Case Studies and Articles

Trail of Tiers – Why Investment Choices Affect CRT Management – Henry & Associates

Trail of Tiers – Why Investment Choices Affect CRT Management – Henry & Associates

Trail of Tiers – Why Investment Choices Affect CRT Management

Too many trustees forget that managing a charitable remainder trust (CRT) isn’t quite like managing a personal or business entity when it comes to recognizing income for tax purposes.  The differences are evident when examining their investment philosophies.  For a charity, even those with highly experienced investment managers and sophisticated board members, almost all of their endowment funds produce income not subject to tax in their nonprofit organization.  As a result, it makes little difference to an exempt organization whether that 10% annual return comes in the form of bond interest, stock dividends or from the sale of appreciating securities.  Income is income, and it’s all generally exempt from income tax.  The same thing can be said about money managers of pension and retirement accounts.  Neither has to think about tax efficiency.  However, for the trustee of a §664 CRT, the accounting rules are somewhat different because of the “4 tier” treatment of income distributions from the trust.  Many advisors are familiar with LIFO and FIFO (last in – first out or first in – first out) treatment when selling assets and reporting tax, but a CRT uses WIFO (worst in – first out).  Because the assets retain the character of the donor’s basis and holding period, even when sold inside the tax-exempt trust the income distributions generate tax liabilities with all income passing out as first tier (ordinary) before more favorable tax treatment can occur.

tiersConsider 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.  As a result, she will receive $50,000 annually from the trust for the balance of her life.  While she will receive some tax deduction for the gift of a future interest to charity, of more concern to her is the tax treatment of the income she receives from her trust.  If the trustee reinvests her $1 million of stock into bonds to preserve principal, all of the income that passes to Susan will be tier #1, ordinary income, taxed to her at nearly 40%.  This means she will get to keep $30,000 of the $50,000 distribution.  That’s a $10,000 annual penalty for an asset that would have otherwise been taxed at just 20%.

Considering the Prudent Investor Rule, suppose the trustee chose to use a portfolio of stocks and bonds, believing this to be the most beneficial for both the income and remainder beneficiary.  Generating a respectable performance with 10% returns annually, the blended portfolio produces bond income, preferred or common stock dividends and some appreciation.  Unfortunately, all of the tier #1 interest and dividend income has to be paid and taxed before any tier #2 capital gains can be used.  This investment strategy produces some growth benefiting the charitable remainderman, but it still has a negative effect on Susan’s spendable income, since it’s still all taxed at ordinary rates.  If the portfolio were more aggressively invested in individual growth stocks or tax efficiently managed mutual funds, more of the income distributions would come from tier #2, realized capital gains, leaving Susan with a distribution taxed at just 20% and handing her $40,000 of spendable income.

Trustees need to remember they have a duty to manage the trust’s assets for the benefit of both the remainder and income beneficiary.  If it can be done without exposing the trust to excessive risk or volatility, I think it can be argued that both sets of beneficiaries benefit from the growth associated with a more equity oriented portfolio inside a CRT.

© 2000 — Vaughn W. Henry


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