Charitable Remainder Trust Strategies
A Charitable Remainder Trust is a split interest trust consisting of an income interest, which is paid to the donor or other beneficiary during the term of the trust, and a remainder interest, which is paid to the designated charity. The purpose of this strategy is to harbor net investment income in a tax-exempt environment while leveling income over a longer period of time to keep MAGI below the threshold amount. CRTs are especially useful when there is a large capital gain that pushes income above the threshold amount. In this podcast, Bob Keebler explores using CRTs in year-end planning strategies for your clients. Visit the AICPA PFP Section’s Post American Taxpayer Relief Act and Net Investment Income Tax Toolkit for more in-depth resources on planning in preparation for year-end.
This podcast was originally recorded Oct. 2, 2013.
ROBERT S. KEEBLER, CPA: On behalf of the Personal Financial Planning Section of the AICPA, welcome to Year-End Planning: Charitable Remainder Trust, CRT Strategies. I'm Bob Keebler and I'll be your host today.
A Charitable Remainder Trust is a split interest trust consisting of an income interest -- generally, to your client or to a child or to their spouse -- and a remainder interest that will pass to charity. During the term of the charitable trust, the income interest is generally paid out to the donor or some other named individual. At the end of the trust term, when the donor dies or when that individual dies or after a term of years, whatever's left in the trust is paid to a charity.
This is a very powerful strategy for someone that wants to make sure property eventually passes to their favorite charity. It's also powerful from an income tax perspective and to reduce the net investment income tax.
One of the leading strategies that's evolving is to use a CRT to harbor net investment income in a tax-exempt environment while, at the same time, leveling income out over a longer period of time to keep modified adjusted gross income below the threshold amount for the net investment income tax. Very important to keep in mind that clients can be -- if they time their sales correctly, they can be in the 0% or 15% capital gains rate. Absent the proper thought and timing, it's very easy to see that clients would get up into a 23.8% rate just for one year when they had a big sale.
So your client -- on Page 5, your client transfers highly appreciated assets to a charitable trust. Annually, they take payments back from that trust. At the donor's death, the charity receives individual assets held in the trust. Now, the goal here is to be able to diversify a concentrated portfolio without having to pay income tax, because what happens is, when the trust sells the property, there is no income tax due because of the special tax-free nature of the trust under Section 664 of the Code.
There are two types of charitable trusts. The Charitable Remainder Annuity Trust or a Charitable Remainder Unitrust. The vast majority of charitable trusts are done as unitrust not as remainder trusts. And, basically, each year, your client will receive a stated percentage of the assets in the trust. In an annuity trust, each year, the beneficiaries receive a stated amount of the initial trust assets each year.
So, in an annuity trust, the distribution would be based -- predicated upon the initial balance of the trust and it would never change. In a unitrust, the distributions will flex, predicated upon the value of the assets in the trust.
Charitable Remainder Trusts can be used to reduce or avoid the surtax and the incremental 5% capital gains tax by smoothing out income, by trying to keep income below the threshold amts. Charitable Remainder Trusts are particularly useful when a taxpayer has a large capital gain that pushes income above the threshold amounts.
Before explaining how the planning works, let's go through some background to help us understand charitable trusts in general.
Now, when your client transfers property into a trust, your client will not realize gain or loss when the property is transferred to the trust. However, there are some exceptions. If there's -- the basis of property is less than indebtedness or the grantor receives property from the charitable trust in exchange for the transfer to the trust.
Now the donor will not realize gain or loss if and when the transferred assets are subsequently sold by the trustee of the charitable trust. The beauty of this, in the right situation, the charitable trust can sell this property completely tax-free.
Now, the character of the income received by the recipient is subject to and controlled by what are called the tier rules. I'm on Page 9, please.
First, distributions from the trust are ordinary income, followed by capital gains, followed by tax-exempt income and, finally, return of principal or basis. Further, although the dollars coming of a CRT might be subject to the net investment income tax, a Charitable Remainder Trust never will be subject to the 3.8% surtax. Further, charitable trusts are not subject to the new incremental 5% capital gains rate, when your income is over $450,000.
So, on Page 10, we've laid out what these tiers look like. When I sell property, the -- my proceeds from the sale of the property will go into one of these baskets. Now, typically, it's going to go into the capital gain basket on my initial sale. And then, when I invest it and start to bring in interest, dividends, tax-exempt interest, it will go in -- those items of income will go into either Tier 1 or Tier 2.
Capital gains will continue to flow into Tier 3 -- or Tier 2, excuse me. And they'll either be short- or long-term, depending upon how long of a holding period you actually had.
Substantial Sale CRT, the goal of the CRT is to eliminate or reduce the 3.8% surtax and the incremental capital gains tax. The goal -- for example, if you had a client that had a piece of property with a fair market value of $3.1 million and a basis of $100,000, if they sold that all in one fell swoop, they would pay tax at 23.8, the 20% capital gains rate plus the 3.8% surtax.
In the alternative -- in the alternative, if they can design a Charitable Remainder Trust, they'll be able to avoid having to pay tax at 23.8% and bring down that weighted-average tax rate.
So let's pretend T has a million-dollar stock position with a basis of zero. Scenario 1, you sell the entire position, incurring the 23.8% tax and a 5% state income tax. In the alternative, if you put the entire position into a 20-year CRUT that's then distributed out 11% a year, how is that gonna look?
