12. Charitable Remainder Trusts, Part 4 of 4

12. Charitable Remainder Trusts, Part 4 of 4

Article posted in General on 9 June 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 9 June 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.


Links to previous sections of book are found at the end of each section.

To this point we have reviewed the standard Charitable Remainder Trust configurations.  There are, however, a variety of different Charitable Remainder Trust structures that have received support from the IRS and tax courts.  These special types of Charitable Remainder Trusts can be particularly attractive when dealing with special types of assets or specific income needs.

One of the earliest alternative forms of Charitable Remainder Trusts was the Net Income Charitable Remainder Unitrust (NICRUT).  This trust operates like a standard Charitable Remainder Unitrust, with the exception that payments to the annuitant will be limited to the lesser of trust income or the unitrust percentage.  This net income restriction can only reduce payments to the annuitant (and thus increase the charitable remainder) as compared with a Charitable Remainder Unitrust.  However, the addition of this net income restriction does not increase the charitable income tax deduction for contributing to the trust.
Given that a Net Income Charitable Remainder Unitrust can only reduce payments to the annuitant, but does not increase the charitable income tax deduction, why would any donor voluntarily choose to accept such a limitation?
The attraction for including a net income limitation relates to the contribution of difficult-to-sell assets to the trust.  A standard Charitable Remainder Trust requires that the payments must be made to the non-charitable beneficiary.  But, if a trust was holding only a single, large, difficult-to-sell asset, this forced payment could mandate an immediate sale of the asset (or some part of it) in order to make the required payments to annuitants.  For a trust established with, for example, valuable artwork, developable land, or closely-held stock, an immediate forced sale could dramatically diminish the sale price.  In this case, the annuitant can be financially better off to forego his or her annual payments until the asset is sold at an appropriate price.  This is not an option in the standard Charitable Remainder Trust, but can be achieved with the addition of a net income limitation on payments.
Today, use of the Net Income Charitable Remainder Unitrust has fallen due to competition from newer alternatives that address the same basic problem of asset illiquidity.  The Net Income Makeup Charitable Remainder Unitrust (NIMCRUT) has a similar provision limiting payments to net income, but also has the added provision that previously foregone payments (due to insufficient income) can later be made up whenever income is larger than the regular payments.  Thus, although payments are still limited to net income, a payment in a particular year may be larger than the standard percentage amount in order to make up past payments that were missed.
Although the annuitant of a NIMCRUT may still receive less than in a standard Charitable Remainder Unitrust, any missed payments come with an “IOU” from the trust promising to pay the missed payment to the extent that future net income exceeds the standard payment.  The annuitant is still not entitled to any more payments than under a standard Charitable Remainder Unitrust, but now any payments missed due to low income could conceivably be made up in some future year.  Thus, the annuitant may receive more under a NIMCRUT than under a NICRUT, but would never receive more than if no net income provisions were included in the trust.  Once again, the IRS support of this addition rests on the reality that the charitable remainder amount can be no less (and may be larger) than that of a standard Charitable Remainder Unitrust.  As with a NICRUT, the calculation of the charitable income tax deduction for a transfer to a NIMCRUT ignores the net income provision, despite the potential for the charity to receive a relatively larger amount.
Although the NIMCRUT represents an improvement from the NICRUT for the annuitant (because missed payments could be made up in the future), this improvement only applies where future income exceeds the standard payment amount.  If future income never exceeds the standard payment amount, then the IOU from the trust will never be paid, and the NIMCRUT will be no better than a NICRUT.  Further, it can easily be the case that the NIMCRUT pays less than the standard Charitable Remainder Unitrust if future income is insufficient to make-up all previous underpayments due to the net income provision.  This difficult reality led to the creation of the next generation of Charitable Remainder Trust variation, referred to as a “flip-CRUT.”
The flip-CRUT is a NICRUT or NIMCRUT that, upon the occurrence of a trigger event, converts to a standard Charitable Remainder Unitrust for the remainder of the life of the trust.  Once again, the charitable income tax deduction remains unchanged as compared with a standard Charitable Remainder Unitrust.  This combination allows for the trust to hold a difficult-to-sell item for any length of time without forcing a sale due to mandatory payments.  But, once the item is sold, the trust can “flip” to a standard Charitable Remainder Unitrust with no net income limitations.

