Investment Hypo within a CRT – Part II – Henry & Associates

       Continuing with the case study for John Anderson, a 72 year-old brokerage firm client, and his $1 million worth of low basis real estate.  His broker has suggested the use of a CRAT, rather than a CRUT.  The broker’s rationale is that John’s age and need for security leans more heavily towards a fixed dollar payment of an annuity trust, as compared to the variable payout produced by the unitrust. 

On the other hand, John is a sophisticated investor who believes in maintaining a diversified portfolio.  He is also concerned about inflationary erosion of his purchasing power, and he reminded the broker that his mother and father both lived well into their mid-90’s  Because of these factors, he has decided to make use of a variable payout charitable remainder unitrust (CRUT).

However, the final nail in the CRAT coffin was when John reviewed the history of CRAT performance and realized that funding a CRAT with capital gain assets might mean that his payouts would be trapped in tax inefficient tier one ordinary income distributions.

        Why is it important to invest tax efficiently? 

       Under the fiduciary accounting system, a CRT funded with appreciated assets and inefficiently managed pays the cost by receiving more highly taxed, tier one ordinary income.  The accompanying IRS data on charitable remainder trusts specifically deals with annuity trusts (CRAT) but contains a valuable lesson about CRT investment management gone wrong.  What conclusions should investment advisors take from these three graphs?

1.   The trusts are typically funded with appreciated assets.  If sold, realized gains would generate federal liabilities taxed at 20%.

2.   The appreciating CRAT value is often due to net ordinary income, short-term gain (taxed at ordinary rates) and long term gains.

3.   The CRAT contains significant pre-contribution appreciation and potential tier two (unrealized capital gain) income.  Unfortunately, the distributions contain mostly tier one ordinary income from interest, rents, dividends, royalties and short-term gains.

       With tax managed sales and purchases, John should be able to receive more tier two income.  Regrettably, most trustees wind up trading in a capital asset for an ordinary income payout.  That suggests a higher standard of investment advice and management should be available to CRT trustees.  Very few trustees or their professional investment managers really understand the limitations of investing inside a charitable trust, even those with very large charitable trusts ($10 million and above) are inefficient. In addition to that group, there are many large charities with trusts under management that may not truly understand how different the management of a CRT is from their endowment accounts.  Seek competent and experienced advisors to achieve the best results for your income and remainder beneficiaries.