Gifts to qualified charitable organizations are completely exempt from federal estate and gift tax. A charitable remainder trust ("CRT") is a popular estate planning tool which allows you or your designated beneficiary to collect a guaranteed income during your lifetime on principal which will then pass tax free to your favorite charity upon your death.

Your CRT trust can be set up to pay a preset amount or a fixed percentage of principal to one or more income beneficiaries annually. The two payment approaches are referred to as a charitable remainder annuity trust or a charitable remainder unitrust. The requirements for qualifying the two trusts for a charitable deduction under the Internal Revenue Code are identical except that the annuity trust requires payment of a specific sum to the income beneficiary, while the unitrust requires payment of a fixed percentage. As a result of this requirement, the annuity trust does not permit additional contributions after the trust is first funded.

The key variables of these irrevocable trusts are 1) income beneficiaries, 2) charitable beneficiaries, and 3) tax effect. These are discussed in turn below.

Income Beneficiaries.  There must be one or more living income beneficiaries to whom the specific sum or fixed percentage is distributed each year. A portion of the amount may also be paid annually to the charitable beneficiary, so long as there is at least one non-charitable beneficiary.

The annual payment must be paid for the life of the income beneficiary, or for a term of years, not to exceed 20 years. The trust can be set up to provide for annual payments equally to a husband and wife, and then to the survivor, until the survivor's death. Payments to the income beneficiaries must be made at least annually, although they may be made more frequently.

If you elect the specific dollar amount payment, then the amount may not be less than 5% of the initial net fair market value of the trust property. Likewise, the fixed percentage annual payment may not be less than 5% of the initial fair market value of the trust property. There is no upper limit on the percentage. The approved percentage is applied against the fair market value of the trust property determined annually. There are three types of payments that can be made from the unitrust:

• The first method is to pay out a fixed percentage of the net fair market value of the trust assets, as revalued annually. It makes no difference what the actual income of the trust is for the year.
• The second method is to pay out income only. The trust pays the beneficiary the lesser of the trust's net income, or the stated percentage.
• The third alternative is to use the income only approach, and include a makeup provision, which provides that if the income in any year exceeds the percentage amount for that year, the excess can be paid out to the beneficiary to make up for those years in which the income was less than the percentage amount. This latter alternative is sometimes used as a retirement strategy. Prior to retirement, the trust is set up and the assets are invested in growth investments that produce little or no current income. At retirement, the investment strategy is reversed, and the assets are put into investments that produce a higher income.

Charitable Beneficiaries.  When the last income beneficiary dies, the remaining trust property must go to one or more charitable beneficiaries, or be continued in trust solely for the benefit of one or more charitable beneficiaries.

It is possible to name one charitable beneficiary, or concurrent charitable beneficiaries, who divide the remaining trust property, or successive charitable beneficiaries (for example, charity A, or if A does not qualify, then charity B).

The person who sets up the trust (the Donor) can reserve the right to remove a designated charity, provided that another charity is named. The right to do that can be executed during the person's lifetime, or he or she can reserve the right to do so in the survivor's will.

Working with Charitable Organizations.  Many charities, such as churches and universities, have Development Offices which will work with your attorney in creating the trust.  Often, the Charity will act as the Trustee which will administer the Trust, make distributions and file all necessary tax returns without cost to the Donor.

The Charity may also have special donor recognition programs for Donors, based on the level of contributions.

If you have a specific charitable organization that you would like to make the beneficiary of the trust, you should contact the Charity's Development Office

Tax Considerations.  When you set up the CRT and transfer property to the trust, you are entitled to a charitable contribution deduction for income tax purposes. The charitable contribution is the value of the remainder interest that goes to the charity, and that is computed based upon the current fair market value of the property and the actuarial tables published by the IRS.

In other words, if you contribute $1,000,000, you do not get a $1,000,000 charitable contribution deduction, because $1,000,000 is not going to the charity immediately. A portion of your contribution will go to the income beneficiaries. Therefore, the actual charitable deduction is calculated based on life expectancies of the beneficiaries and interest rates over time as applied to the underlying trust principal.

The trust itself is exempt from income tax. However, it needs to maintain records, and file a return with the IRS each year, even though it doesn't pay any tax.

When you set up the trust and make a contribution to the trust, you have no income tax consequences, other than the charitable contribution deduction. However, distributions of income are taxable to the non-charitable beneficiaries in the year they are received.

General Comments.  In summary, the CRT is simply an irrevocable trust agreement that is set up by an individual. There is a trustee (or co-trustees), who will take responsibility for managing, investing, and making distributions under the terms of the trust agreement, one or more non-charitable beneficiaries, who are entitled to annual distributions from the trust (typically, for the life of the beneficiary, or the lives of the beneficiaries), and a charitable beneficiary that is entitled to the remaining trust assets, when the current beneficiary is deceased.

Funding the trust with appreciated property can avoid accumulated capital gains tax, and provide a charitable deduction based on current values.  This can provide a welcome immediate tax relief and deduction to the Donor, a lifetime income stream for a worthy non-charitable beneficiary, and a future gift to your favorite charity. 

You should contact your attorney who can assist you in designing the optimum CRT vehicle to provide the maximum tax benefit while providing a significant charitable benefit.

This summary is intended as a source of general information.  If you have questions or desire additional information, please contact Ryan M. Wilson at (517) 377-0897 or rwilson@fraserlawfirm.com.