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How charitable remainder trusts work

Key takeaway

A charitable remainder trust pays an annuity or unitrust amount to its recipients for a permitted term, then passes the remainder to charity.

Start by comparing the payment formula, the treatment of beneficiary distributions and the value reserved for charity. For business owners and real estate investors, also examine how the document treats accounting income and any proposed asset sale.

Choose between a fixed amount and an annually valued percentage

A charitable remainder annuity trust, or CRAT, pays a fixed annual amount equal to at least 5% and no more than 50% of the initial net fair market value of its property.

A charitable remainder unitrust, or CRUT, instead pays a fixed percentage between 5% and 50% of its net asset value, revalued annually.

Both forms must pay at least annually to at least one noncharitable recipient. Payments may run for a life or lives, or for a term no longer than 20 years. Individual recipients must be living when the trust is created.

The charitable remainder must have a value, determined under federal actuarial valuation rules, of at least 10% of the property's net fair market value. For a CRAT, this applies to all initial property. For a CRUT, each contribution is tested separately.

Separate the trust's exemption from the recipient's taxes

A qualifying CRAT or CRUT is exempt from federal income tax, subject to the separate excise tax on unrelated business taxable income. That exemption does not mean contributed capital gain permanently escapes tax.

Beneficiary distributions are classified in this order:

  1. Ordinary income.
  2. Capital gain.
  3. Other income.
  4. Trust corpus, meaning principal.

Each income category includes current income and accumulated undistributed income from prior years. Undistributed capital gain is determined cumulatively on a net basis. The special IRA charitable distribution election has a different rule, addressed below.

Understand income limits before relying on projected payments

If its governing instrument selects a net income limitation, a CRUT pays the lesser of trust accounting income and the regular unitrust amount.

A net income unitrust with a makeup provision, often called a NIMCRUT, may pay additional amounts from later income exceeding the regular unitrust amount. The document must select that provision.

Makeup payments are limited to accumulated shortfalls caused by the income limitation. They depend on actual excess income and are not guaranteed future payments.

Sale proceeds are not automatically accounting income. Proceeds from contributed assets must remain principal through their fair market value at contribution. Proceeds from purchased assets must remain principal through their purchase price.

Remaining proceeds may be allocated to income if the document permits and local law does not prohibit it. Trustee discretion requires a state statute permitting adjustments between income and principal to treat beneficiaries impartially.

For these income limitations, accounting income cannot be defined as a fixed percentage of annual asset value.

A flip changes the payment method after a specified trigger

A properly drafted flip CRUT changes from the income method to the standard unitrust method, using the same percentage, at the beginning of the taxable year following its specified trigger.

The document must specify a date or a single event outside any person's discretion or control. A trigger based on selling defined unmarketable assets is expressly permitted.

Unmarketable assets exclude cash, cash equivalents and assets readily sold or exchanged for either. Before conversion, the selected income limitation still applies. A flip does not promise zero payments before a sale.

After conversion, only the standard unitrust amount is payable. Unpaid makeup balances do not carry forward.

A trust fails charitable remainder trust qualification if its provisions restrict investments in a way that could prevent annual realization of a reasonable amount of income or gain, including through asset sales or dispositions.

Measure the deduction by the charitable remainder

The charitable deduction is limited to the fair market value of the remainder interest. Charity's receipt of part of the annuity or unitrust payments does not increase that remainder deduction.

A return claiming a CRAT remainder deduction must include a full statement computing the remainder's present value.

For an individual, deduction ceilings depend on the property and recipient. Contribution base means adjusted gross income computed without a net operating loss carryback.

  • The general ceiling for gifts to public charities and other qualifying public charity category organizations is 50% of contribution base.
  • Cash gifts to those organizations have a 60% ceiling.
  • Capital gain property given to those organizations has a 30% ceiling.
  • Other gifts generally face the lesser of 30% or the remaining room under the 50% ceiling after public charity category gifts. Capital gain property given to those recipients has a separate lower limit.

An individual's otherwise allowable charitable deductions count only to the extent aggregate charitable contributions exceed 0.5% of contribution base.

Amounts exceeding the 50%, 60% or 30% ceilings may carry forward through the next five years, in order. They retain their category and remain subject to the applicable limit.

For contributed property, the deduction is reduced by gain that would not have been long term capital gain if the property had been sold at fair market value when given.

Match the deduction with its documentation

A single contribution of $250 or more requires a contemporaneous written acknowledgment from the charity meeting the statutory content requirements. Without it, the deduction is unavailable.

A claimed property deduction over $5,000 generally requires a qualified appraisal and the appraisal information required on the return. For a claimed deduction over $500,000, the appraisal itself must be attached.

Those appraisal requirements do not apply to cash, certain inventory, publicly traded securities and certain vehicles. Failure may be excused for reasonable cause without willful neglect.

Trust accounting income

Trust accounting income is income determined under the governing instrument and applicable local law, subject to the special restrictions for net income charitable remainder unitrusts.

Qualified appraisal

A qualified appraisal follows IRS rules and is performed by a qualified appraiser in accordance with generally accepted appraisal standards.

Common questions

How are different classes of ordinary income ordered?

Ordinary income classes distribute from the highest to the lowest federal tax rate, exhausting each class before the next. Capital gains distribute short term gains first, then long term classes from highest to lowest rate.

If classes share a current rate but at least one will have a different future rate, applicable future rates determine their order. Different income types within one class distribute proportionately.

Can I add more property after creating the trust?

A CRAT prohibits additional contributions, while a CRUT may permit them if its governing instrument provides the required contribution year adjustment.

For either form, property passing because of the grantor's death counts as one contribution.

For a permitted addition, use its contribution date value if no valuation date remains that year.

Apply the fixed percentage to existing net asset value, excluding the addition and its later income and appreciation, plus the weighted value of the addition.

Weight the addition by days from contribution through the earlier of year end or payment period end, divided by days from year start through that same endpoint. Each addition must also satisfy the charitable remainder test described above.

Does unrelated business taxable income affect the trust?

Yes, the excise tax equals the trust's unrelated business taxable income, effectively 100% of that income. Determine that income under the federal unrelated business income rules as if the specified exempt organization provisions applied.

The tax is treated as imposed under chapter 42 except subchapter E. It is allocated to corpus and does not reduce taxable income distributed to beneficiaries.

Can an IRA owner use the special charitable distribution election for a CRT?

Yes, through a once in a lifetime election with no earlier election in effect, for a CRAT or CRUT funded only by qualified charitable distributions, with a nonassignable income interest held only by the IRA owner, spouse or both.

The election has a $50,000 base limit adjusted for inflation, with a current IRS figure of $55,000.

Payments from a CRT funded through this election are taxed as ordinary income instead of following the usual distribution categories.

What annual reporting does a charitable remainder trust require?

A charitable remainder trust must file the annual split interest trust information return, give each recipient a beneficiary tax schedule reflecting the current distribution, and attach copies of those schedules to the return.

The return is public, but specified attachments, including Schedule A and beneficiary tax schedules, are protected from disclosure.

A final return for a short taxable year is due on the fifteenth day of the fourth month following termination. An automatic extension request must be filed by the return's due date.

Sources

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