Unitrust

A Unitrust is a sophisticated financial instrument used primarily in charitable giving and estate planning. It falls under the broader category of charitable giving vehicles. This type of irrevocable trust allows a grantor to contribute assets, typically appreciated assets, to the trust, receive an income stream for a specified term or for life, and designate a charitable organization as the ultimate beneficiary of the remaining assets. The defining characteristic of a Unitrust is that the income payments to the non-charitable beneficiary are a fixed percentage of the trust's fair market value, revalued annually.⁸⁴, ⁸⁵, ⁸⁶ This structure aims to provide a variable income stream that can grow with the trust's assets, offering a potential hedge against inflation.⁸², ⁸³

History and Origin

The modern Unitrust, specifically the Charitable Remainder Unitrust (CRUT), was formalized as part of the Tax Reform Act of 1969.⁷⁹, ⁸⁰, ⁸¹ Before this landmark legislation, charitable remainder trusts, often called life income trusts, existed but were less regulated and offered more flexibility, which sometimes led to valuation uncertainties and potential abuses.⁷⁷, ⁷⁸ The 1969 Act introduced stricter rules for charitable trusts to qualify for favorable tax treatment, standardizing arrangements like the Unitrust and Charitable Remainder Annuity Trust (CRAT) and requiring a minimum payout rate.⁷⁴, ⁷⁵, ⁷⁶ This reform aimed to ensure a clearer correlation between the charitable contribution deduction and the actual benefit ultimately received by the designated charity.⁷², ⁷³

Key Takeaways

• A Unitrust is an irrevocable charitable trust where the income beneficiary receives a fixed percentage of the trust's annually revalued assets.⁶⁹, ⁷⁰, ⁷¹
• It provides a flexible income stream that can increase if the trust's asset value grows, potentially offsetting the effects of inflation.⁶⁷, ⁶⁸
• Donors may receive an immediate income tax deduction and avoid immediate capital gains taxes on appreciated assets transferred to the trust.⁶⁴, ⁶⁵, ⁶⁶
• The trust's portfolio is managed by a trustee, who invests the assets to provide income to the non-charitable beneficiary and preserve the remainder for charity.⁶², ⁶³
• Upon termination, the remainder interest is distributed to the specified charitable organization.⁶⁰, ⁶¹

Formula and Calculation

The annual payment from a Unitrust is calculated as a fixed percentage of the trust's fair market value, revalued at least annually. This is known as the "unitrust amount."⁵⁹

Let:

• ( P ) = Payout rate (fixed percentage, typically between 5% and 50%⁵⁸)
• ( V_t ) = Fair market value of trust assets at the beginning of the current year (or designated valuation date)
• ( A_t ) = Annual payout for the current year

The formula for the annual payout is:

[ A_t = P \times V_t ]

For example, if a Unitrust has a 5% payout rate and its assets are valued at $1,000,000 at the start of the year, the annual payout would be $50,000. If the trust assets grow to $1,050,000 the following year, the payout for that year would be $52,500.

Interpreting the Unitrust

The Unitrust payout, while a fixed percentage, results in a variable dollar amount each year. This variability means the beneficiary can receive higher payments if the trust's assets perform well and grow in value, which can be advantageous in periods of economic expansion.⁵⁶, ⁵⁷ Conversely, payouts will decrease if the trust's asset value declines. The design allows the trustee to invest for total return, including both income and capital appreciation, rather than being solely focused on generating current income.⁵⁵ This approach can align the interests of both the income beneficiary and the charitable remainder beneficiary, as growth in the trust's value benefits both.

Hypothetical Example

Consider an individual, Sarah, who owns $750,000 in highly appreciated stock and wants to support her alma mater while also generating an income stream for her retirement. She establishes a Charitable Remainder Unitrust (CRUT) with a 5% payout rate, naming herself as the income beneficiary for life and her university as the charitable remainder beneficiary.

1. Funding: Sarah transfers the $750,000 in stock to the Unitrust. She immediately qualifies for a current income tax deduction based on the calculated present value of the remainder interest that will eventually go to the university. The trust, being tax-exempt, can sell the stock without immediate capital gains tax.
2. Year 1: The trust assets are invested. At the end of the first year (or designated valuation date), the trust's fair market value is still $750,000. Sarah receives a payout of 5% of $750,000 = $37,500.
3. Year 2: Due to favorable market conditions and sound asset allocation, the trust's assets grow to $800,000. The new annual payout for Sarah is 5% of $800,000 = $40,000.
4. Year 3: The market experiences a downturn, and the trust's value drops to $780,000. Sarah's payout adjusts to 5% of $780,000 = $39,000.

