You may have encountered Charitable Remainder Trusts in conversations with others after a liquidity event or through tax professionals discussing strategies for managing large unrealized gains. In the appropriate situation, a Charitable Remainder Trust (CRT) can help address tax efficiency, income planning, and charitable objectives simultaneously.
How a CRT Works
A Charitable Remainder Trust is a split-interest trust funded with appreciated assets such as stocks, business interests, or real estate. Assets are transferred into an irrevocable trust, which provides an income stream to the donor or other beneficiaries for a specified term or for life. At the end of that period, the remaining assets are distributed to one or more charitable organizations.
The CRT is a tax-exempt entity; however income taxes are passed on to the recipient of the income stream. The donor typically receives an immediate income tax deduction based on the present value of the charitable remainder, while recognizing gains over time through trust distributions.
When a CRT Might Be Appropriate
CRTs are commonly used by individuals who hold low-basis, highly appreciated assets and prefer to diversify without triggering a large capital gains tax. Examples include concentrated stock positions, founder shares, or commercial real estate.
Instead of selling the asset personally and recognizing the full tax liability in the year of sale, the trust sells the asset and reinvests the proceeds, allowing more capital to remain invested and generate income.
Key Planning Considerations
- Capital gains deferral: Taxes are spread over time, allowing more assets to remain invested.
- Charitable deduction: An immediate income tax deduction is available to the donor, based on the projected charitable remainder.
- Income stream: The trust provides ongoing distributions, often taxed partially at capital gains rates.
- Portfolio diversification: Proceeds may be reinvested into a more diversified strategy.
- Charitable impact: Assets ultimately support charitable organizations aligned with the donor’s goals.
Types of CRTs
There are two types of Charitable Remainder Trusts, a CRAT and a CRUT. A Charitable Remainder Annuity Trust (CRAT) pays a fixed dollar amount annually, regardless of investment performance. A Charitable Remainder Unitrust (CRUT) pays a fixed percentage of the trust’s value, recalculated annually, and the distribution may fluctuate based on portfolio performance. The type of trust that might be right for a given situation depends on the intentions of the grantor (for example, whether they prefer predictability or potential inflation protection) as well as the asset profile.
When CRTs Tend to Be Most Effective
CRTs may be more attractive in higher interest-rate environments, as the IRS Section 7520 rate used to calculate the charitable deduction generally results in a larger deduction when rates are higher.
Investment performance is particularly important for CRUTs. If trust assets grow faster than the annual distribution percentage, both income payments and the charitable remainder may increase. The trust must be structured so that at least 10% of the original contribution is projected to pass to charity.
Downsides of a CRT
Charitable Remainder Trusts are irrevocable, meaning that once assets are transferred into the trust, they cannot be reclaimed. In addition, CRTs involve a higher level of complexity than many other planning strategies, requiring legal drafting, ongoing administration, and annual tax filings, including Form 5227, all of which can result in additional costs. Finally, because the remainder of the trust passes to charity, heirs do not inherit the trust assets directly. Some individuals address this consideration by using a portion of the trust’s income to fund life insurance held within an irrevocable trust as part of their broader estate plan.
In summary, a Charitable Remainder Trust can be an effective way to convert a highly appreciated asset into a diversified portfolio, a tax-efficient income stream, and a charitable legacy. As with any advanced planning strategy, it should be evaluated within the context of a comprehensive wealth plan. Please reach out to your Wealth Manager if you have questions about CRTs.
