8079 / What is a charitable remainder trust? How are charitable remainder trusts used as planning tools?

A charitable remainder trust (CRT) is a trust instrument that provides for specified payments to one or more individuals, with an irrevocable remainder interest in the trust property to be paid to or held for a charity.¹ CRTs are a notable exception to the general rule that an individual may not take a charitable deduction for a gift of less than his entire interest in property.

The IRC requirements for CRTs are specific and detailed (see Q 8087 to Q 8097). The purpose of these requirements is to assure that a charitable contribution is actually made and that its present value can be determined with accuracy. To be immediately deductible, the gift must be of real property or intangibles; a gift of a remainder interest in tangible personal property is deductible only when all intervening interests have expired or are held by parties unrelated to the donor.²

Although the charitable remainder trust provisions were enacted in 1969, the use of them has grown dramatically since the mid-1980s. With the growth in their popularity came widespread use (and sometimes misuse) of CRTs as a planning vehicle. CRTs can be marketed in conjunction with “wealth replacement trusts.” A typical plan calls for an individual owning appreciated capital gain property to give the property in trust to a charity, but retain a right to payment for up to 20 years or life (and/or the life of other named individuals). The trust becomes owner of the property; it frequently sells the property and reinvests the proceeds. The proceeds may be invested in tax-exempt securities, which may eventually pass Tier 3 tax-exempt income to the beneficiaries (see Q 8100) after any Tier 1 income and Tier 2 capital gain income from the sale of the appreciated property have been distributed.

The CRT/wealth replacement trust combination is designed to provide the donor a charitable deduction based in part on the full fair market value of the gift (subject to the limits explained in Q 8072), remove the property from his estate, defer or avoid tax to the donor on the capital gain portion of the gift (see Q 8100), and provide either a fixed or variable stream of payments that may be tailored somewhat to meet the needs of the donor. “Wealth replacement” is then accomplished through funding life insurance in an irrevocable trust for larger estates in an amount equal to or greater than the value of the property given. Ideally, the cost of the premiums is offset in whole or in part by the tax benefit of the charitable deduction, the unused portion of which may be carried over for up to five years (see Q 8070). At the end of the trust’s term (usually upon the death of the donor or the last noncharitable beneficiary), the trust property goes to the charity, and the life insurance proceeds to the beneficiaries of the life insurance trust.

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Planning Point: The life insurance policy purchased by the trustee of the wealth replacement trust is typically a survivorship policy insuring two lives but payable only at the second death This type of policy is used for two reasons: (1) the premiums are generally more affordable, particularly if one of the donors is otherwise uninsurable; and (2) the payment of the life insurance death benefit typically coincides with the timing when the heirs would normally have received the asset being replaced.

Planning Point: Often the amount of insurance purchased for wealth replacement is equal to the value of the property contributed to the charitable remainder trust. However, this is not a requirement. Depending on the goals of the client, it may be appropriate to purchase less insurance or more insurance. With less insurance, the client’s income distributions bear a lesser burden in supporting the premium payments. With more insurance, the client is able to leverage the life insurance to create a greater benefit to the life insurance trust beneficiaries.

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Planning Point: While charitable remainder trusts and wealth replacement trusts are sometimes presented as an integrated plan, it is important to note there is a proper order to funding these trusts. The wealth replacement trust is usually implemented first in order to ensure that there is no gap in asset protection between the delivery of the contribution to the charitable remainder trust and the purchase of the life insurance policy. One consequence of this order is that the first life insurance premium must be funded out-of-pocket rather than from the income distributions from the charitable remainder trust. Ted R. Batson, Jr., MBA, CPA, Senior Vice President of Professional Services for Renaissance.

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