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The Benefits of CRATs Why create a charitable remainder annuity trust (CRAT)? To provide an annuity for life, while making a gift to charity thereafter. A CRAT is an attractive way to diversify a retirement portfolio, generate income and hedge against outliving one’s wealth. This article explains the benefits of CRAT creation.
Philip R. Fink, J.D., CPA
For more information about this article, contact Prof. Fink at (419) 530-2281 or pfink2@utnet.utoledo.edu.
Executive Summary
Charitable remainder trusts (CRTs) offer many tax and financial advantages when a grantor is a life income beneficiary. A CRT is a tax-exempt trust that disburses all or a portion of its income to one or more individual beneficiaries for a specified term. At the end of the term, the remainder interest passes to a designated charity. CRTs allow a donor to make a charitable gift while not relinquishing the present income stream from a property. There are two types of CRTs–charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). This article explains the various tax and financial advantages of a CRAT when the grantor is the life income beneficiary, and indicates the conditions under which a CRAT is more advantageous than an outright charitable contribution or taking no action.
CRAT vs. CRUT A CRAT annually distributes a fixed percentage of the initial value of assets transferred to the trust over the trust’s term. Thus, a CRAT distributes to the grantor the same amount each year. In contrast, a CRUT distributes each year a fixed percentage of the underlying assets’ fair market value (FMV) for the year in question; as the underlying assets’ FMV increases or decreases, the distribution for that year will correspondingly fluctuate. For individuals using a CRT to supplement their retirement income, establishing a CRAT has the advantage of predictability–a grantor knows how much he or she will receive from the trust each year. With a CRUT, distributions will vary according to the underlying assets’ annual FMV.1
What Is a CRAT? CRATs are used to achieve various financial goals that cannot be accomplished by making an outright charitable contribution (or by not making a contribution at all). Establishing a CRAT is a great way of diversifying an investment portfolio. In addition, individuals can use it as a hedge against outliving their savings. Many charitable organizations are eager for individuals to create CRATs and will readily undertake the necessary administrative tasks.
How Is It Created? A CRAT is created when a grantor transfers property to a trust and names an individual (including the grantor) to receive an income interest, and a charitable organization to receive the remainder. Such a transfer is reportable for gift tax purposes, but the remainder qualifies under Sec. 2522(a)(1) for a gift tax charitable deduction; thus, there is no gift tax liability unless someone other than the donor receives the annuity. Because the transfer is a gift, there is no grantor income tax liability on the transfer of appreciated property; the CRAT takes a carryover basis in the property under Sec. 1015(b). Typically, the grantor will receive an annuity for life; on his or her death, the remainder will go to a designated charity(ies). Alternatively, under Sec. 664(d)(1)(A), the grantor may receive an annuity from the trust for a specified number of years (not to exceed 20). The annual amount paid to the grantor must be at least 5%, but not more than 50%, of the trust assets’ initial FMV. According to Sec. 664(d)(2)(D), the remainder interest’s value must be at least 10% of the trust property’s initial net FMV.
How Is It Taxed? Under Sec. 664(c), a CRAT is generally not subject to income tax unless it has unrelated business taxable income. This is significant, because the trust is exempt from income tax on a sale of appreciated property; any gain a trust realizes as a result of portfolio restructuring will not be subject to tax. Individuals deciding not to make a charitable contribution, but instead to reallocate their portfolio outside of a qualified retirement plan, may pay substantial capital-gain tax.
Typically, when a grantor transfers assets to a CRAT, the CRAT trustee is bound to manage those assets to produce sufficient income to satisfy the required annuity payments to be made to the grantor. In addition, the trustee must preserve assets so that the charity will eventually receive as much property as reasonably possible, while meeting the annuity requirement. According to Regs. Sec. 1.664-1(a)(3), if a trust provision restricts the trustee from investing in this way, the trust will be disqualified as a CRAT. The trustee will be required to sell the trust assets and reinvest the proceeds, to accomplish the annuity and preservation goals.
