The Charitable Remainder Trust—A Powerful Tax Planning Tool

The charitable remainder trust (CRT) is a flexible tax-planning tool that can accomplish a number of important objectives. This article explains how these trusts work and provides a few examples of tax-saving strategies.

What is a Charitable Remainder Trust?
A CRT is an irrevocable trust that provides income during the trust term (usually the life of the donor and his or her spouse) after which the trust assets are donated to charity. There are two types of CRT: the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT).

A CRAT pays the donor (or other beneficiaries) a specified fixed annual income equal to at least 5% of the initial fair market value of the trust assets. Once a CRAT has been funded, additional contributions are not permitted.

A CRUT pays out a fixed percentage (5% or more) of the trust’s value (redetermined annually). Additional contributions are allowed. A CRUT can be set up to pay out the lesser of the fixed percentage payment or the trust’s net income (other than capital gains) for the year. The trust may also provide that the difference between the fixed percentage payment and net income can be “made up” in later years by distributing income in excess of the fixed percentage. A trust that incorporates this “net income with make-up” option is sometimes referred to as a NIM-CRUT.

Tax Planning Benefits
Generation of current tax deduction. When a CRT is established, the donor may deduct the present value of the expected remainder interest (the amount that will be donated to charity). The longer the trust term, the smaller the present value of the remainder interest and, therefore, the smaller the deduction.

Avoidance of capital gains. If highly appreciated assets are used to fund a CRT, the trust can sell the assets without incurring capital gains taxes and invest the proceeds.

Tax deferral. A properly structured NIM-CRUT can produce significant tax-deferral benefits, much like a nonqualified retirement plan. The trust initially invests in high-growth assets that produce little or no income. At a later date (e.g., retirement) trust investments are shifted to income-producing assets. The income beneficiaries then receive the fixed percentage payment plus payments from earlier years that were deferred by virtue of the trust’s “net income with make-up” feature.

Note: The IRS is considering regulations that would restrict the use of this strategy.

Estate planning. Assets contributed to a CRT are removed from the donor’s estate. With proper planning, one’s heirs can enjoy the income from these assets free of estate taxes.

Disadvantages of CRTs include loss of control of assets contributed to the trust and loss of wealth donated to charity (although life insurance can be used to replace this wealth). But if you’re looking for a way to satisfy your charitable desires while generating tax benefits, a CRT may be worth a look.

CRTs are subject to a number of complex rules and restrictions, so be sure to consult a tax advisor.