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CRT Investment Diversification and This article examines tax and investment aspects of the use of a charitable remainder trust (CRT), including how a donor may use a CRT to diversify an investment portfolio, how his investment incentives are affected by transferring assets to a CRT and why tax-advantaged investment vehicles (such as municipal bonds) may be appropriate. Finally, it discusses how investment wrappers (e.g., such as variable annuities and single-member limited liability companies) may provide a donor with flexibility in timing income recognition for CRT distributions.
Jennifer
L. Hall, CPA James
R. Hamill, Ph.D., CPA Craig
G. White, Ph.D., CPA
For more information about this article, contact Dr. Hamill at (505) 277-8890 or hamill@anderson.unm.edu.
Executive Summary
A charitable remainder trust (CRT) is an irrevocable split-interest trust in which one or more noncharitable beneficiaries receive a lead income interest; a qualified charity receives the remainder. If the trust qualifies, an income and gift (or estate) tax charitable deduction for the remainder interest's present value is allowed when funds are transferred to the trust. In addition, the trust is exempt from tax unless it has unrelated business taxable income (UBTI). A CRT offers the flexibility to accomplish various tax planning and charitable objectives. For instance, it is available to a broader range of clients and offers tax-free diversification opportunities similar to a "swap fund."1 This article examines tax and investment aspects of the use of a standard CRT. Familiarity with these topics will help a tax adviser recognize when a CRT is the correct choice for a client. The article first discusses how a donor may use a CRT to diversify an investment portfolio while deferring or avoiding the tax on accrued gains. This discussion includes an analysis of the tax savings and payouts available from a CRT versus the loss of portfolio assets eventually transferred to the charity. Second, the article addresses how a donor's investment incentives are affected by transferring assets to a CRT and demonstrates that a CRT encourages investment in riskier assets relative to non-CRT holdings. Further, it shows how tax-advantaged investment vehicles (such as municipal bonds) may be appropriate for a CRT, despite the trust's tax-exempt nature. Finally, it discusses how investment wrappers (such as variable annuities and single-member limited liability companies (SMLLCs)) may provide a donor with flexibility in timing income recognition for CRT distributions. Overview If a CRT meets Sec. 664's requirements, an income and gift (or estate) tax charitable deduction is permitted for the present value of the charity's remainder interest when money or property is transferred to the trust.2 Further, a CRT is exempt from tax under Sec. 664(c) unless it has UBTI.3 Sec. 664 lists two forms of CRT, the charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT). A CRAT pays noncharitable beneficiaries a sum certain over the trust's life. A CRAT grantor may not make additions of property to the trust beyond the initial contribution. In contrast, a CRUT offers some flexibility in design; a donor may make annual additions to the trust. A CRUT may provide for one of three payment formulas to the lead income beneficiary: 1. Fixed-percentage (standard) CRUT—a fixed-percentage payout independent of the level of trust income (Regs. Sec. 1.664-3(a)(1)(i)(a)). 2. Net income CRUT—a payout of the net income earned by the trust for the year, provided that such income does not exceed the fixed percentage set out in the trust instrument (Regs. Sec. 1.664-3(a)(1)(i)(b)(i)). 3. Net income makeup CRUT (NIMCRUT)—the payout specified in (2) above, except that, for any year in which the fixed-percentage payout specified in the trust instrument exceeds trust income, the excess accumulates and is paid in future years in which trust income exceeds the specified payout. According to Sec. 643(b), trust income is defined by reference to the trust instrument and local law. Regs. Sec. 1.664-3(a)(1)(i)(b)(4) provides that a trust provision that allocates capital gain to trust income is permissible if allowed under local law, although precontribution appreciation cannot be part of trust income. A CRAT's annual payout amount must be between 5% and 50% of the initial value of trust assets. Similarly, a CRUT's annual payout must be between 5% and 50% of the value of trust assets (determined annually). In both cases, the CRT's term may be for the life or lives of the noncharitable beneficiaries (or for a term certain not to exceed 20 years).4 Although both CRATs and CRUTs are exempt from income taxes, distributions to noncharitable beneficiaries are likely to be taxable. The character of distributions is determined in a tiered fashion under Sec. 664(b), as follows: 1. First, as ordinary income, to the extent of the trust's current and previously undistributed ordinary income for the trust's year in which the distribution occurred. 