Investment Choices Affect CRT Management – Part II – Henry & Associates
Trail of Tiers II – More on Why Investment Choices Affect CRT Management
For the trustee of a §664 CRT, the accounting for the “4 tier” treatment of distributions can be best described as WIFO (worst in – first out). Consider the choices made for Susan Barry’s CRAT as an example. She contributed $1 million of appreciated stock in a publicly traded consumer products manufacturer to her 5% CRAT and will receive $50,000 annually from the trust for the balance of her life. Unfortunately, her financial advisor was more interested in selling product than solving problems and suggested that the trust reinvest her stock portfolio inside the CRT with tax-free municipal bonds. His rationale was that the trust would be able to pay out her $50,000 distribution in tax-free income. This is typical for some promoters who have a basic understanding of charitable trusts, but lack a lot of depth.
What actually happens if tax exempts are used as investments in a CRT funded with appreciated property is that all of the unrealized capital gains have to be paid before any tier 3 tax exempt income can pass to Susan. Since she had only $100,000 basis in her $1 million of stock, this means $900,000 of realized capital gains must be paid out (and taxed at 20%) before any of the tax free income can be recognized. Since the tax free municipal bonds only earn 5.25% the trust corpus can’t grow to benefit the charitable remainderman. This becomes even more important in a unitrust (CRUT), as the income beneficiary would be shortchanged as well, since the CRT distributions couldn’t keep up with inflation. In Susan’s CRAT, it would take 18 years of sub-par performance before she could benefit from the tax free income. That’s poor trust management in the opinion of many trust administrators and a few state attorneys general who often oversee CRT performance to protect the charities’ interests.
| Hypothetical Performance Over Ten Years | 5% CRAT | 5% CRAT | 5% CRAT | 5% CRUT |
| $1 million transfer ($100,000 basis) to CRT | 5% Income Portfolio | 5% Income 5% Growth | 10% Tax Efficient | 10% Tax Efficient |
| 1st Year Income Payout | $50,000 | $50,000 | $50,000 | $50,000 |
| Tier #1 Income Distribution Taxed @ 40% | $50,000 | $50,000 | $0 | $0 |
| Tier #2 Income Distribution Taxed @ 20% | $0 | $0 | $50,000 | $50,000 |
| 10th Year Income Payout | $50,000 | $50,000 | $50,000 | $74,305 |
| Remainder to Charity in 10th Year | $1,000,000 | $1,796,871 | $1,796,871 | $1,552,970 |
Trustees have a duty to manage the trust’s assets for the benefit of both the remainder and income beneficiary. It can be done without exposing the trust to excessive risk or volatility and with appropriate custom document provisions, tax efficient investing should be an integral part of any CRT trust management.
© 2000 — Vaughn W. Henry
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