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Charitable remainder trusts.

Charitable remainder trusts (CRTs) permit taxpayers to dispose of highly appreciated assets without incurring capital gains. In such transactions, the taxpayer (grantor) does not sell an appreciated asset him- or herself; instead, the grantor transfers it to a CRT - a tax-exempt entity - which sells it. The amount that would have been paid in taxes - had the grantor sold the asset remains intact as principal and contributes to a higher level of income to the grantor. When the grantor's income interest terminates, the remainder interest passes to a charity or charities named by the grantor.

A CRT's most important benefit is that tax-free sales proceeds can generate more income than tax-diminished sales proceeds. A secondary benefit is that a charitable contribution deduction is generated for income tax purposes when the trust is funded.

CRTs are of particular interest to taxpayers who own highly appreciated assets, to charities and to their respective advisers, including CPAs. This article describes the benefits and operations of such trusts. basis. They are both age 60 and own the building free and clear. Their goal is to generate $250,000 in aftertax income per year. The example assumes a blended federal-state capital gains tax rate of 35% and an ordinary income tax rate of 38%. It also assumes the Paces can invest their sales proceeds and achieve a 10% pretax annual return from the postsale principal.

If the Paces sell the asset themselves, after paying $1,662,500 in federal and state capital gains taxes they will have postsale principal of $3,337,500. This amount will generate $333,750 of annual income, which is subject to $126,825 of income tax each year. Their annual aftertax income is only $206,925.

If, instead, the Paces transfer their property to a charitable remainder unitrust and retain a 10% income interest for life, they will achieve their income objective. Since the CRT pays no tax on the sale, it has postsale principal of $5 million to invest for the Paces' benefit. On the basis of the same 10% yield, they will receive $500,000 per year pretax, or $310,000 aftertax.

Since the remainder value will eventually go to charity, the Paces also receive a $521,300 charitable contribution deduction. Because of charitable contribution limitations, the Paces cannot deduct the entire amount in the first year. Any unused deductions can be carried over for up to five years, saving the Paces nearly $200,000 in income taxes (for simplicity, the itemized deduction reduction provisions of Internal Revenue Code section 68(a) have not been considered here).

See exhibit 1, page 66, for a comparison of the paces' aftertax cash flow between the taxable sale and the CRT sale.

What happens when the Paces die? Because they have other assets, the Paces are well into the 55% estate tax bracket. If they had sold their commercial property themselves, their remaining $3,337,500 principal would be hit with a $1,835,625 estate tax, leaving their heirs only $1,501,875. The combined income and estate tax shrinkage would be 70%!

With the CRT, however, the heirs get nothing, since the $5 million principal in the trust passes to charity. If the Paces are favorably inclined toward their children, they may provide for them in another manner. When the Paces establish the CRT, they might also create a separate irrevocable trust for the benefit of their heirs. The trustee of this trust, usually either a bank or one of the heirs, purchases a life insurance policy (survivorship whole life insurance usually is most cost-effective for this purpose) on Cy and Bea.

In this example, the Paces established such a trust for their three children and gave $50,000 to it each year for nine years using their annual gift tax exclusions. The trustee used the funds to pay the premiums on a $2.5 million life insurance policy on Cy and Bea. Based on the insurance company's current assumptions, the policy will be, fully funded in nine years. The Paces' heirs will receive the $2.5 million life insurance proceeds from the trust free of income and estate taxes upon the second spouse's death. See exhibit 2, page 67.

Ultimately, everyone is better off with a CRT: the Paces, their heirs and, of course, the charity or charities that will receive $5 million when Cy and Bea die.

CRT OPTIONS

A number of alternatives are available when setting up a CRT. The following list is by no means exhaustive, but it describes some of the basic decisions to be made.