Diversification A CRAT is advantageous because it allows a trustee to reallocate the transferred property for the grantor’s benefit. Many individuals approaching retirement might not have an investment portfolio suitable for retirement if they have accumulated large amounts of their employer’s stock (either through stock options or employee purchase plans). The stock value could decline during retirement even though the stock has a history of consistent capital appreciation.2 Contributing such stock to a CRAT allows a trustee to sell the stock and reallocate the proceeds to a diversified basket of various investment classes without incurring capital-gain tax. If an individual attempted to reallocate assets outside of a qualified retirement account, the gain on the stock sale would be taxable, leaving fewer proceeds to reallocate to a more diversified portfolio.
Income Generation Many individuals in their prime working years do not necessarily need to invest in fixed-income securities; accordingly, their portfolios are commonly invested in growth stocks that do not provide income. Even though an individual might have a diversified basket of securities, it might not generate much income. By transferring these securities to a CRAT, a trustee will be able to sell some or most of them and reinvest the proceeds in other securities that will generate sufficient income to meet the required annuity payments. Even in well-diversified total stock market funds, the recent dividend distributions have been just over 1% of the fund’s net asset value.3 By contributing an investment portfolio to a CRAT, individuals can receive an annuity much greater than the income generated by such an index fund. Outright contributions to charity do not generate an income stream. Although they produce a larger charitable deduction, such donations do not generate annuity payments for the remainder of the donor’s life.
Charitable Deduction A grantor receives an income tax deduction for the actuarial value of the charitable remainder. Under Regs. Sec. 1.664-2(c), the annual income stream’s present value (PV) is subtracted from the contributed assets’ FMV to determine the remainder interest’s value. The factor for determining the PV of an income stream payable for a noncharitable beneficiary’s life is found in IRS Pub. 1457, Actuarial Values, Alpha Volume, Table S. The factor for determining the PV of an income stream payable for a term of years is found in Pub. 1457’s Table B. (Special rules apply if an annual noncharitable annuity is payable at other than year-end.) Once this factor is determined, it is multiplied by the amount of the annual payment. The product is the value of the income stream. Subtracting this amount from the contributed assets’ FMV produces the value of the remainder interest. Many individuals who create CRATs do so in a prime earning year, to take a charitable deduction when in a high tax bracket (e.g., the year before retirement). Annuity payments will then be received in retirement, generally a lower tax bracket. Thus, a CRAT involves a disproportionately large charitable deduction immediately, followed by modest annuity payments over several years. If instead, an individual tries to reallocate assets on his or her own, there will be no charitable deduction, and perhaps even a capital gain in the sale year.
Effect of New Law The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) initiated a gradual reduction in income tax rates starting in 2002, until 2006. As a result, individuals can create a CRAT and claim a large tax deduction in a relatively high-tax-bracket year, with the vast majority of annuity payments received in years when tax rates are generally lower. Thus, it is ideal to create a CRAT within this window. If a grantor is contributing appreciated stocks, the charitable deduction will be limited by Sec. 170(b)(1)(C)(i) to 30% of a donor’s adjusted gross income (AGI) in the year the property is transferred, if the charity that will receive the remainder is a public charity. Any deduction above the 30% limit can be carried over for the next five years and deducted in the succeeding years, under Sec. 170(b)(1)(C)(ii). If the charity is a private foundation, Sec. 170(b)(1)(D) limits the charitable deduction to 20% of the grantor’s AGI. The tax savings from deducting the charitable remainder can be invested to create additional income. The grantor could alternatively use these savings to purchase a life insurance policy or create a life insurance trust. The policy’s beneficiaries would receive the insurance proceeds on the grantor’s death instead of the CRAT assets going to charity. According to Sec. 2042(2), if the grantor has no incidents of ownership and does not make a gift of the policy within three years of death, there will be no estate tax on the insurance proceeds. Thus, the heirs can potentially inherit more by receiving life insurance proceeds than by inheriting the assets transferred to the CRAT that would be subject to estate tax. If individuals make testamentary gifts to a charity, their heirs will not receive the contributed assets and they have no way to replace those assets (e.g., with life insurance proceeds). Also, transferors receive an income tax deduction only if they make an inter vivos transfer.
