Navigating the maze of Internal Revenue Code regulations and Treasury Regulations in order to ensure that the Charitable Remainder Trust is qualified and valid under such regulations is complicated and time consuming. While the IRS provides sample language, the samples do not contain other provisions that are commonly incorporated into trust agreements in California, such as standard trustee powers, spendthrift clauses, perpetuities savings clauses, and definitional provisions. A misinterpretation of the complex rules will result in a loss of the income, gift, and estate tax charitable deduction.
Tamara L. Harper, Esq. incorporates these California trust provisions into the trust agreement to the extent they are not inconsistent with IRS mandated requirements. You should engage competent and experienced counsel to prepare a charitable remainder trust.
A Charitable Remainder Trust provides for a specified distribution, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or for a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, charity.
An annuity trust requires that distribution be a sum certain which is not less than 5 or more than 50 percent of the initial net fair market value of the trust assets. A unitrust requires that the specified distribution be a fixed percentage which is not less than 5 or more than 50 percent of the net fair market value of the trust assets determined annually.
The value of the remainder interest in a charitable trust, whether an annuity trust or unitrust, must be a least 10 percent of the initial fair market value of all property placed in the trust. To qualify as a charitable remainder trust, a trust must be either a charitable remainder annuity trust in every respect or a charitable remainder unitrust in every respect. A hybrid that incorporates features of both types will not qualify for the charitable deduction.
CHARITABLE REMAINDER ANNUITY TRUST
By using a charitable remainder annuity trust (“CRAT”), a donor can transfer property to a trust, provide an annuity for a term of years or for the life or lives of an individual or individuals, and deduct as a charitable contribution the present value of the remainder interest that will eventually pass to a qualified charitable organization. The CRAT must pay a sum certain, which is not less than 5 or more than 50 percent of the initial net fair market value of the property placed into trust, to at least one noncharitable beneficiary. This sum must be paid at least annually either for a term of years not to exceed 20 years, or for the life of the noncharitable beneficiary. Unique to the charitable remainder annuity trust is the inability to provide for a fixed percentage payout that is to be increased upon the happening of some event.
The CRAT must be funded all at once and cannot allow any additional contributions to the trust after the initial contribution. There is an exception to this rule for testamentary charitable remainder annuity trusts e.g. passing by reason of death.
CHARITABLE REMAINDER UNITRUST
The charitable remainder unitrust (“CRUT”) is an important deferred giving tool. The use of a unitrust allows a donor to provide a variable annuity payable for a term of years or for the life or lives of an individual or individuals, and to obtain a deduction for the present value of the remainder interest that ultimately will pass to a qualified charitable organization.
A CRUT must pay a fixed percentage, which is not less than 5 or more than 50 percent, of the net fair market value of its assets to one or more beneficiaries, at least one of which is not a charitable organization described in I.R.C. §170(c). Payment must be made at least annually and the unitrust assets must be valued at least annually. Valuation may be required to be completed by an independent auditor and current qualified appraisal.
Additional contributions to a CRUT are permitted only if the trust instrument provides for them and provides for both valuation of the property at the time of contribution and determination of the prorated unitrust amount based on the values.
A CAUTIONARY NOTE
REGARDING MORTGAGED PROPERTIES
Mortgaged property may cause unrelated business income to the trust under the Internal Revenue Code, realization of gain to the donor, and penalties for self-dealing. The transfer of mortgaged property, when the donor is liable for the debt and when the charitable remainder trust may make payments on the debt, will cause the trust to fail to qualify due to treatment as a grantor trust.
A significant advantage may be gained by transferring appreciated property to a charitable remainder trust. After the property has been transferred to the trust, the trustee can sell the property and reinvest the proceeds without the trust or the grantor incurring an immediate income tax on the resulting gain. The grantor will then be taxed on the gain only to the extent authorized distributions made from the trust to the grantor are treated as gain.
WHO CAN BE THE GRANTOR OR TRUSTEE?
The grantor can be any individual, trust, estate, partnership, association, company or corporation. Any money or other property can be transferred to a charitable remainder trust. However, with tangible personal property, there is no income tax deduction if the grantor or related parties are named as income beneficiaries.
The trustee can be any person, including the donor, who often prefers to retain the power to administer the trust assets. However, in a trust in which the donor has the power to affect the income distributions, the donor will be considered the owner of the trust and thus, included with the donor’s own assets for tax purposes. When the trust includes hard to value property such as closely held stock and real estate, an independent trustee is needed.