Payout period. Distributions may be made at the end of each month, quarter, half-year or year. If a short tax year is involved, as is typically the case at both the beginning and the end of the income interest, the payout is prorated. For example, if a CRT established on June 1, 1990, called for annual distributions, the distribution at yearend would be 58.6% (214 days divided by 365 days) of what otherwise would have been the payout for an entire year.

Type. There are two types of CRTs, annuity trusts and unitrusts. An annuity trust pays a fixed dollar amount to the beneficiaries each year. A unitrust pays a dollar amount based on a fixed pereentage Of the unitrust assets' market value. The unitrust assets must be valued at the beginning of each year and the payout for the coming year is based on that amount. The amount (in the case of the annuity trust) and the percentage (in the case of the unitrust) are established when the CRT is created. A unitrust may receive several contributions; an annuity trust may be funded only once. If additional transfers are desired, a new annuity trust must be established.

Payout size. If the CRT is an annuity trust, the payout amount must be at least 5%, but usually no more than 10%, of the value of the initial trust principal. The 10% maximum can be used as a rule of thumb since the intricacies of Treasury regulations section 20.2055-2(b)(1) are beyond the scope of this article. The payout percentage for the unitrust must be at least 5%. There is no maximum payout percentage for a unitrust.

Team. A CRT may pay amounts to the income beneficiary or beneficiaries for a term not to exceed 20 years or for life. It is common for a CRT to provide for a payout over the joint lives of a husband and wife. When the first spouse dies, there is no reduction in the payout. The income interest the surviving spouse inherits from the deceased spouse generally qualifies for the marital deduction and therefore does not generate any estate taxes on the first spouse's death.

A CRT may provide for successor income beneficiaries (children or grandchildren) once the original beneficiaries die. If the original beneficiaries are husband and wife on a joint life basis, the CRT's income interest does not qualify for the marital deduction on the first spouse's death. This frequently will trigger an estate tax liability.

Payout types. If a unitrust is involved, one of three payout types must be selected:

* Straight unitrust.

* Net income unitrust.

* Set income with make-up unitrust.

Straight unitrust. The payout is based on a fixed percentage of the principal. For example, a straight unitrust with an 8% payout and a principal value of $5 million pays out $400,000 in the first year regardless of the unitrust income. If unitrust income exceeds the payout, the excess remains in the unitrust. Conversely, if the unitrust income is less than the payout, the deficiency is paid out of unitrust principal. If at the beginning of year two the total unitrust value grows to $5.5 million, the payout in that year is $440,000. Conversely, if the principal value shrinks to $4.5 million, the payout if, the subsequent year is only $360,000.

Net income unitrust. The unitrust pays out the lesser of unitrust income or the payout, as determined by the unitrust payout percentage. If the preceding example involved a net income unitrust, the income beneficiary would receive $400,000 only if the unitrust income equaled or exceeded that amount. If the unitrust income was only $250,000, that amount would be paid to the income beneficiary.

Net income with make-up unitrust, Any shortfalls caused by the net income provisions are paid out in any subsequent years when unitrust income exceeds the payout, as determined by the unitrust payout percentage. Suppose that in the preceeding example the unitrust provided for a net income with make-up payout. If the unitrust value at the beginning of year two is $5 million, the payout as determined by the unitrust payout percentage is still $400,000. If actual unitrust income is $500,000, the payout at the end of year two is $500, 000, computed as follows:
Year two income $500,000
Less: Percentage
 payout amount (400,000)
Year two make-up amount 100,000
Less: Year one shortfall (150,000)
Shortfall available
 to year three ($50,000)
Year two make-up amount $100,000
Percentage payout amount 400,000
Total year two payout $500,000


Any undistributed make-up income at the expiration of the income interest passes by default to the charitable remainder beneficiary.

CHARITABLE CONTRIBUTION DEDUCTION

When a CRT is funded, the transferor receives an income tax deduction equal to the value of the remainder interest of the principal transferred. Since the CRT is irrevocable, the charitable transfer is locked in when the trust is funded, although the charitable remainderman will not actually receive anything until the income interest expires.