Taxation of Donor’s Annuity Income Tax Sec. 664(b) uses a four-tier system to characterize annuity payments made to a grantor. The annuity payments are first characterized by Sec. 664(b)(1) as ordinary income to the extent a trust has ordinary income for the current year, plus undistributed income of prior years. If the current-year annuity payments exceed the current-year’s ordinary income and prior-years’ undistributed income, the excess will be capital gain under Sec. 664(b)(2), to the extent of the trust’s current-year capital gain and prior-years’ undistributed capital gain. If the grantor transferred appreciated property to the CRAT, the trust will realize capital gain on the sale of the transferred property. Because the trust is generally tax-exempt, it will recognize any realized capital gain when it makes distributions to the grantor greater than the current-year’s ordinary income plus the prior-years’ undistributed ordinary income. Under Sec. 664(b)(3), annuity distributions for the current year that exceed the first two tiers are characterized as "other income." Thus, if the trust invested in municipal bonds, some of the distribution could be characterized as tax-exempt income. Finally, if a distribution exceeds the amounts in the first three tiers, it will be characterized as a distribution of trust corpus by Sec. 664(b)(4). Thus, if an annuity payment is greater than the trust’s ordinary income, a portion of the distribution will be taxed at the capital-gain rate or be tax free. Thus, the grantor would receive a guaranteed income stream for life; some of the income might be treated as a long-term capital gain and some might be tax free.
Estate Tax If an individual creates a CRAT and names himself or herself life income beneficiary, he or she can substantially reduce estate taxes by removing from the estate the entire value of the assets transferred to the CRAT. In contrast, if the assets were instead retained, a larger portion of the portfolio would be used to pay estate taxes. The EGTRRA produces some uncertainty as to estate planning with CRATs. Between now and 2009, the estate tax rates will gradually decline and the unified credit will gradually increase. In 2010, the estate tax will be repealed. However, in 2011, it will be reinstated to 2001 rates, unless legislation is enacted to the contrary. Because establishing a CRAT can significantly reduce estate taxes, the CRAT’s effect on estate planning will be unknown until the tax picture is clarified for 2011 and beyond.
Hedging One advantage of a CRAT is that the annuity payments provide grantors a hedge against outliving their wealth. If an individual has an IRA or Sec. 401(k) or 403(b) plan, or owns securities outside of a qualified plan, he or she has a finite amount of funds to spend. In contrast, CRAT annuity payments can be paid annually for life. From a financial standpoint, having a lifetime guaranteed income stream is a significant piece in the retirement planning pie. Individuals who make outright contributions do not have the luxury of receiving annuity payments (i.e., a security blanket).
Inadequate Trust Assets Although actuarially there must be a minimum of 10% of the transferred property left for charity at the end of the CRAT’s term, there is a slight possibility that the trust’s funds will be exhausted, due to the payout ratio or market conditions. If funds are exhausted, the CRAT would fail to produce income for the beneficiary’s life.
Conclusion For most individuals who have worked hard during their lives to save money and invest it wisely, it is psychologically very difficult to part with their wealth. A CRAT is a good compromise—it allows an individual to be philanthropic while supplementing retirement income. For individuals looking for a little recognition, charities are just as appreciative when a grantor establishes a CRAT as when a donor makes an outright gift. Individuals approaching retirement should consider establishing a CRAT as part of retirement planning. Often, their financial objectives can be better met by establishing a CRAT than by making an outright contribution or doing nothing. Creating a CRAT is an attractive way to diversify a retirement portfolio and generate extra income. It can also be used as a hedge against outliving one’s money. CRATs satisfy philanthropic needs and allow a grantor to enjoy economic benefits. In addition, CRATs can reduce a grantor’s estate tax and increase the heirs’ inheritance. |
