December 11, 2006

Estate planners have several tools and techniques at their disposal for helping clients in meeting their tax and non-tax planning needs. One such technique, the charitable remainder unitrust, also called a CRUT, combines a client’s charitable intentions with the opportunity to spread the receipt and taxation of income over several years. For this reason the CRUT is often a good choice for those who desire to maintain a stream of income during their lifetimes, but who would also like to leave a part of their estate to charity.

Split-Interest Trust

A CRUT is considered by the IRS to be a ‘split-interest’ trust, meaning that one interest in the trust is designated for a non-charitable beneficiary while a separate interest in the trust is given to a qualified charity. Typically the operation of a split-interest trust is divided into two stages: first one beneficiary-type (i.e. either charitable or non-charitable) receives payments from the trust over a period of time, then the other beneficiary-type receives the remaining trust assets.
Several variations of split-interest trusts are available to meet donors’ needs. While charitable lead trusts (CLTs) first make a stream of payments to one or more charitable beneficiaries, then leave remaining trust assets to non-charitable beneficiaries, charitable remainder trusts (CRTs) do the opposite in making payments first to the non-charitable beneficiaries, then transferring remaining assets to the charitable beneficiaries.

While a CRUT is a special type of CRT, a net income make-up CRUT, or NIMCRUT, is further specialized to allow for maximum income deferral opportunities. For this reason the NIMCRUT is perhaps the most popular type of charitable remainder trust, as it allows for the deferral of income to later years, much like a deferred-income retirement plan, while allowing the trustee to maximize the payout amount.

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Tax-Exempt Entity

All CRTs are tax-exempt entities for income tax purposes. Thus, income earned by the trust, including gain on the sale of appreciated assets, is nontaxable to the trust. But just how do the original assets get into the trust, and what are the income, gift and estate tax consequences of putting the assets in the trust? This is where the magic of the CRT comes into play.

Because a CRT is structured as a separate entity for all tax purposes, any transfer of assets to the trust is considered to have at least one gift component. First, the present value of the stream of payments made over the term of the trust will be a gift subject to normal gift tax rules if the beneficiary is other than the donor or the donor’s spouse.

Second, the value of the remaining assets, which are transferred to one or more qualifying charities at the end of the trust term, is a charitable gift. As always, the deduction for gifts of appreciated capital-gain property that will pass to public charities is limited to 30% of the donor’s adjusted gross income in the year of the donation, with a 5-year carryover period for any excess deduction. A note of caution: as a tax-exempt entity, the CRT cannot accept gifts of property encumbered by debt.
Thus, the donor receives a charitable contribution for income tax purposes in the year of the asset transfer, the charitable contribution is exempt from gift tax, and the value of the charitable component has now been transferred out of the donor’s estate for estate tax purposes. A win-win-win!

Income Tax Deferral

As a tax-exempt entity, the trust will not pay income taxes on annual earnings. The level of earnings on trust assets will primarily be determined by the investment decisions of the trustee, who will have a fiduciary responsible to manage the assets.
Typically, highly-appreciated assets are good candidates for a CRT because the trustee can sell the assets, and, as a tax-exempt entity, the trust will not be liable for capital gain taxes. This is one of the biggest benefits of a CRT because the cash that would otherwise have been paid in taxes is now available for investment.

Although income earned by the trust is not taxable, the annual stream of payments made to the non-charitable beneficiary is taxable in the year received.
At this point, the following has been accomplished:

• the donor’s asset has been sold,
  
• capital gain taxes have been avoided,
  
• the potential for future earnings has been increased,
  
• a portion of the appreciated asset has been removed from the donor’s estate,
  
• payments will only be taxed to the donor as he receives them, and
  
• a charitable contribution will be available to the donor in the year of the transfer.
  

The terms of the trust document will provide the guidelines for computing the annual payment, or the unitrust amount, that is paid to the donor. In structuring the CRUT, the donor and his advisers will determine the specific terms of the trust within the following Internal Revenue Code (IRC) guidelines:

• The CRT payment must be made at least annually, and can be made for either a term of years, up to 20 years, or for the life(s) of named beneficiary(ies).
  
• The payout rate must be at least 5%, but not more than 50%, of trust assets, generally valued on a specific date each year.
  
• At least 10% of the trust contribution must ultimately pass to the charitable beneficiaries (calculated based on the present value of the future transfer to charity).
  

Opportunity to Defer Income

A variation of the CRUT, called a net income CRUT, pays the donor the lesser of the net income of the trust or the unitrust amount. Therefore, if a donor wished to defer the receipt of trust payments to later years when other sources of income available to him might be less, or when he might be in a lower tax bracket, the trust assets could be invested for growth in the early years rather than for income. As long as the current year income was less than the computed unitrust amount, only the income amount would be paid out, and the balance of assets would remain in the trust to be invested.

