Can you really accomplish all of the above? The answer is yes, through a provision of the Internal Revenue Code known as a charitable remainder trust (CRT).
The charitable remainder trust is an estate planning vehicle that allows an individual or a married couple to make gifts to a charitable organization through this special trust while retaining an income from the CRT for a specified number of years. Any assets remaining in the trust at the end of the trust term then pass to the specified charity. By using this technique, the donor gets a current income tax deduction equal to the value of the remainder interest that will ultimately pass on to the specified charity.
One of the advantages of a CRT is that it provides a means of unlocking the income-producing potential of a donor's currently nonproductive assets on a tax-favored basis. Nonincome-producing real estate or low-basis stock not producing much income, and subject to possibly substantial capital gains if sold by the owner, can be transferred to a CRT where, if they are then sold by the trust, would have no tax consequences. These proceeds can then be invested by the trust in assets producing substantially more income than before, thus increasing the donor's cash flow.
Assets placed in a CRT also pass at death to the chosen charity and will not be subject to estate taxation. Depending on the amount transferred to the CRT, this savings can often be substantial for wealthy individuals.
Of course, by contributing to a CRT, you are also greatly benefiting the charity of your choice. Without proper estate planning, this amount might well go to the government by way of estate taxes. By contributing to the CRT, you are controlling where your hard-earned money will go.
In recapping the benefits of contributing income to a CRT:
- immediate income tax deduction;
- exclusion from estate taxes or capital gains;
- protected from creditors;
- benefit your charity; 5. assets can be sold by the CRT without any tax consequences and reinvested by the CRT to produce a portfolio to suit your needs (often a combination of mutual funds, bonds and tax-free bonds). Depending on investment performance, this can greatly enhance your cash flow.
A CRT is irrevocable. Once it is drawn and funded, you cannot change your mind and retrieve your donated assets.
CRTs also have a limited lifespan. They can pay a donor an income for up to 20 years. Upon reaching that point, the remaining trust principal is then passed from the trust to the donor's chosen charity. (Through creative planning, in some cases CRTs can be designed to pay the donor income for greater than 20 years.)
In conjunction with a CRT, the donor can create a wealth replacement trust. This trust replaces the assets given by the donor to the CRT. A wealth replacement trust is most often funded with a life insurance policy on the donor's life in an amount equal to or greater than the amount transferred to the CRT. This will benefit the donor's heirs upon his or her death.
By implementing a wealth replacement trust funded with life insurance, one can be assured that his or her heirs will be compensated by an amount possibly even greater than the amount transferred to the CRT. This wealth replacement trust is often prepared on an irrevocable basis. The underlying life insurance policy is owned by the trust, and the insured must have no ownership as defined by the IRS for this trust to be excluded from the insured's estate for estate tax purposes. Of course, as is most often the case with life insurance policy proceeds, they are tax-free to the beneficiaries.
The premium on this life insurance policy is easily paid for with the donor's now greatly improved cash flow resulting from the CRT.
A business owner can also place his or her business in a CRT. It is then sold by the CRT just like any other asset, with no capital gains owed. If a $10 million business is sold free of taxes within a CRT, that amount could be invested in tax-free bonds. At six percent interest, that would produce a tax-free yearly income of $600,000! A wealth replacement trust can then be prepared to replace the dollar value of the business in the donor's estate, using a small percentage of that $600,000 of yearly income created by the CRT.
There are several different types of CRTs available, including:
- Charitable Remainder Annuity Trust (CRAT) -- A CRAT pays the donor a fixed income. Annual payments must be at least five percent of the trust's initial value. This offers the donor a steady, predictable income.
- Charitable Remainder Unitrust (CRUT) -- A CRUT is perhaps the most common form of a CRT. It requires an annual evaluation of the trust's assets. The amount paid to the donor is based on a set percentage of at least five percent of the trust's value (meaning the trust's current value, unlike a CRAT which is based on the trust's initial value). Depending on the trust's investment performance, this may pay the donor more or less than a CRAT. One advantage to a CRUT is that after one is funded, additional assets can be added. This option is not available to a CRAT.
- Pooled Income Trust (PIT) -- A CRAT or a CRUT may require a specific minimum amount of donated assets. For donors looking to establish a CRT with smaller amounts, a PIT may be the answer. A donor's assets are pooled with assets from other smaller donors. Assets are invested by an investment board to produce a specific result, depending on which PIT one joins (growth or income).
- Net Income Makeup Provision Charitable Remainder Unitrust (NIMCRUT) -- In this form of CRT, only the trust income is distributed to the donor, based on the donor's requested rate of return (must be at least five percent). If investment performance in any given year falls short of expectations, then unlike a regular CRUT, trust principal is not touched and the donor only receives the interest earned. What is also unique, besides the trust principal remaining intact, is that the amount not paid to the donor (due to poor investment performance) can be made up for in the future when earned interest exceeds expectations.
In addition to a charitable remainder trust, other forms of charitable giving include:
The Charitable Lead Trust. Here, the charity receives the income during the trust term, and at the end of this term the donor, his or her estate, or someone else named by the donor receives the principal. This is the opposite of a CRT. Similar to a CRT, donated assets are sold by the trust free of any taxation and invested to produce the desired result for the charity. In the years that the charity is receiving income from the trust, the donor is entitled to an income tax deduction. High income taxpayers obtain a current tax deduction, yet preserve the trust assets for themselves or their heirs.
Charitable Gift Annuity (CGA). This is an irrevocable transfer of property to a charity in return for a lifetime of income. The donor receives an income tax deduction upon making the gift, as well as a lifetime income from the charity. Income payments to the donor are reportable and taxable. A percentage of this annuity payment is a return of principal and is not therefore taxable as income to the donor. The American Council on Gift Annuities has established a set of interest rates that the charities adhere to. Payments made to the donor are not as high as one normally would get in a commercial annuity because the council figures the amount passing to the charity to be at least 50% of the donated property's value.
In most cases, the charity will sell the donated property. This gain is received by the charity free of any taxes or capital gains. The charity will then invest these funds as it sees fit. In this way, like a CRT, the donor can receive income from a low basis, low income producing asset.
Example: Mary, 65, has IBM stock worth $500,000. Her cost basis in the stock is $100,000. She wants to give the stock to her favorite charity. The Gift Annuity Council figures a payout rate of 6.5%. Mary will receive a $231,830 income tax deduction. The deduction will be limited to 30% (because appreciated asset was donated to the charity and sold to obtain its fair market value, as opposed to an asset donated at the donor's basis) of her adjusted gross income.
Mary will receive an annual annuity payment of $32,500 for life, of which $2,749.50 will be tax-free and the balance subject to a combination of capital gains and ordinary income taxes. As with a CRT, the donated property is removed from the donor's estate for estate tax purposes.
Charity owned life insurance on the donor's life is also a useful way for a donor to leverage donations to his or her favorite charity. The charity is the owner and beneficiary of the life insurance policy, while the donor is the insured and premium payor. Because the donor has no rights to the policy benefits, he or she gets to deduct the annual insurance premiums from his or her tax return the charity upon the donor's death receives the tax-free policy death benefit. In a cash value policy, the charity also has full access to the policy's cash value through no or low-cost policy loans.
As one can see by this discussion on charitable giving, a donor can obtain tremendous financial and philanthropic benefits through a proper estate planning strategy. Review with your estate planning attorney, advanced life underwriter, and your charity of choice to see which charitable giving instrument is the right choice for you.