Now, what happens is, if you sell immediately, you have more money upfront, but, over time, you are going to -- the weight of those initial income taxes will come back to hurt you. In the alternative, within the charitable trust scenario, after about fifteen years, you actually have more property.
Now, sometimes, what people do is they will insure themselves during that initial period of time until they get to the crossover, just in case they would die, so all that property doesn't pass to charity, leaving nothing to their family.
Many of your clients are going to be very charitably inclined and leaving substantial property to charity is good with them, they embrace that. And if they can do that and save taxes along the way, even better.
One idea that's floating out there is the Retirement CRT. Basically, many of our wealthiest clients cannot save enough for retirement and they're looking for additional tax shelter. If someone is charitably inclined and they're willing to see property eventually pass to charity, during their working years, they can drop appreciated securities into a retirement -- charitable CRT or retirement -- what we call a Retirement CRT and they will not pay capital gains on those sales and they'll be able to defer that gain until a specified event, like reaching age 65.
So, basically, let's say you have this million-dollar position with zero basis. You could sell that or you could drop it into a twenty-year charitable trust. Basically, what we're looking at doing is "Does that make any sense?" because "Are you able to shift income from a 23.8% rate down to maybe a 15% rate? Or even less, if you can mix that with some of the 0% rate?"
And I show you just a little bit of a graph. The problem is, when you sell immediately, you're going to be able to reinvest those proceeds. But, in the long run, if you use a Charitable Remainder Trust, what's gonna happen is you may not have as much money overall with the charitable CRT, but, when you -- if you look at your family and charity as one, you're going to be passing more money to your family and more money to charity combined, because you're carving the government out. You're carving the government out of part of that tax. That's the beauty of that plan.
Now, the Income Shifting CRT is a little bit of a derivative off this. What we're doing with the Income Shifting CRT is, instead of me being the beneficiary of my charitable trust, I have the beneficiary either be my children or, with great care, my grandchildren. And the beauty of that is I'm able to spread that income out to my family. I shift ordinary income, potentially, to my family. I shift capital gains to my family. And I benefit charity along the way.
So there are a number of designs here that we can put together, but, typically, in this type of situation, we'd have something like a standard CRUT and, annually, distributions would go to -- distri- -- the donor would put property in, but the beneficiary would be children and grandchildren. There are a lot of income tax, gift tax and estate tax considerations here. We have to, of course, pay attention to the generation-skipping transfer tax. But, at the end of the day, this can be a very powerful strategy.
So, basically, instead of selling all at once and incurring those taxes, we move the property into a twenty -- twenty-year-old -- or twenty-year CRT or -- and then Scenario 2 or, in Scenario 3, we do the same transaction, except for the benefit of the grandchildren, where we're going to experience lower rates.
And what we found out when we did this is that the trust for the children or grandchildren actually is better than a trust for the donor, because the children and grandchildren are potentially in such a lower rate. Maybe they're in a 15% rate instead of 23.8 or maybe some of the income is even taxed at the 0% rate instead of 23.8.
When you include the benefit to charity in your calculation, you can see just how incredibly powerful this is.
Now when we -- in today's environment, we're doing our planning in a four-dimensional tax system and we want to understand some of the mathematics of that. Now, this is very interesting, what happens is, if I look at paying my taxes in one year versus ten years, even at a 4% discount rate, the present value of those taxes -- by paying them off over ten years rather than one -- is 81%. At a 6% discount rate, we take that to 74%. So, if you did a ten-year CRT, your taxes by spreading them out, even if they were at the same rate, are only 74% of what they -- of -- in present-value terms.
Now, at a 15% rate, the -- everything's the same, but what if we can look at this over a twenty-year period of time? You can see, even at a 4% discount rate, instead of paying a dollar in tax, in essence, you're only paying 68% of that amount. And, again, same math with the 15% rate.
But, then, look at "What if you were able to pay -- if you had to pay 23.8 if you sold all at once and you compare that to a 15% rate, because you get -- you were able to spread it out?” Then what happens is the present value falls way down, because, if you analyze this, if you look at what's driving these variances, the first variance is caused by time value of money, the pure deferral. But the second value is determined by rate arbitrage, very important if you can pull this off for a client.
And, if you look at it over a twenty-year period of time, literally, even at a 4% discount rate, what would have been $100,000 of tax today becomes a 68 -- 68% of that at 23.8, the same rate, or roughly about 41 or 42% of that, if we are able to reduce that rate to 15%. Of course, that would become even lower, if part of that were taxed at the 0% rate.
Now, we've covered a lot of ground today. Hopefully, I've given you a little bit to think about with how to use CRTs in your practice. Keep in mind, the Personal Financial Planning section of the AICPA has done a lot for us. There's a thousand-page, four-volume in-depth guide for practitioners; it's excellent. Also, Forefield has a resource with 3000 different topics covering personal financial planning, including estate, tax, retirement, investment and risk management.
There are also more things coming up this fall. We're going to do a number of conferences, which we have on Page 35 in your materials. And, more importantly, if you can't make the conferences the day of the webinars, those will be taped and they'll be available to you later.
Also, join us in January for the AICPA's Personal Financial Planning Conference. It -- at the ARIA Hotel in Las Vegas, Nevada.
On behalf of the Personal Financial Planning of the American Institute of Certified Public Accountants, this has been Bob Keebler discussing Year-End Tax Planning: Charitable Remainder Trust Strategies.
Thank you for joining us today.