Charitable Remainder Trusts

[By Jane Choi, LUTCF, CLF]

What Is a Charitable Remainder Trust (CRT)?

A charitable gift of a partial interest (a gift of less than the donor's entire interest in property) does not qualify for an income tax, gift tax, or estate tax charitable deduction—with certain important exceptions. One exception to this "partial-interest rule" is for gifts made to charity through charitable remainder trusts that meet statutory requirements. Charitable remainder trusts may provide benefits for both individuals and charities without violating the partial interest rule.

A charitable remainder trust (CRT) is a unique kind of irrevocable trust in which:

• The donor, or one or more individuals designated by the donor, receive(s) income from the trust for life or joint lives, or for a period of up to 20 years, after which the trust terminates, and the trust corpus is distributed to the charitable remainderman.

• The income payout period may last for more than one life, but the present value of the charitable remainder must be 10% or more of the initial value of the property transferred to the trust. As the income payout period stretches out (due to young or multiple beneficiaries), the value of the charity’s remainder interest shrinks under t he time-value-of-money principles, potentially jeopardizing the tax-qualification of the trust.

Because a CRT can be arranged to pay income to the donor (or other individual) for life, it often permits the donor to make a major gift to a charitable institution (and qualify for immediate income tax benefits without losing spendable income).

Funding a CRT

Charitable remainder trusts come in two main forms:

•  charitable remainder annuity trust (CRAT), and

•  charitable remainder unitrust (CRUT).

A donor establishes a CRAT by irrevocably transferring cash or appreciated property to the trustee. Under the SECURE 2.0 Act, an IRA owner age 70½ or older can also choose to fund a new CRT by making a one-time, tax-free distribution from the IRA of up to $53,000 (in 2024). (Spouses may combine their $53,000 distributions into a single CRT.) This distribution does not create a charitable income tax deduction, but it does count toward the donor's required minimum distribution if one is due. Note that a CRT funded in this manner has certain rules and restrictions

General Features

The trust terms require the trustee to pay a specified annual annuity of at least 5% (but not more than 50%) of the initial value of the trust assets to the donor or other designated individual beneficiaries for a certain period of time (often the lives of the beneficiaries), with the trust property passing to a designated charitable institution at the end of this time period. The value of the charitable remainder must be at least 10% of the net fair market value of all trust property as determined at the time of the transfer. The income beneficiary of a CRAT must receive the required annuity payout each year. If the trust does not produce enough income, the trustee will need to invade the principal in order to make the required payout.

A CRUT is also an irrevocable trust that names a charitable institution as the remainder beneficiary, but it pays one or more income beneficiaries a specified percentage of the trust assets as revalued each year. If the trust principal rises in value, the income payout also increases. The specified percentage must be at least 5%, but not more than 50% of the annually revalued trust assets. As with a CRAT, the value of the charitable remainder must be at least 10% of the net fair market value of all trust property as determined at the time of the transfer.

While the CRAT comes in only one basic form, the CRUT comes in four varieties:

• the straight or fixed percentage unitrust

• the net-income (without make-up) unitrust

• the net-income with make-up unitrust (NIMCRUT)

• the "flip" unitrust

Advantages of CRTs for Donors

Flexible Features

While charitable remainder trusts must be irrevocable to qualify for tax benefits, they are nevertheless attractive to donors because they offer not only current income tax benefits but also a number of options that can offset some of the potential disadvantages of irrevocability.

•  The donor may establish a charitable remainder trust during life (inter vivos) or at death (testamentary).

•  The donor can choose a fixed-income payout (charitable remainder annuity trust) for the individual beneficiary(ies) or a variable-income payout in which the payout amount grows or declines with changes in the trust principal (charitable remainder unitrust).

•  The donor selects the payout rate of the trust, within certain legal limitations (e.g., 5% minimum, 50% maximum, 10% charitable remainder value, 5% probability test for annuity trusts). Once the payout rate is selected, it cannot be changed. By careful selection of the trust’s payout percentage, a donor can elect to optimize the charitable deduction or the payout amount.

