Editor: Albert B. Ellentuck, Esq.
The donor’s charitable contribution for funding a charitable remainder annuity trust (CRAT) is the value of the property placed in the CRAT less the present value of the CRAT’s annuity payments. In the case of a charitable remainder unitrust (CRUT), the value of the contributed property is reduced by the present value of the unitrust interest for a term of years or for the life of the income beneficiary. The two methods are different because the CRUT income stream fluctuates with changes in the value of the trust property. The technicalities involved in determining the value of the income stream or the remainder interest are much more complex for a CRUT.
Practice tip: Using commercial software for making these computations is recommended since it enables practitioners to compute various what-if scenarios for testing various income payout rates, terms, and frequencies of payments to assure that the 10% charitable remainder threshold is met.
Charitable Deduction for a CRAT
The rules for calculating the present value of the remainder interest in a CRAT are in Regs. Sec. 1.664-2(c). Generally, the present value of the annual income stream is determined and subtracted from the value of the property transferred to the trust to arrive at the value of the remainder interest. The factors for determining the present value of an income stream payable for a term of years are in Publication 1457, Table B, Term Certain Factors. The factors for determining the present value of an income stream payable for the life of the noncharitable beneficiary are in Publication 1457, Table S, Single Life Factors. Special rules apply for valuing the annuity interest or for adjusting the valuation of the annuity interest if the noncharitable annuity is payable other than annually at year end (e.g., at the first of each year or semiannually, quarterly, or monthly). The applicable factor is multiplied by the amount of the annual payment to compute the value of the income stream. Subtracting this amount from the value of the property contributed produces the value of the remainder interest. The tables (except Table J) for Publication 1457 are available here. Table J, Adjustment Factors for Term Certain Annuities, is in Regs. Sec. 20.2031-7(d)(6).
The value of the remainder interest is normally determined by using the Sec. 7520 interest rate for the month of the transfer to trust. However, the donor may elect to use the Sec. 7520 interest rate for either of the two months preceding the month of transfer. All other things being equal, the higher the Sec. 7520 interest rate, the larger the charitable contribution deduction for a charitable remainder trust (CRT) (see Sec. 7520(a); Regs. Secs. 20.7520-2(b) and 301.9100-8(a)(1)).
Charitable Deduction for a CRUT
The rules for calculating the value of a remainder interest in a CRUT are in Regs. Sec. 1.664-4. Generally, the present value of the remainder interest (i.e., the charitable deduction) in a CRUT is determined by finding the present-value factor that corresponds to the trust’s adjusted payout rate. The present-value factor for a CRUT with an income interest payable for a term of years is in Table D, Term Certain Factors, of Publication 1458. The present-value factor for a CRUT with an income interest payable for the life of the noncharitable beneficiary is in Table U(1), Single Life Factors, of Publication 1458. Most of both tables is reproduced in Regs. Sec. 1.664-4(e)(6). If the income interest is payable for the lives of two individuals, use Table U(2), Last-to-Die Factors, in Publication 1458, which is available here.
Unfortunately, the factors from the tables can rarely be used without first performing a complicated interpolation. However, once the appropriate factor is determined, calculating the value of the remainder interest (and the amount of the charitable contribution) is simply a matter of multiplying the value of the property contributed by this factor.
The value of the remainder interest is normally determined by using the Sec. 7520 interest rate (i.e., 120% of the federal midterm rate rounded to the nearest 0.2%) for the month of the transfer to the trust. However, the donor may elect to use the applicable rate for either of the two months preceding the month of transfer. The higher the applicable rate, the larger the charitable contribution deduction (see Sec. 7520(a); Regs. Secs. 20.7520-2(b) and 301.9100-8(a)(1)).
Limitations on Charitable Deductions to a CRT
Generally, the charitable deduction for contributions to a CRT with a public charity as its remainder beneficiary is limited to 50% of adjusted gross income (AGI). However, if the donor contributes capital gain property to the CRT, the special 30%-of-AGI limitation applies. In addition, if the trustee, donor, or income beneficiary has the power to change the charitable remainder beneficiary, the allowable deduction is subject to the 30%-of-AGI limitation (Rev. Rul. 80-38; Letter Ruling 9452026).
Observation: If the possibility that the remainder interest will not go to a 50%-of-AGI-limit charity is so remote as to be negligible (a subjective standard), then the 50%-of-AGI limit will apply for the taxpayer’s transfer to the trust (Rev. Rul. 80-38).
For contributions to a CRT of capital gain property to a charity not qualifying under the 50%-of-AGI limit, a 20%-of-AGI limit applies (Sec. 170(b)(1)(D)).
Taxation of a Charitable Remainder Trust
The key to the CRT is its tax-exempt status. CRTs with unrelated business taxable income (UBTI) do not lose their exemption from income tax. Instead, they are subject only to excise tax on the UBTI, rather than income tax on all undistributed taxable income (Sec. 664(c)). Note, however, that the excise tax is equal to the amount of the UBTI, so in effect this amounts to a 100% excise tax on UBTI. Further, the tax is treated as paid from principal rather than income, and the UBTI is considered income of the trust when determining the character of the distribution made to the beneficiary (Regs. Sec. 1.664-1(c)).
Since the excise tax on UBTI is equal to the full amount of the unrelated business income, CRTs should continue to avoid, whenever possible, investing in assets or engaging in transactions generating UBTI, even though under the rules, a CRT with UBTI does not lose its exemption from income tax.
