Choosing the Right Charitable Remainder Trust

When someone is interested in supporting your favorite charitable organizations by a deferred gift plan, the simplest methods are a bequest, or life insurance or pension plan beneficiary clauses. The alternative of an irrevocable charitable remainder trust (CRT), however, can meet as many as three personal objectives in addition to reducing death taxes and carrying out the charitable intent. Those objectives include:

• improved income for yourself and/or for others.
• current income tax savings from a charitable deduction.
• avoidance of capital gains taxes if funded with appreciated assets otherwise to be sold.

The Tax Reform Act of 1969 first named and defined these split-interest trusts, and they continue to play a major role in philanthropy. They are available to anyone, can be confidential and are able to use a single transaction and asset to accomplish multiple charitable gifts.

The term of a CRT can be measured (1) by one or more lives in being at the time the trust is first funded, (2) by a term in years not to exceed 20 or (3) by a combination of life or lives in being plus a number of years not to exceed 20. Assets suitable for funding a CRT are cash, appreciated marketable securities and appreciated unencumbered real property. Mortgaged real estate cannot be used to fund a CRT, and using tangible personal property can be problematic.

Two Basic Forms of Charitable Remainder Trusts
The two basic forms of CRTs are the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT).

The major difference between the two forms is the nature of the income payments to individual recipients. CRATs must pay income at a fixed amount per year, expressed either in dollars or as a percentage of the value of the initial funding assets. The payout from a CRUT is variable, expressed as a percentage of the annually redetermined value of trust assets, with potential either for growth or decline in dollar payments. A minor difference is that subsequent supplemental funding is permitted for a CRUT, but not for a CRAT. Also, an annuity trust must have less than a 5 percent probability of being exhausted during its specified term or the life expectancy of annuitants.

A primary factor in choosing between the two basic forms is the age of the income recipient(s). Older grantor-recipients tend to favor the certainty of the annuity trust, while younger persons favor the growth potential of a unitrust to offset inflation. Other considerations can be the risk tolerance of a grantor-recipient, the fixed or variable nature of other income sources, and economic expectations concerning inflation. Also, the nature of funding assets can influence the selection.

Another difference between charitable remainder annuity trusts and unitrusts is in the investment options for a trustee. Because the required payments from a CRAT are fixed, and typically higher than the rates selected for a CRUT, investment is primarily in assets producing fixed income. These generally are long-term investment grade bonds, but can include real property with long-term rental leases.

In contrast, investment of a CRUT usually includes assets with potential for growth in value as well as dollar yield, such as common stocks and stock mutual funds. Note that bonds should be used with caution as a unitrust's investment, no matter how favorable the yield compared to stocks. If at some point interest rates rise, the market value of bond assets will drop. This reduces subsequent income payments, which are based on a fixed percentage of the value of trust assets on the annual valuation date.

The Three Original Unitrusts and Their Characteristics
Unitrusts share certain characteristics in common. Each has an irrevocable charitable remainder at the end of all individual income interests. Income payments to individuals can be annual, quarterly or monthly. The minimum payout percentage is 5 percent, the maximum 50 percent. The present value of future charitable distributions must be at least 10 percent of the initial funding value, and following any additions. (This requirement should be taken into consideration when drafting testamentary funding of a unitrust.) Each type of unitrust, hoever, is distinguished by a different way of determining dollar payments of the income interest. The three original versions are:

• Standard Charitable Remainder Unitrust (referred to as Type I, or STAN-CRUT)
• Net Income Only, Plus Make-up Unitrust (referred to as Type II, or NIM-CRUT)
• Net Income Only Unitrust (referred to as Type III, or NI-CRUT)

Dollar payments to individual income recipients of a standard unitrust must equal the specified payout percentage of annually redetermined asset value. There is a "four-tier" structure of sources from which the trustee must make up the payments: first, from ordinary income earned; second, if that is not sufficient, from past realized capital gains; third, from "other" income (i.e., tax-exempt income); and fourth, from principal if required (also untaxed). Dollars received from each tier retain for recipients the taxable nature of their source. (The same required amount and four sources of payment also apply to annuity trusts.)

Payments from the net income only, plus make-up and the net income only unitrusts do not use the four-teir method of meeting the stipulated payout percentage each year. Trust agreements state that in any calendar year payments to recipients shall be the lesser of ordinary income earned and the stated maximum percentage payout. Generally, realized capital gains are added to the principal, unavailable for payments, and all payments to individual recipients are taxable to them as ordinary income, although the trust document can change this.

STAN-CRUT vs. NIM-CRUT or NI-CRUT
The primary reason for use of the net income only, plus make-up unitrust (Type II) and the net income only unitrust (Type III) is to preserve the principal of the trust in any year in which ordinary income earned is not sufficient to cover the stated percentage of asset value. This can be particularly critical when a unitrust is first funded. Time may be required to sell an asset in order to reinvest and meet the income payments required. Funding assets that usually require a Type II or III unitrust are real estate with uncertain marketability, and low-yielding stock in a company with excellent long-term prospects.

When the facts of a situation suggest that sale and reinvestment can be accomplished, but not in time to provide cash for early required payments, enough cash or readily marketable stock can be added to the initial funding to provide sources for early payments. Another option for a standard unitrust funded early in a calendar year is to specify an annual payment at the end of the year, allowing more time to achieve liquidity.

NIM-CRUT vs. NI-CRUT
When these options do not provide sufficient assurance of meeting the payments of a standard unitrust, either the Type II or Type III is available. In past years, the NIM-CRUT has been the more frequent choice, with its provision that any shortfall in a year between ordinary income paid and the maximum permissible percentage shall be noted and remains subject to make-up payments in any subsequent years that ordinary income exceeds the stated payout percentage.

One writer on the subject, however, has pointed out that when life income recipients have a relatively long life expectancy, the Type III NI-CRUT without make-up provision may be preferable. Until the underlying property is sold and proceeds reinvested for a higher return, the grantor-recipients have essentially the same pre-tax income as previously received from the property, and improved after-tax income after use of the charitable deductions created. This also avoids the temptation to invest eventual sale proceeds for higher fixed income to cover make-up payments, thus foregoing the potential for long-term growth in value and dollar payments.

The "Spigot" Unitrust
Another application of the Type II NIM-CRUT has been to provide supplemental retirement income for the grantors, sometimes termed a "spigot" unitrust. Typically the grantors enjoy high income while fully employed, and fund a make-up unitrust with growth stocks paying little or no dividends, or with cash that the trustee similarly invests. Trustees can shift the investment objective from growth to higher yield when the grantor-recipients need improved income including make-up payments.

This use of unitrusts has come under scrutiny by the Internal Revenue Service, following some aggressive examples it termed "accelerated" and considered abusive of the original concept. The 50 percent maximum annual payout rate and minimum 10 percent charitable remainder value for all CRTs are efforts to meet this concern. On the other hand, the technique also increases the eventual charitable remainder for the benefit of society, and should remain an option when used in the best interest of all parties to the trust.

Please contact Mary Ludwig, Development Director at 712-732-5127, for more information.

The information on this site is not intended as legal, tax or investment advice. For such advice, please consult an attorney, tax professional or investment professional.

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