2. Second, as capital gain, to the extent of the trust's current capital gain and previously undistributed capital gain for the trust's year in which the distribution occurred. 3. Third, as other income, to the extent of current and previously undistributed other income for the trust's year in which the distribution occurred. 4. Fourth, as a distribution of corpus. A loss in any of the above categories can only be used to offset income from the same category; any excess loss in one category can be carried forward indefinitely. Any undistributed amount from a given tier for the year carries forward to subsequent years. Thus, a noncharitable beneficiary will receive taxable income from a distribution to the extent the CRT has undistributed ordinary income or capital gains. The Taxpayer Relief Act of 1997, Section 1089, added an overall constraint on a donor's continued enjoyment of assets transferred to a CRT. The present value of the remainder interest going to charity must be no less than 10% of the trust assets' initial value.5 For a CRUT, the 10% rule applies to each contribution of property to the trust. The value of the remainder interest (which generally equals the current charitable contribution) is calculated using the actuarial tables in IRS Pub. 1458, Actuarial Values, Beta Volume, the income payout specified in the trust and the Sec. 7520 valuation rate. In practice, the 10% remainder rule limits permissible combinations of the payout percentage and term of the noncharitable income interest.
Payout and Trust Term The present value of a CRAT remainder interest is a function of the ratio of the payment amount to the initial value of trust assets, the trust term and the Sec. 7520 discount rate. Exhibit 1 plots combinations of these variables that result in a minimum 10% remainder interest going to charity (assuming a Sec. 7520 rate between 6.5% and 9%). The area to the right of the points shows impermissible combinations that result in less-than-10% remainder interests to charity; the area to the left of the points shows permissible combinations yielding greater-than-10% remainder interests to the charity.
For each annuity payout ratio, the trust term resulting in a 10% remainder interest varies with the Sec. 7520 rate. The higher the Sec. 7520 rate, the longer the permissible term of the trust for a given payout. Why? A higher discount rate reduces the present value of the annuity payments to the income beneficiary. For instance, a CRAT with an annuity payout of 7% of the initial value of assets can have a term of approximately 46 years at a 9% Sec. 7520 rate. A CRAT with the same annuity ratio can only have a term of approximately 29 years at a 6.5% Sec. 7520 rate. Similarly, as the Sec. 7520 rate increases, the permissible payout percentage increases for a given trust term. For a CRUT, the payout percentage and trust term determine the remainder interest to the charity. The Sec. 7520 rate does not affect the trust remainder interest's value, because the calculation assumes the trust assets grow at this rate (the same rate used to discount the payment to the present).6 Exhibit 2 illustrates the combinations of CRUT payout percentage and beneficiary age for a trust based on a single life and a 10% remainder to charity, assuming the valuation and payout dates are the same. The trust term is based on the beneficiary's life expectancy at a given age.
The area to the left of the points represents impermissible combinations of CRUT payout and beneficiary age. The shaded area to the right of the points demonstrates permissible combinations resulting in a greater-than-10% remainder value to the charity. For instance, a 55-year-old grantor who sets up a CRUT with a term based on his life ex-pectancy could receive up to a 13% payout. For either a CRAT or a CRUT, Exhibits 1 and 2 illustrate that the need for a 10% remainder interest to charity limits the permissible trust parameters, making CRTs less attractive to younger grantors. The payout amount must be relatively small for trusts with expected longer terms.
