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Tax News You Can Use

Tier-ed and True: CRT Income Taxation

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Tax News You Can Use | For Professional Advisors

 

Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

A charitable remainder trust (CRT) is a vehicle used to share the benefit of property between individual beneficiaries and charitable beneficiaries. The trust provides for annual payments to one or more individual beneficiaries,1 which can include the grantor, for a term of up to 20 years or for the lifetime of one or more individuals. At the end of the annuity period, the assets are distributed outright to the charitable beneficiaries.2 The annual payment can be a fixed dollar amount (charitable remainder annuity trust, or CRAT) based on a percentage of the value of the CRT when created, or can be recalculated each year based on a percentage of the trust’s assets at that time (charitable remainder unitrust, or CRUT).3 Either way, the payment has to be between 5% and 50% of the value of the assets to qualify as a CRT.4

How are CRTs treated for estate and gift tax purposes?

For lifetime gifts to a CRT, the donor is entitled to an income tax charitable deduction and a gift tax charitable deduction in the year of the gift for the actuarial value of the interest going to charity at the termination of the trust. For testamentary gifts, there is also an estate tax charitable deduction for the actuarial value of the interest going to charity. In all cases, the actuarial present value of the charity’s interest must be at least 10% of the value of the gift to the CRT. The duration of the CRT and the amount of the payout, as well as the IRS determined interest rate at the time of the gift, are used to compute the present value for this purpose.

Often, lifetime CRTs are created naming only the grantor and/or the grantor’s spouse as the annuitants. In this case, no gift tax is incurred. However, it is also possible to create a CRT and name other family members or friends as the annuitants. Donors creating CRTs may be focused on philanthropy and wish to ensure that the assets eventually go to charity after providing a lifetime annuity to an individual beneficiary or may be primarily concerned about finding a tax-efficient way to set up a strict annuity for a beneficiary with spending problems.

Generally, an annuity payable to a party other than the grantor is subject to gift or estate tax. Consequently, when the interest of the other annuitant is one that follows a grantor’s annuity right, the grantor typically retains the right to change or revoke the interest to avoid a gift at the outset. With a two-life CRT, the trust agreement must require some party other than the trust to pay any estate or inheritance taxes imposed at the death of the first annuitant. The IRS sample forms provide that the interest of the second payee is contingent upon their assuming responsibility for any such taxes.5

Who pays the income tax on CRT income?

CRTs are considered charitable trusts for federal income tax purposes, and they are tax-exempt. The trust does not pay tax on the income it earns. This is not the end of the story, however. When the trust makes a payment to an individual beneficiary, that amount is income in the hands of the recipient. The type of income is characterized in tiers, and the distribution is treated as a distribution from the first tier, then the second, etc. Note that the income in a particular tier may have been earned in a prior year but not distributed until a later year.

How does the tier system work?

  • Tier 1 consists of ordinary income such as interest income and dividends.
  • Tier 2 consists of capital gains that are not taxed as long-term capital gains. First, short-term gains are distributed, followed by gains from the of sale of collectibles, followed by gains from the sale of real estate subject to recapture tax.
  • Tier 3 consists of long-term capital gains.
  • Tier 4 consists of non-taxable income. This includes federally tax-exempt income and return of principal.

Example:

Arvind created a $1,000,000 CRAT to pay him a $70,000 annuity for life (7% of the initial fair market value of the assets). At his death, the remainder will be paid to his favorite charity, Busytown Hospital Foundation. The first annuity payment is made to Arvind on December 31, 2024. Below is a summary of the income earned by the CRAT during 2024:

When the CRAT trustee pays Arvind $70,000 for 2024, it will be treated under the tier system as consisting of:

  • First, taxable interest of $25,000, tier 1.
  • Second, qualified dividend income of $10,000, tier 1.
  • Third, short-term capital gains of $5,000, tier 2.
  • Fourth, long-term capital gain of $30,000, tier 3.

Suppose in 2025, the CRT only earns $10,000 of qualified dividends and taxable bond interest of $15,000.

The 2025 distribution would be treated as consisting of:

  • First, taxable interest of $15,000, tier 1.
  • Second, qualified dividends of $10,000, tier 1.
  • Third, long-term capital gains (earned in 2024 but not distributed) of $20,000, tier 3.
  • Fourth, return of principal of $25,000, tier 4.

