Charitable Remainder Trusts (CRTs): What They Are and How They Work
A Charitable Remainder Trust (CRT) is a planning tool available to those with highly appreciated assets. Properly utilizing CRTs can help accomplish income tax, charitable giving, and estate planning goals, and if used correctly, charitable remainder trusts can save you thousands of dollars in taxes.
In this article, we’ll explain how a CRT works, how CRT taxes work, what the benefits of a CRT are, and we’ll highlight common pitfalls people make when trying to implement their own CRT strategy.
CRTs Are a Charitable Trust
Although a CRT can be a useful tool to help you achieve income tax and estate planning goals, it’s important to note that a potentially large portion of the assets held in this type of trust will ultimately go to charity. Therefore, CRTs should be created only by those who are charitably inclined.
How Does a CRT Work?
A charitable trust (like other trusts) is formed by executing a trust agreement. Since trust agreements are generally irrevocable, it's important to have a clear understanding of how they work. The trust agreement is drafted according to the specifications of the grantor and will define the parameters of the trust. There are several terms and concepts to be familiar with regarding the formation of a CRT.
Grantor
The grantor of the trust is the one who sets up the trust and contributes assets to the trust once it’s formed. It's common to have one grantor or sometimes two, as in the case of a married couple.
Assets Being Contributed
Once set up, the trust is funded with assets such as stocks (including private stock), mutual funds, etc. In general, the best assets to contribute to a CRT are those that have significantly appreciated (low basis assets). It’s generally not advisable to contribute assets from a flow-through operating business or from debt-encumbered real estate.
Term of the Trust
The trust term defines the life of the trust and can be set to a particular number of years or to the period of the grantor’s life (or joint lives if there are two grantors).
Charitable Deduction
In the year the trust is funded by the grantor, the grantor receives a charitable deduction on their personal income tax return. This deduction is essentially equal to the present value of the remaining assets expected to be received by the remainder beneficiary at the end of the trust term. The math works such that a higher deduction is received in a higher interest rate environment (the IRS publishes monthly interest rates used for these calculations, known as the Section 7520 Rates).
Annuity Payments
Each year of the trust term, the trust makes an annuity payment to the income beneficiary (defined next). The required annuity payment can be paid out quarterly, semi-annually, or in full at the end of the year (which will be laid out in the trust agreement).
The trust agreement will define one of two common ways to determine the annuity payment amount.
The first (and most popular) way would be a unitrust amount, which would make this a CRUT. This method takes the fair market value of the trust as of the first day of the year, and applies a pre-defined percentage to it, to calculate the required annuity payment for the year. This would be the year’s annuity payment and would need to be paid to the income beneficiary per the pre-defined schedule. If the assets in the trust increase over time with good investment performance, the unitrust amount paid to the income beneficiary will also increase.
The second common method is through the use of a fixed annual annuity amount, which would make it a CRAT. This method is administratively easier than a unitrust amount in that you do not need to calculate the annual amount to be distributed (as it is fixed with the trust agreement), but it is potentially riskier if the trust’s investments decrease in value over the years. If the CRT investments don’t perform well, the trust corpus (the assets that were contributed to the trust) may be rapidly depleted, frustrating income deferral goals and resulting in little to no distribution to the ultimate charity.
Income Beneficiary
The income beneficiary receives the trust’s annuity payment during the trust term. This is generally the grantor of the trust, and this person will receive a Schedule K-1 (tax form) from the trust each year. Ultimately, the annuity amount will determine the taxable income needed to be recognized by the income beneficiary on their personal income tax return.
Remainder Beneficiary
The remainder beneficiary receives the trust’s remaining assets at the end of the trust term. This beneficiary is set by the grantor and must be a charity. The charity will receive all remaining assets at the end of the trust term, which is what gives this trust its name: Charitable Remainder Trust.
CRT Tax Example
The CRT itself does not pay taxes and is considered a tax-exempt entity. (With the exception of unrelated business taxable income UBTI, which is beyond the scope of this article.)
Instead, any income that the trust earns over its life will accumulate at the trust level and be taxed by the income beneficiary on their individual income tax return when the annuity payments are received via their Schedule K-1. As mentioned above, there are two main types of charitable remainder trusts: the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT), with the primary distinction being the method in which the annuity payment amount is calculated.
The K-1 generated by the trust will show the taxable income to the income beneficiary, broken out by character of the income: taxable interest, dividends, capital gains, tax-exempt interest, etc. The character of the income on the K-1 is determined by the character of the income that has been earned and accumulated within the trust, with the “worst” taxed income being used first (i.e., ordinary income versus long-term capital gains).
For example, if the annuity payment is $100k for the year and there was $75k of interest earned by the trust during the year and $100k of long-term capital gain (LTCG), the Schedule K-1 would report $100k of total income (equal to the annuity payment). The income would be broken out as $75k of interest and $25k of LTCG, because interest is taxed at ordinary rates and would be used first, while the LTCG is taxed at a preferential rate. The remaining LTCG of $75k is accumulated at the trust level as ‘undistributed capital gains’ and is subject to the same ordering rules as above each subsequent year.