Generally, UBTI includes income the CRT earns from a trade or business that is not substantially related to an exempt organization’s purpose, reduced by any expenses incurred in carrying on the business (Secs. 512(a) and 513(b)). Thus, for example, trade or business income from a partnership of which the trust is a member can create UBTI if the partnership is engaged in a business unrelated to the charity’s exempt purpose (Secs. 512(c) and 514).
Income from a publicly traded partnership, limited partnership, or limited liability company may result in UBTI if the entity conducts a trade or business. Thus, CRTs should avoid investing in passthrough entities, to eliminate the possibility that they will be allocated income that is UBTI. Also, debt-financed income (i.e., income produced by assets acquired with borrowed funds) is UBTI (Sec. 514). Therefore, investing in partnerships that are not engaged in a trade or business may still result in UBTI if the partnership incurs debt. Likewise, a CRT should avoid incurring debt on its own, since that can produce UBTI.
Taxation of Trust Distributions
The character of distributions received by current income beneficiaries of a CRT is determined using a separate-tier system (Sec. 664(b)). This tier system establishes an order for the distribution of four categories of income and corpus. Any distribution received by a beneficiary is deemed to have come from the first category to the extent of current-year or accumulated income in this category. When all current and accumulated income in the first category has been exhausted, the ordering proceeds to the second category of income, and so on. The four categories of income are as follows:
- Distributions are first taxed as ordinary income to the extent of the trust’s ordinary income for the current year plus its undistributed ordinary income from prior years. When there are different classes of income in this category (e.g., qualified dividends and other income taxed at the “regular” tax rates), distributions are treated as coming first from the class subject to the highest tax rate and ending with the class subject to the lowest tax rate (Regs. Sec. 1.664-1(d)(1)(ii)(b)). Thus, interest income is considered distributed before qualified dividends. Any ordinary loss for the current year first offsets undistributed ordinary income from prior years. Any excess loss is carried forward to reduce ordinary income in future years (Regs. Sec. 1.664-1(d)(1)(iii)(a)).
- Distributions in excess of the ordinary income tier are taxed to the beneficiary as capital gains to the extent of the CRT’s current or accumulated capital gains. The trust’s long-term gains and losses are combined, as are its short-term gains and losses. If the result is a net long-term gain and net short-term gain, the short-term gains are deemed distributed first. If short-term gains exceed long-term loss or long-term gains exceed short-term loss, the net gain (either short-term or long-term) is deemed distributed or carried forward. If the result is a net capital loss (short-term loss in excess of long-term gain or long-term loss in excess of short-term gain), the net loss is carried forward (Regs. Sec. 1.664-1(d)(1)(v)).
Note: Qualifying dividends are treated as distributed before short-term capital gains, which are taxed like ordinary income, and before any of the other higher-taxed categories of capital gain (25% or 28%). In other words, even though qualified dividends are taxed at the lower capital gains rate, they are not considered capital gains and are not allocated to the second tier.
- Distributions in excess of the first two income tiers are taxed as other income exempt from tax to the extent of current or accumulated tax-exempt income (Regs. Sec. 1.664-1(d)(1)(ii)(a)(3)). This category includes tax-exempt interest and other nontaxable income (e.g., life insurance proceeds, gifts, and inheritances).
- Any remaining distributions are treated as made from principal (Regs. Sec. 1.664-1(d)(1)(ii)(a)(4)).
Assigning Classes Within Categories
Within the ordinary income and capital gain income tiers, items are assigned to different classes based on the tax in effect when each type of income in that category is accounted for by the trust (Regs. Sec. 1.664-1(d)(1)(i)(b)). For example, a CRT could include a class of qualified dividend income and a class of all other ordinary income (e.g., interest income and rental income) in its ordinary income tier. Likewise, the capital gains tier could include separate classes of long-term capital gain taxed at 15% or 20% (depending on the beneficiary’s ordinary tax bracket) and unrecaptured Sec. 1250 gain taxed at 25%.
After items are assigned to a class, the tax rates may change so that items originally assigned to two (or more) separate classes would be taxed at the same rate in the year the income is distributed. If the changes to the tax rates are permanent, any undistributed items in those classes are combined into a single class. If the changes to the tax rates are only temporary (e.g., the new rate for a class will sunset in a future year), the classes are kept separate and the order of that class with the higher future rate in relation to other classes in the category with the same current tax rate is determined based on the future rate or rates applicable to those classes (Regs. Sec. 1.664-1(d)(1)(ii)(b)).
Caution: CRTs are often advocated as a means to unlock the gain inherent in an appreciated asset and receive a tax-exempt annuity in return. This is accomplished by having the donor contribute an appreciated asset to a charitable remainder trust and take back an annuity or unitrust interest, then having the trust sell the asset and reinvest the proceeds in tax-exempt securities. Assuming there is no express or implied obligation on the trustee to sell the asset and reinvest in tax-exempt securities (Rev. Rul. 60-370), it is often argued that this technique avoids the tax liability on the capital gain inherent in the asset contributed and provides a tax-exempt income stream to the beneficiary. However, under the tier system of allocating income to the beneficiary, the income stream received by the beneficiary will be deemed capital gain income (due to the accumulated gain on the sale of the appreciated asset) until the entire gain has been allocated. Only when this gain is exhausted will the beneficiary receive tax-exempt income. Thus, although the gain is not immediately recognized, the income beneficiary will have to report the entire gain before recognizing any tax-exempt income.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 14th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, Timothy Fontenot, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.