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Using Charitable Remainder Trusts, Part 1
Roger Silk | 07-25-01
Charitable remainder trusts have become a popular vehicle to help clients defer taxes and make a charitable donation. In this column and my next one, I'll demonstrate under what circumstances a charitable remainder trust makes the most sense.
This column will focus on situations in which the clients are most interested in maximizing their aftertax wealth and are considering a charitable remainder trust as a means for doing so.
The Ins and Outs of Charitable Remainder Trusts
A charitable remainder trust is a split interest trust in which a donor retains an interest in specified cash flows and a charity owns the remainder interest. The trust creator gets an immediate income tax deduction for the value of the remainder interest donated to charity, and the trust itself is not subject to income tax.
Consider the example of a donor who owns stock worth $1 million, for which he paid $500,000. If he sold the stock, he'd pay capital gains of approximately $100,000 (more in many states) on the $500,000 gain, leaving $900,000 to invest.
If he instead gives the $1 million to a charitable remainder trust, the trust can put the entire $1 million to work and the donor gets an immediate income tax deduction. The size of that deduction is determined by the value of the assets placed in trust, the applicable monthly federal interest rate (the AFR), the cash flow interest retained by the grantor, and the length of the trust.
Now, instead of having $900,000 to do with as he pleases, the donor has a right to receive a stream of cash flows from the trust. Note that taxes aren't avoided but rather deferred. The donor will pay tax on those cash flows from the trust as they're received.
The law requires that the remainder beneficiary--a charity--get at least 10% of the amount that goes into the trust. In practice, this puts an upper limit on the amount that the donor can receive as annual cash flows. So in the example above, the actual value of the donor's cash flows may turn out to be worth more or less than $900,000.
There are two types of charitable remainder trust, which differ only in how the cash flows to the donor are calculated. With a Charitable Remainder Annuity Trust (a CRAT), the cash flows are fixed at the beginning of the trust and don't change. With a Charitable Remainder Unit Trust (a CRUT), the cash flows are set as a fixed percentage of the value of the trust assets. The advantage of a CRAT is that the cash flows are known in advance. The disadvantage is that they cannot grow. A CRUT has the reverse features.
Using a Charitable Remainder Trust to Maximize Aftertax Wealth
People who are purely concerned with maximizing their own wealth and have no interest in charity will rarely benefit from a charitable remainder trust, despite the trust's tax advantages. A simple example will show why.
Let's assume that we're dealing with a 65-year-old donor, that the expected rate of return on assets is 8%, that the current section 7520 rate (used for valuing annuities) is 7%, and that the donor has a basis ratio (the ratio of the donor's basis in the assets to the current fair market value) of 50% in the assets to be donated. To simplify the tremendous complexity of the multitiered tax rules that apply to charitable remainder trust distributions, we will assume that only the 20% capital gains rate is relevant. (To the extent that this last assumption is too low, it will make charitable remainder trusts look better.)
To further simplify, we will assume that the donor never spends any of the cash received but instead reinvests it at the market rate (8% by assumption) after paying taxes. We can then calculate how much the donor will have at his life expectancy and how much will remain for charity. By comparing these amounts to the amounts that would result if there were no trust, we can determine whether the trust produces a net benefit or not.
If the donor in our base case uses a charitable remainder annuity trust (CRAT), at age 82 (his approximate life expectancy) he will have accumulated $192 for every $100 contributed. In addition, the CRAT will still have $101, which will go to charity.
But what if the donor hadn't bothered with the CRAT, and instead just sold the appreciated property, paid the tax, and reinvested the proceeds. Given the same return and tax rate assumptions, our donor would have accumulated $258 by the age of 82.
Even when the basis ratio is a minuscule 10%, a CRAT still doesn't produce greater net wealth for the donor. Our 65-year-old with a CRAT accumulates the same $192. With his lower basis, he pays more tax if he simply sells the assets, but even so at age 82 he has accumulated $235.
A charitable remainder trust produces tax benefits mainly by means of deferral. In the above case, the deferral is never enough to overcome the fact that the donor is giving away a portion of the assets. A basic rule of thumb is that a wealth maximizing prospective donor should not set up a charitable remainder trust, because only rarely will doing so increase the donor's personal benefit.
As Congress intended, charitable remainder trusts mostly make sense only for people with genuine philanthropic interest. However, before philanthropists elect to create a trust, they should compare it to the alternative of contributing some of the property to a private foundation, selling the rest, and reinvesting the proceeds. I will examine this alternative in greater detail later in my next column.
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