•  The donor may make additional contributions to a CRUT, if desired, after the initial contribution. A CRAT cannot receive additional contributions.

Customizing a CRT

Income beneficiaries. The donor selects one or more income beneficiaries to receive income from the trust.

Income payments. The donor chooses how long income from the CRT will be paid to the income beneficiary(ies):

•  for their lifetimes

• for a term of years (not to exceed 20), or

• for the lifetime(s) of the beneficiary(ies), followed by a term of years.

Charitable remaindermen. The donor names one or more charities as the remainder beneficiaries of the trust. The donor may retain the right to change the charitable remaindermen.

Trustee. The donor names the trustee. This could be the donor, the charitable remainderman, a third party (e.g., attorney, accountant, relative, etc.), or a financial institution with trust powers. The donor may retain the right to change the trustee.

Right to Revoke

While the selection of income beneficiaries is irrevocable, the donor may retain a testamentary right to revoke these income interests by will to avoid making a completed gift during life for federal gift tax purposes. By doing this, a completed gift only occurs as each income payment is made to an income beneficiary. (The donor cannot make a gift to himself or herself, of course, if the donor is the income beneficiary). The gift tax annual exclusion may apply to reduce or eliminate any gift tax for the donor on these annual gifts of trust income to individual beneficiaries, if such beneficiaries are deemed to hold present interests in the trust.

Investment Discretion

The trustee of a CRT has discretion over the investment of the trust assets but must handle the investment in a prudent and reasonable fashion and comply with applicable state laws (e.g., Uniform Prudent Investor Act, Uniform Principal and Income Act, Trust Codes) and federal laws (e.g., Internal Revenue Code, Philanthropy Protection Act). As a general matter, the trustee can balance the income needs of the income beneficiaries with the remainder interest (protection of principal) of the charitable remainderman.

Common Characteristics of CRATs and CRUTs

CRATs and CRUTs have a number of characteristics in common, and, as we shall see later, a number of dissimilarities.

•  A CRT must be irrevocable—there can be no possibility that the remainder interest will revert to noncharitable beneficiaries.

•  The annual payout percentage cannot be less than 5% of the initial value of the trust in the case of a charitable remainder annuity trust, or less than 5% of the annually revalued trust corpus in the case of a charitable remainder unitrust (more on this shortly, including the unitrust exceptions).

•  The trustee cannot make any payment to noncharitable beneficiaries other than the annuity amount or the unitrust amount.

•  The annuity or unitrust amounts are deemed to be taxed in accordance with the four-tier system, in the following order of priority: (1) current and accumulated ordinary income; (2) short-term capital gain, followed by long-term capital gain; (3) "other income" (usually meaning tax-exempt interest); and (4) tax-free return of corpus.

•  The trust itself is generally exempt from federal income tax.

•  The trust must meet either the definition of a CRAT or a CRUT at its inception, and must function exclusively as such thereafter.

•  The term of the trust must be measured by the life or lives of one or more individuals living at the time the trust is created, or by a fixed term of not more than 20 years.

•  The payout percentage rate cannot exceed 50% of the initial value of CRAT assets, or 50% of the annually revalued CRUT assets.

•  The present value of the charitable remainder must be at least 10% of the fair market value of the assets transferred to the trust.

•  The trust must specify a contingent charitable remainderman in case the primary charitable remainderman ceases to exist or ceases to be a qualified charitable organization.

•  CRTs are subject to the private foundation prohibitions and excise taxes with respect to self-dealing, excess business holdings, jeopardy investments, and taxable expenditures.

•  The trust instrument cannot restrict the trustee from investing the trust corpus in a manner that will produce a reasonable income or gain.

Differences Between CRATs and CRUTs

Annual Payout

The most important difference between a CRAT and a CRUT is the way the annual payout to the income beneficiary is defined.

In a CRAT, the annual payout is a sum-certain annuity amount—a fixed percentage of the initial value of the property transferred to the trust. For example, if a donor transfers $100,000 to a CRAT and the payout percentage is 5%, the income beneficiary will receive $5,000 each year until the trust terminates, regardless of the fluctuating value of the trust principal or the earnings of the trust.

