Charitable remainder trust

What Is a Charitable Remainder Trust?

A charitable remainder trust (CRT) is an irrevocable trust that allows an individual to donate assets to a charitable organization while retaining an income stream from those assets for a specified period or for life. CRTs are a significant tool within the broader field of estate planning and philanthropy, enabling donors (known as grantors) to receive financial benefits during their lifetime, defer taxes, and ultimately support a chosen cause. These trusts are structured as "split-interest" vehicles, meaning they have both non-charitable income beneficiaries and a charitable remainder beneficiary.²⁵, ²⁶ Upon the trust's termination, the remaining trust assets are distributed to the designated charity.²⁴

History and Origin

Charitable remainder trusts gained prominence with the passage of the Tax Reform Act of 1969 in the United States. Before this legislation, there were instances of abuse where donors claimed large charitable deductions for gifts to trusts, but the actual benefit received by the charity was minimal. To curb these abuses and provide clear guidelines, the IRS established specific regulations for CRTs under Internal Revenue Code Section 664. These regulations standardized how such trusts must operate, including minimum and maximum payout rates and the requirement that the charitable remainder interest must be at least 10% of the initial fair market value of the assets contributed to the trust.²², ²³ The Internal Revenue Service (IRS) continues to monitor and propose changes to regulations to prevent misuse, such as those announced in March 2024 concerning certain charitable remainder annuity trust transactions.²¹

Key Takeaways

• A charitable remainder trust (CRT) allows donors to contribute assets to a trust, receive income for a period, and then donate the remainder to charity.
• CRTs are irrevocable trusts, meaning their terms generally cannot be changed once established.
• Donors may qualify for an immediate income tax deduction and can defer or avoid capital gains tax on the sale of appreciated assets transferred to the trust.²⁰
• There are two main types: Charitable Remainder Annuity Trusts (CRATs), which pay a fixed annuity, and Charitable Remainder Unitrusts (CRUTs), which pay a fixed percentage of the annually revalued trust assets.
• The IRS sets specific rules, including minimum and maximum payout rates (5% to 50%) and a minimum charitable remainder interest (10%).¹⁸, ¹⁹

Interpreting the Charitable Remainder Trust

A charitable remainder trust is interpreted primarily by its payout mechanism and the tax implications for the grantor and beneficiaries. The two most common types of CRTs are the Charitable Remainder Annuity Trust (CRAT) and the Charitable Remainder Unitrust (CRUT).

A Charitable Remainder Annuity Trust (CRAT) pays a fixed annuity amount each year to the non-charitable beneficiary. This amount is set as a percentage (between 5% and 50%) of the initial fair market value of the assets contributed to the trust.¹⁷ Once established, additional contributions to a CRAT are not permitted, and the payout remains constant, regardless of the trust's investment performance. If the trust's income is insufficient to cover the payout, the principal must be invaded.¹⁶

A Charitable Remainder Unitrust (CRUT) pays a fixed percentage (also between 5% and 50%) of the trust's value, which is revalued annually.¹⁵ This means the annual payout can fluctuate. If the trust assets grow, the payout increases; if they decline, the payout decreases. CRUTs allow for additional contributions after the trust's inception.¹⁴ There are also variations of CRUTs, such as Net Income Charitable Remainder Unitrusts (NICRUTs) and Net Income with Makeup Charitable Remainder Unitrusts (NIMCRUTs), which tie payouts to the trust's actual income.¹³

Payments received by beneficiaries from a charitable remainder trust are taxable and reported on Schedule K-1 (Form 1041). The taxation follows a specific order: ordinary income, then capital gains, then tax-exempt income, and finally, a return of principal.¹²

Hypothetical Example

Consider an individual, Sarah, who owns highly appreciated stock valued at $1,000,000, which she purchased for $100,000. She wants to support her alma mater and also generate an income stream for her retirement.

Sarah establishes a charitable remainder unitrust (CRUT) and transfers the $1,000,000 in stock to it. The trust document specifies an annual payout of 6% of the trust's value, revalued each year, for her lifetime. The trust is irrevocable, and the university is designated as the charitable remainder beneficiary.

Upon funding the CRUT, Sarah avoids paying capital gains tax on the $900,000 appreciation when the trustee sells the stock. The trustee then reinvests the full $1,000,000 into a diversified portfolio. Sarah also receives an immediate income tax deduction for the present value of the charitable remainder interest.

In the first year, assuming the trust assets remain at $1,000,000, Sarah receives a payout of $60,000 (6% of $1,000,000). If, in the second year, the trust's value grows to $1,050,000, her payout for that year would increase to $63,000 (6% of $1,050,000). This continues for her lifetime. After her passing, the remaining assets in the trust will be distributed to her alma mater.

