Charitable Remainder Trust Allows Sale of Appreciated Assets Without Immediate Capital Gains Tax

Many older persons own appreciated assets that yield little or no income.  These same clients eventually experience the need for an increase in their monthly cash flow as their deteriorating health prompts them to hire caregivers whose assistance will allow them to remain in their homes.  Selling low yield but highly appreciated assets in order to reinvest the proceeds at a higher rate of return usually means that the seller will have to pay substantial capital gains taxes on the appreciation in the assets, thus reducing the amount of principal remaining available for reinvestment.  The depletion of principal caused by the payment of income taxes may not leave the seller with much, if any, in the way of increased income.

If, however, instead of selling the assets the person were to donate them to a charitable remainder trust, the assets can then be sold by the trust.  Because it is the charitable trust, and not the former individual owner, who is selling the property, no immediate capital gains tax is payable.  The trust can reinvest all of the proceeds, with no reduction in principal for the payment of capital gains tax.

For example, an elderly person with highly appreciated but non-income-producing land might consider donating that land to a charitable remainder trust.  The trust would then sell the land, invest all of the proceeds in incoming-producing investments, and pay to the elderly person whatever income stream he or she has selected.

A charitable remainder trust is an irrevocable trust established pursuant to Internal Revenue Code Section 664.  The donor or other person can receive an income interest for life or for a period of up to 20 years.  A charity described in IRC section 170(c) must receive whatever is left in the trust at the end of the period.  It is not necessary for the donor to make an irrevocable decision as to the identity of the ultimate charitable beneficiaries at the time the trust is established.  He or she can reserve a power to redesignate the charity or charities that will receive the remainder interest.

Many older persons may have charitable intentions and desire a higher level of income, but would reject a charitable remainder trust on the grounds that, since the trust remainder is distributed to charity at their death, they would be disinheriting their families.  If the older person is insurable, there is a possible solution to this problem.  With part of the increased income, the older person can purchase a life insurance policy and pay the premiums from the increased income.  Alternatively, the client can establish an irrevocable life insurance trust and use part of the income from the charitable trust to make gifts to the insurance trust, which then would use the funds to purchase and maintain the policy.  Upon the older person’s death, the assets in the charitable remainder trust are distributed to charity, and the life insurance proceeds provide an inheritance for the donor’s family.

The donor of a charitable remainder trust is entitled to an income, gift, or estate tax charitable deduction based on the present value of the charitable remainder interest.  See Regs. 1.664-2(c), 1.664-(b)(5) and 20.2031-7.  Thus, in addition to avoiding capital gains taxes, the donor receives the additional advantage of a charitable deduction on his or her income tax return.  Further, since estate or inheritance taxes (which would reduce the ultimate amount inherited) may be eliminated by this planning, the face amount of a life insurance policy that is meant to “replace” the lost inheritance need not be for the full amount of the assets transferred to the trust.

Under very specific IRS rules, a charitable remainder trust must be established in the form of either an annuity trust or a unitrust.

Charitable Remainder Annuity Trust (CRAT)

An annuity trust is a charitable remainder trust that pays the income beneficiary a specified sum, which must be not less than five percent of the initial net fair-market value of all property placed in the trust.  See Section 664(d).  Under this type of trust, the beneficiary receives a specified amount each year, without regard to the actual income of the trust.  After the annuity trust is established, no additional contributions may be made to it.  Because the amount of annual income payable to the noncharitable beneficiary of an annuity trust is fixed, inflation inures to the benefit of the remainder beneficiary (i.e., the charity).

One important requirement for an annuity trust is that there must be at least a five percent (5%) likelihood that there will in fact be a charitable remainder – that is, that the annuity income beneficiary will not use up the entire trust corpus.  This raises a concern in establishing the trust, since the Code and Regulations specify five percent as the noncharitable beneficiary’s minimum interest but do not specify any maximum percentage.  Actuarial tables used by the Internal Revenue Service must therefore be reviewed while drafting an annuity trust in order to ensure that the percentage being used is low enough, when viewed against the expected rate of return or investments, so that a charitable remainder will theoretically exist.

Charitable Remainder Unitrust (CRUT)

A unitrust is a charitable remainder trust in which a fixed percentage of not less than five percent (5%) of the fair market of the trust assets valued annually is distributed to the noncharitable beneficiary.  See Section 664(d)(2).  A type of unitrust known as a NIMCRUT may provide that the trustee is to pay the income beneficiary only the amount of trust income, even if that is less than the amount required to be distributed.  If the trustee paid less than that amount in earlier years, because, for example, real property had not yet been sold, the trustee can “make up” the difference by later paying a larger amount to the income beneficiary.

Unlike the annuity trust, additional contributions may be made to a unitrust either during the lifetime of the income beneficiary or by a testamentary addition by the donor.  If the trust permits these additional contributions the trust document must provide that, for the taxable year of the trust in which an addition is made, the unitrust amount must be computed by a formula set out in Reg. 1.664-3(b).  Because the annuity amount is not fixed, a unitrust protects the income beneficiary against the ravages of inflation.

Internal Revenue Code Section 2511(c)

Unfortunately, the 2010 estate and gift tax law is a mess, and Internal Revenue Code Section 2511(c), effective for gifts made during 2010, may significantly affect charitable remainder trusts.

The Internal Revenue Service has already attempted to provide guidance about Internal Revenue Code Section 2511(c).  IRS Notice 2010-19 states that “[C]ertain transfers in trust are treated as transfers of property by gift even though such transfers would have been regarded as incomplete gifts, or would have been treated as transfers under the gift tax provisions in effect prior to 2010. … Section 2511(c) broadens the types of transfers subject to the transfer tax under Chapter 12 to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax.  Accordingly, each transfer made in 2010 to a trust that is not treated as wholly owned by the donor or the donor’s spouse … is considered to be a transfer by gift of the entire interest in the property under section 2511(c).”

Doesn’t this language mean that a transfer to a trust is either a completed gift or it is not? If so, perhaps nobody should establish and fund a charitable remainder trust during 2010. First, one way of reading the current IRS interpretation of Internal Revenue Code Section 2511(c) is that the entire amount contributed to a charitable remainder trust is a completed gift, even the amount retained as the income interest. Under that interpretation, only part of the gift would be deemed to charity, and the remainder would utilize the grantor’s lifetime gift tax exemption. Second, a trust that provides for a successive income interest would also be treated as a completed gift, because the retention of a power of appointment over that interest (as is usually done) would not cause it to be an incomplete gift during 2010.

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