This handout is designed to illustrate the use of Charitable Remainder Trusts for income tax and estate tax planning and to answer some questions you may have with regard to its use.

1.0 WHAT IS A CHARITABLE REMAINDER TRUST?

A Charitable Remainder Trust (“CRT”) is a form of irrevocable trust in which you transfer cash or property and retain the right to receive payments (“Trust Payout”) for life, or for a selected term, and where any remaining amount of the trust passes to a charity you select after death or at the end of the selected term. Because the charity is the ultimate remainderman, the IRS treats the trust as income tax-exempt.

2.0 WHAT BENEFITS DOES A CRT PROVIDE?

2.1 Benefits to Charity. Because the charity or charities you select is named as remainder beneficiary of the CRT, the charity obviously benefits from creation of the trust. However, even if you are not charitably motivated, the tax-exempt nature of the trust may still make the CRT an excellent income tax saving vehicle to you.

2.2 Benefits to You.

(a) Capital Gains Tax Prevention. If highly appreciated assets are transferred to the CRT, the tax-exempt nature of the trust allows it to sell the assets and defer, and potentially avoid, any capital gains tax that would otherwise be imposed if you sold the assets yourself. In this situation, a CRT effectively allows you to convert the appreciated assets into a lifetime income stream without imposition of capital gains taxes on the sale.

(b) Charitable Deduction. Upon creation of the trust, you will get a deduction for the value of the interest passing to charity even though the charity will receive no interest for several years. The deduction varies depending upon the terms of the CRT, but typically ranges between 10-15% of the current property value transferred to the CRT.

(c) Estate Planning Options. In certain circumstances, placing assets in a CRT can provide a greater estate tax benefit to your family than simply transferring the property outright to them at death. In every case, however, because the trust assets ultimately pass to charity, no estate tax will be imposed on the trust assets upon your death.

(d) Retirement Planning. If a specific type of CRT is used, the CRT may effectively provide you a type of personal retirement plan whereby income can be deferred during your working years and distributed to you in increments after you retire.

3.0 HOW DOES THE CRT WORK WITH CAPITAL ASSETS?

3.1 If you hold highly appreciated assets (such as real estate or stocks) that you wish to sell, you transfer the assets to the CRT and name one or more qualified charities as the remainder beneficiary.

3.2 The trustee of the CRT can then sell the assets and re-invest the proceeds. Because the trust is income tax-exempt, no capital gains, tax will be imposed on the sale by the CRT and the full proceeds of the sale can be re-invested.

3.3 You, or your designee, will be named as the income beneficiary of the CRT and retain the right to receive the Trust Payout from the trust for life (or for a selected term). While each Trust Payout you receive from the CRT will be subject to income tax, most of this income is likely to be post-sale earnings generated by the re-invested trust assets. Only to the extent the Trust Payout exceeds income generated by the re-invested trust assets is the prior capital gain recognized, and then only as distributed out of the trust.

3.4 Example. Assume you hold stock purchased many years ago for $100,000 that is now worth $2,000,000 and that you wish to sell. If you sold the stock without a CRT, approximately $475,000 in state and federal capital gains would be imposed on the sale and you would have $1,525,000 to reinvest. If you earn 8% on this $1,525,000, you would generate an annual income stream of $67,000 (after payment of income tax of 45%). If you live twenty-five years, and the proceeds are reinvested, the total lifetime annual income stream would be worth $2,949,889.

If you instead transferred the stock to the CRT, retained an annual Trust Payout of 8% of the CRT’s assets for life, and the CRT sold the stock, the CRT would have the full $2,000,000 to reinvest. At the same 8% investment return, the CRT would produce $160,000 of income annually and provide you an annual income stream of $88,000 (after payment of income tax of 45%). In this case, if you live twenty-five years and the proceeds are reinvested, the total lifetime annual income stream would be worth $3,868,707. Additionally, you would receive a charitable deduction when the property is transferred to the CRT of approximately $200,000, depending upon your age, and approximately $2,000,000 would pass to charity upon your death.

4.0 CAN I USE THE CRT WITHOUT DISINHERITING MY CHILDREN?

Yes. Although the assets transferred to the CRT ultimately pass to charity, in certain circumstances, a CRT can be combined with other estate planning tools to increase the amount you pass to your children at your death. This can be achieved in one of following two ways:

(a) Use Income Tax Savings. As shown above, if you anticipate selling highly appreciated assets, the use of a CRT can generate greater annual income than reinvesting the after-tax proceeds from the sale of the assets. When the income tax savings arising from the charitable deduction is also considered, in many cases, your total accumulation of assets outside the CRT will exceed the accumulation if you had sold the assets yourself.

