The 10 Per Cent Solution — CRT Planning Traps
The 10 Per Cent Solution — CRT Planning Traps
Vaughn W. Henry
As a result of changes to tax law, be aware that there are a few wrinkles that crept into the creation of a charitable remainder trust (CRT). In an effort to force charitable intent and minimize abuses, the §1089 section of the Taxpayer’s Relief Act of 1997 now mandates a 10% remainder value for the charity’s portion of the split interest gift. What factors affect the charity’s remainder? Number and age of beneficiaries or length of trust term, per cent payout to the income beneficiary, type of CRT and contributed asset, the §7520 120% applicable federal rate (AFR) and initial contribution all affect the tax deduction. However, the remainder is also significantly affected by the investment returns inside the trust and the IRS has little control over that influence. For this reason, the trustee needs to be very aware of the long-term results of a diversified and well-structured portfolio.
TRAPS
When discussing a CRT as a planning option, pay close attention to the charitable remainder calculations. From a practical perspective, it just means taking more care to make sure the trust qualifies. Concerns about having a CRT eligible as a tax-exempt trust under §664 are made more difficult if there are either high payouts or young income beneficiaries. During the planning process, the problem often occurs if there is a large disparity between ages of the income beneficiaries, e.g., parent – child or with spouses of much different ages. It may also occur if several income beneficiaries are included, for example, if a grandparent attempted to set up a trust for his 4 grandchildren. The choice between per cent payout and per cent deductibility also needs to be examined over the time frame of the trust. Unfortunately, too many planners view income tax deductions as the primary motivation to establishing a CRT. In reality, the power of the trust is in conserving the capital gains and investing the entire sale proceeds of an appreciated asset inside a trust that compounds the investment performance tax-free. An added benefit is the control or influence over the trust’s social capital disposition that becomes an important component of the plan for many families.
OPTIONS
If the CRT does not qualify, then a term of years trust (not to exceed 20) or a CRT with a lower income payout might. In the example above, the 5% payout is already the least allowable, so it may make sense to try to include fewer income beneficiaries instead. How could this work? In the case of a married couple, consider offering the younger, healthier and probably female partner the income beneficiary designation. If she’s the last to die (a statistical probability), then the income stream would pass to the family unit as it would have if both spouses were each receiving 50% of the CRT. There is no difference. However, if she predeceased her spouse, then he loses all the future income benefits and there is an increased risk to consider. To reduce the risk of income loss to the non-income beneficiary, an insurance policy could be acquired for a term long enough to recover the value of the contribution.
RESULTS
A successful unitrust produces a steady stream of increasing revenue; if properly invested, it also delivers tax efficient income. Besides benefiting the income beneficiary, high quality investment returns also produce a larger corpus for the charity. In the example above, the IRS assumes that the trust won’t generate more than the AFR of 6.6% and that seems to be an unrealistically poor return for a trustee’s performance over the young income beneficiaries’ 50 year life expectancy. Moving the trust investments from an 8% return eventually producing $1.1 million to 10% means that $2.8 million goes to charity instead, and a 12% return generates $7.3 million to charity. The fiduciary obligation to manage for both current income and the deferred beneficiary should encourage the trustees to look long term and seek sophisticated investment counsel for best results.