A charitable remainder trust (“CRT”) is a type of irrevocable trust that creates a “split interest” in contributed property between the taxpayer and one or more tax-exempt charities. This type of irrevocable trust structure provides three separate tax benefits: (a) an immediate charitable deduction to the taxpayer equal to a certain percentage of the value of the contributed assets; (b) the deferral of the capital gains taxes on assets contributed to the CRT; and (c) the avoidance of any estate taxes for assets contributed to the CRT. The CRT planning proceeds as follows:
- CRT Creation and Gifting. The taxpayer creates the CRT agreement and decides what property to transfer in ownership to the CRT. The CRT is a separate legal entity with its own tax identification number, as a tax-exempt entity, and requires annual tax filings. The taxpayer creating the CRT can be the initial trustee of the CRT.
- Valuation and Annual Term Payments. The contributed property is valued as of the date of the contribution. If the CRT is structured as an “annuity” CRT (or “CRAT”), then regardless of how much variation exists in the valuation of the CRT assets throughout its administration, the taxpayer receives the same annuity amount annually. For example, the CRT could be structured so that the taxpayer is to receive $30,000 annually, regardless of the performance of the assets then held by the CRT. If the CRT is structured as a “unitrust” CRT (or “CRUT”), then the taxpayer will receive an annual distribution equal to a certain percentage of the assets of the CRT, as revalued annually. For example, the CRT could be structured to receive 5% of the assets of the CRUT, as revalued annually. The taxpayer would receive $30,000 in one particular year, then $40,000 in the next year.
- Length of Term. The taxpayer would receive these annual payments for a specified period (the “term.”) Some taxpayers create the term to last for his or her entire lifetime; others for only a specific time period (e.g., 10, 15 or 20 years). Regardless of whether the taxpayer is alive at the end of that specified term, the remaining assets are paid out to the specified charity or charities.
- Income Tax Characterization of Distributions to Taxpayer During Term The CRUT itself, while a non-profit entity, is required to file a tax return. The tax return shows an amount, called the “distributable net income” (“DNI”), that is comprised of interest, dividends and capital gains. To the extent that the trust has distributable net income in a given year, then the taxpayer will need to report that DNI on her personal tax return in a particular year in an amount up to the required distribution amount in that particular year. For example, if the taxpayer is entitled to a $50,000 distribution in a particular year, and if the DNI for the trust was $30,000, then $30,000 would be reported as taxable income to the taxpayer, and the remaining portion of the payment ($50,000 less the $30,000 taxable portion or $20,000,) would be a tax-free distribution to the taxpayer.
- Immediate Income Tax Deduction. In the year of the contribution to the CRT, the taxpayer is entitled to a charitable income tax deduction. The amount of the immediate charitable income tax deduction will depend upon (1) the length of the term, (2) the amount of the annuity or the unitrust percentage, (3) the assumed rate of return set by the IRS at the time of the contribution of the assets to the CRT, and (4) the value of the property contributed to the CRT.
As with other types of irrevocable gifting structures, taxpayers should be particularly careful about the income tax implications of creating a charitable remainder trust. While the charitable remainder trust is itself not subject to income taxes, the required annual distributions made “back” to the taxpayer during the initial term period are subject to income taxes. The taxpayer would pay taxes first to the extent of the charitable trust’s ordinary income tax liability, and then to the extent of the charitable trust’s capital gains. As a result, if substantial taxable events occur in a particular year (e.g., sale of a highly-appreciated asset), the taxpayer’s annual distribution will be subject to taxes.