Living (Revocable) Trusts
Estate Taxation - Federal & Vermont
Estate Planning for IRA's/Pensions
Life Insurance Trusts
Family Limited Partnerships
Grantor Trusts (GRATS & GRUTS)
Qualified Personal Residence Trusts
Charitable Trusts (CRATS & CRUTS)
Special Needs Trusts
Chittenden District Probate Court
Vermont Tax Department
(CRATS & CRUTS)
What are CRATS and CRUTS?
Why Create a Charitable Trust? Tax Benefits
The Income Tax Deduction
Disadvantages of CRATS and CRUTS
Strategies to Maximize Benefits - An Example
"CRAT" is an acronym standing for "charitable retained annuity trust." "CRUT" stands for "charitable retained unitrust." These types of trusts, specifically authorized by the Internal Revenue Code, are created by an individual (the "grantor"). In each case, one or more individuals (usually including the grantor) receive payments from the trust for a term of years or for the lifetimes of the individual(s). When the income interests end, the assets pass to a qualified charitable organization identified in the trust document.
A CRAT pays a fixed amount to the income beneficiary. Payments must be made once a year, or more frequently, and are not dependent on the actual income earned by the trust. The payment must be equal to or greater than 5% of the assets originally contributed to the trust. The failure to make the required payment to the income beneficiary results in disqualification of the trust as a CRAT. Once the CRAT is created and funded, no additional assets may be added to the trust.
A CRUT is a little different. This type of trust pays a fixed percentage (a minimum of 5% or more) of the trust assets to the income beneficiary each year. If the assets appreciate, the required payment increases; if they depreciate, the payment goes down. The trust assets are revalued once a year in order to determine the correct amount of the payment. Like a CRAT, the failure to make the required payment to the grantor results in disqualification. Unlike a CRAT, additional property can be contributed to a CRUT after the initial creation and funding of the trust.
CRATS and CRUTS have a number of valuable income, gift and estate tax attributes, and are therefore valuable planning tools. To understand the purpose of these trusts, it is necessary to understand how they are taxed.
When a charitable trust is created, the grantor has essentially split the trust into two pieces: (1) the income stream (the "annuity") payable to the income beneficiary, and (2) the trust assets remaining when the annuity ends (called the "remainder"). Since the trust is irrevocable, the "remainder" must pass to a charity -- therefore, a gift has been made to the charity. This gift results in a charitable income tax deduction for the year in which the assets are transferred to the trust. Since the charity must wait until the end of the trust term to receive the remainder, the value of the remainder is less than the present value of the trust property -- for the same reason that a dollar is worth more today than it is ten years from now (see the example of how the present value of a remainder is valued, below).
After the value of the remainder is determined, there are a number of complex rules which can further limit the amount of the income tax deduction allowed. Generally, the extent of the limitation depends on the type of charity selected and/or the type of property transferred (these rules apply to all charitable gifts, not just those involving CRATS and CRUTS).
Types of Charitable Organizations
Charitable organizations are divided into two categories which are relevant in determining the limitation on the deduction for a charitable gift. Perhaps the most common are the "50% charities," which include schools, churches, hospitals, and organizations that receive most of their support from the public (such as the Red Cross). The deduction for a gift to a 50% charity is limited to 50% of the donor's adjusted gross income (AGI) in the year the gift is made (in other words, you cannot use a charitable gift to write-off more than half of your income in any given year). If this limit is exceeded, the excess deduction can be carried forward for up to five years, subject to the 50% rule in each year.
If a charitable organization is not a 50% charity, it is a 30% charity. This category of charities includes private foundations -- a common beneficiary of CRATS and CRUTS. Deductions for gifts to these charities is limited to 30% of the donor's AGI in the year the gift is made, and the same five year carry forward rule applies.
Types of Property
Long term Capital Gain Property
Long-term capital gain property is, simply, property which would generate a long-term capital if sold.
If long-term capital gain property is donated to a 50% charity, an income tax deduction is allowed for the full fair market value of the gift -- subject to a separate 30% AGI deductibility ceiling. This means that the entire gift is deductible, but that the gift is further limited by the 30% rule.
If long-term capital gain property is donated to a 30% charity, the deduction is (with one major exception) limited to the donor's basis in the donated property. This means that no deduction is allowed for the value attributable to the appreciation of the asset being gifted. This is a key limitation which can make a gift of appreciated property to a CRAT or CRUT undesirable where the ultimate beneficiary is a 30% charity (such as a private foundation). In addition, a separate 20% (AGI) deductibility ceiling applies for gifts of this type.
The major exception to the above rule is for gifts of publicly traded stock. If you transfer publicly traded stock to a CRAT or CRUT, and the charitable organization named in the trust document is a 30% charity, you are permitted to take a deduction for the full fair market value of the remainder interest. The same 20% AGI limit and five year carry forward rules apply.
