- Early Termination Of A Charitable Remainder Trust: Does Your CRT Need CPR or a DNR?
- January 15, 2005 | Author: Bradley J. Kalscheur
- Law Firm: Michael Best & Friedrich LLP - Milwaukee Office
During the "irrational exuberance" of the 1990's stock market increases, many clients created charitable remainder trusts (CRTs), which allowed them to make a tax-deductible contribution to a charity, while retaining a stream of income for themselves. Also, if grantors contributed low basis, high value stock to the CRT, the CRT was able to liquidate that appreciated stock and invest in a more diversified portfolio with no recognition of capital gain.
Overview of Charitable Remainder Trusts
By way of review, charitable remainder trusts come in two forms: annuity trusts and unitrusts. A Charitable Remainder Annuity Trust ("CRAT") pays a fixed sum to designated noncharitable beneficiaries for a fixed period of time (not to exceed 20 years) or for the lifetime(s) of the beneficiaries. The fixed sum must be at least 5% of the initial principal of the trust and cannot be greater that 50% of initial fair market value of the property placed in the CRAT. The annual payout is the same each year. Additional contributions to the trust are prohibited.
A charitable remainder unitrust ("CRUT") pays a fixed percentage amount of the trust assets valued annually to the beneficiary. Thus, payouts vary with annual investment results. The unitrust payout must be at least 5% of the trust assets and cannot be greater than 50% of the fair market value of CRUT assets valued annually. Additional contributions are permitted.
When property is transferred to a charitable remainder trust, there is no gift tax payable on the transfer if the donor or his or her spouse is the income beneficiary. The value of the charitable remainder interest must be at least 10% of the fair market value of the property transferred on the date it is contributed to the trust.
A CRAT is generally preferable where simplicity of administration is desired, or where the trust assets may be difficult to value from year-to-year. On the other hand, a CRUT permits future contributions to be made and creates a potential hedge against inflation for the unitrust recipient.
As long as the rate of return that the assets earned inside the CRT exceeded the amount that needed to be annually distributed to the grantor of the CRT, it was a win/win situation for both the grantor and the charity. For example, if the CRT was structured to pay out 8% annually to the grantors and the trust assets earned 9%, the 1% spread between the amount earned and the amount paid out to the grantors inured to benefit of the ultimate charitable beneficiaries.
As anyone with any stock holdings is well aware, in 1999 and 2000 the dot com bubble burst and the economy dipped into recession. In 2001, the terrorist attacks of 9/11 further caused investment returns to plummet to levels from which they are only now starting to return. As a result of the downturn, the investment returns earned by many irrevocable CRTs from the 1990's are not exceeding the annual required payouts to the grantors.
If grantors established charitable remainder annuity trusts (CRATs), lower investment returns are generating lower income. In order to pay the set dollar annuity each year, Trustees must dip into principal of the CRAT. In this situation, the grantors and the charitable remainder beneficiary may begin to wonder if there will be any principal left for the charity at the end of the CRT term.
If grantors established charitable remainder unitrusts (CRUTs) and lower returns cause the Trustee to dip into principal to make the annual payment, the donor may be receiving diminishing unitrust amounts each year. If the annual unitrust payment is based on a set percentage of the assets from the previous year, each year the principal is reduced, that results in a proportionate reduction in the unitrust amount.
Other situations in the grantors' lives may have changed to cause them to want to terminate a CRT. When the CRT was established, they may have needed the income stream, and now they may not need that income anymore. The donors may have wanted to "test drive" a charity by postponing a gift until the end of the CRT term, and they may now want to have those charities benefit immediately. A grantor may be serving as Trustee of the CRT and may not want to continue the administrative requirements (like investment of the funds and filing tax returns) related to the CRT. Or, the CRT may have served its purpose for removing a highly appreciated asset out of the grantors' taxable estate with little or no capital gains consequences.
Early Termination of a Charitable Remainder Trust
What to do with an underperforming, high percentage payout CRT, to save assets for both the grantors and for the charities, or a CRT that grantors just want to terminate for other reasons? One option is to terminate the CRT, through a procedure by which all the interested parties agree, which results in distributions to both the grantors and the charity. Such a termination may be made only if permitted under the law governing the trust. Wisconsin has a statute that permits such termination; Illinois does not. Alternatively, the CRT may be deemed terminated through assignment of the income interest from the grantors to the charitable remainder beneficiaries. If the income interest is to be assigned, the trust document must not contain a spendthrift provision that would otherwise prevent such assignment.
Upon the termination of a CRT, the Trustee distributes to the grantors or some third party the actuarial value of the annuity or unitrust interest (the "income interest"). The value is determined using the discount rate in effect under § 7520 on the date of termination. The balance of the CRT will be distributed to the charitable remainder beneficiaries.
