Clients generally have a mix of goals for their wealth—for their lives, for their heirs, and for charity.
Certain vehicles have the ability to help clients achieve combinations of these goals, depending on the client’s specific facts. Congress has provided tax incentives in the Internal Revenue Code (the Code) to fund these vehicles during life by providing either charitable income tax deductions, gain deferral, or a combination of each.
First, some terminology. Unfortunately, these trusts are given a very foreboding name by the Code—they are termed “split-interest trusts” under section 4947. That’s simply because each of these split-interest trusts has two different classes or sets of beneficiaries—one exclusively charitable and one exclusively non-charitable. They are irrevocable trusts from which payments go to one set of beneficiaries for a specified period of time, with the remainder going to the other set of beneficiaries. The National Association of Charitable Gift Planners and The American Council on Gift Annuities have issued a joint statement on the Biden Administration’s FY 2022 Budget Request to Congress arguing against the elimination of the benefits of split-interest gifts.1
I. Two Key Types of Split-Interest Trusts
A “charitable remainder trust” (often referred to as a CRT) is a split-interest trust where someone (or multiple someones) have an interest in the trust’s property for an initial period of time.2 After that initial interest terminates, the “remainder” that is in the trust goes to a pre-designated charity (hence the name charitable remainder trust). Generally, the initial beneficiary receives distributions from the trust during the specified initial period of time (see below for more about the taxability of these distributions).
Upon the termination of the initial beneficiaries’ interest, the remaining trust corpus is distributed to charity. For example, if a person establishes a trust providing a retained interest to the donor for life and then to the donor’s spouse for that person’s life, the donor and then the donor’s spouse receives a payment stream from the trust assets, with the remainder at the end of the second life going to the designated charity or charities.
Because a CRT can provide a stream of payments to an individual for a term of years (or perhaps their life expectancy), the trust may help with retirement while ensuring some control over charitable beneficiaries of the estate. The CRT transaction provides a partial tax deduction, based on the amount of the trust corpus that will eventually be transferred to the charitable beneficiaries.3
The reverse is also possible. A “charitable lead trust” (or CLT) is an irrevocable split-interest trust where the charity has the first interest in the trust’s property, followed by non-charitable interests. For example, if you establish a trust where a designated charity has an interest for a fixed term of years, say 15 or 20 years, the CLT can provide that any remaining property at the end of that time will be distributed outright or retained in trust for certain beneficiaries, such as the trust grantor’s children and/or grandchildren. A CLT is not a retirement vehicle; instead, it’s a method of using interest rates and the charitable term to reduce the value of the taxable gift being made to the remainder beneficiaries.4
II. Types of First Interests, Payouts, Other Restrictions, and Filings
Of course, for these to work, there are restrictions on the types of “first interests” that are created.
A CRT donor may name the donor or someone else to receive the trust’s income stream for a term of up to 20 years or for the life or one or more non-charitable beneficiaries. In the example above, that was the life of the donor and then the life of the donor’s spouse. The trust document designates one or more charities to receive the remainder of the donated assets at the end of that initial interest period. Those may be public charities or private foundations (though there are reduced income tax benefits and can be investment limitations in the case of a private foundation remainderman). In some cases, the trustee may retain the power to change the charitable beneficiaries during the term of the trust. Both charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs) are permitted. A CRAT will distribute a fixed annuity amount each year, and no further contributions to the trust are permitted. CRUTs, however, distribute a fixed percentage of the balance of the trust assets (as revalued annually), and additional contributions may be made to the trust.5
The type of assets that may be donated to a CRAT or CRUT is limited to cash, publicly traded securities, real estate, and certain closely held stock (but not S Corp stock) and other complex assets.
The contribution to a CRAT or CRUT results in a tax deduction the amount of which is based on the type of trust, its term, the projected income payments to the initial interest beneficiaries, and IRS interest rates based on assumptions of trust asset growth rates. It is important to note that the amount of the tax deduction is determined up front: it does not change if the value of the assets actually provided to the charity at the “end” (i.e., the termination of the initial interest period) are less than calculated. The CRAT or CRUT income payout to the donor or other beneficiaries must be at least 5% but no more than 50% of the trust assets and may be made monthly, quarterly, semi-annually or annually. The payout rate must be projected to provide the charity at least 10% of the value of the assets initially transferred. For CRATs, the maximum rate cannot exceed a rate that creates less than a 5% probability that the trust will leave nothing to charity. (Due to the pandemic, the section 7520 rate used to value charitable interests in trusts has been exceptionally low. The rate, provided monthly by the IRS, is 1.2% for August 2021, per Rev. Rul. 2021-14.)
Other types of CRTs include NICRUTs (Net Income Charitable Remainder Trusts), NIMCRUTs (Net Income Makeup Charitable Remainder Trusts), and “flip” versions of these. Part II will deal with these and other instruments.