As you can see, the $70,000 distribution in 2025 will include the portion of long-term capital gains from 2024 that were not taxed to the beneficiary in 2024, before any portion is treated as a return of principal. In planning the CRT, funding it, and managing the investments, it is important for the grantor, the trustee and the annuitant to work with their tax advisors to understand the tax consequences of those decisions for each party.

How are CRTs used in estate planning?

CRTs are used for estate planning in a variety of situations. One is where the taxpayer is interested in making a current irrevocable gift to charity but needs to retain an income stream. This provides assurance to the taxpayer that the charity will receive the remainder regardless of what happens to the rest of the estate, which can be particularly important for taxpayers concerned about creditor claims.

CRTs are also used by taxpayers who intend to primarily benefit charity at death but would like to provide one or several individuals with a lifetime payment. This is often useful when providing for a beneficiary who does not have descendants or where the annuitant’s surviving family is not the intended beneficiary of the grantor. They are used when a grantor could benefit from a larger charitable income tax deduction in the current year but still needs some income from the assets. Recently, they are being used as the beneficiaries of IRAs to approximate the life expectancy payout no longer available after the SECURE Act6 and as the recipients of the permitted $50,000 one-time distribution from an IRA as a Qualified Charitable Distribution.7

The most common use of the CRT in estate planning is the contribution of highly-appreciated property to the CRT due to the trust’s tax-exempt status. When the CRT sells the property, it does not pay tax on the capital gains. This does not mean that the gains escape taxation, however. As the payments are made, the tier system will put the capital gains in tier 3, and then through the tier system passed out to the annuitant over time depending on the other income earned by the trust. The benefit is that they are not typically recognized by the annuitant in a single year, which can avoid having the capital gains push the taxpayer into a higher bracket for income tax purposes, or generate extremely high adjusted gross income (AGI) in one year that could impact Medicare premiums or eligibility for certain deductions and credits tied to AGI levels.

In Conclusion

A CRT can be a powerful planning tool for both tax planning and philanthropic purposes. Lifetime gifts to CRTs can provide a way to lock in the charitable income and gift tax deductions today for what will ultimately pass to charity, while providing the grantor (or another beneficiary) with a predictable income stream. They can spread out tax on capital gains over multiple years. Testamentary CRTs can provide an individual beneficiary with a reliable source of income and can mimic life-expectancy payouts for an inherited IRA. We believe that expert tax and estate planning advice can help maximize the tax benefits when incorporating a CRT into a taxpayer’s overall wealth plan.

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  1. We classify these payment recipients in a CRT as the “individual” beneficiaries. However, there is the ability to make payments to other entities or charities as long as there is at least one non-charitable beneficiary.
  2. The grantor may retain or grant to the annuitant a power to name or change the charitable beneficiaries before the end of the annuity term.
  3. Variations on the charitable remainder unitrust (CRUT) are a “net-income” or NICRUT, where the individual beneficiary receives the lesser of net income or the unitrust amount, and a “net-income with makeup” or NIMCRUT, where the individual beneficiary receives the lesser of net income or the unitrust amount, and the difference between the net income and the unitrust amount is accrued so that in a later year, when there is more net income that could be distributed, the trustee can distribute “make-up” amounts based on the accruals. A third variation is a “FLIP-CRUT,” which is a NICRUT or NIMCRUT that, upon the happening of a certain event, such as the sale of a particular asset or the passage of a certain amount of time, flips to being a regular CRUT. This is often used when the trust is funded with an appreciating asset that is not generating income initially.
  4. The IRS publishes and regularly updates sample forms for CRTs. These contain the tax required provisions, but drafting a complete trust will require adding investment powers, trustee succession provisions and other language not related to qualification as a CRT.
  5. See Rev. Proc. 2005-54.
  6. For more information on this technique, see Tax News You Can Use – Vol 19:23, Charitable Remainder Trust as IRA Beneficiary (seismic.com)
  7. For more information on this technique, see Tax News You Can Use – Vol 18:23, QCDs From an IRA: What's New and What's Not (seismic.com)

Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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