How the wealthy use trusts to give to charity, to collect income, to save tax

CRTs are recommended for high-net-worth clients who want to give back but are also interested in an income stream, especially if they are asset-rich but cash-poor, according to Katie Sheehan, managing director at SVB Private. Given the amount of administrative work, CRTs generally aren’t worth the time without at least $1 million in assets, she added.

“It’s suitable for people who want to do some good, do some charitable planning, remove some assets from their taxable estate, but don’t have all those benefits to go to charity,” Sheehan said. “You can use these strategies to have your cake and eat it too.”

The tax-saving tactic is making a comeback after falling out of favor during the low-interest years.

As the interest rate has risen, the rate the IRS uses to calculate the remaining interest — which goes to charity — has also risen. Funders get a larger upfront deduction because a higher rate means trust assets will grow faster and more will be left to the charity at the end of the term.

There are two types of CRTs and this is how they work

There are two main types of CRTs, each with their own advantages and disadvantages.

In the case of a charitable remainder annuity trust (CRAT), the annual income is determined from the outset when the trust is funded.

Here’s how a charitable remainder annuity trust (CRAT) might work in practice, according to Sheehan:

Consider an 80- and 81-year-old couple who decide to fund the trust with $1 million. They select 7% as a lifetime payout percentage. Assuming the assets in the trust grow at an annual rate of 5%, approximately $365,000 would be tax deductible and the remaining $635,000 would be nondeductible. On an annual basis, the income beneficiary would receive $70,000 for life expectancy. When the couple dies, what remains in the trust will pass tax-free to charity.

The second type, charitable remainder unit trusts (CRUTs), are more popular in Sheehan’s experience, but also more complicated. Unlike CRATs, you can add assets to the trust after it is funded. The income percentage is determined when the trust is established, but the payout is determined using current the fair market value of the trust, which is recalculated each year, rather than the original value. If the assets in the trust skyrocket after the trust is funded, the beneficiaries get a higher income.

Sheehan gave an example of how a CRUT would work with the same couple and a similar trust with $1 million in assets, a lifetime term and a 7% percentage payout:

In this case, approximately $480,000 would be tax deductible and the remaining $520,000 would be nondeductible. The calculations assume a 5% growth and income rate for the trust’s assets. On an annual basis, the income beneficiary would receive 7% of the fair market value of the trust’s assets, recalculated each year for 11 years, (ie, life expectancy). In the first year, the couple would receive $70,000 — just like a CRAT — but the payments would increase annually as the trust’s assets appreciate. At the end of this term, the remaining amount will pass tax-free to the charity.

There are some strings attached

The IRS has several requirements for CRTs, including:

• The maximum term is 20 years or the lifetime of the funder of the trust
• The trust pays an income to at least one living beneficiary
• You cannot withdraw assets from the trust
• The annual payment to the beneficiary (or beneficiaries) must be between 5% and 50% of the trust’s fair market value
• At least 10% of what remains in the trust after payouts must go to a designated charity

The last provision is the most complicated. If you select a payout percentage that is too high, your trust balance may not be enough to pass the collection to the IRS.

If the CRT meets all the requirements, the beneficiary must pay income tax on the distributions, but there are several tax savings, including:

• The grantor receives an early income tax deduction on the estimated amount that will go to charity when the trust ends
• The grantor does not have to pay tax on the assets placed in the trust
• Capital gains tax on the assets in the trust is deferred until it is paid to the beneficiary of the income.

The latter advantage is a big plus for business owners who want to sell in the near future and donate some of the proceeds, according to Eric Mann, a partner at Neal Gerber Eisenberg.

For example, if a business owner sold a $10 million company that appreciated by $9 million in value, that increase would be subject to capital gains tax at the time of liquidation. Instead, they can put the company into a CRT before selling it, and since the trust is exempt from capital gains tax, the entire $9 million can be reinvested. The tax burden is spread over time because the beneficiary only pays the capital gains tax on the distributions.

“It allows clients to invest the entire proceeds instead of the net amount, while satisfying their charitable goals at the end when the client dies,” Mann said.

While there are many technical aspects, CRTs are actually relatively simple compared to other estate planning techniques, Sheehan said.

“These are prescribed by the IRS,” she said. “We know as long as our math works, they’re going to pass muster to the IRS.”