By Don Wilkinson, CEO, Family Office Consulting
Knowledgeable investors should be familiar with the Charitable Remainder Trust (CRT)—an estate planning strategy that produces a win-win situation for an individual and the charity(s) of his or her choice. Now there are some new wrinkles that are beneficial and should be reviewed with your advisors.
CRTs can be structured to increase an individual's income, avoid capital gains taxes, lower or eliminate estate taxes and serve as a bonus retirement plan-- plus serve humanity with wealth after passing on.
You might note that there are two types of CRTs. The two differ on how the payout is calculated. A charitable remainder annuity trust (CRAT) is where payment to the income beneficiary is a specified dollar amount. The charitable remainder unit trust (CRUT) is where payment is a percentage of the value of the trust calculated each year. When the income beneficiaries die, the remaining assets go to charity(s) named earlier.
Case Study of a Charitable Remainder Trust
George and Mary are a good example of a CRT done right. George and Mary lived on an 80-acre farm outside of Joplin, MO. They farmed their acreage for many years. George died and Mary was left to tend to the farm herself after all their children had moved on.
During the time Mary was struggling with the farm, a federal highway was built close to the property. One day Mary received an offer from a real estate firm to buy all 80 acres to build a mall.
The price offered was $10 million. Luckily, Mary knew a local financial planner personally who offered to help her with the deal. As the farm was originally purchased having a very low basis, the advisor put Mary in a charitable remainder trust.
By establishing a CRT, Mary has reaped the following benefits:
- Mary does more than minimize the capital gains tax, she avoids it all together. The present capital gains being 15% saves Mary over $1.5 million in capital gains taxes.
- Mary's CRT mandates an annual payout of 5%. That is about $500,000 yearly in income for Mary.
- Mary received a huge tax deduction based on the charitable contribution to the trust. It was so large that the IRS will let her carry the unused portion forward for five years.
- No estate tax will be due at her death.
Besides these benefits, there is still another value-added benefit of the CRT that individual investors and their advisors should note.
What if the CRT holder's life circumstances changed and he needed immediate liquidity instead of receiving CRT income payments for the rest of his life?
Charitable Remainder Trusts Can Be Sold to Gain Liquidity
As said, the CRT is a split-interest trust that an individual or beneficiary donates money or property and retains the right to have a specified cash flow each year usually for the duration of life (joint life with a spouse). Nevertheless, the CRT can also be sold. This is allowable not only to be sold at the seller's income interest but also possibly at a premium to the new present value (NPV) of the CRT. This also normally would be a cash transaction for the CRT seller.
Whatever the reason (divorce, business reversals, investment losses. etc), cash may be a necessity for a distressed individual holding a CRT. But selling an individual's income stream in a CRT may not be driven exclusively by a distressed need for liquidity but also by value maximization.
Value maximization represents a premium to the individual's NPV of holding the CRT. It may make more sense to trade off the lengthy, uncertain payment stream governed by the individual's life expectancy and replace the process with an immediate lump sum payment.
Thus the CRT allows the beneficiary to avoid a capital gains tax on the donated assets, to remove an asset (stocks, property, etc) from his taxable estate and receive an income tax deduction for the amount going to the charitable beneficiary.
The prime reason individuals welcome subscribing to a CRT is the obvious tax benefit. Contributing to their favorite charity may be secondary. Most individuals achieve favorable tax benefits in the early life of a CRT usually in the first year. After receiving the charitable deduction, the individual must keep the CRT going the rest of their lives to reap the tax benefits.
Therefore, if a lifelong income stream becomes less important to the beneficiary, then the idea of selling the individual's CRT income stream becomes attractive. Thus, a niche market has sprung up for holders and buyers of CRT income interests.
Tax Considerations
Why would a buyer be interested in purchasing—at a premium—a CRT income interest?
It's all about tax brackets. For example if the beneficiary (seller) is in the 30% bracket, each dollar from the CRT income stream is worth 70 cents. If the buyer is in a lower tax bracket, each dollar is worth closer to 100 cents. This potential spread of 30 cents on the dollar makes for an excellent opportunity for the beneficiary to sell at a premium at NPV.
Tax exempt organizations and individuals with different tax situations (i.e. net operating losses (NOLs), capital loss carry forwards, etc for example) may offer a situation where the income from a CRT is worth more to a buyer than the same interest is to an income beneficiary.
In short, in the best-case scenario, the seller gets a premium and the buyer gets a discount. A marriage made in heaven.
The sale of a CRT income interest is a capital transaction so it is generally taxed at capital gains rates, which at present are at a most favorable rate. In fact, capital gains rates (around 15%) have never been lower for the past 70 years.
And what about the tax/legal implications about this type of transaction? Apparently, after due diligence, there are no legal snags to the sale of CRT income interests. Each case, however, should be examined on its own merits.
In the case of IRS scrutiny, it is generally recognized by the number of letters on the subject (Private Letter Ruling 200127.23), is the sale of CRT interest is a capital transaction. What this means to the seller who has held his interest for over a year, the sale may be a long-term capital gain, which is taxed at the most favorable rate.
Many CRT Benefits Even Without Sale
As for Mary, she's under no financial distress or seeking value maximization. She has named her church and local hospital to receive the $10 million in the trust when she dies. For now, she avoids a huge capital gains tax, does not have to dodge suggestions from relatives (she took out an insurance policy for heirs) and does not have to give half of her estate to the government when she dies.
For additional information on liquid CRTs, call Don Wilkinson at 800 288-7002. Contributing to portions of this article was Roger D. Silk, and Evan D Unzelman, "Selling a CRT Income Interest", featured article in Wealth Strategies Journal (Aug 2008).