Tax Treatment of Early Termination of a CRT
Although any termination takes the form of a distribution of the present values of the respective interests of the income beneficiaries and the charitable remainder beneficiaries, in substance it is a sale of the income beneficiaries' interest to charities (the remainder interest holder). The termination is treated as if the grantors are selling the income interest. The income interest will be considered a capital asset. The holding period for the assets in the CRT is carried over from the previous owners. Therefore, if the holding period is more than one year, any capital gain recognized on the "sale" will receive favorable long-term capital gains tax rates.
The amount realized by the grantors on the deemed sale of the income interest equals the present value of the remaining income interest. The cost basis used to determine the gain on disposition will depend on the recipient of the terminated income interest. The basis of the assets in the CRT is allocated pro rata between the income interest and remainder interest for purposes of determining any gain on the sale.
If the disposition is not part of a transaction in which the entire interest in the CRT is transferred to a third party (i.e. someone other than the grantors), the Treasury Regulations hold that the basis of the assets going back to the grantors will be disregarded, so the grantors will have zero basis when calculating the gain. Therefore, if the income interest reverts to the grantors, the entire present value of the income interest will be capital gain to the grantors. But, if the income interest is transferred to someone other than the grantors, which includes the charitable remainder beneficiaries, the cost basis will be the basis of the assets inside the CRT, which will reduce, if not eliminate, any gain on disposition.
Finally, if the income interest passes to a charity, either through contribution to the charity after it reverts to the grantors or if the grantors assign their interests in the income interest to the remainder charity, the grantors will receive both an income tax charitable deduction and a gift tax charitable deduction equal to the present value of the income interest. This deduction will be reduced if the grantors receive anything back from the charity, like a charitable gift annuity.
Example 1: John and Jane Doe, the Trustee of the CRT, and the remainder beneficiaries all agree to terminate the Doe CRT. The Does will receive the income interest on termination and the charity receives the remainder interest. The remaining income interest has a present value of $2,000, and the remainder interest has a present value of $4,000. The basis of the assets in the CRT is $3,000, which is allocated pro rata: $1,000 to the income interest and $2,000 to the remainder interest. The Does will recognize capital gain on the termination equal to $2,000 ($2,000 present value of the income interest less $0 basis because basis is disregarded).
Example 2: Same facts as Example 1, but instead of having the income interest revert to the Does, they assign it over to either the charitable remainder beneficiary or some other charity. In this case, the disposition is part of a transaction in which the entire interest in the CRT is transferred to a third party, therefore, the basis allocated to the income interest is not ignored in calculating any gain on the transaction. The Does will recognize capital gain on the termination equal to $1,000 ($2,000 present value of the income interest less $1,000 basis). They also receive an income tax charitable deduction of $2,000, which is subject to all the normal limitations on deductibility of charitable contributions.
Private Foundation Issues on Early Termination
Charitable remainder trusts are treated as private foundation for purposes of determining if they will be subject to certain excise taxes, including those for termination of private foundation status, self-dealing, and taxable expenditures.
CRTs, in accordance with their terms, are required to make mandatory annuity or unitrust payments to the grantors as holders of the income interests. If all parties to the CRT decide to have an early termination of the CRT and to distribute the trust property, this decision does not render the payment any less mandatory nor does it make this action discretionary with the Trustee. Accordingly, any proposed early termination of a CRT and the distribution of its property to the income and remainder beneficiaries will not constitute a termination of a private foundation.
A tax is imposed on any act of self-dealing between a private foundation and a disqualified person. The self dealing excise tax does not apply to any amounts payable under the terms of a CRT to income beneficiaries, and, for purposes of the self-dealing excise tax, an exempt organization, which includes most charitable remainder beneficiaries, are not disqualified persons. Thus, a proposed early termination of a CRT, and the early termination payments made to the income and remainder beneficiaries will not be acts of self-dealing.
A tax is imposed on private foundations for making "taxable expenditures," which include payments for other than their charitable purposes. A CRT's distribution to the charitable remainder beneficiaries will be an expenditure that is in furtherance of its charitable purposes. Therefore, an early termination of a CRT will not constitute a taxable expenditure.
If the grantors do not wish to administer the CRT any further, termination of the CRT is a viable option. The CRT is created by an irrevocable trust, therefore, care must be taken that such termination is done properly. If the grantors desire to benefit the same charity as the remainder beneficiary, the simplest method, if the trust allows, is an assignment of the income interest to the charitable remainder beneficiary.
Alternatively, if grantors wish to retain some form of income stream, either a new CRT could be created using the terminated income interest, or the grantors could take back a charitable gift annuity from the charities. As we approach year end, the termination of an unproductive or unwanted charitable remainder trust may be a good technique to maximize charitable deductions. Please consult your professional advisors if you would like to consider termination of any irrevocable trust.