Common trigger events permitted to generate such a “flip” from a NICRUT/NIMCRUT to a standard CRUT include the sale of a difficult-to-value asset or the annuitant’s reaching a specific age.  Thus, a flip-CRUT can be used both for difficult-to-sell assets and to address retirement planning needs where the annuitant may want to postpone receiving payments until reaching a retirement date.

In a flip-CRUT, prior to the trigger event the annuitant receives the lesser of the fixed percentage of trust assets or income from the trust.  Once the trigger event occurs, the annuitant receives a fixed percentage of trust assets for the remainder of the duration of the trust without regard to the trust’s income.  (Note that once a trust is converted to a standard CRUT as a result of the trigger event, there will be no “make-up” of any past missed payments.  Prior to the trust flipping, a make-up payment could have been possible if the flip-CRUT was initially a NIMCRUT, but no make-up payments are allowed once the trust converts to a standard CRUT.)
Suppose, for example, that the donor funded a 5% flip-CRUT with a non-income producing piece of land worth $1,000,000.  Before the land was sold, the trust would receive no income, and thus would make no payments to the annuitant.  However, once the land was sold, the trust would convert to a standard CRUT and the annuitant would receive 5% of the trust assets each year for the duration of the trust.  This 5% is fixed and would not change regardless of how much income is earned in a particular year.

When Charitable Remainder Trust payments are limited to income (either permanently or for a time prior to “flipping” into a standard CRUT), the trustee can gain substantial control over the payment stream simply by changing the underlying investments.  There are a variety of investments that offer opportunities for appreciation, but produce little or no income.  Examples include non-dividend paying growth stock or limited partnership interests, artwork and collectibles, and developable land.  When such investments held by a NICRUT or NIMCRUT generate no income, no payments would need to be made.

Why is this attractive?  Consider a situation where the donor wishes to create a source of retirement income for himself, but first wants the assets to accumulate in a tax-free environment for several years.  The donor can create a flip-CRUT converting from a NIMCRUT to a standard CRUT upon the donor’s reaching age 65.  Prior to age 65, the donor/trustee can invest in non-income producing assets, insuring that he will receive no payments and recognize no income.  Upon reaching age 65, the trust becomes a standard CRUT and the donor can immediately take a percentage of all assets, regardless of the income received by the trust.  But what about all of the missed payments?  One clever approach is to design the NIMCRUT phase where post-contribution capital gains are specifically defined as income.  In the year prior to the retirement date (and “flipping” of the trust), the trustee could sell all of the investment assets, recognize large capital gains and use these gains to pay all outstanding IOUs (payment make-up provisions).  The net effect can be to preserve all of the payments, but postpone their distribution until the desired ages.  The distribution need not be so drastic as to make all sales and make-up payments in the final year.  These sales and the resulting make-up distributions could be timed over several years to smooth the annuitant’s receipt of income.  Through the use of these techniques, however, the donor/annuitant can design an income stream that matches his or her retirement and tax planning goals. 

Commercial deferred annuities are an investment which can be designed to generate no income recognition by the trust prior to a decision by the trustee to withdraw funds.  This can be an ideal investment allowing the income “spigot” to be turned off and on at will.  The annuity can accrue income that is not distributed to (or recognized by) the trust until payment is requested by the trustee.  Once income is desired, the annuity can immediately be paid to the trust, creating a flood of income that can be used – in the case of a NIMCRUT – to make up past foregone payments.  (This relies in part on a special provision in the income tax code which treats payments from an annuity contract as entirely ordinary income if the annuity is owned by a trust.) However, this particular approach generates more concerns than other investments.  Specifically, there is a concern that the use of this investment may constitute “self-dealing”.  Although an early Technical Advice Memorandum provided some guidelines, since 1997 this practice has been under review by the IRS, and the IRS has specifically stated that it will not make any rulings related to the use of commercial deferred annuities in a NICRUT or NIMCRUT.  Thus, the tax outcome for this particular arrangement is less secure, given the IRS concerns.