In a CRUT, on the other hand, the annual payout is a unitrust amount—a fixed percentage of the annually revalued trust corpus. So, if the payout is 5% but the CRUT has grown in value from $100,000 at its inception to $120,000 in the second year of its existence, the income beneficiary will receive $5,000 in the first year and $6,000 as the second-year payout. If the trust’s value, then drops to $80,000 in the third year, the income beneficiary will receive only $4,000 for the third-year payout.

Additional Contributions

A CRAT cannot accept additional contributions, and the trust instrument should prohibit them.

A CRUT, on the other hand, may accept additional contributions (because of the annual revaluation feature), but it is not required to do so—therefore, the trust instrument may authorize or prohibit additional contributions.

Payouts of Trust Income Only

The trust instrument for a CRUT may provide for the payout of all trust income in any year in which total trust income is less than the amount required by the fixed percentage (a "net income unitrust"). Further, the trust instrument may provide that any income shortfalls for years in which trust income was less than the fixed percentage may be made up at a later time (a "net income with make-up unitrust," or NIMCRUT). These provisions are planning options for the donor.

A "flip" unitrust allows a net income unitrust to flip or change into a straight or fixed percentage unitrust once a triggering event occurs, such as the disposition of illiquid or hard-to-market assets (e.g., real estate or closely held stock). Thus, during its initial net income unitrust phase, the flip unitrust will pay no income if no income is actually earned, but once the trust asset has been sold and the proceeds reinvested, then the trust changes to a straight CRUT and income is paid thereafter pursuant to the percentage payout requirement.

More on Charitable Remainder Annuity Trusts

Qualification Requirements for a CRAT

A CRAT must satisfy these requirements to receive tax-deductible contributions and to be income tax-exempt:

•  The trust must be irrevocable.

•  The annuity amount must be a sum certain that is payable to the donor or other designated individual beneficiary(ies).

•  The annuity amount must be paid out annually or at more frequent intervals, as prescribed in the trust instrument.

•  The annual annuity payment cannot be less than 5% of the initial value of the assets transferred to the trust, nor more than 50%.

•  The trust must provide income benefits to one or more individuals for life, or for a fixed term not to exceed 20 years.

•  If trust income for the year is insufficient to make the fixed payment, the trustee must invade the principal to pay the full annuity amount.

•  At the time the trust is established, the actuarial probability that the principal will be completely depleted during the trust term cannot exceed 5%.

•  Due to the fixed income payout obligation, additional contributions to an existing CRAT are not allowed. A donor would have to establish a new trust to receive any additional contributions. Of course, a donor who wants the option to make additional contributions should establish a CRUT instead of a CRAT.

•  The remainder interest must be payable to a qualified charity, and the present value of the charitable remainder must be at least 10% of the value of the contribution to the CRAT.

Caution: It is important to ensure compliance with both the 5% probability test and the 10% minimum charitable remainder requirement.

When a CRAT Is Appropriate

Charitable remainder annuity trusts are popular when both equity values are sluggish and interest rates are high. Ideally, the CRAT donor would like to lock in a high-income payout rate that will last over many subsequent years of fluctuating interest rate movements.

The CRAT also appeals to the donor who wants the certainty of a fixed-dollar payout and is willing to sacrifice the potential income growth and flexibility available with the unitrust in order to gain this certainty.

Potential donors should probably contemplate a minimum corpus of $100,000 to set up a CRAT. The fees associated with the administration of a CRAT often make smaller amounts infeasible. Some charitable organizations may set a different minimum as a matter of institutional policy if they are to serve as the trustee.

Deduction for Charitable Remainder

There are present value of the charity’s remainder interest is deductible for federal income and gift tax purposes (an inter vivos CRAT) or for federal estate tax purposes (a testamentary CRAT).

There are various factors that affect the donor's deduction for setting up a CRAT that meets all of the qualification requirements:

•  the amount transferred to the trust

•  the life expectancy of the income beneficiary (or joint life expectancy if multiple beneficiaries are named), or the term of years specified as the trust term

•  the payout rate selected by the donor

•  the frequency of the payout (monthly, quarterly, semiannually or annually)

•  the applicable federal rate (AFR) chosen by the donor from among those available at the time the trust is established.