Selecting Property to Contribute A CRT can be funded with cash or property. While cash contributions are simple and provide a trustee with maximum flexibility to select investments, a significant advantage of a CRT is the ability to shift unrealized appreciation from long-term capital gain assets to the tax-exempt trust.7 A contribution of appreciated long-term capital gain assets allows the donor a deduction based on the property's fair market value (FMV) (limited to the present value of the charity's remainder interest).8 Closely held stock may be a good candidate to fund a CRT, although a charitable trust is not an eligible S shareholder.9 The trust must be able to sell or redeem the stock to satisfy the donor's diversification goals (and, perhaps, to create sufficient income to pay the specified income payout). Real property is also a good funding candidate, provided it produces income (or may be sold to produce income), although if it is encumbered, several problems may arise if it transferred with the debt. First, the trust may be taxed on UBTI under the Sec. 514 debt-financed income provisions,10 with the adverse result that it loses tax-exempt status; thus, all of the trust's income becomes subject to tax under Regs. Sec. 1.664-1(c). Second, the trust's payment of the grantor's liability may be self-dealing under Sec. 4941(d), with the potential for a penalty. Finally, the transfer will be a part-gift, part-sale, under Regs. Sec. 1.1011-2. A donor could select unencumbered real property or pay the debt before the transfer. Alternatively, the grantor could remain personally liable for the debt and continue to make payments. However, if the trust is required to make payments on the grantor's behalf, it may not be qualified even if the grantor remains personally liable for the debt. The trust's payment would create a grantor trust if trust income were applied to discharge the grantor's legal obligation.11 However, the IRS has ruled that debt-financed income would not arise when real property was contributed to an umbrella partnership real estate investment trust (REIT) because the debt was, pursuant to the REIT's customary practice, paid shortly after the transfer.12
Analysis of Tax Savings A CRT is expected to serve several types of clients. One group is individuals with a desire to aid charities; a CRT offers them the opportunity to achieve this goal at a reduced price, together with the ability to share in the future economic benefits accruing from trust asset ownership. A second group is taxpayers who may have no charitable intent. This group may be attracted to the CRT structure due to its tax-exempt status, allowing for tax-free disposition of appreciated assets, together with the ability to use the trust terms and the definition of trust income to continue to use trust assets to achieve financial objectives. A framework can help determine the net benefit or detriment to a taxpayer who selects a CRT over an alternative means of investing. This analysis involves a comparison of a sale of an asset, followed by a reinvestment of the after-tax proceeds in an appropriate investment opportunity, with a gift of the asset to a CRT in exchange for a retained income interest. The CRT strategy allows for investment of the asset's full value (undiminished by the tax cost), but requires that some portion of such value be transferred to a charity. Any comparative analysis must consider a variety of factors, including the magnitude and anticipated timing of the tax cost if the asset is sold, any legacy that may otherwise be available for the CRT donor's heirs if all assets are not expected to be consumed during the donor's lifetime, the value of the charitable deduction and the anticipated return on investment. For simplicity's sake, this article assumes a taxpayer has a zero-basis asset with a $1 million FMV. He intends to sell the asset either to diversify his investment portfolio or to invest in a more attractive opportunity. The analysis assumes that a donor transfers this asset to a CRT, followed by a sale and an investment of proceeds in an asset yielding the Sec. 7520 rate.13 To transfer only the minimum value to the charity, this article assumes a 37-year CRUT with a 6% payout when the Sec. 7520 rate is 7.2%.14 The asset value retained by the donor, on an after-tax present-value basis, is then compared to that available from a taxable sale of the asset outside of a CRT. The sale alternative assumes payment of a 20% capital gain tax, followed by an investment of after-tax proceeds at the same rate of return as is earned by the CRT investment. The owner again requires a 6% annual payout.15 With highly appreciated property, the tax savings from the charitable deduction and the foregone capital gain tax could more than offset the cost associated with transferring 10% of the present value of the asset to charity. Under this scenario, an alternative investment outside of a CRT would be funded with only $800,000 after paying capital gain taxes.16 At expiration, the non-CRUT assets would be available as a legacy to the grantor's heirs, but are assumed to be subject to a 55% estate tax rate. Exhibit 3 demonstrates that the CRUT strategy, using the specified assumptions, can result in a net benefit to the donor of $183,383.17 Assets are divided among the client, the heirs, the government and the charitable beneficiary. With a CRT, the client retains 94% of the value of the assets contributed to the trust. This amount may be explained to a client as consisting of the 90% retained interest in trust assets after transfer of 10% to the charity, increased by the tax savings attributable to the charity's interest (i.e., 90% + 39.6% of the charity's 10%), for a total of 94% after-tax. Without a CRT, the client retains only 76% (after-tax) of the economic value of the assets. This is the assumed 80% retained after paying the capital gain tax due on sale, reduced by the value not consumed during the donor's lifetime. Of course, state tax savings from the CRT strategy may enhance the advantages of the charitable gift.