One creative approach to Charitable Remainder Trust planning is to design a flip-CRUT that converts on the sale of an economically insignificant, but difficult-to-value, asset.  The traditional flip-CRUT is designed around the sale of a substantial difficult-to-value (and hence, often difficult-to-sell) asset.  However, the difficult-to-value asset need not be a substantial one.  It can, in fact, be a single share of a closely-held company.  In this case, the asset itself is economically insignificant, but allows the trustee to “flip” the trust from a NIMCRUT to a standard CRUT at will by selling the asset.  Commentator Conrad Teitell labels this a “flex-CRUT” because it is so flexible.
The typical Charitable Remainder Trust transaction involves the transfer of a substantial, highly appreciated asset to the trust.  It may be the case that the donor’s wealth is substantially tied to one property and the donor may not wish to contribute the entire property to a Charitable Remainder Trust.  In such cases, a donor can choose to contribute an undivided share of the property to the Charitable Remainder Trust.  Typically, this transfer would be made prior to a sale in an effort to shelter some of the recognition of capital gain.  Although the donor would still recognize capital gain on his share of the property at its sale, the share of the property owned by the Charitable Remainder Trust would not generate an immediate capital gains tax.  Further, the donor might choose to make several contributions of undivided interests to a Charitable Remainder Trust in order to spread out the charitable income tax deductions over a longer period of time.  For example, by donating 10% undivided interests each year for 10 years, the donor creates 10 years’ worth of charitable income tax deductions rather than one large deduction in the first year.  This may help to co-ordinate the charitable deductions with the income limitations on such deductions.  Although charitable income tax deductions exceeding income limitations may be carried over for up to five years, spreading out the transfers may result in larger deductions due to the appreciation of the underlying property.
Comparing Charitable Remainder Trusts to Charitable Gift Annuities is much like comparing the artist’s paint palette with a number 2 pencil.  Charitable Gift Annuities are relatively simple, standardized agreements, often contained in a one or two page form document.  For most charities, all of their Charitable Gift Annuity agreements are identical except for the payment amount and named annuitant.  In contrast, Charitable Remainder Trusts are individually created to the specifications of the donor.  Although Charitable Remainder Trusts must comply with the IRS guidelines, within those guidelines, there is enormous freedom and flexibility.
Some examples of the flexibility of Charitable Remainder Trusts (as contrasted with typical Charitable Gift Annuities) include the ability to name an unlimited number of public charity or private foundation beneficiaries and the ability to change the named charitable beneficiary whenever desired.  There are, of course, consequences of different choices.  For example, gifts to a Charitable Remainder Trust where the remainder could possibly be paid to a private foundation will be subject to the income limitations and property valuation rules applicable to gifts to private foundations.  The donor can create a Charitable Remainder Trust that will pay to any number of beneficiaries for any number of lives (where Charitable Gift Annuities are limited to a maximum of two lives).  The donor can create a Charitable Remainder Trust that will pay for a fixed number of years, up to 20.  (Charitable Gift Annuities may pay for one or two lives but not for a fixed number of years.)  If the Charitable Remainder Trust employs an independent trustee (i.e., not controlled by the donor), the trust can also create restrictions as to when certain annuitants will receive payments.  Although the Charitable Remainder Trust must still make the required payments (of a fixed dollar or fixed percentage amount), the trust document may change the recipient of those payments.  This “sprinkling” power (although it can be administered only by an independent trustee and not by a donor-trustee) can create amazing planning opportunities.  For example, the payments can contain a “spendthrift” provision protecting them from being attached by creditors.  Thus, for annuitants other than the donor, the payments can be protected from divorce, lawsuits, or bankruptcy.  If the donor wishes to prevent his annuitant children (or grandchildren) from becoming lazy “trust fund” kids, he could limit the payments to a particular beneficiary to some multiple of their earned income.  (Any un-claimed annuity payment would still need to be paid to other beneficiaries so that the total payment distributed was still fixed.) The donor could even require that annuitants pass a drug test in order to receive annuity payments.  Almost any rules that can be imagined by the donor and administered by an independent trustee that are not against public policy can be included in a charitable trust document.  Its flexibility is almost limitless.
As a famous example of such flexibility, we can examine the Charitable Remainder Trust from the estate of hotelier Leona Helmsley.  Typically, the provisions of Charitable Remainder Trusts are not publicly available, because these are private documents.  However, in this case, the Charitable Remainder Trust was a testamentary trust (i.e., created in the will).  Because the will is a public document, the provisions of this testamentary trust also became public.  This trust required that the grandchildren beneficiaries must visit the grave of their father at least once each calendar year in order to receive their annuity payment.  Because this trust was to be administered by an independent trustee (and not by the donor herself), such “sprinkling” powers are acceptable.  In the event that a beneficiary did not comply with the rules, that beneficiary would lose his payment and the payment would go to another named beneficiary.
Any trust, including a Charitable Remainder Trust, can be thought of as a basket.  Like a basket, a trust holds things.  In particular, trusts hold title to valuable assets and administer those assets in accordance with the instructions found in the trust document.  However, certain types of assets can create problems when owned by a Charitable Remainder Trust.