This example illustrates how Sarah's income adjusts with the performance of the trust's assets, offering a dynamic income stream.

Practical Applications

Unitrusts are widely used in estate planning and philanthropic strategies. They offer a mechanism for individuals to make significant charitable contributions while retaining a stream of income.⁵³, ⁵⁴

• Highly Appreciated Assets: They are particularly beneficial for donating highly appreciated assets, such as real estate or marketable securities.⁵¹, ⁵² By transferring these assets to a Unitrust, the grantor avoids immediate capital gains taxes that would typically be incurred if they sold the assets themselves.⁴⁹, ⁵⁰ The trust can then sell the assets tax-free and reinvest the proceeds for income generation and growth.⁴⁷, ⁴⁸
• Income for Life or Term: Unitrusts can provide income for the grantor, their spouse, or other named beneficiaries for life or a term of up to 20 years.⁴⁵, ⁴⁶ This makes them a flexible tool for retirement planning or supporting family members.
• Diversification of Portfolio: For individuals with a concentrated position in a single stock or asset, a Unitrust allows for the diversification of that asset without triggering immediate capital gains tax, as the trustee can sell the original asset and reinvest the proceeds into a more diversified portfolio.⁴³, ⁴⁴ This can help manage investment risk.⁴²
• IRS Requirements: The IRS provides specific guidelines and sample trust instruments for establishing charitable remainder trusts, including Unitrusts, to ensure they meet the criteria for tax-exempt status and charitable deductions.⁴⁰, ⁴¹ Further details on these regulations can be found on the IRS website.³⁹

Limitations and Criticisms

Despite their advantages, Unitrusts have certain limitations. The primary drawback is their irrevocability; once assets are transferred, the grantor cannot reclaim them, even if their financial circumstances change.³⁷, ³⁸

• Income Volatility: While the variable income stream can be a hedge against inflation, it also means that payouts can decrease during periods of poor market performance, which might pose a challenge for beneficiaries reliant on consistent income.³⁵, ³⁶
• Complexity and Cost: Establishing and administering a Unitrust can be more complex and costly than simpler charitable giving methods due to ongoing valuation requirements and IRS compliance.³⁴ Professional administration by a trustee (often a financial institution) is typically required, incurring fees.³³
• Illiquid Assets: While Unitrusts can accept illiquid assets like real estate, annually valuing such assets can be challenging and costly.³² The trust also needs sufficient liquidity to make the annual payments, which might necessitate selling parts of the illiquid asset if income is insufficient.³¹
• Trustee Challenges: Trustees face the ongoing challenge of managing the trust's investments to balance the income needs of the non-charitable beneficiary with the goal of preserving and growing the remainder interest for the charity. This balancing act can be particularly difficult in volatile market conditions.²⁹, ³⁰ Challenges faced by trustees of charitable remainder unitrusts are sometimes highlighted by legal reviews.²⁸

Unitrust vs. Charitable Remainder Annuity Trust (CRAT)

The Unitrust is often compared to a Charitable Remainder Annuity Trust (CRAT), another type of charitable trust. The fundamental difference lies in how the income payments are determined.

A Unitrust may be preferred by grantors who anticipate growth in the trust's assets and desire a rising income stream, while a CRAT offers the predictability of fixed payments, suitable for those who prioritize stable income.¹¹, ¹²

FAQs

Q1: What is the main purpose of a Unitrust?

A Unitrust serves two primary purposes: to provide a stream of income to a non-charitable beneficiary (often the grantor) for a period, and to ultimately contribute the remaining assets to a designated charity. It offers tax benefits, such as an immediate income tax deduction and the avoidance of immediate capital gains taxes on donated appreciated assets.⁹, ¹⁰

Q2: Can a Unitrust be changed or dissolved after it is set up?

No, a Unitrust is an irrevocable trust. Once it is established and funded, the grantor cannot change the terms, reclaim the assets, or alter the charitable beneficiary.⁷, ⁸

Q3: How is the payout from a Unitrust taxed?

Payments received by the non-charitable beneficiary from a Unitrust are generally taxable. The income is typically taxed in a specific order: first as ordinary income, then capital gains (short-term, then long-term), then tax-exempt income, and finally as a tax-free return of principal.⁶ The trust itself is generally tax-exempt, meaning it pays no tax on its income or capital gains.⁵

Q4: What are the minimum and maximum payout rates for a Unitrust?

According to IRS regulations, the fixed percentage paid out by a Unitrust must be at least 5% and no more than 50% of the trust's fair market value, revalued annually.³, ⁴ The remainder interest that will eventually go to charity must also be at least 10% of the initial net fair market value of the assets contributed to the trust.¹, ²