The above example is based on simplified assumptions and must be adjusted for a client's actual desires and to include, among other items, issues such as:
Investment Issues A properly structured CRT combines tax incentives with the ability to retain much of the economic benefits of direct asset ownership. In addition to the benefits of tax-exempt status, the trust income tax provisions applicable to a CRT allow certain flexibility in defining income (and the timing of distributions). The combination of these factors allows for flexibility in structuring trust investment strategies and timing income payments. The trust investment strategy determines the beneficiaries' tax and financial benefits. While the final investment decision must be left to the trustee, a grantor should consider the effect of the CRT tax provisions on various investment strategies when determining the advisability and implementation of a CRT strategy. Once the choice is made to use a CRT, there are endless investment opportunities from which to choose. A trustee needs to understand the implications of alternate investment strategies for all trust beneficiaries. The following section discusses the implications of certain investment strategies, including the income beneficiary's preference for the level of investment risk, the investment's nature and the timing of income distributions.
Risk vs. Risk-free Investment Strategies The dynamics for choosing an investment strategy are somewhat different inside a CRT than outside it. The most important issue for the income interest holder is maximizing the net after-tax cashflows received from the CRT. The income beneficiary is not as concerned about preservation of the trust's underlying asset as is the remainder interest beneficiary. While a CRUT income beneficiary will, through an increased unitrust payout, benefit from any appreciation in trust assets, the bulk of any such gain eventually passes to the charity. On the other hand, the same sharing of detriments occurs for any depreciation in trust asset value. In effect, the CRT structure creates, for the income beneficiary, a cushion against downside investment risk.18 Once assets are placed inside a CRT and returns are subject to the terms of the split-interest arrangement, the income beneficiary, while still desiring positive investment returns, is no longer as sensitive to a potential loss on investment as he would be for investments outside a CRT. To illustrate this point, the net after-tax cashflows of two alternate investments of $1 million inside a standard (fixed-percentage) CRUT paying 6% per year are compared.19 The first is a taxable, risk-free investment earning 6% per year; the second is a taxable, risky investment with two possible outcomes, 12% and 0%, each with a probability of 50%. With an assumed 39.6% tax rate, each investment has an expected return of 6% (pre-tax) and 3.624% (after-tax) if the investment is made outside of a CRT. Next, the effects on the income beneficiary of pursuing the same investment options inside a CRT are compared. In each year, the risky investment made within a CRT provides a higher after-tax expected net cashflow for the income beneficiary than the risk-free investment. If the risky investment yields a good (i.e., 12%) outcome, the income payout increases with the value of the trust assets, benefiting both the income and remainder interests. On the other hand, if the risky investment yields a bad (i.e., zero) outcome, the income beneficiary will still receive a 6% payout, albeit on a smaller base than under the good outcome scenario. The payout for the bad outcome is, in year one, a return of corpus originally contributed by the trust donor. Because the payout is a return of corpus, it is tax-free (tier four) to the income beneficiary, netting an after-tax payment even higher than the payout under the good outcome.20 This illustration does not suggest that the income beneficiary desires a bad (i.e., zero income) outcome to the trust. The income beneficiary expects that trust assets will be invested to grow; the risky investment is assumed to produce an expected annual growth. However, it does suggest that the safety net, provided by the ability to dip into assets that would otherwise go to the charity to satisfy the fixed-percentage payout, offers an incentive to hold the trust assets in investments with greater volatility for a given expected return. Of course, investment strategy raises fiduciary issues (discussed below). The CRT payments received by the income beneficiary, including corpus distributions to satisfy a fixed-payout requirement, represent "investment return"; the beneficiary receives an economic benefit whether the payment is coming from trust income or corpus. This return definition may be contrasted with that of an investment outside of a CRT—the investor owns the underlying assets funding the investment and suffers a dollar-for-dollar detriment for negative outcomes that require him to invade investment capital to satisfy income needs.