Subchapter S corporations are closely held (100 or fewer shareholders) corporations that are taxed in ways similar to partnerships.  A Charitable Remainder Trust cannot hold subchapter S Corporation shares.  This is not due to any restriction from the rules of Charitable Remainder Trusts, but rather due to the shareholder requirements of subchapter S corporations.  Shareholders in such corporations must normally be natural persons.  Although there are exceptions to this rule, a Charitable Remainder Trust is not one of them.  (One exception allows public charities to hold subchapter S stock, thus allowing a Charitable Gift Annuity in exchange for such shares.)

What options are available for the donor who wishes to transfer the ownership of a business to a Charitable Remainder Trust, when the business is a subchapter S corporation?  The corporation itself can contribute appreciated assets to a Charitable Remainder Trust and receive income for up to 20 years (lifetime income is not available for non-persons).  Both the charitable income tax deduction and subsequent income payments pass through to the shareholders and no capital gain is immediately recognized upon the sale of the asset.  This is not a perfect solution, however, because it cannot be used to transfer “substantially all” corporate assets to a Charitable Remainder Trust, and payments cannot be made for annuitant lifetimes.  Of course, a donor who controls the corporation could change its corporate form to a C-corporation by ceasing to make the S-corporation election, but such conversion has its own tax consequences that may be independently unattractive.