WHAT ABOUT THE BENEFICIARIES?
Charitable remainder trust income must be paid to one or more persons, at least one of which is not a charitable organization, for a term of years not exceeding 20 years or the life of the individual. Upon termination of the required payments to the income beneficiaries of a charitable remainder annuity trust or unitrust, the remainder interest in the trust must be transferred to, or for the use of, a qualified charitable organization as described in I.R.C. §170(c).
Donors should be cautioned that some of these organizations do not qualify for the 50 percent income tax charitable deduction, the gift tax charitable deduction, or the estate tax charitable deduction. Thus, it is my opinion that in order to assure the higher income tax percentage limitation when the donor intends the remainder to be received by public charity, that the trust further require that the organization selected as an alternate remainderman also qualify under I.R.C. §170(b)(1)(A).
If any provision is included with the charitable remainder trust that allows the donor to dictate the trust’s investment policy, no charitable deduction for income, gift, or estate tax purposes will be allowed.
If any provision is included within the trust that allows the power to alter the amounts paid to beneficiaries of a trust could cause the individual to be the owner of a trust or part of a trust, even though the individual is not directly a beneficiary, and consequently the trust will not qualify as a charitable remainder annuity trust or charitable remainder unitrust.
Charitable remainder annuity trusts and charitable remainder unitrusts are distinct entities under the law. These trust are not “exempt organizations,” however, they are generally exempt from income tax, except when they have unrelated business taxable income as defined in I.R.C. §512. These trusts may accumulate income tax free, any realized income or gain in excess of the amount required to satisfy their obligations to noncharitable income beneficiaries.
The income tax consequences of a deferred gift are determined by a variety of factors, including, the type of trust selected, the length of the noncharitable beneficiary’s interest, the age and number of the noncharitable beneficiaries, the amount of the annuity percentage rate, and the applicable federal interest rate. The tax consequences should be discussed with your tax professional, CPA and attorney. A charitable contribution is available for the present value of the remainder interest that will pass to a qualified charitable organization. If you would like further information about calculating the present value of the remainder interest, please contact Tamara L. Harper for an initial office consultation.
The gift tax consequences are determined by a number of factors, such as whether the noncharitable interest is for a fixed term or created for the life or lives of an individual or individuals, whether the donor or spouse or other individual is the beneficiary, and whether there is a power to revoke the income interest. Generally, when there is a transfer of property to a charitable remainder trust in which an income interest is retained for the donor for a period of years, there are no gift tax consequences, and the gift of the remainder interest qualifies for the gift tax charitable deduction. I.R.C. § 2522(c)(2)(A). When the income interest in a charitable remainder trust is created for successive lives, the gift tax consequences may differ. If you would like further information unique to your situation, please contact Tamara L. Harper for an initial office consultation.
The estate tax consequences are dependent upon whether the arrangement is for a fixed term or for the life or lives of an individual or individuals, or whether the beneficiary is the donor, donor’s spouse, or another person. For fixed term arrangements, the estate tax consequences will depend on whether the donor retained a testamentary power to revoke the beneficiary’s interest and whether the interest expired before the donor’s death.
Generally, the annuity and unitrust amounts paid by the charitable remainder trusts to the noncharitable beneficiaries are taxable to the recipients. The beneficiaries are required to treat the individual distributions in accordance with a four-tier order of distribution pursuant to I.R.C. §664(b). This is a complicated area and is beyond the scope of this article.
In conclusion, the charitable remainder annuity trust is advantageous for a donor who wants the income beneficiary to receive a fixed amount during the term of the trust, because the amount of the required annual distribution can be fixed, at not less than 5 or more than 50 percent of the fair market value of the assets on the date of transfer to the trust. The income beneficiary, however, will have no protection against inflation and no additional contributions are allowed. If you wish to make a series of contributions, you should consider a charitable remainder unitrust.
The unitrust is the preferred tool to hedge against inflation, since the annual distribution to the unitrust beneficiary is determined annually by the value of the trust’s assets. The uncertainty of the amount of the annual payment to the beneficiary in a volatile market, however, is a disadvantage in addition to the added administrative cost of the annual valuation of the trust’s assets as discussed above. The ability to make additional contributions after the initial transfer may outweigh this burden, however, and the same trust can be funded with several transfers of property.
As always, I appreciate your referrals and your business and look forward to working with you and showing you ways to protect and maximize your wealth and assets.