At first glance, a Charitable Remainder Trust is the trifecta of estate planning techniques: Increases your lifetime income or that of your chosen beneficiary. Check. Reduces immediate and future tax consequences found in some other estate planning scenarios. Check. Provides a charitable foundation with funding after you or your beneficiary’s death or other termination of the trust. Check.
But those benefits can be void or moot if:
The Charitable Remainder Trust was created by Congress as part of the Tax Reform Act of 1969 as an answer to a number of planned gift vehicles that were being used in estate planning as tax shelters with little or no real charitable intent. To prevent the abuses that had been perceived in the existing plans, the law contained very strict guidelines to be met for the trust to qualify for the tax advantages intended by the Act.
The structure of a Charitable Remainder Trust involves the transfer into an irrevocable trust of a high-value – and preferably highly-appreciated -- asset that meets the criteria set by law. While the trustee may have some flexibility during the life of the trust such as changing the charity designated to receive the proceeds, the nature of an irrevocable trust is such that once the asset is in the trust, it cannot be later retrieved for other purposes without tax penalties.
The irreversible nature of the trust is rewarded with tax advantages that are immediate as well as long-term, such as:
The primary advantage of a Charitable Remainder Trust is the ability to receive regular income distributions during the beneficiary’s life without significant tax consequences. The method of the distribution can take different forms. In one scenario, a percentage of the trust assets is distributed periodically as directed by the trust based upon the value of the trust. This arrangement is referred to as a Charitable Remainder Unitrust
In the alternative, if you or your chosen beneficiary will need a more reliable income until death, a fixed income option called a Charitable Remainder Annuity Trust will provide predictable income regardless of the performance of the trust. This latter arrangement must be carefully monitored, however; if the trust assets do not continue to increase due to market fluctuations, interest rate changes or other issues, the fixed distributions may eventually exceed the value of the trust, leaving nothing for the designated charity and thwarting the intent of the trust, possibly resulting in tax penalties.
The most advantageous assets used to fund the trust will have significantly appreciated in value since their purchase date. This will take advantage of the lack of capital gains assessed on the asset when it is placed into the trust as opposed to an outright sale of the assets. Examples of these assets, other than cash, include publicly-traded securities and real estate. In the latter example, as many homeowners age and become empty-nesters, they want to sell the family home and downsize or retire to a different location. Selling the home and placing the proceeds into a Charitable Remainder Trust can have huge tax advantages as opposed to an outright sale of the home.
A Charitable Remainder Trust must have a trustee to administer and protect the trust assets. A trustee with significant expertise in this particular type of trust is the best option, or at least someone familiar with investments, estate tax, accounting and reporting. As noted, even a small misstep can nullify the trust, not only voiding any tax advantages the trust was intended to provide, but possibly even costing more than the trust was created to save in the first place.
Even with its unique treatment of taxes and its noble intentions, a Charitable Remainder Trust is sometimes not the best option. In addition to the pitfalls already mentioned about failing to properly administer the trust, other considerations are inherent in the requirements of the trust.
One such requirement is that whenever an asset is transferred into the Charitable Remainder Trust, its present value must be at least 10% of the amount projected to go to the chosen charity at the termination of the trust. This is addressed in the “probability of exhaustion” terms, and is particularly true of the Charitable Remainder Annuity Trust which analyzes whether there is a greater than 5% chance that the trust assets will be exhausted before distribution to the charity due to the life expectancy of the annuitant.
A Charitable Remainder Trust can be a very useful estate planning vehicle under the appropriate circumstances and when planned correctly. But many of the advantages, especially those related to tax consequences, can disappear or even become punitive if the Charitable Remainder Trust violates any of the guidelines implemented at the time this mechanism was created, primarily because of the remedial nature of its design.