From the March 2009 issue of Wealth Manager Web • Subscribe!

Timing May Not Be Everything

For the past few months, I've expressed how current market conditions, combined with certain estate and tax planning strategies, can produce remarkable results. Depressed asset values and a historically low applicable federal rate (AFR) have created an environment where strategies such as grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs), and self-canceling installment notes (SCINs) are commonly cited as effective wealth management tools--and for good reason. Prudent wealth management, however, requires that you choose a strategy to address an existing issue--not that you choose a strategy and then, after the fact, find an issue to address.

This article focuses on a common strategy--the charitable remainder trust (CRT)--which continues to be considered an effective solution regardless of market conditions and interest rates. While the choice of a CRT is more a matter of the client's condition than the market's, the wealth manager must understand more than just the basic concept. I have often heard from advisors who introduced the CRT concept to clients, initially to rave reviews, only to have those feelings squashed because the advisor did not understand key details of the planning strategy.

Reviewing the basics

Attorneys, CPAs and wealth managers alike are well aware of the CRT because it is an effective strategy that can provide a client with multiple benefits. Eligibility for a charitable income tax deduction, a capital gain deferral, an ongoing income stream, and a charitable gift or bequest are all primary features of the CRT. How can one planning tool provide so many benefits? Read on.

A CRT is a tax-exempt split-interest trust, meaning there are two beneficiaries to the trust--an income beneficiary and a remainder beneficiary. The income beneficiary is commonly the donor (client) who funds the trust, although anyone can assume the role. The remainder beneficiary is an IRS-qualified charity and therefore provides the trust with its tax-exempt status.

Here's how it works: A client contributes appreciated assets to the CRT but retains a right to receive a payment--at least annually--for the term of the trust. The trust term can last for the life of the income beneficiary or for a fixed term of no longer than 20 years. The payment amount can be fixed; this is called a charitable remainder annuity trust (CRAT). Or it can vary as a percentage of the trust's fair market value each year--as a charitable remainder unitrust (CRUT). At the end of the trust term, all assets remaining in the trust pass to the designated charitable beneficiary. It is important to understand that the performance of the trust assets will directly affect the amount of the payout (in the case of a CRUT) and the amount that ultimately passes to charity.

What are the advantages of this? When the client (donor) funds the trust, he or she is eligible to receive a charitable income tax deduction equal to the present value of the remainder interest to pass to the named charity. The income tax deduction will vary based upon the amount of income to be paid. Choosing a higher payout will result in a lower subsequent deduction. A higher payout also reduces the present value that ultimately passes to charity. Another benefit is the CRT's tax-exempt status as a separate tax-paying entity. This allows the trust to sell appreciated assets without incurring immediate capital gains taxes. Generally, the capital gains--or some portion thereof--will be distributed to the income beneficiary.

Other benefits associated with the CRT include an income stream that can last for a term of years or for the income beneficiary's life--a tax-efficient way to generate retirement income. A primary concern of wealthy clients is the pending estate tax. A CRT allows assets to pass directly to charity, thus removing them from the gross estate. Finally, the CRT provides the client a mechanism for meeting his or her philanthropic goals.

Too good to be true?

Sounds like a slam dunk for the right client, and it certainly could be. The CRT is commonly mentioned as a planning strategy for addressing issues that arise when the client has a concentrated, highly appreciated stock position, appreciated real property, or even business interests. While clients in these situations may benefit from a CRT, their advisors must dig much deeper before committing to such a strategy, or some unpleasant surprises may come along that put the advisor in a bad light and make the client wary of his future advice.

Not all assets are alike

The amount to fund the trust, the amount of the deduction, and the amount of the payout are probably the top three concerns of any client contemplating the implementation of a CRT. The advisor, however, should immediately focus on what kind of assets will be used to fund the trust.

When it comes to funding a CRT, not all assets are suitable. Certain types of assets can be toxic in a CRT because they produce unrelated business taxable income (UBTI). UBTI is income earned by a tax-exempt entity but produced by non-exempt activities--activities not associated with the entity's tax-exempt purpose. It is not always easy to recognize which assets may produce UBTI, but common examples include stocks pledged against margin debt, business interests and mortgaged real estate. Clients should check with their tax professionals to determine which assets to use.
Why is UBTI so problematic? Prior to the Pension Protection Act of 2006 (PPA), UBTI would essentially negate the CRT's most valuable quality--its tax-exempt status. The PPA, however, relaxed the rules. Now, any UBTI produced by the CRT's assets will not cause the trust to lose its tax-exempt status; rather, the income is subject to a 100% excise tax--steep to be sure, but a much better result than the previous alternative.

UBTI is most prevalent when mortgaged real estate is being considered to fund the CRT. Although the real estate market has been declining fiercely, many clients continue to hold real estate with significant capital gains. Most are devoted lifelong real estate investors who may have accumulated substantial amounts of property over decades. Now--as they watch their net worth deteriorate--some clients in this niche are interested in tax-efficiently divesting some of their concentrated wealth. The problem is that because leverage is what often made these clients wealthy in the first place, you can expect leverage to remain a major component of that real estate portfolio.

With some adjustments, however, the debt obstacle can be overcome. One obvious solution is to remove the debt. However, cash flow constraints may make this impossible. Another solution is to shift the debt to another property--a simple solution prior to 2008, but increasingly difficult with the present uncertainty of the credit markets. A more complex but potentially feasible solution may be to arrange a sale of an interest in the property to the named charity. The sale would allow for the debt to be paid, and the client could contribute his or her remaining shares to the CRT. The charity and CRT could then sell the property as joint tenants, which--because the client is not a party to the sale--avoids any self-dealing issues.

Although falling markets and interest rates are not advantageous factors for creating a CRT, these trusts continue to be considered a viable planning tool for the right client in the right situation. Before suggesting a CRT, however, be sure you understand not only the concept, but also how the property under consideration may affect the outcome. You may also need to consult appropriate tax and legal professionals.

Gavin Morrissey, JD (gmorrissey@commonwealth.com), is the director of advanced planning at Commonwealth Financial Network in San Diego, Calif.

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