One of the most extreme forms of taxation comes when a Charitable Remainder Trust receives unrelated business taxable income (UBTI).  Unrelated business taxable income is generated when the trust earns money by engaging in the operation of a business rather than simply being a passive investor.  Such income is taxed at a 100% rate.  Simply put, the IRS takes all of it.
Typical investments do not generate unrelated business taxable income, because they are passive.  Dividends, interest, annuities, royalties, rents from real estate, and capital gains are not unrelated business taxable income, so long as none of them involve debt financing.  Conversely, if any of these sources of income are generated from debt-financed investments, then the income does qualify as unrelated business taxable income.  Although rents from real estate will not be unrelated business taxable income – so long as there is no debt on the real estate – active management of businesses involving real estate, such as running a hotel, parking lot, convenience store, or coin-operated laundry, will create unrelated business taxable income.  The key distinction is that when the trust is actively participating in the operation of the business, the resulting income is unrelated business taxable income.  (Of course, the trust can be a shareholder in a corporation that engages in such activities, because then the trust is simply a passive investor rather than a manager.)
The extreme taxation of unrelated business taxable income in Charitable Remainder Trusts can produce surprising results.  Consider a situation where a Charitable Remainder Trust receives a gift of a $1 million house transferred from a donor who had a $100,000 basis in the house.  The trustee decides to authorize $100,000 of improvements to the house in order to get it in top condition to sell.  Because the trustee has no other trust assets, he obtains the $100,000 by taking out a mortgage on the house.  As a result of making the improvements, the house is later sold for $1.2 million and the mortgage is paid off at the sale.  Clearly, the $100,000 investment was a good idea because it increased the value of the home by $200,000, right?  Unfortunately, no.
Remember that dividends, interest, annuities, royalties, rents from real estate, and capital gains are not unrelated business taxable income, so long as none of them come from debt financing.  However, in this case we have a capital gain from debt-financed property (due to the $100,000 mortgage).  Thus, the capital gain becomes unrelated business taxable income.  Unrelated business taxable income in a Charitable Remainder Trust is taxed at 100%.  Consequently, the entire capital gain must be forfeited as a tax payment.  Although an extreme example, this shows the importance of avoiding unrelated business taxable income in a Charitable Remainder Trust.
The Charitable Remainder Trust, like a private foundation, has strict rules against engaging in transactions with disqualified persons.  Rather than reviewing these transactions to determine if they were beneficial to the charity or the Charitable Remainder Trust, all such transactions are simply prohibited.  As a result, the Charitable Remainder Trust is not permitted to sell, lease, loan, or allow any use of assets by the trust’s creator, contributor, trustee or their ancestors, descendants, or spouses.  For example, a donor could not contribute a house to a Charitable Remainder Trust and allow his daughter to live in the residence prior to its sale.  This would be a use of assets by a descendent of a contributor to the Charitable Remainder Trust and would thus be a prohibited act of self-dealing.  Self-dealing can result in disqualification of the Charitable Remainder Trust.
One of the defining characteristics of a Charitable Remainder Trust is that it is an irrevocable trust.  However, in some cases exceptions to this irrevocability have been allowed.  For example, the IRS has previously allowed for the premature termination of a Charitable Remainder Trust, with a distribution of the assets based upon the present value of all interests.  Note that this has been allowed previously, but is not a universally guaranteed option.  For example, the IRS would not want to authorize such divisions where the lifetime annuitant was aware of some health condition that substantially shortened his or her life expectancy.  In that case the calculated present value of the annuitant’s interest, based on normal life expectancies, would substantially overstate the value of the annuitant’s share.  Nevertheless, if both the annuitant and remainder beneficiary agree, such division might be possible.  The actual termination and distribution would likely require the intervention of a state court in order to circumvent the irrevocable nature of the trust agreement, because the trust itself is an entity created by state law.  Federal law establishes only the federal tax treatment of the trust, but cannot create or dissolve the trust.
Another example of creativity that received approval by the IRS in a private letter ruling dealt with the charity’s immediate need for funds to construct a building.  Normally, a Charitable Remainder Trust would not be useful for such needs.  The Charitable Remainder Trust typically pays nothing to the charity for many years or a lifetime.  As a creative way around this limitation, the Charitable Remainder Trust was authorized to segregate funds and pledge them as collateral for a loan taken out by the charity.  The lender was protected by the ability to seize the funds in the event of non-payment.  The charity was able to immediately build the building while planning to pay off the loan with the charitable gift received from the Charitable Remainder Trust at its termination.  In this way, the donor was able to see the impact of his gift immediately.
Charitable Remainder Trusts are, fundamentally, the most powerful complex tool available to gift planners.  Charitable Remainder Trusts can be part of even more powerful, and more complex, planning when combined with other trusts.  For example, a Charitable Remainder Trust can pay its remainder interest to a private family foundation with some part of the value of the charitable income tax deduction and annual payments used to purchase estate-tax-free life insurance through an Irrevocable Life Insurance Trust.  The flexibility and possibilities from Charitable Remainder Trusts are almost limitless.  This chapter simply paints the broad outlines for what is possible.  As complex as these arrangements can become, fundamentally, their purpose is to (1) trade a charitable gift for income and (2) reduce taxes.  Consequently, investigating the use of these instruments is warranted whenever a donor would like to make a substantial gift, receive income, and avoid income and capital gains taxes.

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