Online calculators make it easy to compute the amount of the donor's deduction, or even to calculate several scenarios with different values to compare the effects on the payout and deduction.

The 5% Probability Test for CRATs

The 5% probability test requires that the annuity amount cannot be so large that there is a greater-than-5% probability that the corpus will be exhausted before the (last) noncharitable beneficiary dies, the trust terminates, and the charity receives its remainder [see Rev. Rul. 77-374, 1977-2 C.B. 329; see also Ltr. Rul. 8152019].

The applicable federal rate (AFR) used in charitable deduction calculations reached historically low levels recently. For example, for a split-interest gift made in November 2023, the donor could calculate the charitable deduction using the rate for September 2023 (5.0%), October 2023 (5.4%), or November 2023 (5.6%). A donor will usually select the highest rate available to maximize the deduction for a CRT.

If a CRAT is required to pay out 7% and the pertinent AFR is significantly lower, the risk increases that the trustee will have to invade the principal to make the payout. Thus, the CRAT may fail the 5% probability test. Recognizing that low interest rates in recent years have greatly limited the use of a CRAT as an effective charitable giving vehicle, the IRS issued Rev. Proc. 2016-42, which allows the trust to terminate early if assets become depleted to the extent that failure of the 5% probability test is imminent. This is technically accomplished by treating the threat of exhaustion as a "qualified contingency" under IRC §664(f)(3).

Provided that the sample language in Rev. Proc. 2016-42 is included in the CRAT verbatim, the trust need not be tested to determine whether it continues to satisfy this qualification requirement. The IRS sample language applies to trusts created after August 8, 2016.

If a donor has drafted a testamentary CRAT into a will (or wills, for a married couple), the CRAT could come into existence at a time of low AFRs. Even with fairly elderly income beneficiaries, the CRAT might fail to qualify for the income tax and estate tax charitable deductions without a formula or other precaution written into the trust language. Working with an advisor, such a donor can use a codicil to change the CRAT into a CRUT, which is not subject to the 5% probability test (since the CRUT payout is not fixed but is tied to the floating annual value of the trust principal) [Ltr. Ruls. 7915038 and 8419005].

The 10% Remainder Value Test

A CRAT must provide for a charitable remainder with a present value equal to 10% or more of the value of the property transferred to the CRAT, as determined at the time the trust is established. If calculation software indicates a problem with this test, the donor may have to limit the number of income beneficiaries, select older beneficiaries, or choose lower payout rates (but not below 5%) to ensure that the CRAT meets the 10% test.

IRS Model CRAT Forms

In 2003 and 2016 the IRS issued model CRAT forms with preapproved trust language to conform to statutory and regulatory changes since the prior model CRAT forms were issued [Rev. Procs. 2003-53 through 2003-60, released in IRB 2003-31, and Rev. Proc. 2016-42, released in IRB 2016-34].

More on Charitable Remainder Unitrusts

Qualification Requirements for a CRUT

A charitable remainder unitrust (CRUT) must satisfy these requirements:

•  The trust must be irrevocable.

•  The trust must provide income benefits to one or more individuals for life (or joint lives) or for a term of not more than 20 years.

•  The income may be paid annually, semi-annually, quarterly, or monthly, as defined in the trust instrument.

•  The trust must pay out a fixed percentage of the net fair market value of the principal, as redetermined annually, to the donor or other individual income beneficiary or beneficiaries (i.e., a "regular" or "straight" CRUT). Alternatively, the trust may pay out annually to the income beneficiary the lesser of the fixed percentage or the actual trust income for the year (i.e., a "net-income" CRUT).

•  In the case of a net-income CRUT, the net income earned during some payment periods may be less than the fixed percentage amount. Therefore, a special "make-up" provision may be included in a net-income CRUT to allow the trustee to maintain a record of such shortfalls. These shortfalls may be made-up in future payment period(s) when the net income earned exceeds the fixed percentage amount. The net income CRUT with this "make-up" provision is also known as a "NIMCRUT."