Practical Applications

Charitable remainder trusts are a versatile tool in financial planning and philanthropy. They are frequently used by individuals who hold significant appreciated assets, such as real estate, privately held stock, or highly appreciated securities. By transferring these assets to a CRT, the donor can sell them within the trust without immediate capital gains recognition, allowing the full value of the asset to be reinvested and generate income.¹¹

Beyond the income stream and tax deferral, CRTs are applied in several ways:

• Retirement Planning: They can provide a predictable or growing income stream during retirement, especially for those with illiquid, appreciated assets they wish to convert to income without a large upfront tax bill.
• Estate Tax Reduction: Assets placed into an irrevocable trust are generally removed from the donor's taxable estate, potentially reducing future estate tax liability.¹⁰
• Legacy Giving: CRTs allow individuals to make substantial charitable gifts while ensuring their financial needs are met during their lifetime. This facilitates significant contributions to universities, hospitals, and other charitable organizations.
• Succession Planning: For business owners, a charitable remainder trust can be used to sell a business to a third party or transfer it to the next generation or an Employee Stock Ownership Plan (ESOP), minimizing taxes on the sale.⁹

Limitations and Criticisms

While beneficial, charitable remainder trusts have limitations and are subject to scrutiny. One primary limitation is their irrevocable nature. Once assets are transferred into a CRT, the grantor loses control over them, and the terms of the trust generally cannot be changed. This means the donor cannot retrieve the assets or change the charitable beneficiary without significant legal and tax implications.

Another consideration is the complexity and cost of establishing and administering a CRT. They require legal expertise to draft the trust document and ongoing administrative costs for trustee services, accounting, and annual tax filings (Form 5227).⁸

Furthermore, the payout rate limitations (between 5% and 50% annually) and the 10% minimum charitable remainder interest requirement can restrict flexibility. If interest rates are low, for instance, it might be more challenging to meet the 10% remainder test for a CRAT with certain payout rates and terms.⁷

Historically, the IRS has expressed concern over and even targeted certain CRAT transactions due to perceived abuses where promoters claimed permanent avoidance of ordinary income and capital gains.⁵, ⁶ This highlights the importance of ensuring that CRTs are established and managed in strict compliance with IRS regulations to avoid penalties and potential recharacterization of the transaction. The complexity also means that if the trust is not managed properly or if the underlying assets perform poorly, the income stream to the beneficiary could be less than anticipated, and the ultimate gift to charity might be reduced.

Charitable Remainder Trust vs. Charitable Lead Trust

The charitable remainder trust (CRT) and the charitable lead trust (CLT) are both "split-interest" trusts used in philanthropic planning, but they reverse the order of beneficiaries.

In a Charitable Remainder Trust, the non-charitable beneficiary (often the grantor or their family) receives the income stream (annuity or unitrust payments) for a specified period, and the charitable organization receives the remainder of the trust assets at the end of the trust term. The donor receives an immediate income tax deduction for the present value of the future gift to charity.

Conversely, in a Charitable Lead Trust, the charitable organization receives the income stream (the "lead" interest) for a set number of years. At the end of the trust term, the remaining assets revert to the non-charitable beneficiaries (often the grantor's heirs). The primary purpose of a CLT is typically to transfer assets to heirs with reduced estate tax or gift tax implications, rather than to provide income to the donor. The donor may also receive a current income tax deduction, depending on the structure of the CLT.

The confusion between the two often arises because both involve a mix of charitable and non-charitable beneficiaries and offer tax advantages. However, their primary function and the timing of benefits are distinct: CRTs provide income to individuals first, then charity, while CLTs provide income to charity first, then individuals.

FAQs

What assets can be placed into a charitable remainder trust?

A wide variety of assets can be placed into a charitable remainder trust, including cash, publicly traded securities, real estate, and privately held business interests. Highly appreciated assets are often chosen because transferring them to a CRT allows for their sale without immediate capital gains tax, maximizing the amount that can be reinvested.⁴

Are charitable remainder trusts truly irrevocable?

Yes, charitable remainder trusts are generally irrevocable. This means that once the trust is established and assets are transferred, the grantor cannot reclaim the assets or unilaterally change the terms of the trust, including the beneficiaries or the payout schedule. This irrevocability is a key feature that provides the tax benefits associated with CRTs.

What are the tax benefits of establishing a charitable remainder trust?

The primary tax benefits of a charitable remainder trust include an immediate income tax deduction for the present value of the charitable remainder interest, the deferral or elimination of capital gains tax on the sale of appreciated assets contributed to the trust, and the removal of the trust assets from the grantor's taxable estate for estate tax purposes.², ³ The annual income payments to the non-charitable beneficiary are taxable, following specific IRS rules regarding the character of the income.¹