Note that most trusts will start with a significant amount of LTCG arising from the sale of the highly appreciated asset that was initially contributed to fund the trust.
Why Do People Use CRTs?
The reasons why people use CRTs vary on a case-by-case basis, but generally speaking, the planning opportunities and potential benefits of creating a CRT can be considered from an (1) income tax perspective, (2) an estate planning perspective, and (3) a philanthropic perspective.
Why People Use CRTs Reason #1 – Income Tax Planning
First, one of the most popular income tax planning opportunities with CRTs is if you have a large, unrealized gain on a stock position, you could contribute this to a CRT. Since the trust itself does not pay tax, the sale and resulting recognition of capital gain would not happen immediately. The gain to recognize would be limited to the annuity payment each year and any excess gain would accumulate at the trust level until it is used (as described above). Thus, this is a way to help diversify out of a concentrated, highly appreciated position, without needing to recognize gain on the entire amount in the year of sale.
A second income tax planning opportunity is the charitable deduction you receive in the year of funding the trust. The deduction is essentially equal to the present value of the expected amount to be received by the remainder beneficiary (the charity) at the end of the trust term, which is calculated with the help of software. This can be a good planning tool to use in a particularly high-income year, if you are charitably inclined and have an interest in any of the above as well.
A final strategy for state residency planning may come into play if you combine the charitable deduction and the capital gain deferral strategy. Imagine a taxpayer who currently lives in California and is in the highest income tax bracket and has plans to move to a lower tax state in the future. They can set up their CRT while a California resident in a high tax year, contribute highly appreciated stock to get their charitable deduction, and then have the CRT sell the stock. In a subsequent year they then move to Florida or Texas (or another low/no tax state). After establishing residency in the new low/no tax state, distributions from the CRT carrying out capital gain income will be taxable for federal but not to California (since they’re no longer residents). This strategy essentially allows you to diversify while a California resident and avoid California tax on any future distributions occurring after you leave the state.
Other CRT strategies beyond the scope of this article may include the use of a FLIP CRUT, or NIMCRUT, or contributing qualified small business stock (QSBS) to the CRT.
Why People Use CRTs Reason #2 – Estate Planning
From an estate planning perspective, CRTs help transfer a portion of your assets out of your estate. There is no gift tax impact upon the creation and funding of the trust, and at the end of the term, the assets that are remaining in excess of the annual annuity payments will transfer to a charity of your choice and outside of your estate.
Please note, however, that during the trust term, while you, as the grantor, are receiving annuity payments, the assets of the trust are includable in your estate.
This technique is what is called a “freezing” technique, since the original contribution value will still be in your estate, but the appreciation while in the CRT, and the amount that goes to charity will be out of your estate.
Why People Use CRTs Reason #3 – Charitable Giving Planning
Finally, your charitable goals are another main reason to consider a CRT, as the remainder beneficiary of the trust assets is a 501(c)(3) charity of your choice.
Note that more than one charity can be identified in the trust, and there may also be some flexibility to change the charity in the future (so long as it is still an IRS-approved 501(c)(3)). You may also structure the remainder to go to a Private Foundation or even a Donor Advised Fund.
The annuity payments can provide annual income to the grantor to help cover living expenses or their lifestyle, while the trust continues to appreciate, and the end balance goes to a charity.
Per the rules for a CRT, a minimum amount is required to remain in the trust at the end of the term, meaning the charity is required to receive (at a minimum) 10% of the value of the funds that were initially contributed to the trust. This prevents a grantor from making the annual annuity too high and not leaving anything in the trust at the end of the term.
With that said, a well-performing CRT can still result in the donor receiving more value than the original amount contributed, even after the charity receives the remainder.
Common CRT Pitfalls
One of the main pitfalls of setting up a CRT is the administrative burden of making sure the trust is in compliance with the trust agreement.
This means making sure the correct annuity payments are calculated (if necessary) and distributed in accordance with the agreement, as well as the preparation of the annual tax return. The tax return (Federal Form 5227 and its state equivalent) can be relatively challenging to prepare. And keep in mind that there is a fiduciary duty to both the income and remainder beneficiaries to get the numbers right, including the complex ordering rules for K-1 income character.
Each state is different in the treatment of these trusts; however, at least for California, they still require this return type to be mailed to them, as opposed to being filed electronically, which can create an added burden.
Another consideration to make, which may be fairly obvious based on the nature of the trust, is that a potentially large portion of the assets of the trust will go to charity. Most would agree that the assets going to charity is objectively a good thing, but it can be in opposition to your estate planning goals for family members.
If you are not a particularly charitably inclined person, this is something that needs to be thought through carefully. You may not want so many assets to go to a charity, instead of to your direct beneficiaries (family or friends).
Final Thoughts on Charitable Remainder Trusts (CRTs)
Charitable Remainder Trusts are a common tax planning vehicle and can be a great tool in helping you properly plan for your wealth.
If you are considering setting up a CRT and want to discuss whether or not it would be a good fit for you, please reach out to start a conversation. Alternatively, we can also help if you have a CRT and want to review if it’s being administered correctly and performing to expectations.