(b) Combine with Life Insurance. To ensure your heirs receive their inheritance when you die and the trust assets pass to charity, “replacement” life insurance can be purchased to replace the assets passing to charity. The premiums for the life insurance can often be paid out of the “excess” income generated from the CRT. If the insurance is held by an insurance trust, the proceeds from the policy will pass to your heirs without imposition of estate tax at your death. Because no estate tax is imposed on the CRT assets passing to charity at your death, the entire transaction should be estate tax-free.

Example. Based on the facts from the above example, if you used only the excess cash flow from the sale of the stock to purchase a second-to-die life insurance on your and your spouse’s life and the policy was purchased in a life insurance trust, your children would receive the full proceeds at your death. Assuming you are insurable, this excess cash flow should allow you to purchase between $1,000,000 and $2,000,000 in insurance. Note that if you simply sold the stock and passed the net proceeds of $1,525,000 to your heirs at death, estate taxes of up to $686,250 would be imposed and your heirs would receive only $838,750. As a result, the CRT can produce between $200,000 to $1,200,000 in more wealth for your heirs. This is in addition to the $2,000,000 that is estimated will pass to charity at your death.

5.0 WHAT ARE MY INCOME CHOICES?

There are three basic types of CRTs qualified as tax-exempt trusts and each provides for a different method to compute the Trust Payout:

(a) Charitable Remainder Annuity Trust (“CRAT”). A CRAT is a type of CRT with a fixed Trust Payout that is based on a percentage of the original fair market value contributed to the CRT. While this type of CRT ensures you a guaranteed amount regardless of the earnings of the CRT assets, it does not allow you to share in the appreciation occurring inside the tax-exempt CRT.

(b) Charitable Remainder Unitrust (“CRUT”). A CRUT provides a Trust Payout that is based on a percentage of the current fair market value of the CRT assets, determined annually. If you choose a Trust Payout that is less than your expected annual return, the fair market value of the CRUT will grow over time and the Trust Payout will correspondingly increase. On the contrary, if the Trust Payout rate exceeds your expected annual return or the assets produce a lower return than expected, the fair market value of the CRUT will decrease over time and the Trust Payout will correspondingly decrease.

(c) Net Income Make-Up Charitable Remainder Unitrust (“NIMCRUT”). A NIMCRUT is a variation of the CRUT whereby the lesser of actual income generated by the trust assets or the Trust Payout is made to the income beneficiaries annually. To the extent actual income is less than the Trust Payout, that amount can be withdrawn in later years from actual income to the extent actual income exceeds the Trust Payout. This device was created to allow one to transfer non-income producing property to a CRT without forcing the CRT to sell the property or retransfer portions of the property back to the donor. However, the NIMCRUT can be used as a type of substitute retirement vehicle by having the CRT invest in non-income producing property during your working years, thereby accumulating a large make-up amount, and then have the CRT generate “income” that can be distributed to you upon retirement.

6.0 HOW HIGH CAN THE TRUST PAYOUT BE?

Statutory rules prohibit Trust Payout percentages in excess of 50% of the contributed property and mandate that the percentage must be low enough to ensure that the present value of the interest passing to charity upon conclusion of your life (or the selected term) is at least 10% of each contribution to the CRT. Additionally, other rules require the Trust Payout to be no lower then 5%. As a practical matter, the maximum permitted Trust Payout depends upon the government interest rate (“Applicable Federal Rate”) at the time of contribution and either the age of the income beneficiar(ies) — if the Trust Payout is guaranteed for life, or the length of the term — if the Trust Payout continues for a selected term. For example, with a 7.0% Applicable Federal Rate, if the income beneficiaries are a husband and wife in their mid-50’s, the highest Trust Payout rate they may receive for their joint lifetimes is 8 1/4%. The maximum Trust Payout rate rises to 12% for spouses in their mid-60’s and falls to 6% for spouses in their mid-40’s. If there is only one lifetime beneficiary, a donor in his or her mid-60’s can retain a Trust Payout as high as 13 1/2%. If the Trust Payout is instead made for a fixed term of 20 years, rather than for life, the Trust Payout rate can be as high as 10 1/2% per year regardless of the age of the beneficiaries.

