Charitable giving is often an important part of an individual’s tax and estate planning strategy. One popular vehicle for charitable giving is a Charitable Remainder Trust (“CRT”), which can provide significant tax benefits for the donor and a stream of income for non-charitable beneficiaries during their lifetime.
CRTs are valid, they can have some tax savings and should be considered for those who have charitable intentions.
The concepts around CRTs are straightforward. There are some variations and terminology used in the industry that make these trusts sound more complex than they are. There are also some tax promoters who take positions that result in “too good to be true” scenarios involving CRTs which can make it difficult for those who are considering CRTs to research them and see whether they might be a right fit.
The recent Gerhardt v. Commissioner, 60 T.C. No. 9 (2022) provides an opportunity to consider the rules for CRTs. In this case, the U.S. Tax Court considered whether distributions from the CRT were ordinary income for the beneficiaries and, in doing so, it explains how CRTs are taxed.
Facts & Procedural History
The Gerhardts learned about using Charitable Remainder Annuity Trusts (“CRATs”) for wealth preservation in 2015 and formed several CRATs with the assistance of a tax advisor.
Each CRAT had several charitable remaindermen and required the trustee to pay the beneficiaries an “Annuity Amount” for five years.
The CRATs sold contributed properties and used the proceeds to purchase Single Premium Immediate Annuities (“SPIAs”), which paid the grantors an annuity for two years. The CRATs reported the annuity payments as distributions to the grantors on Form 5227 and issued Schedules K-1 to the grantors, reporting only the interest income received.
The IRS audited their returns and determined that all the payments received by the grantors from the CRAT-funded annuity were ordinary income to them and issued notices of deficiency for 2016 and 2017, increasing their gross income.
About Charitable Remainder Annuity Trusts
The CRAT may sound like a complex arrangement. It really isn’t any more complex than other trusts. A trust is just an agreement to hold title to property for another and the arrangement is typically evidenced by a written document. The trust is treated as a separate entity from the parties for most purposes, including tax purposes.
A CRAT is just a type of trust that allows individuals with substantially appreciated capital gain property to make a charitable donation while still receiving a stream of income during their lifetime. The lifetime income is funded by having the trust purchase an annuity (compare this to a charitable remainder unitrust or CRUT).
The trust is set up so that a specified amount, at least annually, is paid to the grantor or other designated noncharitable beneficiaries for a predetermined period of time. After this period, the remaining assets in the trust must be transferred to one or more qualified charitable organizations. The trust is irrevocable, so there are only limited opportunities to change it once it is set up.
When appreciated property is transferred to a CRAT, the grantor recognizes no gain. This is just a function of the standard trust rules. Contributions to a trust do not trigger income tax. The transfer can trigger a sizeable charitable deduction for the grantor. This is computed based on the value of the property that will eventually go to the charity, which is determined by an appraisal.
Tax for the CRAT & Beneficiaries
The trust is tax-exempt. It pays no income tax. Therefore, if a CRAT sells appreciated property that it receives from the grantor, it can do so without itself paying tax on the sale.
However, noncharitable beneficiaries of the CRAT must pay tax with respect to distributions from the trust. Congress has established specific ordering rules for the characterization and reporting of annuity amounts distributed by a CRAT to its income beneficiaries.
The distributions from a CRAT to income beneficiaries are deemed to have the following character and to be distributed in the following order: ordinary income, capital gain, other income, and nontaxable distribution of trust corpus. By following these ordering rules, the income beneficiaries of the CRAT can determine the appropriate tax treatment of the distributions they receive from the trust.
To ensure compliance with the statutory ordering rules, CRATs are subject to strict reporting requirements. A CRAT must file an annual information return on Form 5227 and issue a Schedule K-1 to each income beneficiary, properly describing the tax character of all distributions each year.
Investments in the CRAT
A CRAT provides the donor with a fixed income stream for life or a specified term of years, with the remainder going to charity at the end of the term. One way to generate that fixed income stream is to invest in a Single Premium Immediate Annuity or SPIA.
An SPIA is an insurance product that provides a fixed, regular income payment in exchange for a lump sum payment upfront. By investing in an SPIA, the CRAT can guarantee a fixed annual payment to the non-charitable beneficiary for the term of the trust. This allows the donor to receive a stream of income from the trust while also benefiting a charitable cause.
Investing in an SPIA can also provide the CRAT with some benefits in terms of tax efficiency. For example, the portion of the annuity payment that represents the return of the CRAT’s principal investment is tax-free, while the portion that represents earnings is taxable as ordinary income to the non-charitable beneficiary. Additionally, since the CRAT is a tax-exempt entity, it can receive the full value of the annuity payment without any tax liability.
The Carryover Tax Basis Issue
The grantors in this case contended that the fair market value of the appreciated property was the appropriate measuring stick. The IRS and court concluded that the grantor’s basis, which transferred to the CRAT, was the relevant number.
This involves Section 1015 and the carryover basis rules. This section says that the contribution of appreciated property to the trust is the lower of the fair market value or the grantor’s basis. Using the lower basis amount results in a larger gain for the trust.
This is important as it dictates the gain that is computed by the CRAT when it sold the appreciated property. While the CRAT did not pay tax on the gain as it is a non-profit entity/trust, the gain is considered in the ordering rules for the trust distributions.
Once the trust made distributions, it had to apply the ordering rules. With the higher gain amount noted above, this resulted in the distributions being treated as ordinary gains to the beneficiaries. The court rejected the grantors’ low-basis argument but had it accepted it, the distributions would have been tax-free to the beneficiaries as you work thru the ordering rules and get to the last item, i.e., a tax-free return of trust property.
Non-Tax Considerations for CRTs
When creating a CRAT, there are several non-tax issues that individuals should consider, including:
- Asset allocation: The assets that are placed in a CRAT will determine the income stream that the individual will receive. It is important to carefully consider the asset allocation to ensure that the income stream is sufficient to meet the individual’s needs.
- Selection of trustee: The trustee of a CRAT will be responsible for managing the assets and distributing income to the beneficiary. It is important to select a trustee who is experienced and trustworthy.
- Charitable organization selection: The charitable organization that will receive the assets from the CRAT should be carefully selected. It is important to choose an organization that aligns with the individual’s values and has a strong reputation.
- Investment strategy: The investment strategy for the assets placed in a CRAT should be carefully considered. It is important to choose an investment strategy that will generate sufficient income while also preserving the principal.
- Duration of the trust: The duration of the CRAT should be carefully considered. Individuals should determine how long they want the trust to last and when they want the charitable organization to receive the assets.
- Charitable beneficiary restrictions: Some CRATs may have restrictions on the types of charitable organizations that can receive the assets. It is important to carefully review any restrictions to ensure that they align with the individual’s values and goals.
Overall, individuals should carefully consider these non-tax issues when creating a CRAT to ensure that the trust is structured in a way that aligns with their goals and values.
Cases like this give CRTs a bad name. CRTs were not intended to provide a “too good to be true” outcome when it comes to taxes. They do provide significant tax benefits to grantors. These trusts allow grantors to receive an upfront charitable deduction and defer recognition of capital gains on appreciated property transferred to the trust. While the distributions received by noncharitable beneficiaries are subject to ordinary income treatment, grantors can still time their distributions to minimize tax liabilities in lower-income years. While there may be drawbacks in terms of tax rates, the benefits of a CRT should not be overlooked. Those with charitable intentions should consider CRTs as part of their tax and estate plans.