CRAT or
CRUT?
Selecting the Right Trust for Your Needs
One would think a simple “either
– or” decision would be the easiest to make, but as it turns out it is not
always so straightforward. Take the
choice of charitable remainder trust. Which
works better for the client – the annuity or one of the unitrust variations? Well, many prospective trust makers throw the
choice back to their advisors, assuming that because there is a legal,
financial planning, or accounting professional designation or degree that their
advisors know what is best. As it turns
out, that’s not necessarily so since so many professionals now specialize and
can’t be expected to know all the problems associated with every tax planning
situation, and few know anything about §664 split interest trusts. It is not reasonable to expect litigators and
general practitioners to know about obscure tax rules any more than a
psychiatrist would be competent to perform a kidney transplant. The possession of an MD, CFP, CPA, or JD
designation only provides a framework for future knowledge and experience. What is most important is the practical
application of that knowledge, and with charitable remainder trusts, there are
precious few professionals who have ever seen one, much less understand them. As an example of the compartmentalization
found among professionals, examine the planning that went into former President
and Mrs. Clinton’s 1997 tax returns.
Arguably, while the
The
“It Takes a President to Overpay the IRS”, New York Times,
For most planners who don’t specialize
in charitable planning, their assumption that a CRAT is best for old folks and
a CRUT is best for younger donors isn’t necessarily the best way to make a
decision about a trust that’s irrevocable.
This is especially true when the timeline of the CRT, something with
which a donor must deal for years, is considered. Disagreements among advisors often pop up over
investments inside a CRT since few financial advisors really understand the
fiduciary accounting peculiarities of investing for a tax-exempt CRT. Because a charitable trust invests over a
long time horizon, and the trust does not usually pay income tax on its growth
or income, chasing returns and reacting day to day is not the style of
investing that works best for the CRT. Add
to the long term view the very real concern about avoiding unrelated business
income that may be unintentionally created when a broker uses a margin account,
acquires partnerships or other working interests that expose the trust to
“toxic income” that loses the CRT its tax-exempt status.
A well drafted CRUT allows,
even encourages, additional contributions; however, it is not an option in the annuity
trust. Trustees need to properly fund
the CRAT and be extra cautious to ensure that it is just one straightforward
transaction and not in bits and pieces over a period of days. With a charitable remainder annuity trust
(CRAT), the payout is irrevocably set in a fixed dollar amount at the inception
of the trust, and this rigidity creates several potential problems for trustees
managing the trust and its investments.
Which trusts work best? Sometimes knowing which trust will not work
is a good place to start. For example,
if a donor contributes cash or publicly traded stock, that is a workable
solution, but if undeveloped land goes into to a CRAT, the downside risks are
numerous.
- Will the asset produce enough income to meet the
required income distributions? A
CRAT may not defer required distributions and being illiquid is not an
excuse.
- If the asset is not an income-producing asset, is
it readily marketable to make the required distributions?
- If the CRAT does not have enough liquidity to
meet the obligations of the trust, is the asset easily partitioned in
order that the income beneficiary can receive an in-kind distribution? As an added insult, those in-kind
distributions typically trigger capital gains tax liabilities, so the
beneficiary receives his or her land back and has a tax bill to boot. That is a recipe for an unhappy client –
advisor relationship.
- Was the contribution of the asset matched with
enough additional cash to pay insurance, property taxes, maintenance,
marketing, and operating expenses?
Remember, there can only be one contribution in a CRAT, so any cash
transfer has to occur simultaneously with the transfer of the real estate
deed.
- Generally speaking, a CRAT is a better tool for a
donor unconcerned with eroding purchasing power, and it is typically used
for clients with little tolerance for volatility and short term needs,
i.e., less than ten years, otherwise inflationary pressures diminish the
value of the income distributions.
- The minimum annuity paid at least annually must
be at 5%, but cannot exceed 50% of the initial fair market value of the assets
contributed to the trust. In most
cases to prevent trust exhaustion, a CRAT paying out more than 6.5% is a
concern.
- After the Taxpayer Relief Act of 1997 passed, the
charity's calculated remainder interest must be worth at least 10% of the
value initially transferred to the trust.
This severely restricts young individuals from having a life income
interest in any CRT, and restricts payouts to lower levels for many
trusts, especially if there are more than two income beneficiaries.
