The Many Varieties of Charitable Remainder Trusts
In our last article, we went over the basic characteristics of a Charitable Remainder Trust (CRT). We discussed the basic structure of this category of trust and gave examples of who might benefit from using them and what benefits they may receive. To recap, a CRT is an irrevocable trust that provides income to one beneficiary, either for a specified term or for life, and then transfers the remaining balance of the trust assets to a charitable beneficiary. Because a CRT is irrevocable and charitable, it bestows a number of tax benefits to the person who funds the trust (the settlor). The settlor receives a current income tax deduction, and potentially lowers their estate tax bill. Additionally, the trust is tax exempt, so it is able to sell low basis assets without having to pay capital gains. A CRT allows a settlor with highly appreciated property to diversify and receive a larger income stream then they could without a CRT. As these trusts are quite popular, there are a large number of variations available to those who wish to use them. In this article we will go through some of the more popular types.
Charitable Remainder Unitrust (CRUT)
A Charitable Remainder Unitrust (CRUT) is a CRT that pays out a percentage of the fair market value of the trust assets each year to the income beneficiary. In a CRUT, the trustee has to determine the value of the trust every year in order to determine the value of the income distribution that the trustee will distribute to the income beneficiary or beneficiaries. The trustee will distribute to the income beneficiary(s) a percentage of the trust between 5% of the trust value, and 50% of the trust value. The percentage that you choose for the income distribution, combined with the applicable federal rate given by the IRS, will determine how large your initial income tax deduction will be. Because the value of the trust determines the annual distribution, it is wise to get an outside appraisal of the trust value every year. If the trust assets make more than the distribution amount, then the trust assets will grow. If the income on the trust assets is less than the distribution amount, then the trustee will need to distribute principal to the beneficiaries. While the trust itself is exempt from taxes, when the trustee distributes the assets to the beneficiaries, the IRS requires the beneficiaries to pay taxes on distribution. Therefore, if the trust assets make 5% income, but needs to distribute 10%, then the trustee will have to sell trust assets to distribute the other 5%. In this case, the character of the income to the beneficiary will be 5% ordinary income, and 5% capital gains. With CRUTs, if you select a distribution rate that outpaces the growth rate of the trust assets, in general, the annual payments to the beneficiaries will decrease, and the remainder interest that will go to the charitable beneficiary will also decrease.
Income Only CRUTs are similar to regular CRUTs, but they contain a provision that the trustee will only distribute the lesser of the actual income made by the trust assets or the percentage of the trust assets listed in the CRUT document. This will allow the trustee to initially hold assets that do not generate income, and avoid the requirement to distribute a percentage to the beneficiaries. This can be beneficial if the beneficiary initially has a high enough income to not require distributions from the trust. The value of the trust assets will grow in the years when there are no distributions, creating a larger income stream in the later years of the trust. This can also lead to lower income taxes by matching distributions to years where beneficiaries are in lower tax brackets.
A flip CRUT combines an income only CRUT and a Standard CRUT. This type of trust acts like an income only CRUT for a certain number of years, or until a predetermined event occurs. Normally, the predetermined event is the sale of an asset used to fund the trust. With a Flip CRUT, you typically fund the trust with a highly appreciated, non-income producing asset. The asset grows during the early years of the trust where, presumably, either the beneficiaries are in a high tax bracket, and/or they do not need the income stream. Once the beneficiaries need the income, or the predetermined time is up, the trustee will sell the non-income producing asset and create a more liquid, high income portfolio. At that point the beneficiaries will receive a fixed percentage of the fair market value of the trust assets, as in a standard CRUT. By letting the assets grow during the initial period of the trust, you create a higher income stream for the beneficiaries in the later years of the trust. Unlike an income-only CRUT, however, you are not limited in these later years to the actual income of the trust.
Net Income with Makeup CRUT (NIMCRUT)
A NIMCRUT is generally an income-only trust with a makeup provision that can make the trust provide the beneficiaries with a distribution amount that is above the predetermined payout rate, if the trust income was below the payout rate in a previous year. To give an example: say the trust assets have a fair market value of $1,000,000 and a payout rate of 7%. In year 1, the trust only makes 4% income on the trust assets. In year 1, the payout to the beneficiaries will only be $40,000. This creates a $30,000 deficit from the $70,000 which would be the payout if this was a standard CRUT. If the trust makes 11% in year 2, then the payout to the beneficiaries will be $100,000, or the $70,000 unitrust amount, plus the $30,000 makeup payment for the previous year’s deficit. Like a Flip CRUT, a NIMCRUT can allow the trustee to schedule when the income beneficiaries will receive distributions from the trust, and create higher distributions in later years of the trust.
Charitable Remainder Annuity Trust (CRAT)
CRATs are a form of trust that provides a fixed payment of between 5% and 50% of the initial fair market value of the trust assets to one or more non charitable beneficiaries for a term of years, or for the lives of the income beneficiaries. CRATs are different from CRUTs because in a CRAT, the dollar amount of the distribution remains constant, regardless of the fair market value of the trust assets in the year of distribution. The settlor fixes dollar value of the annuity payments when creating the trust. The settlor and beneficiaries cannot change this amount no matter what happens to the value of the assets in the trust. You cannot add additional assets to a CRAT after you create it. If the fair market value of the assets in the trust reaches zero, then the distributions end.