A charitable remainder trust enjoys several tax advantages, but is also subject to several restrictions.Income Tax Charitable Deduction
The donor receives an immediate income tax charitable deduction based on the present value of the charity’s remainder interest. This deduction is calculated pursuant to a formula using the percentage payout stated in the trust, the life expectancy of the income beneficiary(ies) and the interest assumption reflected by the AFR (Applicable Federal Rate) for the month of the gift or either of the two preceding months. The selection of a higher AFR can allow for a greater income tax charitable deduction.
If appreciated property is donated to the trust, then the deduction is limited to 30% of the donor’s adjusted gross income (AGI). The deduction may be claimed in the year of the gift and, if any portion exceeds the percentage limitation in that year, may be carried over and deducted for up to five subsequent years.Capital Gains Tax
Appreciated property can be transferred to a CRT without the donor incurring capital gains tax on the disposition of the property. The trustee can sell the property, reinvest the full sale proceeds, undiminished by capital gains taxes, to produce a high income inside the trust. Thus, the donor converts an appreciated asset into an improved cash flow, and the capital gain on the trustee’s sale goes into tier 2 of the 4-tier system (see below).Trust Is Income Tax Exempt
The CRT itself is income tax-exempt and pays no income tax on interest, dividends, rents, or capital gain unless it receives certain kinds of tainted income, i.e. unrelated business taxable income (“UBTI”). Note that an excise tax on a CRT that produces UBTI is limited to the UBTI itself.Income Taxation of Beneficiaries: The Four-Tier System
Income paid to the beneficiaries of a CRT is taxable to these recipients in one of four tiers or categories, in the following order of priority:
• ordinary income;
• capital gain income, with net short-term capital gains deemed distributed before net long-term capital gains;
• “other income,” generally meaning tax-exempt income; and
• tax-free return of principal.
Under Reg. §1.664-1(d)(1), the highest taxed income or gain within the first two tiers to be paid out first, followed by each lower taxed income or gains within the same tier. After all of the income and gain within each class of the first (ordinary income) tier has been exhausted, distributions will be deemed to come from the highest-taxed class in the second (capital gains) tier, and so on.
Thus, ordinary income that is taxable up to 35% will be deemed distributed before qualified dividends (now taxed only up to 15%). Then capital gains will be paid out, beginning with the highest taxed gain (35%, 28%, 25%, 15%, and 0%). In other words, 15% dividends from the first tier will be deemed distributed before 35% short-term capital gains from the second tier.
To the extent the trust earns ordinary income from dividends, interest, rents or other sources, then this income retains its taxable character when paid out to and reported by the beneficiaries. All ordinary income is deemed to be distributed before any capital gains is deemed distributed.
Likewise, before any tax-free “other income” can be reported, all capital gain on the trust assets which accrued prior to donation to the trust, must be accounted for as the income is paid. This income is taxed at capital gains rates. After all such pre-gift capital gain is accounted for, then the income may be tax-free. Due to this rule, it is impossible for a CRT to pay tax-free income immediately following the donation of appreciated assets and the subsequent sale of these assets and reinvestment of the proceeds in tax-exempt bonds.
Finally, after all ordinary income, capital gains and “other income” have been exhausted, the trust is deemed to have made tax-free distributions of principal. And this can happen in years in which the trust’s earnings performance is poor and it must nevertheless meet the trust’s percentage payout requirement.
Under the 1997 revision of the Uniform Principal and Income Act, which has been adopted by nearly every state, the trustee of a CRT may invest for a “total return,” and the trustee has the power and duty to reallocate this total return annually to either income or principal. For instance, a portion of realized capital gains could be allocated to income, or a portion of interest could be allocated to principal, if the trustee concludes that a particular allocation is necessary to balance the interests of the income and remainder beneficiaries.
In response to the new uniform act, the IRS issued final regs that revise the definitions of principal and income for purposes of IRC Sec. 643(b). Under these regs, charitable remainder unitrusts may allocate capital gain to income, but only when permitted under local law or the trust instrument itself, not in the trustee’s discretion [Reg. §1.664-3(a)(1)(b)(3)].Gift Tax Considerations
Whether or not a donor will incur gift tax upon the creation of a charitable remainder trust during the donor’s lifetime depends on who is the beneficiary of the CRT.
Of course, the present value of the charity’s remainder interest is entirely deductible for gift tax purposes.
• If the donor is the only income beneficiary of the CRT, no gift of the income interest is made since the donor cannot make a gift to himself.
• If the donor’s spouse is the income beneficiary, any gift to the spouse is sheltered from taxation by the gift tax marital deduction. This is true whether the spouse is the initial beneficiary (who has a right to payments from the trust right away) or a survivor beneficiary (who will receive payments after the death of the donor).
• If someone other than the donor or spouse is an income beneficiary of the trust (a non-spouse beneficiary), then federal gift tax may be owed. If a non-spouse is named as an initial income beneficiary, the present value of his or her income interest is a taxable gift of a present interest. This is true even if the donor and/or a spouse is named as a beneficiary as well. If the non-spouse beneficiary is an initial beneficiary, up to $13,000 (subject to indexing after 2011) of this value may be shielded from federal gift tax by using the annual exclusion. If the non-spouse beneficiary is named as a survivor beneficiary, there is no available annual exclusion because this is a gift of a future interest that does not qualify for the exclusion.
If there is a taxable gift, the donor can cover that amount with a lifetime gift tax credit. In 2011, the gift tax applicable credit can shelter up to $5 million in lifetime taxable gifts from the gift tax. Note that the gift tax applicable credit is unified with the estate tax applicable credit.
Note: A donor can avoid making a taxable lifetime gift of an income interest to a non-spouse if the donor retains the right to revoke the income interest in his or her will (and only in a will—a right to revoke held during the person’s lifetime would disqualify the CRT).Estate Tax Considerations
Of course, the value of the charity’s remainder interest is entirely deductible for estate tax purposes if payable to a qualified charity.
If a donor names him/herself as the income beneficiary of a CRT, the portion of CRT assets that becomes part of the estate and subject to estate taxation depends on the term of the trust. For instance, if a donor is alive at the end of a fixed-term CRT, there are no estate tax consequences. However, if the donor dies before the end of the trust term, the value of the income interest is included in his or her estate. If the donor is the single beneficiary of a CRT, the regulations put forth the proper formula to ascribe the value of CRT assets to the estate [Reg. Sec. 20.2036-1, 20.2039-1].
If a donor names the spouse as the sole income beneficiary of a CRT, there are no estate tax consequences. This is true even though lifetime gifts are included in estate tax calculations, because a gift of a CRT income interest is one of the exceptions under the qualified terminal interest property rule and so the transfer is covered under the unlimited marital deduction.
If a donor names someone else besides the spouse as an income beneficiary of an inter-vivos CRT, the trust is not considered part of the donor’s estate. However, the value of the lifetime gift of the income interest is included in the estate, though the estate receives a credit for any gift tax previously paid on that gift.
Concerning testamentary CRTs created through a will upon the donor’s death, the value of the income interest for a named non-spouse beneficiary will be subject to the estate tax.