8088 / What is a charitable remainder annuity trust?
A charitable remainder annuity trust (CRAT) provides to a noncharitable beneficiary a fixed payment at least annually of not less than 5 percent nor more than 50 percent of the initial net fair market value of all property placed in the trust, with an irrevocable remainder interest to be paid to or held for a charity.1 For example, the trust may provide for concurrent payment of $400 monthly to one spouse for life and $600 to the second spouse for life, or it may provide for payment of $1000 monthly to the spouses for their joint lives and then to the survivor for life.2 The payment amount is fixed at the inception of the trust, valuation occurs only once, and the payout cannot be limited to the net income of the trust. Furthermore, the donor cannot make additional payments to the trust.3
10 percent remainder interest requirement. The value of the remainder interest (i.e., the deduction) must equal at least 10 percent of the initial fair market value of all property placed in the trust.4 The value of a remainder interest for this purpose is calculated using the IRC Section 7520 interest rate, which is published every month by the IRS. The calculation of the deduction can be made using the current rate for the month the gift is made or either of the previous two months’ rates. See Q 8099 for an explanation of the calculation of the deduction. The probability that the remainder interest will be paid to a charitable beneficiary must not be so remote as to be negligible (this is known as the probability of exhaustion test). Generally, the probability is so remote as to be negligible if there is a greater than 5 percent probability that a CRAT annuity payment will exhaust the trust assets and defeat the charitable purpose by the end of the trust term.5
Planning Point: The IRS has released a sample provision that may be included in the documents governing the CRAT. The new sample provision provides for termination of the CRAT if an annuity payment amount would result in the value of the trust principal (multiplied by a discount factor) dropping below 10 percent of the value of the initial trust corpus. Including this provision will prevent the CRAT from failing to meet the “probability of exhaustion” test, and thus, failing to qualify as a CRAT. 6
Planning Point: For a charitable remainder annuity trust, the charitable deduction increases as the IRC Section 7520 rate increases; therefore, one should choose the highest rate of the three month period for the best charitable deduction.
Noncharitable beneficiary. The IRC requires that the trust payout be made to one or more persons (at least one of whom is not a charitable organization and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not exceeding 20) or for the life or lives of the individual or individuals.7 All individual beneficiaries must be living at the time of the creation of the trust.8 The trust may provide that a beneficiary’s interest will terminate on the happening of a specified contingency.9
IRC Section 664 and regulations thereunder require that to qualify as a charitable remainder trust, a trust must meet the definition of, and function exclusively as, a charitable remainder trust from the time the trust is created. No payments other than those described may be made to anyone other than a qualified charity. Following the termination of all noncharitable payments, the remainder interest is transferred to the charity or retained by the trust for the benefit of the charity.10
Example: Patty is 74 years old and owns stock worth $100,000 today that she purchased a few years ago for $40,000. If Patty were to sell the stock, she would incur long-term capital gains of $60,000; assuming a 15 percent capital gains bracket, the tax would equal $9,000. This would leave her with only $91,000 to reinvest. Patty decides to give the stock to a charitable remainder annuity trust. She elects a 6 percent payout or $6,000 each year throughout her lifetime. Patty is entitled to a charitable income tax deduction of $46,144 assuming quarterly trust payments and a 3.4 percent 7520 rate. If Patty is in a 28 percent income tax bracket, this deduction will save her $12,920. In addition, Patty is not subject to up-front capital gains taxes when funding the trust or when the trustee sells her stock and reinvests it. However, the distributions from the charitable remainder annuity trust to the income beneficiaries are subject to tax under a 4-tier structure. See Q 8100.