•  The fixed percentage payout cannot be less than 5% nor more than 50% of the annually revalued trust corpus.

•  The donor can make additional contributions to a regular or net-income CRUT, as well as to a NIMCRUT.

•  The remainder must be payable to a designated "qualified" charity (pursuant to IRC §170).

•  The present value of this charitable remainder interest must be at least 10% of the initial contribution and of any subsequent contribution, as measured at the time of the contribution.

Caution: Reliable gift design software should be used to ensure compliance with the 10% minimum charitable remainder test.

The Net-Income Unitrust, With and Without Make-up

The net-income unitrust is a variation possible only with a CRUT. The trust agreement can direct that each annual payment is to be the lesser of:

•  the specified percentage of the trust’s value for that year, or

•  the net income actually earned by the trust.

Under this option the trust agreement may (but does not have to) provide that, if the annual payout is less than the specified percentage in one or more years, the accumulated "income deficits" will be made up in subsequent years in which income exceeds the specified percentage. When a net income unitrust has a make-up provision, it is sometimes called a NIMCRUT.

The NIMCRUT technique can be used to time trust income payouts to coincide with the donor’s need for retirement income. The donor might fund the trust with non-income producing assets, or the trustee might invest the trust corpus initially in assets that produce little or no income. When the donor reaches retirement age, the trustee would then convert the corpus to income-producing investments and begin to pay out trust income (including any make-up amounts, if called for by the trust instrument).

"Flip" CRUTs

A charitable remainder unitrust (CRUT) may include language that allows the trust to change its payout method from a net-income unitrust to a straight, fixed-percentage CRUT on a specified date or upon the occurrence of a triggering event specified in the trust instrument.

The flip option is particularly attractive when the donor wishes to donate illiquid or hard-to-market assets such as real estate or closely held stock. If the trustee does not sell the real estate or stock right away, or if the property does not earn any income inside the trust, the net-income limitation relieves the trust from the obligation of paying the unitrust amount to the income beneficiary (often the donor) via distributions in kind or of partial interest, with no cash to pay the income tax, or via a forced sale of the contributed property.

However, once the trustee sells the illiquid asset and reinvests the money in income-producing assets (or once some other triggering event occurs), the donor or other income beneficiary may prefer a more predictable payout than the net-income limitation will permit. If the CRUT includes a flip provision, the trustee can make the fixed-percentage payout without being limited to the trust’s net income in years when that is less than the unitrust amount.

The flip unitrust was designed to satisfy the income beneficiary’s desire for flexibility in the payout method within an irrevocable trust. In a flip unitrust, the net-income limitation serves to:

1. negate the fixed-percentage payout during the initial period of the trust, and

2. disappear at the point when it could begin to adversely affect the income beneficiary.

The Flip Requirements: The trust instrument of a net-income CRUT (with or without a makeup provision) can provide for a switch to a straight CRUT if the following requirements are met [Reg. §1.664-3(a)(1)(i)(c-f)]:

•  the unitrust percentage stays the same after the flip

•  the flip is triggered on a specific date or by a single, specific event (more on this shortly)

•  the flip is to be effective on the first day of the CRUT’s taxable year that follows the triggering event

•  a CRUT may flip only from a net-income unitrust (with or without makeup) to a straight, fixed-percentage CRUT

•  when the CRUT has a makeup provision, the trust instrument must state that any unpaid makeup amount as of the flip date is forfeited

•  a CRUT may flip only once.

It is worth restating that a CRUT may flip only from a net-income unitrust (with or without make-up) to a straight, fixed-percentage unitrust. No other type of flip is permitted. A charitable remainder annuity trust (CRAT) cannot flip to any type of unitrust, nor can a straight unitrust flip to a net-income unitrust.

No income tax deduction can be taken for the permanently forfeited make-up amount when a NIMCRUT flips to a straight CRUT. Note that any make-up forfeiture will benefit the charitable remainderman, partially negating the adverse consequences to the charity of the flip in the payout method.

Events That Can Trigger a Flip: Examples of permissible triggering events mentioned in the regulations include the following:

•  a specific trigger date.