The trustee will file Form 5227 for the CRT (CRAT or CRUT) using a calendar tax year. The tax return has schedules which track various ‘buckets’ or ‘tranches’ of the trust’s income & corpus. As distributions are made, those distributions will be taken from the different tranches, in order of “worst to best” as outlined by the Code.
For example, assume that a CRAT has an annual payment to the beneficiary of $100,000. Assume that at the beginning of the year, the CRAT has the following balances:
- $50,000 of accumulated, undistributed qualified dividend income
- $600,000 of accumulated, undistributed long-term capital gains (LTCG)
- $0 tax-exempt interest
- $350,000 of corpus
Assume that during the year the CRAT earns $10,000 of qualified dividends on its investments, $10,000 of short-term capital gains (STCG), and $20,000 of LTCGs. The CRAT has no expenses (if it did, they would be allocated pro-rata against these items).
The distribution of $100,000 is, taking the tranches of income from “worst to best”, (a) first, $60,000 of qualified dividends (i.e., the total amount of the earnings during the year and the accumulated but undistributed dividend income); (b) then, $10,000 of STCGs (again, the total in the trust, since there is only STCG earnings and no STCG accumulation); and (c) finally, $30,000 of LTCGs (out of the total $620,000, consisting of $20,000 LTCG earnings and the $600,000 of LTCGs in the trust at the beginning of the year). These are the amounts that will be reported to the beneficiary on a Schedule K-1 from the trust and are taxable on the beneficiary’s individual income tax return.
At the close of the year, the CRAT would have the following balances:
- $0 of accumulated, undistributed qualified dividend income
- $0 of accumulated, undistributed STCGs
- $590,000 of accumulated, undistributed LTCGs
- $0 tax-exempt interest
- $350,000 of corpus
CRUTs function in a substantially equivalent manner.
Note that both CRATs and CRUTs would also keep track of “post-2012” and “pre-2013” tranches of income, as any amounts that are distributed to a beneficiary from a “pre-2013” tranche is not subject to the section 1400A tax on net investment income.6
A CLAT requires that the designated charities receive an annuity for the term of the initial interest, generally a specified percentage of the initial value of the trust’s assets each year (e.g., 5% of the initial fair market value of the trust assets). At the end of the term, the trust terminates and the non-charitable beneficiaries receive whatever assets remain in the trust.
A CLAT files both a Form 1041 and a Form 5227. The CLAT claims a charitable deduction on the Form 1041 for the amount distributed to charity during the year and may elect to use part of the next year’s charitable distribution in the current year. If it does so, it will need to track the amount of any such “borrowing” and account for it in the following year. This strategy is often beneficial in a year where the CLAT triggers an unusually large capital gain. If the trustee is monitoring the realized gains and can see that the remaining unrealized gains are nominal, there’s no real downside from making the election.7
III. Benefits of Use of Split-Interest Trusts
A chief benefit of split-interest trusts is the ability to time when income is taxed while increasing the benefit of the government subsidy of charitable giving.
A CRT is especially valuable to a donor whose assets consist of highly appreciated properties held long term that would be subject to capital gain taxation on substantial realized gain if sold. The in-kind donation to the trust avoids donor taxation of the gain while potentially providing a significant tax deduction based on the assumed value at the time the charity assumes the remainder interest. The trust’s investment income is exempt from tax; and if the trust sells trust assets, that sale is also exempt from tax. Of course, the income beneficiary will be subject to income tax on any income received from the trust during the initial interest period.
A grantor CLAT can generate a charitable income tax deduction for the present value of the income stream going to the charity. The donor must, however, pay an income tax on all the CLAT’s income during the initial interest period (including the amount paid to the charity). Donors may want to use the grantor-CLAT strategy in order to generate a significant deduction to offset an usually large gain from a unique event, such as a liquidation, bonus or other one-time receipt of gain.
A non-grantor CLAT may be used when an immediate deduction is not a goal and the donor’s primary purpose is to transfer assets in a tax-efficient way to beneficiaries. The donor receives a deduction against the value of the assets going to the beneficiaries at the CLAT’s end of term. Unlike a grantor CLAT, the trust rather than the donor pays income tax on the CLAT income and the trust receives a charitable deduction for the amounts paid to the charity during the initial interest period. This may be particularly efficient if the donor funds the CLAT with income-producing property on the income of which the donor would otherwise have to pay tax.
IV. Other Factors to Be Considered
Both CRTs and CLTs are subject to the same list of regulations and restrictions which govern private foundations, including prohibitions on self-dealing and an extensive list of prohibited transactions.
Some states have rules which require charitable trusts to register with their Secretary of State’s office, even if the trust is not actively soliciting any donations.