The charitable remainder unitrust: a versatile tool for avoiding capital gains.

• Author: Gianno, Mark

The Code, while complex in application, is remarkably simple in design. Generally, if income is earned, income taxes are owed; if assets appreciate, capital gains tax is due on their sale; and, at death, there is an estate tax on assets before beneficiaries receive anything.

However, the Sec. 664(c) charitable remainder unitrust (CRUT), a remarkable tool for protecting family wealth, allows a taxpayer to sell highly appreciated assets without recognizing capital gain. The taxpayer, as trust grantor and trustee, can control the investment of trust assets, and receive, for life, an annual stream of trust income(1) that can continue to be paid after the grantor's death to a spouse, children and/or grandchildren.(2) After the death of the last income beneficiary, the corpus is distributed to the charity of the grantor's choice.

Avoiding capital gain recognition is not the only tax benefit. In addition, under Regs. Sec. 1.664-3(d), the trust grantor receives an immediate charitable deduction of the fair market value (FMV) of the charitable remainder interest. Assets contributed to the trust avoid estate tax at death. Perhaps more importantly, trust assets are free from the claims of creditors (including Medicaid). Sec. 664(c) provides that the CRUT itself is only taxed if it has unrelated business taxable income.

One article has described the CRUT as "a tax break for the middle class."(3) Another accurately portrayed these trusts as the ideal tool for the "transition planning" period.(4)

Why Establish a CRUT?

The motives for charitable giving are many and varied. The First Circuit, in Crosby Valve & Gage Co.,(5) noted that if deductibility of a charitable contribution depended on the contribution being given out of "detached and disinterested generosity," an important area of tax law would become entagled in an uncertainty woven of judicial value judgments; according to the court, charitable giving is motivated by numerous factors, including desire to evoke community goodwill, desire to avoid community ill will, public pressures of other kinds, tax avoidance, prestige, conscience-salving and even, perhaps, a vindictive desire to prevent relatives from inheriting family wealth.

For taxpayers not motivated solely by a "detached and disinterested generosity," the CRUT is ideal. By funding the trust with highly appreciated assets and designating the payment of the remainder to charity, rather than making an outright sale of such assets subject to capital gains tax, the income and principal generated by such assets can easily be tripled.

Historically, the Federal government has been a strong supporter of charities. Congress, in Section 201(e)(1) of the Tax Reform Act of 1969, created CRUTs to encourage charitable giving.

Regs. Sec. 1.664-3(a)(6) provides that the trust remainder must be left to a Sec. 170(c) charitable organization. However, the designation of the charitable recipient can be set up to be revocable, so that the grantor has the option of changing the charitable beneficiary or the proportion of the bequest that is to go to each of multiple charitable beneficiaries.(6) If the taxpayer agrees to irrevocably designate a charity, the charity might offer to help defray the costs of trust drafting and administration.

Illustrating CRUT Advantages

The wealth-protecting power of the CRUT is best illustrated by example. The H and W family is comprised of H, age 62, and his wife W, age 60. Like many of their contemporaries, H and W recently elected early retirement. H and W's two sons are each in their late 30s, married with young children, and comfortably successful. However, they are aware of the future expenses they face in educating their children (H and W's grandchildren). Further, the sons have not saved significantly for their own retirement. H and W are primarily concerned with preserving their retirement fund, and generating sufficient income from it. They would also like to assist their sons financially to the extent possible without jeopardizing their retirement plans.

H inherited real estate and 1,000 shares of publicly traded stock from his parents' estates more than 20 years ago. Over the years, the stock has remained in his portfolio and reaped dividends, while the real estate was rented. The basis and FMV of the assets are as follows:

Basis FMV Appreciation Stock $45,000 $ 95,000 $ 50,000 Real estate 0 155,000 155,000 According to IRS actuarial tables, either H or W will be alive in 2019, 24 years from now.(7) Their investment risk profile is such that they can comfortably achieve 8% income and 2% growth per year on investments, using a combination of bonds, stocks and mutual funds.

H no longer wishes to maintain the upkeep on the real property and would like more income from his stock portfolio. H and W are in the 28% Federal income tax bracket and pay 6% state income tax. H is in the 55% Federal estate tax bracket, and will pay 3% commission on a sale of the stock and 6% commission on a sale of the real estate.

Seeking to avoid capital gain recognition, H is considering transferring the assets to a CRUT instead of selling them. However, he is unsure whether he wants the trust to maximize current income or to increase the assets left to his children.

H's alternatives, illustrated in Exhibit I on page 437, are as follows:

1. Outright sale of assets by H and investment of the proceeds (Alternative 1).

2. Transfer of the assets to a CRUT in which H and W are the lifetime income beneficiaries. The trust sells the assets and invests the proceeds with intent to maximize current income (Alternative 2).

3. Transfer of the assets to a CRUT in which H and W are the lifetime income beneficiaries, and...