•  the sale of "unmarketable assets" (defined below) such as real estate or restricted (Rule 144) stock.

•  the marriage or divorce of the noncharitable (income) beneficiary.

•  the death of the noncharitable beneficiary.

•  the birth of a child to the noncharitable beneficiary; and

•  the attainment of a specified age by the noncharitable beneficiary.

Caution: A permissible triggering event must be outside the control or discretion of the donor, trustee(s), income beneficiary, or any other person [Reg. §1.664-3(a)(1)(i)(c)(1)]. The sale of unmarketable assets would seem to be within the trustee's control, but it is listed as a permissible triggering event—an intended exception to the general rule.

"Unmarketable assets" are assets other than cash, cash-equivalents, and assets that can readily be sold [Reg. §1.664-1(a)(7)(ii)].

Examples of impermissible triggering events include:

•  a sale of marketable assets by the trust, which would put the timing of the flip squarely within the trustee’s control

•  a beneficiary's request that the trust flip to a straight unitrust

In the case of a pre-existing CRUT that was reformed to comply with the flip requirements, the triggering event cannot occur in a year prior to the year in which the CRUT was reformed.

Suppose the triggering event is defined in the CRUT as the date of the donor’s retirement. Will this pass muster? Probably not, since the retirement date is within the donor's discretion and control.

Accelerated Unitrusts

The IRS has issued regulations to halt "accelerated unitrusts"—a technique designed to avoid capital gains taxes by placing highly appreciated property into a charitable remainder unitrust with a very short term and a very high payout rate.

An elaborated version of the accelerated unitrust technique enables the trustee to borrow to pay the unitrust amounts rather than selling assets. Because the payments are not derived from trust income or capital gains, they are reported as a tax-free return of corpus under IRC §664(b)(4). In the last year of the trust, the trustee either sells the appreciated assets to repay the loan or distributes them to the charitable beneficiary (subject to a contractual obligation to repay the loan).

To prevent the use of CRTs for converting capital gains into tax-free corpus, the final regulations have a "deemed sale" rule. The IRS will treat a CRT as having sold, in the year of the trust payout, a pro rata portion of the trust assets. Capital gain income will flow out to the income beneficiary under the tier system rather than as a tax-free return of corpus [Reg. §1.643(a)-8(b)(1)].

The regulations can be utilized as a de facto safe harbor for short-term, high-payout CRTs. A CRT that complies with (1) the 10% minimum charitable remainder rule, (2) the 50% maximum payout rule, and (3) the deemed sale rule—and that doesn’t otherwise abuse the tier system—offers significant advantages to certain types of donors. Consider, for example, a young and wealthy entrepreneur who, in the past, has not been considered a likely CRT grantor due to having a long life expectancy. By using, say, a 5-year term certain CRT and a 40% payout, the entrepreneur could recover much of the original contribution and still leave a significant remainder to charity that meets the 10% test.

However, a major concern is the broad reach of Reg. §1.643(a)-8(b)(2), which states that transactions intended to circumvent the regulations will be disregarded. A donor should always seek the advice of a seasoned attorney when establishing a CRT.

IRS Model CRUT Forms

In August 2005, the IRS issued model CRUT forms with pre-approved trust language to conform to statutory and regulatory changes since the prior model CRUT forms were issued 15 years earlier [Rev. Procs. 2005-52 through 2005-59, released in IRB 2005-34].

More on a CRT Funded from an IRA

The SECURE 2.0 Act created the opportunity to fund a CRT with a one-time qualified charitable distribution (QCD) from an IRA of up to $53,000 (in 2024). This can be a CRAT or a CRUT. In either case, the CRT generally follows the restrictions already covered in this section, with a few important differences:

•  The IRA distribution must go directly to create a new CRT that meets the qualifications for a charitable income tax deduction—a minimum payout rate of 5% and, in the case of a CRAT, the 5% probability test (or the 10% alternative termination test).

•  No charitable income tax deduction is allowed, but the distribution (which counts toward the donor's required minimum distribution if one is due) is free of tax.

