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Charitable Remainder Trusts: Not Necessarily For The Charitable Minded
The name "Charitable Remainder Trust" would seem to indicate a Trust intended to benefit a charitable organization. While it is true that a Charitable Remainder Trust ultimately benefits a charity, this type of trust can have even more economic benefits for a donor and the donor's family. If you have any asset (i.e., stock or real estate) that has substantially appreciated but does not produce enough income, a charitable remainder trust may provide a number of significant economic benefits.
How Does a Charitable Remainder Trust Work?
The owner of the appreciated asset, called the Donor, transfers the asset to a charitable remainder trust. The Donor chooses an amount of income he or she wishes to receive during the Donor's life or for a specific time period. The Donor can also choose to have the trust pay that amount to a surviving spouse or child for life or for a specific time period. (However, naming anyone other than the Donor and the Donor's spouse could result in a gift tax or the need for filing a gift tax return). The amount paid can either be a fixed amount determined at the start of the trust, called an annuity amount, or a fluctuating amount based on a fixed percentage of the annual value of the asset, called a unitrust amount. The annuity amount guarantees an amount to the Donor or other beneficiary, while the unitrust amount fluctuates yearly with the value of the asset to compensate for inflation. The amount chosen, however, must be one that, based upon the period of payment and current interest rates, would leave a remainder to the charity.
At the end of the life of the beneficiaries or the specified time period set out in the trust, the remainder of the trust is distributed to a charity as determined by the Donor.
How does the Charitable Remainder Trust Benefit the Donor and the Donor's Family?
When the Donor transfers assets to the Charitable Remainder Trust, the Trustee is able to sell the assets without paying any capital gains tax because the Trust is considered a charity. As a result, the Trust is able to reinvest the full proceeds into other assets which can produce more income. Regardless of the investment, the Trust is required to pay the Donor the specified income stream. Additionally, the Donor receives a charitable deduction against his current income for income tax purposes in the year that the asset is transferred to the Charitable Remainder Trust. The amount of the deduction is based upon the value of the asset, the interest rate at the time of the transfer, and the actuarially determined life expectancy of the Donor which determines the length of time before the charity receives anything from the trust.
Since the trust is required to pay a specified rate of return to the Donor regardless of the performance of the investment, the Donor may use some of the additional income distributed to him or her, that the Donor was not previously receiving, to purchase life insurance through an irrevocable life insurance trust to benefit the Donor's family. In doing so, the Donor will replace the original asset transferred to the Charitable Remainder Trust, which would have been taxable in the Donor's estate, with life insurance proceeds that will pass to his children without being subject to estate taxes.
An example of this is as follows:
Donor has $500,000 of stock held for more than one year for which he originally paid $100,000. The stock pays a dividend equal to one percent of the value of the stock ($5,000). If Donor were to sell the stock, he would pay capital gains tax of 20 percent on the $400,000 appreciation or $80,000, leaving $420,000 to be invested. If the Donor could then achieve a 10 percent annual dividend on his investment, the Donor would receive $42,000 per year from this asset. At the Donor's death, this asset is left to his wife, which she then leaves to their children. Depending on other assets in the estate, there could be as much as a 55 percent estate tax on the asset, leaving $189,000 to the children.
If, instead, the Donor transferred the stock to a Charitable Remainder Trust, no capital gains tax would be payable on the sale of its investments, and there would be $500,000 to invest. The Donor could choose to receive either a fixed amount (the annuity amount) or a percentage (the unitrust amount) which would be used annually to determine the distribution amount. For this example, the Donor chose an annuity amount of $50,000 per year to be distributed to him and his wife or the survivor of them regardless of the actual performance of the investment. Remember, Donor was only receiving $5,000 worth of annual dividend income prior to creating the Charitable Remainder Trust. Donor then sets up an irrevocable life insurance trust which will purchase a $500,000 life insurance policy payable to his children on the death of the Donor and his wife. The $500,000 will not be taxable in his or his wife's estate because it is owned by an irrevocable life insurance trust. The Donor gives $8,000 of his $50,000 annual annuity amount to the insurance trust to pay premiums on the life insurance.
In summary, regardless of whether Donor is charitably inclined, he has received the following economic benefits in creating a Charitable Remainder Trust:
- The Donor has replaced an asset worth $500,000 and taxable in his estate (stock) with a non-estate taxable asset also worth $500,000 (life insurance).
- The Donor has converted an asset producing minimal income (one percent) into an asset producing much greater income (10 percent) without paying capital gains tax on the sale of stock.
- The Donor received a current charitable deduction based on the value of the remainder interest to go to Charity.
Of course, the IRS is very clear as to how both the charitable remainder trust and the irrevocable life insurance trust must be structured. Any of our estate planning attorneys are available to discuss this estate planning strategy with you.
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