Charitable Education Trusts for Grandkids – Henry & Associates

Charitable Education Trusts for Grandkids – Henry & Associates

Charitable Education Trusts for Grandkids

Vaughn W. Henry © 1999

“There are two systems of taxation in our country:

one for the informed and one for the uninformed.”

Honorable Learned Hand (1872-1961)

Many planners believe a CRT only works for older income beneficiaries. However, there is a way for a family to fund both philanthropic goals and meet educational needs. How and why does it work? It takes the tax-free compounding of assets and uses an IRS §664 “spigot trust” to precisely control income. In the Watson family, Richard and Pam have several preteen grandchildren to help through college. However, they didn’t want to use the traditional gifting via the UTMA/UGMA approach. Instead, a CRT lets them ensure their own philanthropic legacy and still provide funds for educational expenses. In the simplest terms, Richard created individual trusts to benefit each of his grandchildren by transferring $50,000 of appreciated telephone company stock to each charitable remainder trust. By naming his granddaughter, Hannah, as the sole income beneficiary of the first “term of years” trust, he started the college funding plan last year. While most charitable trusts are intended to last over a life expectancy, this trust is designed to terminate after just 10 years and pass the remainder to the family’s charity, a donor advised fund at the local community foundation. By creating a 6% payout NIMCRUT, Richard will receive an income tax deduction of $27,858 for his $50,000 gift to the trust. Since the trust only operates for a limited time, it allows Richard and Pam to jointly make an “income interest” gift to Hannah valued at just $22,142, allocated to lifetime and generation skipping exempt gifts. Since Hannah is only 11 years old, she’s not expected to need college funding for 7 more years, so the investment will be structured to produce only growth and no “distributable” income for the first six years, allowing the CRT to grow. When Hannah turns 18, the “spigot trust” modifies the investment and pays out income for tuition at her lower marginal income tax rate.

While the trust’s performance depends on the underlying investments, it’s very important to select a tool that allows precise control of income recognition. The other common problem with a NIMCRUT is the inability to actually access the make-up account without compromising the total return portfolio of investments. “Spigot trusts” are inherently complex, so a careful review of all the options should be made. Of the many products available to the Watson’s financial advisor, a well-diversified portfolio of equities for growth may be found in a number of deferred annuities. Some advisors might question putting an ordinary income producing tax deferred product into a tax-exempt trust, but there are compelling reasons to do so, if the annuity has been especially designed to work within a CRT. The “garden variety annuity” will have too many design flaws to work properly inside a NIMCRUT, but if the document allows annuity use, it should be considered. Ordinary income tax treatment of distributions isn’t likely to be an issue for such young income beneficiaries with their already low tax rate. The other usual concerns about pre 591/2 restrictions and non-natural persons owning annuities aren’t an issue inside the exempt CRT; instead, understand why the “recognition” of annuity income works in favor of the “spigot trust”.

Given the time frame of the trust, a growth-oriented set of investments should be selected. If it performs better than expectations, Hannah will receive even more income for college expenses and the charity will benefit by having a larger remainder. As designed now, the charity should receive $104,761 while Hannah will have $42,491 of income, taxed at her lowest marginal rate, to help her pay tuition and board. The advantage to this technique for the Watson’s estate plan is that it:

• removes an appreciating low basis asset from the estate without incurring capital gains liabilities
• funds a significant growth asset without significant gift or generation skipping tax liabilities
• keeps control of assets that otherwise would be taxed and returns them to a family influenced charity
• creates an income tax deduction for a higher income older generation, with five more years of tax relief if the deductions can’t all be used in the first year

It’s not a technique for all clients or donors, but in the right situation, it works well. For a hypothetical evaluation, have our office run an illustration.