•  All payments from the trust will be taxed as ordinary income. The donor is essentially spreading out the tax that would have been due on the IRA distribution over time, which can be advantageous.

•  Spouses may each make a $53,000 distribution from their respective IRAs and combine them to create a single $106,000 CRT.

•  The CRT cannot make income payments to anyone other than the IRA owner and/or the owner's spouse. The income interest is nonassignable.

•  Whether a CRAT or a CRUT, the CRT cannot accept additional contributions.

•  The trust term may not be limited to a term of years.

Choosing the Right CRT Option

Donor objectives and motivations often will make one CRT form more appropriate than the others.

Charitable Remainder Annuity Trust

A donor may wish to choose a CRAT when donating an asset that already earns a fixed income (e.g., a corporate or tax-exempt bond or rental property). A CRAT also allows the donor to avoid the capital gains tax (when the trust is funded with appreciated property) and remove the donated assets from the donor’s gross estate.

Older donors who desire a fixed income may also prefer a CRAT. While a charitable gift annuity also provides a fixed income with an attractive payout rate (depending on the age of the income beneficiaries at the time the gift is made), the charity may not offer gift annuities in the state where the donor lives, or the asset the donor wants to use to fund the gift annuity might not be acceptable under the charity's policies.

Straight or Fixed-Percentage CRUT

A donor with a relatively long life expectancy may choose the straight CRUT, with the principal invested for growth. Over the long term, the trust may pay out more income as the principal grows in value and some of this growth or appreciation is realized and paid as income.

Net-Income CRUT

A net-income CRUT does not burden the trustee with having to sell the property right away to pay the unitrust amounts, as would be the case with a straight CRUT. Therefore, the net-income CRUT may be appropriate when:

• the asset to be donated produces little income or is difficult to sell, and

• the income beneficiary has little current need for additional income.

The natural markets for the net-income unitrust are high-earning professionals, executives, business owners, and investors who:

• are generally between the ages of 40 to 60, and

• hold substantially appreciated property that would create a significant capital gains tax liability if sold, is illiquid or hard to market, and produces little in the way of current income

For example, an individual transfers fully depreciated real property to a net-income CRUT. The trustee holds the asset until such time as it can be sold on favorable terms, and pays no capital gains taxes. There is no need to worry about a forced, untimely sale to pay the fixed-percentage unitrust amount.

NIMCRUT

A "make-up" provision may be added to a net income CRUT to allow payment of the "income deficits" from earlier years in the future when the trust produces more annual income. This will be especially attractive to the donor who has no need for additional current income, but who anticipates a need for higher income in the future, perhaps after retirement.

Flip Unitrust

The flip unitrust option allows a net income CRUT or a NIMCRUT to convert (or "flip") to a straight CRUT when a permissible triggering event occurs such as the sale of the illiquid asset(s) used to fund the trust. This will be useful when the donor does not want the trust payout restricted by the net income limitation after the asset is sold or some other flip-triggering event occurs.

Tax Consequences of a CRT

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 the donor funds the trust with appreciated property, then the deduction is limited to 30% of the donor’s adjusted gross income (AGI). The donor may claim the deduction in the year of the gift and, if any portion exceeds the percentage limitation in that year, it may be carried over and deducted for up to five subsequent years.

Capital Gains Tax

The donor may transfer appreciated property to a CRT without incurring capital gains tax on the disposition of the property. The trustee can sell the property and 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, such as i.e., unrelated business taxable income or 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) within the first two tiers, the highest taxed income or gain will 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 tier (ordinary income) has been exhausted, distributions will be deemed to come from the highest-taxed class in the second tier (capital gains), and so on.

Thus, ordinary income that is taxable up to 37% will be deemed distributed before qualified dividends (taxed only up to 20%). Then capital gains will be paid out, beginning with the highest taxed gain (short-term capital gain—taxed at 37%, 35%, 32%, 24%, 22%, 12% and 10% or long-term capital gain—taxed at 20%, 15% or 0%). In other words, 20% dividends from the first tier will be deemed distributed before 37% short-term capital gains from the second tier.

To the extent the trust earns ordinary income from dividends, interest, rents, or other sources, 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 are 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.

