John P. Dedon
Charitable remainder trusts (CRTs) are a widely used and accepted charitable and estate planning tool. CRTs allow donors to accomplish their charitable objectives and obtain immediate income tax advantages and estate tax relief. As the case studies below illustrate, CRTs work well for business owners who are charitably inclined and concerned about estate taxes or retirement income. A CRT is timely to consider for end-of-year planning.
There are two types of CRTs: an annuity trust and a unitrust. Broadly stated, a unitrust pays out a fixed percentage of the annual value of the CRT principal typically to the donor for the donor’s (or donor and spouse’s) lifetime. In contrast, an annuity trust pays a specific amount annually for the term of the trust. Both can be for life, joint lives, or set terms. While the CRT itself is generally tax exempt, the annuity or unitrust distributions may be taxable to the donor depending on the type of income earned by the trust. At the end of both types of CRTs, the remaining principal passes to one or more charities chosen by the donor. Although unitrusts are frequently used more than annuity trusts, this article suggests an annuity trust may provide greater advantages to the business owner.
The advantage of the annuity trust is that, upon creation, the donor creates certainty in the planning in the following respects: (1) the income tax deduction is known up front; (2) the amount and term of the annuity is certain; (3) the charity is not waiting until the donor’s death for its distribution; and (4) as long as the IRS guidelines are followed, it is unassailable.
What are the primary requirements of an annuity trust?
■ The annuity is paid at least annually to at least one noncharitable beneficiary.
■ The trust term cannot last longer than 20 years. (It can also last for the lifetime of the donor or other recipient of the annuity, but the model proposed in this article typically assumes a short limited term.)
■ The annuity amount is at least 5 percent of the initial fair market value of the property initially placed in the CRT (for example, for a $1 million contribution, the annuity is at least $50,000).
■ The annuity amount is less than 50 percent of the initial fair market value of the property initially place in the CRT (for example, for a $1 million contribution, the annuity is less than $500,000).
■ The present value of what will ultimately be distributed to the charity, measured again at the time of contribution to the CRT, is at least 10 percent of the property transferred to the CRT (for example, for a $1 million contribution, the present value of the remainder to charity must be at least $100,000).
■ There must be less than a 5 percent chance that the CRT property will be exhausted prior to the end of the term.
■ At the end of the term, the CRT property is distributed to charity (typically one or more public charities, but it could also be a private foundation).
The annuity trust is a premier planning tool in a number of settings. Consider the following cases for these business owners. Each case assumes the donors are charitably inclined and are looking to maximize the income and estate tax benefits pertaining to charitable contributions. (The numbers will vary depending on tax rates and the IRS interest rate, which changes monthly.)
Sale Of Business
Mr. Donor is considering selling his automobile dealership and hoping to realize approximately $10 million. Because he inherited the dealership from his father 42 years ago when the basis in the stock was $200,000, he would have capital gain tax on the sale approximating $1.5 million. Mr. Donor has contributed through the years to the Automobile Trade Association’s public charity to provide scholarships for auto technicians. Prior to entering into negotiations for the sale of the business, Mr. Donor transfers 10 percent of his stock to his CRT, created as an annuity trust for an eight-year period. The CRT sells the stock. Not only does he achieve a tax deduction of $106,289, but he also defers capital gain on the sale of $147,000. For eight years, he receives $122,000 per year, and the charity receives $312,464 at the termination of the trust (or more if the assets inside the CRT appreciate at greater than 5 percent).
Increase Cash Flow And Diversify
Mr. Donor was one of the founding members of a community bank in Northern Virginia. After several acquisitions, he has seen his meager investment grow to more than $6 million worth of public stock in The Great Virginia State Bank. Mr. Donor is a great fan of The Great Virginia State Bank but is disappointed that it pays virtually no dividends, leaving him asset-rich and cash-poor. He also agrees with his broker’s advice to diversify his holdings. He has contributed over the years to the Appalachian Trail Association, a tax-exempt charity supporting Mr. Donor’s favorite national park. Mr. Donor transfers $1 million of his bank stock to his eight-year charitable remainder annuity trust. The CRT sells the stock, may defer capital gain, and reinvests in a diversified portfolio generating greater income. Mr. Donor receives a tax deduction of $106,289. For eight years, he receives $122,000 per year, and Appalachian Trail Association receives $312,464 at the termination of the trust (or more if the assets inside the CRT appreciate at greater than 5 percent).
Turbo charging the benefit
One disadvantage of a CRT is that assets inside it pass ultimately to charity, not to family. Satisfying charitable objectives may be important to Mr. and Mrs. Donor, but perhaps not to their disinherited children. It is easy to dismiss the children, thinking, “It is the Donors’ money to do as they want, not the greedy children’s money.” It is more difficult when you are actually Mr. and Mrs. Donor, sitting alone for Christmas dinner because the disgruntled (and spoiled) children have boycotted.
Estate planning professionals have long known part of the solution is to replace the CRT assets with life insurance owned by an irrevocable trust. This planning involves replacing the assets placed in the CRT and passing to charity with life insurance, an asset for the family and estate tax excluded because it is owned by an irrevocable trust.
Life insurance products, irrevocable trusts, gifting issues and other critical components of coupling a CRT with insurance are outside the scope of this article. However, insurance can provide many solutions in conjunction with a CRT. Take these two alternatives:
1) First, the donors in our first case study, Mr. and Mrs. Auto Dealer need insurance to help with the payment of estate taxes. The insurance product in their case would likely be inside an irrevocable trust to avoid estate tax, and would be tailored heavy on the death benefit and light on the policy cash value.
2) The donor in the second case study, Mr. Banker is looking for greater income and financial security in later years. He can still use the death benefit in the event of his premature death, but that is not his first priority. The insurance product in his case would likely be owned by him personally, not an irrevocable trust, and the product would take advantage of the tax-free buildup inside the policy that could be drawn upon with tax-free loans in later years.
Of course, the annuity received by the donor is his to do whatever he chooses. However, by coupling the annuity CRT with tailored life insurance, the donor can end up in an enhanced financial position and still accomplish his charitable objectives. For these reasons, the annuity trust should always be considered as one of the donor’s charitable alternatives.
Charitable Remainder Trusts are wonderful tools to help donors accomplish their charitable objectives. In addition to leaving assets to charity, they provide current income tax advantages as well as a continuing income stream. When considering the two types of charitable trusts, Charitable Remainder Annuity Trusts, are worthy of greater consideration.
John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedononestateplanning.typepad.com.Tweet