CRT investment diversification and risk-taking strategies.

• Author: Hall, Jennifer L.
• Position: Charitable remainder trusts

This article examines tax and investment aspects of the use of a charitable remainder trust (CRT), including how a donor may use a CRT to diversify an investment, portfolio, how his investment incentives are affected by transferring assets to a CRT and why tax-advantaged investment vehicles (such as municipal bonds) may be appropriate. Finally, it discusses how investment wrappers (e.g., such as variable annuities and single-member limited liability companies) may provide a donor with flexibility in timing income recognition for CRT distributions.

A charitable remainder trust (CRT) is an irrevocable split-interest trust in which one or more noncharitable beneficiaries receive a lead income interest; a qualified charity receives the remainder. If the trust qualifies, an income and gift (or estate) tax charitable deduction for the remainder interest's present value is allowed when funds are transferred to the trust. In addition, the trust is exempt from tax unless it has unrelated business taxable income (UBTI). A CRT offers the flexibility to accomplish various tax planning and charitable objectives. For instance, it is available to a broader range of clients and offers tax-free diversification opportunities similar to a "swap fund."(1)

This article examines tax and investment aspects of the use of a standard CRT. Familiarity with these topics will help a tax adviser recognize when a CRT is the correct choice for a client. The article first discusses how a donor may use a CRT to diversify an investment portfolio while deferring or avoiding the tax on accrued gains. This discussion includes an analysis of the tax savings and payouts available from a CRT versus the loss of portfolio assets eventually transferred to the charity. Second, the article addresses how a donor's investment incentives are affected by transferring assets to a CRT and demonstrates that a CRT encourages investment in riskier assets relative to non-CRT holdings. Further, it shows how tax-advantaged investment vehicles (such as municipal bonds) may be appropriate for a CRT, despite the trust's tax-exempt nature. Finally, it discusses how investment wrappers (such as variable annuities and single-member limited liability companies (SMLLCs)) may provide a donor with flexibility in timing income recognition for CRT distributions.

Overview

If a CRT meets Sec. 664's requirements, an income and gift (or estate) tax charitable deduction is permitted for the present value of the charity's remainder interest when money or property is transferred to the trust.(2) Further, a CRT is exempt from tax under Sec. 664(c) unless it has UBTI.(3)

Sec. 664 lists two forms of CRT, the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT). A CRAT pays non-charitable beneficiaries a sum certain over the trust's life. A CRAT grantor may not make additions of property to the trust beyond the initial contribution. In contrast, a CRUT offers some flexibility in design; a donor may make annual additions to the trust. A CRUT may provide for one of three payment formulas to the lead income beneficiary:

1. Fixed-percentage (standard) CRUT--a fixed-percentage payout independent of the level of trust income (Kegs. Sec. 1.664-3(a) (1) (i) (a)).

2. Net income CRUT--a payout of the net income earned by the trust for the year, provided that such income does not exceed the fixed percentage set out in the trust instrument (Regs. Sec. 1.664-3(a) (1) (i) (b) (i)).

3. Net income makeup CRUT (NIMCRUT)--the payout specified in (2) above, except that, for any year in which the fixed-percentage payout specified in the trust instrument exceeds trust income, the excess accumulates and is paid in future years in which trust income exceeds the specified payout.

   According to Sec. 643(b), trust income is defined by reference to the trust instrument and local law. Regs. Sec. 1.664-3(a)(1)(i)(b)(4) provides that a trust provision that allocates capital gain to trust income is permissible if allowed under local law, although precontribution appreciation cannot be part of trust income.

   A CRAT's annual payout amount must be between 5% and 50% of the initial value of trust assets. Similarly, a CRUT's annual payout must be between 5% and 50% of the value of trust assets (determined annually). In both cases, the CRT's term may be for the life or lives of the noncharitable beneficiaries (or for a term certain not to exceed 20 years).(4)

   Although both CRATs and CRUTs are exempt from income taxes, distributions to noncharitable beneficiaries are likely to be taxable. The character of distributions is determined in a tiered fashion under Sec. 664(b), as follows:

1. First, as ordinary income, to the extent of the trust's current and previously undistributed ordinary income for the trust's year in which the distribution occurred.

2. Second, as capital gain, to the extent of the trust's current capital gain and previously undistributed capital gain for the trust's year in which the distribution occurred.

3. Third, as other income, to the extent of current and previously undistributed other income for the trust's year in which the distribution occurred.

4. Fourth, as a distribution of corpus.

   A loss in any of the above categories can only be used to offset income from the same category; any excess loss in one category can be carried forward indefinitely. Any undistributed amount from a given tier for the year carries forward to subsequent years. Thus, a noncharitable beneficiary will receive taxable income from a distribution to the extent the CRT has undistributed ordinary income or capital gains.

   The Taxpayer Relief Act of 1997, Section 1089, added an overall constraint on a donor's continued enjoyment of assets transferred to a CRT. The present value of the remainder interest going to charity must be no less than 10% of the trust assets' initial value.(5) For a CRUT, the 10% rule applies to each contribution of property to the trust. The value of the remainder interest (which generally equals the current charitable contribution) is calculated using the actuarial tables in IRS Pub. 1458, Actuarial Values, Beta Volume, the income payout specified in the trust and the Sec. 7520 valuation rate. In practice, the 10% remainder rule limits permissible combinations of the payout percentage and term of the noncharitable income interest.

   Payout and Trust Term

   The present value of a CRAT remainder, interest is a function of the ratio of the payment amount to the initial value of trust assets, the trust term and the Sec. 7520 discount rate. Exhibit 1 plots combinations of these variables that result in a minimum 10% remainder interest going to charity (assuming a Sec. 7520 rate between 6.5% and 9%). The area to the right of the points shows impermissible combinations that result in less-than-10% remainder interests to charity; the area to the left of the points shows permissible combinations yielding greater-than-10% remainder interests to the charity.

   [Exhibit 1 ILLUSTRATION OMITTED]

   For each annuity payout ratio, the trust term resulting in a 10% remainder interest varies with the Sec. 7520 rate. The higher the Sec. 7520 rate, the longer the permissible term of the trust for a given payout. Why? A higher discount rate reduces the present value of the annuity payments to the income beneficiary. For instance, a CRAT with an annuity payout of 7% of the initial value of assets can have a term of approximately 46 years at a 9% Sec. 7520 rate. A CRAT with the same annuity ratio can only have a term of approximately 29 years at a 6.5% Sec. 7520 rate. Similarly, as the Sec. 7520 rate increases, the permissible payout percentage increases...