7.0 WHO CAN RECEIVE TRUST PAYOUTS FROM THE CRT?

A Trust Payout from the CRT can be made to anyone. To the extent you and your spouse are the only non-charitable income beneficiaries, no gift or estate tax should be imposed on the creation of the CRT or expiration of the CRT term. If another person, such as a child, is chosen as an income beneficiary, the donor will typically have made a taxable gift to the named beneficiary equal to the value of the contribution to the CRT minus the value of the interest passing to charity. However, a single donor can name another person as successor beneficiary if they retain the power to revoke that interest prior to death. In this case, unless you revoke the successor beneficiaries interest, the value passing to the successor beneficiary will be included in your estate for estate tax purposes at your death.

8.0 WHAT TYPES OF PROPERTY ARE SUITABLE FOR A CRT?

8.1 Marketable Assets. A CRT works best with appreciated property such as publicly traded stock and unencumbered real estate.

8.2 Business Interests. A CRT can also be used for closely-held businesses, partnerships, limited liability company interests, and capital assets inside partnerships. While these uses tend to make the CRT slightly more complicated, the use of a CRT with such assets can produce outstanding benefits.

8.3 Encumbered Real Property. A CRT may also work with encumbered real property, but only if certain specific requirements can be met.

8.4 Unavailable Assets. The main category of property for which a CRT is generally unavailable are operating businesses with an asset sale.

9.0 HOW DIFFICULT IS CREATING AND MAINTAINING A CRT?

Like any income or estate tax savings device, there is some work involved in administering a CRT. The creation of the CRT involves the determination of the appropriate type of CRT, the drafting of the CRT agreement, and the transfer of assets to the CRT. Once created, the CRT will be required to file annual tax returns and appropriate distribution amounts must be determined annually. However, much of this work can be accomplished with the aid of your CPA and the complexity to you can be kept to a minimum.

10.0 WHO SHOULD BE THE TRUSTEE?

While you are not prevented from serving as trustee of your CRT, it is better to name another person because you can lose the tax advantageous of the CRT if it is not properly administered. You can name either another individual, such as a family member, to serve as trustee or appoint a corporate trustee to serve. Many people choose a corporate trustee due to their greater investment and administrative expertise. A charity may also be willing to serve as Trustee (sometimes without charge) if irrevocably named as a remainder beneficiary. Regardless of who you select as trustee, however, you can retain the ability to remove and replace the trustee at anytime during the term of the CRT.

11.0 CAN I CHANGE THE CHARITABLE REMAINDER BENEFICIARIES?

Most CRTs are drafted to allow the donors unlimited ability to remove and replace the charitable beneficiaries named in the trust document at any time during their life. You also can retain the ability to irrevocably designate a specific charity as a remainder beneficiary to part of all of the CRT.

12.0 CAN THE REMAINDER BENEFICIARY BE A PRIVATE FOUNDATION?

12.1 Rather than passing the trust assets outright to a public charity upon your death (or conclusion of the selected term), you can instead name a private foundation as the remainder beneficiary. The private foundation can be then-existing or can be created upon termination of the initial income term (i.e., upon your death according to your wishes). A private foundation effectively allows you (or your children) to continue to control the trust property even after your death.

12.2 The main disadvantage to naming a private foundation as remainder beneficiary is that your charitable deduction may be limited depending on the asset you transfer to the CRT. If this is the case, you may want to name a community foundation as remainder beneficiary since the deduction rules are more generous, but still allow you to retain some control over the trust assets.

13.0 WHAT ARE THE DISADVANTAGES OF A CRT?

13.1 Loss of Access to Principal. The main detriment to a CRT is that you have limited access to the trust principal, even though the amount of the trust principal will likely be greater with the CRT.

13.2 Pre-arranged Sale. The IRS does not allow you to avoid capital gain on the sale of property contributed to the CRT if the sale was pre-arranged prior to contribution. Generally, the IRS looks to whether the CRT is obligated to sell the assets as part of the pre arranged sale in determining whether to attribute the gain to the donor or the CRT. While some negotiation of an upcoming sale will not likely cause attribution of the gain to you, it is imperative that no formal negotiations be finalized and you should transfer the property to the CRT as early as possible.

13.3 Investment Restrictions. Because the CRT is a tax-exempt entity, there are some restrictions on the types of investments in which the CRT can invest trust assets. Generally, the CRT is prevented from investing in operating businesses and businesses in which you hold a controlling interest.

Clay R. Stevens © 2010