Benefits of a Charitable Remainder Trust

By J. Kevin Meaders, Esq., a Georgia-based attorney and FreeWill Fellow

Charitable Remainder Trusts (CRTs) are sadly a very overlooked tax planning tool. Perhaps people are turned off by the word “charitable,” which may insinuate that the sole purpose of the trust is to benefit a charity. Though there is certainly a charitable component, the CRT is more of a tax savings tool that “borrows” a charity’s tax-exempt status to save on the following tax situations.

Capital Gains Taxes

For property and assets that have appreciated over time, capital gains taxes can consume almost a third of their value, in effect making the IRS and state governments a large part-owner of your asset.

For example, an asset with a long-term gain of $1,000,000 could be subject to up to $298,000 in taxes! And collectibles are taxed at an even higher rate.

Also note that there is an additional 3.8% federal Medicare tax on capital gain sales, and of course whatever taxes your state imposes.

Additionally, a large gain appearing on your tax return can increase the taxation of other income such as pensions, IRA distributions, dividends, and even social security benefits.

Estate and Gift Taxes

The estate tax exemption has changed frequently over the last three decades, ranging from $600,000 to over $12 million. The future value of the exemption is unknown, but taxation of an estate has historically been rather heavy, ranging from 40% to 55%.

The gift tax exemption has generally been the same as the estate tax exemption. In addition, there is an annual gift tax exclusion that must be used each year, or it is lost forever.

Collectibles

The Taxpayer Relief Act of 1997, while lowering the maximum capital gains rate on gains from the sale of most assets to 20%, left the maximum rate on gains from the sale of collectibles at 28%. On top of that, there is an additional 3.8% federal Medicare tax on collectibles, and whatever taxes your state imposes.

The types of assets considered collectibles are listed in the Internal Revenue Code under Section 408(m) and proposed regulations. Collectibles under this section include:

• Any alcoholic beverage
• Any rug or antique
• Any metal or gem
• Any work of art
• Any stamp or coin (with limited exceptions)
• Any other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m)

This last category has been used as a catch-all. If it is rare, it is likely a collectible. Case law is replete with taxpayers not claiming a collectible that was later deemed so by the IRS, resulting in additional taxes, penalties, and interest.

Depreciation Recapture

Owners of rental real estate or commercial property may have depreciated their buildings and improvements. Upon selling these properties, the owner will be required to recapture this depreciation (and pay taxes on it) in addition to any capital gain realized.

Your depreciation recapture is ultimately based on your normal income tax rate. Depreciation recapture is applied to any amount of your gain that can be attributed to the depreciation deductions you took previously. Additionally, if you are in a higher-than-average income tax bracket, you might also need to pay a 3.8% net investment income tax.

Required IRA Distributions to Beneficiaries

Prior to the passage of the SECURE Act in 2019, non-spousal beneficiaries of an IRA could “stretch” the decedent’s IRA based on their own life expectancy, providing significant tax savings to the beneficiary.

After 2020, this option is no longer available. Non-spousal beneficiaries are now required to distribute the entire IRA within a 10-year period. This is taxed as ordinary income on top of the taxable income the beneficiary is already earning, often driving their tax liability into higher brackets.

The CRT as a possible solution

The Charitable Remainder Trust is a tax-exempt, irrevocable trust that is funded by donated assets (usually highly appreciated) which pays income to individual non-charitable beneficiaries for a period of lives and/or years, after which the remaining trust assets pass to qualified charities you have selected, or your family’s Donor Advised Fund.

The Testamentary Charitable Remainder Trust (T-CRUT) is a special kind of trust created after your death where assets (usually a large IRA) are transferred to it tax-free. The trust then pays income to your chosen beneficiaries for a matter of lives and/or years, after which the remaining corpus (principal) transfers to charities you have selected, or your family’s Donor Advised Fund.

The popularity of the T-CRUT has soared since the passage of the SECURE Act in 2019, which essentially eliminated the “stretch IRA” for non-spousal beneficiaries, requiring complete payout over a ten-year period, with associated taxation. The T-CRUT is often used as a replacement for the stretch IRA since it allows many beneficiaries to receive payments based on their life expectancy.

Any assets transferred to a Charitable Remainder Trust are immediately removed from the taxable estate. This is also true of a Testamentary Charitable Remainder Trust. Both the CRT and the T-CRUT can be useful tools in reducing or eliminating estate and gift taxes.

Too Good to be True?

You would be surprised how often I get this question. The truth is that it is absolutely true.  In fact, it comes right out of the tax code: 26 U.S. Code § 664. The Charitable Remainder Trust provides significant benefits.

Benefits of a Charitable Remainder TrustCreated by Act of Congress in 1969Removal from the taxable estateClear IRS guidance and supportCurrent income tax deductionShelter from capital gains taxIncreased cash flow with favorable tax treatmentAsset protectionA meaningful charitable legacy instead of meaningless taxes

What’s the Catch?

When you study the inner workings of the Charitable Remainder Trust, you discover that essentially your bottom line commitment to charity is 10%. This is to say that when the trust is initially funded, there must be at least a 10% remainder interest left to charity at the end of the trust term, and that may not be for 50 years or more!

So essentially, you are trading all that tax liability today for a 10% charitable gift at some point in the future — perhaps 50 years hence. All the while, the trust is growing tax-free and income is being paid to you or your family. And you get to take a tax deduction today for your future charitable donation.

There are two drawbacks to a Charitable Remainder Trust

The obvious one is that it is irrevocable, and once assets have been transferred to the trust, you no longer have access to the entire principal. If your goal is to use the entire proceeds of the sale of your asset to buy a large ticket item, like a yacht or a horse farm, the CRT is probably not for you.

As with any irrevocable trust, the other drawback is that there are initial establishment expenses, and there is ongoing maintenance. The trust must be created by an attorney competent in irrevocable trusts, the assets need to be invested so that there is liquidity and no violations of various rules, annual tax forms must be filed, and four-tier accounting must be maintained by a CPA competent in Charitable Trusts. The annual maintenance costs (CPA, attorney, investment advisor) are generally paid by the trust itself after the initial trust creation. Finally, and perhaps the most difficult hurdle, each of these parties need to communicate, cooperate, and coordinate.