Note that a 3.8% surtax is imposed on net investment income for higher earning taxpayers. As a result, the distribution from a CRT characterized as ordinary income or short-term capital gains could be taxed at 40.8%, while qualified dividends or long-term capital gains could be taxed at 23.8%.  

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 Uniform Fiduciary Income and Principal 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 Uniform Fiduciary Income and Principal Act, the IRS issued final regulations that revise the definitions of principal and income for purposes of IRC §643(b). Under these regulations, 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)].

Also, the Uniform Prudent Investor Act, which has been adopted by a majority of states, permits the trustee to delegate the responsibility of day-to-day investment decisions, though not to abdicate oversight altogether.

Gift Tax Considerations

The present value of the charity's remainder interest is entirely deductible for gift tax purposes. However, a donor may or may not incur gift tax on the creation of a CRT (during the donor's lifetime) depending on the trust's named beneficiary.

•  If the donor is the only income beneficiary of the CRT, the donor is not making a gift of the income interest (since the donor cannot make a gift to himself or herself).

•  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 the donor may owe federal gift tax. 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, the value of the gift 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 ($13.61 million in 2024). 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 the donor's 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.

Transaction of Interest

IRS Notice 2008-99 describes a transaction of interest involving a charitable remainder trust (CRT):

•  The grantor contributes appreciated property to a CRT.

•  The trustee sells the appreciated property and reinvests the proceeds in new assets.

•  The grantor and charity coordinate the sale of their interests in the CRT to a third party for approximately the fair market value of the assets within the CRT.

Unfortunately, the IRS has some concerns about donors using a transaction of interest as a tax avoidance technique.

Summary of Tax Advantages of CRTs

 The donor qualifies for an immediate income tax charitable deduction for the present value of charity's remainder interest in the year that the charitable remainder trust is established. Part of the deduction may be deferred for up to five years if the percentage limitation is a factor.

 The donor does not owe any capital gains tax on appreciated property used to fund the trust.

 A CRT is income tax exempt (unless it receives certain kinds of tainted income).

 The donor (or other income beneficiary) receives an income for life or for a term of years from the CRT—distributions that are taxed under the "four-tier system." If the trust corpus is invested in bonds that pay tax-exempt interest, that interest will flow through to the income beneficiaries.

 The donor can reduce federal gift and estate taxes by transferring assets out of the estate and into the CRT. If the only income beneficiaries are the donor and/or the donor's spouse, the assets donated to the trust escape federal gift and estate tax due to the unlimited charitable and marital deductions.

Administration of Charitable Remainder Trusts

Duties of a Trustee

The trustee of a CRT has a number of significant responsibilities, including:

•  Prudently invest the trust assets.

•  Pay out income to the beneficiaries.

•  Prepare the trust's tax return.

•  File Form 5227 with the IRS annually (used to report the financial activities of a split-interest trust).

•  Provide all income beneficiaries with a Schedule K-1 (Form 1041), summarizing their annual payments.

Donor as Trustee

The donor may serve as trustee, or may select another entity such as a bank, trust company, or the charity itself. A survey by the Partnership for Philanthropic Planning suggests that younger donors are more likely to serve as trustee, while older donors are more likely to hire a fiduciary or ask the charity to serve as trustee.

Charity as Trustee

Applicable state law dictates whether a charitable organization may serve as trustee. Where state law allows, the charity should serve as trustee only after careful consideration of the potential liabilities and administrative costs, and only with the final approval of its board of trustees.

If the charity serves as trustee, it may hire an agent (such as a bank) to fulfill all or some of the trustee responsibilities. If the charity hires an agent, the agent may still send out income checks with a cover letter from the planned giving officer with news about the charity. The charity (as trustee) may pay the costs of trust administration using trust income and/or principal or may assume the costs as an operating expense.

Institution as Trustee

An entity such as a bank or trust company can serve as the trustee. A donor who wishes to choose an institutional trustee should compare fees, investment policies, history, etc. An institutional trustee may be better qualified to manage certain assets, such as real estate, but may charge additional fees depending on the trust’s assets (per its expertise).

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