Congress continually changes the rules with respect to charitable gifts of appreciated property -- prior to making a gift of appreciated property to a CRAT or CRUT, you should consult a tax advisor regarding the allowable income tax deduction.
The donor of a CRAT or CRUT can retain the power to change the charity which will receive the remainder interest (a very attractive feature of charitable trusts). If you retain this power (which many clients do), and do not limit the permissible donees to 50% charities, the IRS will treat the CRAT or CRUT as having a 30% charity as the beneficiary -- and the more restrictive rules regarding deductions for appreciated property will apply. This is a hidden tax trap: to avoid these limits, your trust document should specifically prohibit you from selecting any organization which is not a 50% charity.
Ordinary Income Property
Ordinary income property is property which would generate ordinary income if sold -- including property which would generate a short-term capital gain. The income tax deduction for a gift of this type of property is always limited to the donor's basis, regardless of the type of charity which will receive the remainder interest.
Creation of a charitable trust will not have gift tax implications unless one of the beneficiaries of the annuity is someone other than the donor or the donor's spouse. If, for example, a child is named as a beneficiary of some or all of the annuity portion of the trust, the annuity is a gift to the child. The value of the gift depends on several factors, including the timing of payment to the child, the amount and duration of the payments, the child's age, and prevailing interest rates.
A major benefit of creating a charitable trust is the avoidance of estate taxes. When the trust terminates, all of the trust assets pass to a charity. As a result, none of these assets are subject to estate taxation (even if they were included in the donor's estate, an estate tax charitable deduction is allowed for bequests to charity).
CRATS and CRUTS have some disadvantages which should be considered before they become part of your estate plan.
The major disadvantage with these types of charitable trusts is that they must be irrevocable in order to achieve the tax benefits described above. Irrevocable transfers should be approached cautiously -- if there is any possibility that the asset might be needed for the grantor's welfare, other estate planning options should be considered. Remember also that, with a CRAT, you cannot add assets to the trust (you can with a CRUT, but you are required to revalue the trust assets annually).
A disadvantage of a CRAT is that by definition, it pays a fixed income during the life of the trust. If the CRAT is designed to last many years, inflation could erode the buying power of the income paid from the trust. Since the trust is irrevocable, the income recipient cannot change the amounts received from the CRAT.
In comparison, a disadvantage of a CRUT is that the income can fluctuate. If the trust experiences poor investment results, the income will decline (since it is based on a % of the fair market value of the assets, revalued annually).
An example illustrates the tax advantages of a plan utilizing a charitable trust. Assume Mr. Jones owns $500,000 of publicly traded stock with an income tax basis of $50,000. The investment outlook for the stock is not good, but the low tax basis creates a large tax liability upon sale. Assume further that Mr. Jones, age 66, establishes a CRAT in June of 2013 -- funded with all of the stock. He and his wife (age 67) are the income beneficiaries. At their deaths, any assets remaining in the trust will pass to their local church (a qualified charity). He retains the right to receive $30,000 annually for his life and the life of his wife. Using the income taxes they saved by creating the trust (see below), they purchase a $500,000 second-to-die life insurance policy which they place in an irrevocable trust for the benefit of their children.
Establishing the CRAT, and purchasing the life
Income tax deduction for the year 2013:
Compare selling the stock in order to diversify:
Income taxes paid on stock sale
Obviously, coupling a CRAT with a second-to-die
life insurance policy greatly increases the net benefit to the donor, charity
and the donor's heirs. The benefit to all three totals over $1.3
million, compared to slightly over $600,000 for selling the stock outright.
Another current planning idea is to use a charitable trust as a substitute for a qualified retirement plan. For some small business owners, maintaining a qualified plan is difficult due to the cost of providing benefits to all employees (as required by pension laws). A special type of CRUT can be established which permits annual contributions to the CRUT (partially tax deductible) with a payout beginning to the donor in the future. Since the CRUT is tax exempt, the buildup in value within the CRUT is not subject to income tax. If structured properly, the benefits from this type of trust can closely mimic the benefits of a qualified plan without meeting the rigid requirements under pension laws. This is a very sophisticated use of charitable trusts, and should therefore be approached with caution.
Although there is some downside to establishing a charitable trust, in the right situation it can significantly enhance the benefits of an estate plan while fulfilling a desire to benefit a favorite charity.
For a recent article on creative uses of charitable trusts, visit the Creative Uses page.
If you have any questions regarding Charitable Trusts or any aspect of the estate planning process, please contact Richard W. Kozlowski, Esq. at (802) 864-5756 or by e-mail.
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