Illustrations By James Yang
In the past, planners could go their entire careers without ever rendering advice about investments in a CRT. Charitable remainder trusts, often recommended by advisors, were rarely implemented by clients. But that's changing now, observes Gail Cohen, with the New York investment management firm Fiduciary Trust International. "Charitable giving is up," Cohen says, "and we've seen a real boom in charitable remainder trusts."
There's good reason for the boom. Clients who gift assets into a charitable remainder trust get a current income tax deduction for doing so, then receive, or have designated beneficiaries receive, income from the trust until death (or for a pre-determined number of years), after which the trust terminates and the assets remaining in it - which are outside the client's taxable estate - go to charity.
One popular CRT variant is the charitable remainder unitrust (CRUT), which pays the income beneficiary a fixed percentage, called the unitrust rate, of the trust's total assets. Also common are make-up unitrusts (NIMCRUTs), which distribute the lesser of trust net income or the unitrust percentage; when trust income for the year fails to meet the unitrust rate, the shortfall accumulates and is paid out - made up - in future years in which the trust earns more than the unitrust percentage.
At base, managing the investments in a remainder trust is like any sphere of comprehensive financial planning: It's predicated upon the client's objectives, taking into account tax ramifications and other salient factors, such as the type of trust the donor has established. Say a beneficent client comes to you with a NIMCRUT, and the income beneficiary doesn't currently need distributions from the trust but might down the road. "That's one of the absolute best times to use variable annuities, because an annuity creates income when you tell it to," says Atlanta planner Jack Harmon. Prior to annuitization, when the beneficiary doesn't need cash, the trust will have no income, and its make-up account accumulates. Later, when the beneficiary wants to receive payments from the trust, annuitize the VA. "Then you can do all that catch-up (under the trust's make-up provision) and have an income that's far in excess of the unitrust rate you originally set yourself up for," Harmon says.
When a charitable remainder trust is established for a relatively short duration, fixed-income instruments are the way to go, according to Louisville, Kentucky, advisor David Bohannon. "When we're looking at five years, I use hardly any equities - maybe a 20, 25% exposure. With a short term, if there is a downturn in the market, we simply don't have the time to recoup principal." On the other hand, trusts drafted to last decades, or to provide payouts over the course of two lives (e.g., the donor and spouse), are excellent candidates for equity investments, since a long time horizon gives the trust a chance to rebound from dips in the market encountered along the way. "Right now I'm working on a charitable remainder trust where we have established a 20-year term," Bohannon says. "We're probably looking at a portfolio that's 80% equity."
Hold on a sec - stocks in the portfolio of a trust? Doesn't that violate rules of fiduciary duty?
Once upon a time, yes. Nowadays, no.
"Most states have adopted the prudent investor rule, which allows much broader investment philosophies than 20 years ago, when trustees were limited to investing in Treasury bills and other conservative things," says Florida estate planning attorney Leonard J. Adler, with Greenberg Traurig P.A. "You can't go out and buy junk bonds, but you can invest in the stock market. You invest for growth."
Or at least you can, in theory.
In actual practice, implementing a growth strategy could prove to be a challenge. The grantor of a CRUT, for example, may not want the trust to buy equities, fearing that a stock market drop would turn the annual percentage payout into fewer dollars of income. She might prefer the trust own safe, low-yield asset classes - ones that could result in the trust's annual distributions exceeding its income, eroding principal and, ultimately, the remainder received by charity at the end of the trust term. That puts the investment advisor in a bind: The prudent investor rule mandates that the CRT be invested to meet the needs of both the income beneficiary and the remainderman (the charity), either of whom can sue if they feel they've received the short end of the stick. Attorney Tom Giachetti, who defends planners accused of malpractice, says, "When the investment advisor discusses with the grantor how the money's going to be invested, the advisor should absolutely reduce the grantor's wishes to writing, and the advisor, to the extent that he may disagree or recommend otherwise, should also indicate that in writing. That's the best way an advisor can protect himself," says Giachetti, with Stark & Stark, in Princeton, New Jersey. (Owning an errors and omissions insurance policy doesn't hurt, either.)
Fortunately, soaring stock prices in recent years have made it easier than ever to convince donors to invest their CRT money in equities, observes Michael K. McMahan, a registered principal with Raymond James Financial Services in Gastonia, North Carolina. "I have an 85-year-old client who has over $1 million in a 10% charitable remainder unitrust. Originally he had the money all in individual bonds, in spite of our counsel otherwise." But the bonds returned less than the payout percentage, and the grantor saw his trust's principal dwindle. "Then he understood that it was better to expose the money to the equity markets, which we did, and he has since recovered what he lost with the bonds," says McMahan, adding that the client's trust is now fully invested in stocks.
Not all who manage for growth are comfortable with a portfolio that's 100% equities, especially when the trust is a CRUT. As mentioned above, nosediving stock prices (e.g., a brief market correction that just happens to coincide with the CRUT's annual valuation) could pummel the payout. "You need a certain amount of bond exposure or you set yourself up for a big jolt in income," says fee-only wealth manager Stewart Welch III, who typically parks 15% to 20% of remainder trust assets in bonds. A second reason for owning bonds is to provide the trust with the cash it needs to make payment to the income beneficiary. "Having bonds in there provides a measure of liquidity," says the founder of The Welch Group, Birmingham, Alabama. "We have a client with a charitable remainder trust that has $750,000 in it. It pays 7%, so the annual distribution is about $50,000. What we've done is a three-year bond ladder [total of $150,000] of government bonds that mature every January, to give us ready cash," Welch says.
