General Practice, Solo & Small Firm DivisionMagazine
Estate and Financial Planning
On the Flip Side: A New Spin on Charitable Remainder Trusts
By Christopher P. Cline
A charitable remainder trust (CRT) pays a specified amount to one or more individuals either for their lives or for a fixed term not exceeding 20 years. A charitable remainder annuity trust (CRAT) pays a fixed amount equal to at least 5 percent of the trust assets on the creation of the trust to the noncharitable beneficiary each year. A charitable remainder unitrust (CRUT) pays to the noncharitable beneficiary a fixed percentage (unitrust amount) of the trust assets revalued each year. The net income with makeup CRT (NIMCRUT) is a variant of the CRUT. The noncharitable beneficiary of a NIMCRUT receives the lesser of the specified unitrust amount or the trust’s net accounting income. Any deficiency between the amount of net income paid and the unitrust amount in any year is paid in a future year when the trust income exceeds the unitrust amount.
A significant benefit of a CRT is that the donor receives a current income tax charitable deduction equal to the actuarially determined present value of the remainder interest passing to charity on the date the donor makes the gift to the CRT. A CRT is also not subject to federal and state income tax unless it has unrelated business taxable income under Code § 512. The noncharitable beneficiary, however, is subject to income tax on payments he or she receives.
The donor who intends to sell a business or other asset through a CRT will face an unpleasant choice. Either the donor can use a CRUT and take the chance that the trust will not sell the asset immediately, or the donor can use a NIMCRUT and take the chance that the trust’s income will never equal the unitrust amount. To solve this dilemma, lawyers have suggested using a CRT that begins life as a NIMCRUT but that converts to a straight CRUT after the trust sells certain assets-a flip unitrust. A flip unitrust has the advantage over a straight CRUT of not requiring the trustee to distribute trust assets until the CRT sells the business or other asset. After the sale, the CRT would convert to a straight CRUT and the CRUT would pay the noncharitable beneficiary the original unitrust amount.
CRTs have been marketed as an alternative to a qualified retirement plan, whereby the donor creates a NIMCRUT that invests only in high-growth, low-income assets during its early years. Because the trust has little or no accounting income, the actual distributions from the trust are low, thereby increasing the amount of future makeup payments.
CRTs were used to make gifts to a client’s children at a small gift tax cost, known as a "near zero CRUT." Under this plan, a donor would establish a NIMCRUT, usually with a capital-gains-as-income provision that named the donor as a noncharitable beneficiary for a term of years, after which the donor’s children succeeded the donor as the noncharitable beneficiaries.
New proposed CRT Regulations, if made final, will: allow donors to create flip unitrusts under certain circumstances; eliminate the ability of a trustee of a CRUT or CRAT, but not of a NIMCRUT, to make the payment to a noncharitable beneficiary for a given year within a reasonable time after the end of that year; impose appraisal requirements on CRT donors or related or subordinate parties serving as trustees of CRTs holding hard-to-value assets; eliminate the use of near-zero CRTs; and require the allocation of the proceeds of sale of any trust asset to trust principal to the extent those proceeds represent the fair market value of the asset at the time the donor contributed the asset to the trust.
The CRT Regulations state that a CRUT agreement may provide that the trust will pay the lesser of income or the unitrust amount during the "initial period" of the CRUT and will pay the unitrust amount for the remaining period of the CRUT if four conditions are met. First, 90 percent of CRUT assets must consist of "unmarketable assets" (90 percent Test). Second, the CRUT instrument must trigger the change of payment method on the earlier of (1) the sale or exchange of a specified asset or group of assets that the donor contributed to the trust on its creation; or (2) the sale or exchange of "unmarketable assets" if, immediately afterward, the fair market value of the unmarketable assets in the trust equals 50 percent or less of the total fair market value of all trust assets. Third, the payment method must change at the beginning of the first calendar year following the sale or exchange that triggered the change. Fourth, after the payment method has changed, the trustee must pay at least annually only the unitrust amount and not any makeup amount that accrued while the trust was a NIMCRUT.
Because 90 percent of the trust assets must consist of unmarketable assets, it may be difficult to determine whether a CRT qualifies as "flippable." If the donor wishes to contribute both unmarketable assets, and cash or publicly traded securities, the donor should consider creating two CRTs, one that will hold only the unmarketable assets and contain appropriate "flip" provisions, and the other that will hold the cash or publicly traded securities assets.
If the donor wishes to contribute both unmarketable assets and cash or publicly traded securities, the donor should consider creating two CRTs, one that will hold only the unmarketable assets and contain appropriate "flip" provisions, and the other that will hold the cash or publicly traded securities assets. Alternatively, the donor could contribute the cash or publicly traded securities to the CRT only after the trustee sells the unmarketable assets and the CRT has "flipped."
Effective for taxable years ending after April 18, 1997, the governing instrument of a CRT that pays a unitrust or annuity amount only must require that the trustee pay that amount to the noncharitable beneficiary for each taxable year "no later than the close of the taxable year for which the payment is due." The CRT Regulations, however, allow NIMCRUT agreements to continue to give the trustee a reasonable time after the close of the year for payments to the noncharitable beneficiary.
The CRT Regulations state that, when determining "income" for purposes of NIMCRUT distributions, proceeds from the sale or exchange of any asset the donor contributes to the trust must be "allocated to principal and not to trust income at least to the extent of the fair market value of those assets on the date of contribution." A NIMCRUT agreement can deem only post-contribution gains as accounting income. The CRT Regulations provide that pre-contribution capital gains cannot be allocated to principal, but the CRT Regulations are silent about the liability account requirement.
Two aspects of the Taxpayer Relief Act of 1997 (TRA 97) should be noted. First, the percentage payment to the noncharitable beneficiary (of either a CRAT or a CRUT) cannot exceed 50 percent of the trust assets. Second, the value of the remainder interest passing to the charity must be at least 10 percent of the fair market value of the trust assets on the date of contribution to the CRT. TRA 97 also contains relief provisions if this requirement is violated.
Christopher P. Cline is a partner with Lane Powell Spears Lubersky LLP in Portland, Oregon.
- This article is an abridged and edited version of one that originally appeared on page 6 in Probate and Property, November/December 1997 (11:6).