Nature of Investments Generally, one does not invest in tax-advantaged securities inside a tax-exempt entity. Tax-advantaged investments often carry a lower market return for a given risk that reflects the tax benefit. Economists call this lower return, measured on a pre-tax basis, an "implicit tax" (municipal bond investors are well aware of its existence). The lower pre-tax return suggests that municipal bond investments are best suited for high-tax-bracket investors, certainly not tax-exempt investors. However, the CRT structure redefines investment returns to the income and remainder beneficiaries and, thus, may redefine investment strategies. A trustee may want to consider the benefits of tax-exempt investments to an income beneficiary when deciding on an investment strategy.
The tax-exempt investment strategy is beneficial to the extent there is no other trust undistributed ordinary income or capital gain that would recharacterize the distribution as coming from tier one or tier two. Trusts funded with highly appreciated assets (as is usually the case) may have a large reservoir of undistributed capital gain. In any case, a trustee should at least be aware of the advantages of tax-exempt securities when weighing the alternatives, to best meet beneficiaries' needs.
Donor's Control of Investment Strategy The preceding section suggested that the income beneficiary's investment objectives may influence the trustee's selection of investments. This suggestion raises the issue of how much control the beneficiary may have over the trustee. According to Regs. Sec. 1.664-1(a)(3), a trust fails as a CRT if its terms restrict the trustee "from investing the trust assets in a manner which could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets." Although trust terms cannot restrict a trustee to a specific investment, a grantor may specify which investments are most desirable.21 Under Regs. Sec. 1.664-3(a)(3)(ii) and –3(a)(4), a grantor may be the trustee if no powers are retained to alter, amend or revoke the trust terms to change the distribution of income to noncharitable beneficiaries or the charitable remainder. The right to change the order in which income beneficiaries receive their interests is a prohibited power.22 In several letter rulings, the IRS considered the extent to which an obligation to choose a certain investment strategy may be placed on a trustee. In Letter Ruling 7802037,23 the IRS ruled a CRAT provision that trustees hold, invest and reinvest trust principal only in tax-exempt securities during the grantor's life restricted trust investments to the point of trust disqualification. In Letter Ruling 7803029,24 a trust provision expressed the grantor's belief that mutual funds represented the most desirable form of investment and authorized the trustee to invest in particular mutual funds. The IRS ruled that, because the provision did not restrict the trustee from investing in any other types of securities or any other kind of property, the trust qualified as a CRT. In Letter Ruling 9825001,25 an attorney/trustee signed a deferred annuity contract that allowed the CRT income beneficiary to achieve the financial objective of deferring income through a NIMCRUT feature. In considering whether such an investment was an impermissible act of self-dealing, the IRS held that "the relevant question is whether the deferral of income is a permitted use." Because the independent trustee was not compelled to invest in the annuity, the fact that he took into consideration the beneficiary's needs was insufficient to create an act of self-dealing. The IRS stated that the issue was whether the investment unreasonably affected the CRT. Because the charity's interest was not affected, the deferred annuity was a permissible investment, notwithstanding its congruence with the grantor's financial objectives.