- Because there is a very real possibility of a
CRAT collapse in a poor investment environment, these trusts must also
meet a 5% probability test [Rev Rul
77-374]. If the trust fund has a
greater than 5% chance that it will exhaust before the trust terminates
and passes to the charity, then the trust will not produce an income tax
deduction or qualify as a CRT.
|
CRAT vs. CRUT invested in
a growth mutual fund |
Too many
trustees take an ultra- conservative and shortsighted investment approach to
preserve principal. However, prudent
investment management is important if the income distributions are going to
be tax efficient and the remainder value is to appreciate for the benefit of
the charitable beneficiary. As an
example of a well balanced equity approach, an annuity trust (CRAT)
established on January 1, 1990 and funded with $250,000 that purchased diversified
GFAA shares (after fees) would produce significant gains, even with the fixed
dollar annual income distributions of $12,500 (5% of the initial value)
made through the end of the trust period.
While this specific trust is historically accurate in depicting annual
returns even through several real market corrections, there is no guarantee
of similar performance in the future; however, this particular fund has produced
a trust remainder value of $928,488 as of Using
exactly the same investment vehicle and historical time horizon as the CRAT above,
a 5% charitable remainder unitrust (CRUT) that pays a fixed percentage
of the trust (annually revalued, so the payouts vary with the trust’s
investment performance), yet it still produces a significant return of
$765,884 for the remainder beneficiary and the income interest is enhanced to
offset the effects of inflation. A
variable payout CRUT takes a percentage of a well-invested and diversified
trust and increases in value. The CRUT in the example produced $273,444 of
aggregated income over the twelve year period. Compared to the CRAT’s income payments of
just $150,000, it should be obvious that the variable payout unitrust offers
more opportunity for growth if the investment performs properly. Besides having a greater opportunity for an
improved income stream, an equity based trust investment tends to produce
more tier two (realized capital gains) income. Remember, realized gain taxed at the more
efficient 20% rate leaving the income beneficiary with more spendable income,
rather than being penalized at the highest marginal ordinary federal rate of
up to 38.6%. |
|
Select Appropriate Charitable
Remainder Trust |
|
|
Which CRT Works Best? |
|
|
§ 644 Trust Options |
CRAT |
SCRUT |
FLIPCRUT |
NIMCRUT |
|
Is Current Income Needed? |
Y |
Y |
Y** |
Y*** |
|
Spigot Income or Deferral Strategy
Allowed? |
N |
N |
Y** |
Y*** |
|
Contribution of Hard-to-value Illiquid
Assets |
N |
N/Y |
Y |
Y |
|
Multiple Contributions Allowed |
N |
Y |
Y |
Y |
|
Fixed and Secure Income Desired |
Y |
N* |
N* |
N* |
|
Easy to Understand |
Y |
Y |
N |
N |
|
Preferred for Younger Income
Beneficiary |
N |
Y |
Y |
Y |
|
Flexible |
N |
N |
Y |
Y |
|
* Depends on payout rates that are
lower than CRT investment portfolio’s performance |
|
|
**
Depends on FLIP triggering event |
*** Depends on underlying assets
inside CRT |
© 2002 -- Vaughn W. Henry
Gift
and Estate Planning Services
217.529.1958
-- 217.529.1959 fax
VWHenry@aol.com
on
the web at gift-estate.com
CRT Planning and Books
Vaughn W. Henry
Henry & Associates
Gift and Estate Planning Services
22 Hyde Park Place
Springfield, IL 62703 USA
Phone: (217) 529-1958 Fax: (217)529-1959
Toll-free: (800) 879-2098
E-mail: VWHenry@aol.com
CONTACT
US FOR A FREE
PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct.
Please note -- there's much more to estate and charitable planning than simply
running software calculations, but it does give you a chance to see how the
calculations affect some of the design considerations. This is not "do it
yourself brain surgery". Knowing when a CRUT is superior to a CRAT or which type of
CRT is best used with which assets and what investments "poison the trust" is critical. Although it may be counter-intuitive,
sometimes a lower payout CRUT makes more sense and pays more total income to
beneficiaries. Why? When should you use a CLUT vs. CLAT and what are the traps found in each lead
trust. Which tools work best in which planning scenarios? Check with our office
for solutions to this alphabet soup of planned giving tools.
