. This result will also apply where the donor has terminated this revocation power, but dies within three years of such termination.
Replacing the Donated Asset
Since the CRT will eliminate any testamentary disposition of property to the donor’s heirs (other than a potential continuing income interest), it may be desirable to replace the value of the asset contributed. A life insurance policy can often be used as an asset with which to replace a donated asset. When life insurance is used in such a manner, the donor’s heirs are provided with the insurance proceeds, while the charity receives the CRT property.
In the case of my client, Mr. Jones, a $350,000 life insurance policy on Mr. Jones’s life could be purchased, naming his children as the beneficiaries. When Mr. Jones dies, the charity will receive the assets in the trust and Mr. Jones’s children will receive the life insurance proceeds.
Whether Mr. Jones devises the parcel of land to his children or names them as the beneficiary of his life insurance policy, the children will be in the same economic position. If they inherit the parcel, the children will be able to sell the same and share the $350,000 sale proceeds, unreduced by a capital gains tax. Alternatively, the children could receive and share the $350,000 insurance proceeds.
In order for the asset replacement strategy to work, the life insurance policy should be a type that allows the owner to increase the death benefits. This way, the anticipated insurance proceeds can be increased to reflect the appreciation in the value of the asset that was contributed to the CRT. There are many types of whole life policies that will allow sufficient flexibility in selecting the amount of the death benefit. A qualified life insurance agent should be able to match the proper policy with the donor’s needs.
Another issue that should be addressed when replacing an asset that was contributed to a CRT with a life insurance policy, is the payment of future premiums. It is possible for the donor to use the tax savings resulting from the charitable contribution, and the cash flow provided by the CRT, to pay the premiums on the life insurance policy.
Finally, if it desirable to remove the life insurance policy from the donor’s taxable estate, an irrevocable life insurance trust should be considered. Under the Tax Code, if the donor owns the life insurance policy, or is deemed to have “incidents of ownership” in the policy, the death proceeds will be includible in his or her taxable estate, thus undermining any estate tax planning involved in establishing the CRT. This undesirable result can be eliminated by establishing an insurance trust to own the life insurance policy.
The CRT can be an important tax planning instrument. When properly structured, both the donor and the charity can be beneficiaries of one’s eleemosynary tendencies.