Some planners pursue growth and income in the remainder trusts they manage. With today's low yields, however, the income portion of a such a portfolio can drag total return. To combat that problem in one CRUT that's invested 60-40 in favor of income, Bay Shore, New York, planner Charlie Hughes buys closed-end mutual funds rather than individual fixed-income instruments. "The market prices of these closed-end fixed-income funds are 10% to 15% below their NAVs, so the yields are rather extraordinary. With closed-end funds investing in government securities, we can get yields above the long-term Treasury rate - yields close to 7%," Hughes said in December.
Although a CRT is not a tax-paying entity - a grantor can gift low-basis stock into a remainder trust, have the trust sell it, and incur no capital gains tax - there nevertheless are tax angles to consider when devising the trust's asset allocation. CRT distributions are subject to income tax, and the nature of the income earned in the trust, overlaid by a system of four tiers, dictates how the payment is taxed to the income beneficiary. Derisively described by one advisor as "the WIFO method of taxation - worst in, first out," the first tier is ordinary income earned by the trust. In other words, to the extent the CRT has earned ordinary income, the income beneficiary receives that first. The second income tier is capital gains (current year gains first, then any undistributed prior-year cap gains), followed by municipal bond income, and, lastly, tax-free return of principal.
Suppose a 5% CRUT is initially funded with $1 million of zero-basis stock, posits Cohen, who is a senior vice president at Fiduciary Trust. "Trustee sells the stock and reinvests the million dollars" - the full million, since the CRT itself pays no tax - "and when the first year's payment comes out, you look for the ordinary income earned that year by the trust." Say it's $10,000. Under the tiering rules, the first $10,000 of the $50,000 distribution ($1 million trust value times the 5% unitrust rate) is construed as ordinary income. The next tier is capital gains, which the trust has realized to the tune of $1 million, so the remainder of the payment is cap gain income. If the following year the trust earns another $10,000 in ordinary income and realizes no new gains, the distribution would consist of $10,000 of current year ordinary income (first tier) and $40,000 of prior-year cap gains (second tier). At this rate, of course, it will take years to distribute the $1 million of capital gain, but that's hardly a bad thing. "When you've got so much capital gain buried in the trust, the issue becomes minimizing ordinary income so that the distributions will come out as capital gains," says accountant David A. Krahn, in the Minneapolis office of Larson, Allen, Weishair & Co., LLP. And of course you want to avoid earning municipal bond interest in a trust with mega-cap gains, since you have to distribute the entire gain before you get to the tax-free income tier. (Do munis ever make sense in a CRT? Yes, say the pros, if the trust was initially funded by cash or an unappreciated asset.)
One obvious way to avoid generating ordinary income in a CRT is to load its portfolio with non-dividend-paying stocks. "But you clearly need to look at your fiduciary responsibility to be sure you have the right risk-reward ratio," Krahn warns. A safer alternative may be tax-managed mutual funds. "They invest so as to generate nothing but long-term capital gains inside the trust, and often no gains at all," says Raymond James's McMahan, who likes State Street Research Legacy Fund, a large-cap (more akin to the Dow than the S&P 500) tax-efficient fund that has distributed neither dividends nor cap gains the last couple of years, filling the first two income tax tiers with nothing but zeroes. "That is a perfect instrument for a charitable remainder trust because you can literally have an income beneficiary receiving tax-free cash flow from the trust," McMahan says, explaining that his clients' CRTs sell shares of the fund when cash is needed to make payment to the income beneficiary. Yes, a portion of the sale proceeds is capital gain, but the rest is tax-free return of principal. "So it's a very tax efficient strategy," McMahan says.
Most planners say they won't recommend CRTs to clients who lack bona fide charitable intent. Still, the tax advantages of gifting assets to a remainder trust, selling them inside the CRT, and reinvesting the full proceeds lures many a non-beneficent individual into creating these vehicles. Bohannon, who acts as planned giving manager for the Louisville charity Home of the Innocents when he's not running his planning firm Consultants Corner Inc., advises tax-driven donors to gift assets that aren't growing, since you give away less with a non-appreciating asset. "If the donor has minimal intent on the remainder interest to charity, I will fund the trust with the asset in their portfolio that is appreciating the least," Bohannon says.
In terms of practice management, investing charitable trust assets isn't much different from overseeing investments outside a CRT, at least not for Upland, California, planner Nancy Langdon Jones. "We design the portfolio and discuss with the grantor what we expect it to do, just like for any client," Jones says. "I have quarterly meetings where we review the performance - make sure it's still meeting the objective - and discuss whether anything needs to be changed."
Although remainder trusts are being implemented more frequently these days, managing CRT assets is still a small arena of investment advising. And, a charity may actually try to keep you from getting that work. Some charitable organizations, when initially sitting down with a potential donor and her planner, will say that the latter can not manage the assets, that they have to, Jones says. "And I just mention, 'That's odd, because with some of these other charities, I'm managing the assets.' Then the charity says, 'Well, we guess that would be okay.'"