Developing a tax strategy that allows for income and current income tax benefits is a key goal for many individuals and families. One potential solution to this challenge is to establish a charitable trust.
These trusts can offer donors the ability to make a charitable gift while retaining an income stream from the donated assets, and may also provide an immediate charitable income tax deduction for a portion of the value of the assets transferred to the trust.
Among the various types of charitable trusts, NIMCRUTs are considered by many to be the “best of the best” in terms of tax planning due to their unique features, which include a make-up provision that allows for future adjustments if the trust’s annual income payments are less than the required minimum amount. However, as with any financial strategy, there are potential pitfalls to be aware of when establishing a NIMCRUT or any other type of charitable trust. In this article, we will explore the benefits and potential drawbacks of charitable trusts, with a particular focus on NIMCRUTs, and provide guidance on how to navigate these complex financial instruments to achieve your financial and charitable goals.
About Charitable Remainder Unitrust
A Charitable Remainder Unitrust (“CRUT”) is a type of irrevocable trust that allows a donor to make a charitable gift while retaining an income stream from the donated assets. It is similar to a Charitable Remainder Annuity Trust or CRAT.
When a donor establishes a CRUT, they transfer assets to the trust, which are then managed by a trustee. The trustee invests the assets and pays the donor (and/or other designated beneficiaries) a fixed or variable income stream for a specified period of time, which is typically the lifetime of the donor. At the end of the trust term, the remaining assets in the trust are distributed to one or more designated charitable organizations.
The amount of income that the donor receives from the trust is based on a fixed percentage of the trust assets, which is determined when the trust is established. The donor receives a charitable income tax deduction for the present value of the charitable remainder interest in the trust, which is the amount that is expected to be paid to the designated charity at the end of the trust term.
CRUTs offer several potential benefits to donors, including the ability to:
- Receive a steady stream of income from the donated assets while still making a charitable gift
- Avoid or defer capital gains taxes on appreciated assets that are transferred to the trust
- Receive an immediate charitable income tax deduction for a portion of the value of the assets transferred to the trust
- Support charitable causes that are important to the donor
However, there are also some potential downsides to consider, such as the fact that the assets in the trust are irrevocably transferred and cannot be returned to the donor, and the possibility of reduced income payments if the trust investments underperform.
The last point above, about underperforming assets is where NIMCRUTs come in. The “Net Income Make-Up Provisions” or “NIMCRUT” is a type of charitable remainder unitrust.
With the NIMCRUT, the donor transfers assets to the trust, receives a partial tax deduction for the charitable contribution, and then receives income from the trust for a specified period of time as with other CRUTs. The income payments can be fixed or variable, but they must be at least 5% of the initial fair market value of the trust assets.
The NIMCRUT differs from a traditional CRUT in that it includes a “make-up provision.” Under the make-up provision, if the trust’s annual income payments to the donor are less than the required minimum amount, the trustee can “make up” the difference in future years when the trust generates more income than the required payment. This allows the donor to potentially receive higher income payments in the future if the trust performs well.
Structuring the NIMCRUT
NIMCRUTs often hold a variety of assets. The idea is typically to invest in growth assets during the donor’s accumulation years and then sell the assets and/or invest in income assets during the donor’s retirement years or when the donor wants to receive income.
This allows the trust to have little or no income during the donor’s accumulation years, resulting in little or no trust distributions during those years. When the donor begins receiving income they are able to receive the amount stated in the trust plus an additional amount to make up for the underperforming years.
This can allow prolonged tax-free build-up, current income tax deductions and a steady stream of income when the donor desires. This timing is most often achieved by investing in zero coupon bonds, partnerships or LLCs, or even variable annuity contracts. The partnership, LLC, and variable annuity contract options allow the trustee to turn the investment income on and off at will, which allows the trustee to most effectively make distributions when most appropriate for the donor.
Potential Problems With NIMCRUTs
Remember that most NIMCRUTs are established with appreciated property, which when sold by the trust does not result in capital gain for income tax purposes. Thus, the gain is typically appreciation that occurred before the trust was established. The regulations prohibit such gain from being allocated to trust income, regardless of whether the state allows the trustee to allocate the gain from trust principal to trust income.
This is where the NIMCRUT can fail. The NIMCRUT may have no trust income or items that can be allocated to income or it may have a very short term for the trust so that it is impossible to time the distributions in a way that benefits the donor, as would otherwise be the case.
There can be other investments that pose issues. The NIMCRUT may invest in variable annuities, which result in ordinary income when they are paid out. In these instances, the donor is giving up the option to pay a lower capital gains tax currently in exchange for tax deferral and a higher ordinary tax at a later time. This can be particularly problematic for older clients or for trusts with shorter maturities. This is even more problematic in that all of the annuity income in such situations is fully taxable, rather than it being partially taxable and partially a return of basis as when individuals own and receive annuity income.
CRUTS and NIMCRUTs offer donors the ability to make charitable gifts while retaining an income stream from the donated assets. While CRUTs provide donors with a fixed or variable income stream for a specified period of time, NIMCRUTs include a “make-up provision” that allows for future adjustments if the trust’s annual income payments are less than the required minimum amount. Both types of trusts have potential downsides to consider, such as the irrevocable transfer of assets and the possibility of reduced income payments. It is essential to consult with a qualified tax attorney before establishing a charitable trust to determine which type of trust is most appropriate for one’s financial and charitable goals.