For example, suppose in Year 1 John contributed $1 million on January 1, the annual valuation date, to a net income CRUT with a payout rate of 5%. The computed unitrust amount for the current year is 5% of the January 1 value, or $50,000. If the trust assets were invested in low-dividend-yielding stocks that paid $40,000 during the year, the trust would pay John only $40,000, and the $10,000 difference from the unitrust amount would remain in the trust and be invested to generate additional future income.

Net Income Make-up Provision

In the example above, the $10,000 shortfall in income from the unitrust amount would not be tracked for John, but future payments would be dependent each year on the amount of income generated. If John wanted to preserve his claim to the full unitrust amount, the trust could be drafted to contain a make-up provision that would direct the trustee to track the amount of such shortfall each year. John would then be entitled to a make-up payment of the accumulated shortfalls in any year that the net income of the trust exceeded the unitrust amount. Such a trust is called a net income make-up CRUT, or NIMCRUT.

To continue John’s example, suppose in Year 2 the trust changed its investment strategy and earned dividends of $70,000, and the value of the assets on the annual valuation date was $1.2 million. The net income provision of the trust would provide that John be paid the lesser of the net income of $70,000 or the unitrust amount of $60,000 (5% of the $1.2 million value). Thus, $10,000 of the dividend income would not be paid under this provision. However, the make-up provision allows for payment of the Year 1 shortfall of $10,000, so that John’s total Year 2 payment is $70,000 (the $60,000 Year 2 unitrust amount plus the Year 1 shortfall).

Capital Gains as Income

Trust income, or fiduciary accounting income, is defined in the Internal Revenue Code and is not the equivalent of income reported for income tax purposes. A major difference in the two computations is that capital gains realized on the sale of assets are traditionally not considered to be income for fiduciary accounting purposes. Sec. 643(b); Reg. Sec. 1.664-3(a)(1)(i)(b)(3).

Thus, the sale of appreciated assets will not generate net income for purposes of computing the annual payout to the donor. If a trustee has been investing for growth in order to defer income, this rule could severely limit the amount of income the donor would be able to receive from the trust. Fortunately, there is a way to mitigate this negative outcome so that the donor is not blindsided by this rule.

IRC Sec. 643(b) provides that capital gain may be treated as income if allowed under applicable state law and the trust instrument so provides. This rule does not apply, however, to gain related to the appreciation inherent in assets contributed to a trust, but will apply to post-contribution appreciation. Thus, any built-in gain will not be allocated to trust income at the sale of the asset, but will be considered to be trust principal.

Let’s say John in our example contributed an undeveloped parcel of land in Year 1 to a NIMCRUT when the land was valued at $1 million and had a tax basis of $400,000. In On January 1,Year 10 the trustee sold the land for $5 million, for a gain of $4.6 million. Because there was no traditional accounting income earned during the year (e.g. dividends, interest, rents or royalties), John does not receive a payout in Year 10.

Trust Provision Necessary to Allocate Capital Gain to Income

Alternatively, assume the trust instrument contained a provision that defined fiduciary accounting income to include post-contribution capital gain. In this case, the trustee would allocate $600,000 of the gain to trust principal and $4 million of the gain, which was attributable to post-contribution appreciation, to trust income.

As in our previous scenario, the unitrust amount is 5% of the value of trust assets, or $250,000. Further assume that the cumulative payment shortfall from the unitrust amount over the previous 9 years is $1 million. In this case, John receives a payout of $1.25 million in Year 10 (the lesser of net income of $4 million or the unitrust amount of $250,000, plus the net income make-up of $1 million). The remaining sale proceeds would be invested for future income. In this case, a provision to include post-contribution capital gains in income is worth $1.25 million!

All CRTs must annually file Form 5227, Split-Interest Trust Information Return, by April 15 of the year following the taxable year, and attach Form K-1, Form 1041 for each beneficiary receiving taxable income during the year. Further, Form 1041-A, U.S. Information Return, Trust Accumulation of Charitable Amounts, must be filed for any year the trust is not required to pay out all the current year net income. Trustees should review the instructions to these forms for additional attachments required with the first return. Additionally, the donor will need to file a Form 709 gift tax return for the year assets are contributed to the CRT.

The charitable remainder unitrust may be an appropriate estate planning vehicle for clients who own appreciated assets and are charitably inclined, but who are not ready to part with the entire asset or its potential income. The income tax charitable deduction generated by the contribution may be just the thing for a client facing an unusually large gain in a particular year. Because the make-up provision of the NIMCRUT allows for the accumulation of income to be paid in later years, this type of CRT has been compared to a nonqualified retirement plan. For the right client in the right situation, tax advisers would do well in introducing the combined charitable and retirement planning aspects of CRTs.