Using Investment Wrappers to Control CRUT Income Timing When a CRT is created, the income beneficiary may not need income distributions until a later time, perhaps at retirement. A deferral of distributions, and income, is possible using a NIMCRUT. A distribution from a NIMCRUT is limited to the trust income, which is determined under the trust terms and applicable local law, according to Sec. 643(b). As mentioned earlier, for any year in which there is inadequate trust accounting income to provide the fixed-percentage payout, the deficit will accumulate to be paid to the income beneficiary in future years when trust income exceeds the specified payout. This income "make-up" feature has made the NIMCRUT a popular tool for retirement planning. To take advantage of this feature, the trust income must be timed carefully and properly managed. A variable annuity is one means to defer income until annuity payments commence, but it also has certain disadvantages. The recent development of the SMLLC may (as discussed below) provide a superior strategy to defer distributions and income. Variable annuities have been used to hold investment assets inside a NIMCRUT, because the trust will not have trust accounting income until a distribution is made from the annuity to the trust.26 The variable annuity can be used to receive dividends and proceeds from the sale of contributed assets. The trustee may choose to accrue appreciation within the annuity contract, without creating NIMCRUT trust accounting income. By not triggering income, the trust is not required to make an unwanted income distribution to the beneficiary. The IRS has ruled that, when applicable state law treats only the receipt of cash or property as trust income, the mere right to receive distributions does not create trust income.27 Variable annuities have some flexibility in the funds and assets in which to invest. However, they are limited to investments in publicly traded securities and may be further limited by the issuer of the annuity. The major drawback of the variable annuity is that all income flowing from it is taxable as ordinary income under Sec. 72(u)(1)(B), regardless of how derived. Further, variable annuities carry administrative and other fees that reduce the overall return to the beneficiaries. SMLLCs are creations of state law; the number of states permitting such entities has dramatically increased following the issuance of the final check-the-box regulations, which confirmed the Federal income tax treatment under Regs. Sec. 301.7701-3 of an SMLLC as a disregarded entity. An SMLLC provides a way to defer distributions and income in a NIMCRUT without the disadvantages associated with a variable annuity. Because an SMLLC is a disregarded entity for income tax purposes, any income it earns is treated as income of the CRT owner (and is therefore tax-exempt for Federal income tax purposes). However, because a SMLLC exists under state law, the trust generally does not have accounting income until the SMLLC makes a distribution to the trust.28 As with a variable annuity, an SMLLC can help control the timing of trust income, by judicious timing of distributions. Because a CRT is the sole owner, the trustee will have complete control over SMLLC distributions.29 An SMLLC does not have many of the drawbacks of a variable annuity and can invest in a wider array of funds and assets without ongoing administrative fees. More importantly, the income flowing from an SMLLC to a NIMCRUT retains its character. By holding investments in an SMLLC, trust beneficiaries are not precluded from receiving tax benefits on income from tax-preferred investments.
Conclusion Despite recent actions by Congress and Treasury to curtail "abusive" CRT transactions, the surviving CRT provisions continue to provide taxpayers with incentives for meeting charitable and investment objectives. A CRT allows a donor to diversify an investment portfolio or to shift assets to more attractive investments, without paying tax on inherent gain. In appropriate circumstances, the tax benefits of a CRT (which include an income tax deduction and avoidance of capital gain tax) can dominate the lost value of assets transferred to the charity. The CRT structure also creates unique investment preferences for the income beneficiary. To the extent the donor can influence the selection of investments, the CRT may encourage greater investment in risky assets and in tax-advantaged investment vehicles than would be the case outside of a CRT. While CRT assets are growing, an investment wrapper (e.g., an SMLLC) can help control the timing of income distributions. These investment strategies increase a taxpayer's tax savings and economic benefits. |
