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Do you have a highly appreciated asset that you would like to sell but are hesitant to because you don’t want to pay the capital gains tax? One possible solution could be to establish a Charitable Remainder Trust, (CRT), a strategy that has been around since the 1960s.
Quote of the Month
“…all you are doing is renting the charity’s tax-exempt status”
– Mark Carley, CPA/PFS
Family Office Advisor
Why should I consider this?
A Charitable Remainder Trust is tax-exempt so there will be no taxes paid when the trust sells the appreciated asset. But that’s not all. “Double Tax Leverage” is accomplished when you gift assets to a CRT. Not only is the recognition of the capital gain avoided, but the donor creates an immediate charitable income tax deduction equal to the present value of the remainder interest of the gift to the trust.
But, you ask, shouldn’t I have a charitable intent to make a gift to a charitable trust? Despite its name – Charitable Remainder Trust – giving the gift might just be a throwaway. An argument can be made that all you are doing is renting the charity’s tax-exempt status. Although the donor is making a charitable gift, the CRT provides multiple benefits back to the donor. It allows you as the donor to defer capital gains tax, to grow money in a tax-deferred manner and lastly, like an annuity, it pays you a steady stream of income.
You make an irrevocable gift to a trust that is designed to provide some level of income to a designated beneficiary,
(yourself, a family member or other named individual), followed by a final distribution of the remainder of the assets to a
charity. And make no mistake, a CRT is a separate legal entity that requires much care and attention. An attorney must
draft a trust agreement, an accountant must prepare annual tax filings, an investment advisor must develop and monitor
an investment strategy for the assets and a trustee (it may be the donor) must carry out the provisions of the trust
agreement in accordance with IRS rules and regulations.
The Basics – How Does it Work?
Once the gift is made, the trust is required to pay a distribution, at least annually, to at least one income recipient, (a noncharitable
beneficiary), for a specified period of time. The income period can be for one or more lifetimes or for a term
of up to 20 years. At the end of the income term, the remainder interest is paid to at least one charitable recipient. Thus, where the trust gets its name.
In creating the trust, at least 10% of the “statistical” fair market value of the gift must be part of the remainder interest to be paid to the charitable beneficiary once the income term expires. This calculation is made upfront. Once the trust is in place and operating, the trust cannot lose its qualification as a CRT if the present value of the remainder interest subsequently falls below the minimum original qualifying amount. Mathematically this can happen if the assets in the trust perform at a rate of return significantly below the income payout rate.
Generally, distributions (payouts) to income recipients can be made in one of two ways. A fixed sum Annuity Payment of not less than 5% of the initial fair market value of the gift is paid to the income beneficiary. Alternatively, a fixed percentage Unitrust Payment (standard payout option) of not less than 5% of the fair market value of the assets of the trust valued annually is paid to the income beneficiary.
The Annuity Payment format will provide certainty to the income recipient as they can expect to receive a constant dollar amount from the trust for its term. Think of it as a fixed pension payment – unfortunately, one that is not adjusted for inflation. This payout format may be attractive because you want the assurance of a steady cash flow regardless of any fluctuations in trust value. However, under this format, any excess return over the payout rate accrues to the benefit of the charity – the remainder beneficiary.
A Unitrust Payment, with its variable payout format, provides an opportunity for more creative cash flow planning. A donor that chooses a payout rate that they expect will be less than the return the investments earn in the CRT will see the dollar amount they receive grow from year to year. This means the excess return accrues to the benefit of the income recipient, unlike the Annuity Payment. An increasing income stream will also allow the recipient to recoup the value of their original gift in a shorter period of time. The following chart illustrates the cumulative value of payouts over time.
One scenario from the graph shows if you selected a 5% payout rate and the CRT earned, on average, 7% then you recoup your $1,000,000 gift in 17 years. So it looks like you did indeed rent from the charity its exemption from tax.
Notes on Taxation & Investments
A CRT is required to report the amount and character of all distributions made to income recipients. A four-tier system is used to determine the taxable nature of the payouts. Distributions are paid and characterized in the following order: ordinary income, capital gains, other income, (this includes tax-exempt income), and finally return of corpus, (principal). Generally, the rules provide that the highest taxed income is distributed first. So, before you get to tier two, you have to first exhaust tier one and so on.
As a fiduciary, the trustee must manage the trust assets for the benefit of both the income recipient(s) and the charitable remainder. Generally, the trustee can invest in any type of investment asset. It should not hold an investment that generates any unrelated business taxable income, (UBTI), or it will lose its tax-exempt status. This prevents the trust from obtaining an unfair advantage over its non-exempt commercial rivals. Although allowed to invest in tax-exempt securities, such as municipal bonds, the trustee should consider avoiding them because of the four-tier taxation system described above. The CRT was most likely funded with a highly appreciated asset that was sold once inside the trust. The resulting capital gain will probably prevent the trust from reaching the third tier and making a tax-exempt payout. As
a result, the trust is better off buying higher-yielding taxable bonds since municipals are typically a lower-yielding investment.
Implementing a Charitable Remainder Trust is not without risk. The income recipient(s) could die before the total gift is returned to the donor. Yet, capital gains tax was deferred, money grew in a tax-deferred manner and you received a stream of income for a period of time. And don’t forget – the charity still benefitted.
Also note, that there are ways to mitigate the risk of dying early – you could always buy life insurance. And the tax benefit from an upfront gift will help pay for the insurance.
Please contact your Lexington advisor to determine if a Charitable Remainder Trust is a strategy that may work for you.
Lexington Wealth Management is a group comprised of investment professionals registered with Hightower Advisors,LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Lexington Wealth Management and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Lexington Wealth Management and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.
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