The size of the deduction is based on

* Whether the CRT is an annuity trust or unitrust (the unitrust yields the lower tax deduction).

* The payout frequency - annually, semiannually, quarterly or monthly (the more frequent the payout, the lower the tax deduction).

* The size of the payout (the higher the income payout, the lower the income tax deduction).

* The term of the income interest. In the case of a term for life, this factor is based on the income beneficiary's or beneficiaries' life expectancy (the longer the income term, the smaller the deduction).

* The available applicable federal rate (AFR). Each month the Internal Revenue Service publishes a table of interest factors. Here, the factor used is 120% of the midterm AFR, compounded annually and rounded to the nearest.2%. The AFR from either of the two months preceding the CRT funding date also may be used (the higher the AFR, the lower the deduction).

The Internal Revenue Service has published tables to help calculate this deduction. Fortunately, there also are a number of software packages for this purpose.

ALTERNATIVE MINIMUM TAX (AMT)

When a charitable contribution deduction is created by the transfer of an appreciated asset to a CRT, there is an AMT preference item. For purposes of calculating the amount of the preference item, the total basis of the asset in the hands of the donor is allocated between the income interest and the remainder interest. Since the deduction available for an appreciated asset usually is limited to 30% of adjusted gross income, it is possible part of the deduction will be carried forward to the next year. If this is the case, there will be no preference item until the basis of the remainder interest is fully deducted. For example, if the value and basis of the remainder interest are $521,300 and $26,065, respectively, there will be no preference item until the deduction exceeds $26,065. At that point the AMT preference amount will equal 100% of the deduction taken.

OTHER CONSIDERATIONS

The operation of a CRT may be affected by a variety of other factors.

* Unrelated business taxable income (UBTI). UBTI can result in income taxation of all CRT income. This is disastrous in a tax year when a highly appreciated asset is sold. The transfer of encumbered property to a CRT may trigger similar results.

* Definitions of income and principal. These definitions have a significant impact on the payout amount when net income and net income with make-up unitrusts are employed.

* Beneficiary. The charitable beneficiary might be named irrevocably or the taxpayer might reserve the right to change the beneficiary's identity.

* Trustee selection. The trustee, appointed by the taxpayer, can be a banker, adviser, the charity or, in some cases, the taxpayer.

* Additional factors. The charitable contribution deduction also is affected by the nature of the asset transferred to the CRT, past depreciation deductions and the type of charitable beneficiary. As a result, it is critical the taxpayer's advisers work as q team when analyzing the potential use of a CRT. The team typically should include a CPA, attorney, trust officer, investment adviser and insurance agent.

MAINTAINING CONTROL

The CRT allows taxpayers to better control the ultimate recipient of a large part of their net worth. Ultimately, a charity will benefit from the taxpayer's estate, but instead of being a charity of the government's choosing, the recipient will be a charity of the taxpayer's choosing.

EXECUTIVE SUMMARY

* Charitable remainder trusts (CRTs) provide vehicles for taxpayers to sell certain highly appreciated assets without paying income taxes on the realized gain.

* CRTs Are Not Appropriate for every taxpayer or for every asset, but they should at least be evaluated every time the sale of a high-value, highly appreciated asset is under consideration.

* CRTs Have Many Pitfalls for the unwary. Any asset in the CRT that produces unrelated business taxable income could result in income taxation of all CRT income, which is disastrous if it occurs in the year in which the appreciated asset is sold.

* Successfully implementing a CRT requires that client's advisers work as a team. This team might include a CPA, attorney, investment adviser, insurance agent and trust officer.

* CPAs Who Develop CRT expertise and have relationships with the aforementioned professionals can provide material benefits not only to their clients but also to local charities and to the community.
COPYRIGHT 1993 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Birgen, Robert M.
Publication:Journal of Accountancy
Date:May 1, 1993
Words:2328
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