In my blog post last month (A Simple Strategy for Achieving Clients’ Charitable Goals: the Donor-Advised Fund), I provided an overview of the potential benefits of using donor-advised funds (DAFs) as part of a charitable giving strategy. Although DAFs are great for relatively simple planning situations, what if your charitably minded clients have more complex needs and goals? 

Over the past few years, improving stock market conditions, rising income tax rates and a growing number of baby boomers seeking ways to supplement retirement income have contributed to a resurgence in the use of the charitable remainder trust (CRT). A general understanding of how the CRT works can help you determine whether it’s an appropriate charitable planning vehicle for your clients. 

How CRTs Work

A CRT is a split-interest trust, meaning there are two beneficiaries: an individual income beneficiary and a charitable remainder beneficiary. The trust can be established to pay income at least annually for a term of years (no more than 20) or for the lifetime of the income beneficiary.

The income stream can be structured as a fixed dollar amount, as in the case of a charitable remainder annuity trust (CRAT), or as a percentage of the trust’s annual fair market value, as in the case of a charitable remainder unitrust (CRUT). For the trust to qualify as a CRT, the payment must be 5% or more of the trust’s fair market value. 

Upon completion of the trust term or the death of the last income beneficiary, all remaining assets pass to the charitable organization named as the remainder beneficiary. 

A Compelling Tax Situation

This may not sound too exciting up to this point, but naming a charitable organization as the remainder beneficiary creates a very compelling tax situation: it makes the trust tax exempt. Because the trust is tax exempt, the client funding a CRT will receive an income tax deduction equal to the present value of the remainder interest, and the assets will be removed from his or her taxable estate.

In addition, the trust will not be liable for any taxes when it sells assets used to fund the trust.

The income beneficiary will have to pay tax on payments received from the trust; however, if properly managed, the taxation of those payments may be at rates no higher than preferred capital gains rates.

How a CRT Works: John

John is a 60-year-old executive for ABC, a publicly traded company. He has accumulated significant wealth in shares of ABC over his career and plans to retire at the end of the year.

John has always provided monetary support to his local church and would like to make the church a beneficiary to a portion of his estate when he passes away. 

John works with his advisor and an attorney to create a CRT that will pay him 5% of the value of the trust each year. John funds the trust with $500,000 of ABC stock, which has a tax cost basis of $250,000. John immediately receives a $189,185 income tax deduction upon funding the trust.

The ABC shares are sold by the CRT trustee without incurring capital gain tax, which would otherwise be payable if the shares were sold outside of the trust. The proceeds of the sale are then reallocated into an appropriately diversified portfolio.

Assuming the trust portfolio grows at a rate of 7%, John can expect to receive payments totaling approximately $627,000 over his 21-year life expectancy.

When John dies, the approximate remainder of $717,900 will pass to his church. 

The Benefits to John

Under this scenario, the CRT provided John with the following benefits: 

  • A significant income tax deduction
  • A tax-efficient method for diversifying a concentrated position
  • Retirement income
  • A charitable legacy 

As you can see, the CRT can be a powerful planning tool for the client looking to both benefit a charity and supplement retirement income. Keep in mind, though, that this is a simplified overview of how this type of trust works.

Be sure to work with a qualified attorney when implementing a CRT as part of your clients’ financial plans.

Stay tuned to learn about additional strategies that you may find helpful in your planning practice.