Many charitably inclined clients abstained from making significant outright donations to charity or creating or funding charitable remainder trusts (CRTs) during the recent economic and tax law uncertainty. They still may be reluctant to donate substantial amounts of assets outright, even with the ongoing economic recovery and limited increased clarity in income and transfer-tax laws.1 Clients may prefer instead to create or fund a CRT to retain the use or availability of their assets for cash flow “just in case” and have the trust property ultimately pass to charity.

While CRTs can be useful for transfer-tax planning, they typically are used primarily by charitably inclined clients who can benefit from income tax-efficient investing and increasing their current or deferred cash flow. These benefits can be especially attractive for those clients who want to sell a substantial appreciated concentrated asset and then diversify their holdings.

Many clients also were satisfied buying and holding long-term investments in a more stable economy. They now tend to reallocate investments more frequently to take advantage of opportunities in certain asset classes or sectors or manage risk due to volatility or geopolitical events. But reallocating assets usually triggers income tax consequences, so that's also why a CRT may be a good option. A CRT allows for tactical reallocations for purely investment reasons and dilutes any overriding concerns about triggering immediate income taxes.

Types of CRTs

The four main types of CRTs are charitable remainder annuity trusts (CRATs), charitable remainder unitrusts (CRUTs), net-income with make-up charitable remainder unitrusts (NIMCRUTs) and flip-charitable remainder unitrusts (FLIP-CRUTs). There's also a net income charitable remainder unitrust (NICRUT), which is less frequently used because it lacks the “make-up” feature of a NIMCRUT. Each CRT has its own economic advantages and disadvantages and is affected differently by a trustee's investment strategy and asset allocation. They all, however, have the following characteristics that may affect their economic efficacy:

  • CRTs are tax-exempt entities that have specific benefits and restrictions affecting their investment returns.
  • The trust's payout (rates and frequency) and term and the value of trust assets have a direct impact on investment strategies and asset allocation models.
  • Donors must consider the “10 percent rule” (that is, the present value of the charity's remainder interest must be at least 10 percent of the value of the property when it's contributed to the CRUTs and CRATs) and the “5 percent depletion rule” for CRATs2 (that is, when determining the payout rate to non-charitable beneficiaries).
  • CRTs can't or shouldn't hold certain types of assets due to adverse tax consequences (for example, unrelated business taxable income (UBTI)3 will incur an excise tax, or an S corporation will lose its S corporation status4).
  • Because the private foundation rule against self-dealing applies to CRTs,5 donors and trustees must consider which assets to contribute to the trust or which assets the trust should acquire.

Tax Implications

CRTs' unique income tax structure makes them effective for income tax and investment planning purposes. When the trustee sells a trust asset, the sale proceeds (not diminished by capital gains tax resulting from the sale) can be reinvested for greater distributions and overall return. A four-tier income tax structure dictates the income tax treatment for distributions from CRTs for the non-charitable beneficiaries in the following order:6

  • Ordinary income, to the extent of the trust's ordinary income for the current year and then undistributed ordinary income for prior years.
  • Capital gain, to the extent of capital gain for the current year and then undistributed capital gain (determined on a cumulative net basis) for prior years.
  • Other income (for example, tax-exempt interest), to the extent of that income for the current year and then undistributed income for prior years.
  • Trust principal.

Under this four-tier structure, income subject to the highest tax rate is deemed distributed before income subject to a lower tax rate. For instance, in the first tier, current interest income is deemed distributed before current qualified dividends. Then, undistributed interest income from prior years is deemed distributed before undistributed income from qualified dividends from prior years. Current short-term capital gain is deemed distributed before current long-term capital gain. And then undistributed gains from prior years are deemed distributed.

There are also rules for netting different classes of capital gains and losses. In each tax year, current and undistributed gains and losses within each class are netted to determine the net gain or loss for that class. The classes of capital gains and losses then are netted against each other.7 Investment advisors may consider tax loss harvesting to offset gains and losses from investment income in a particular tax year for each CRT, depending on a grantor's individual tax situation. The type of income and timing of realized gains have a direct impact on the tax treatment of distributions to the non-charitable beneficiaries.

A donor's contribution to an inter vivos CRT may provide an income tax deduction to the grantor (donor) for the present value of the charity's remainder interest. But a possible charitable income tax deduction of the present value of the charity's remainder interest tends to be a client's secondary motivation in funding a CRT. Testamentary trusts allow for a step-up in basis at the death of the testator/donor on unrealized gains (which reduces potential capital gains tax under the four-tier income structure).

UBTI

CRTs may invest in private equity and hedge funds primarily to enhance potential returns and diversify portfolios. CRTs may also own interests in business entities or other assets that may be considered an active trade or business. These interests can create potential tax problems — especially UBTI, which is gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it, less certain allowable deductions.8

Generally, investment income isn't subject to UBTI unless it's derived from debt-financed or debt-acquired property. If the investment is in a pass-through entity (for income tax purposes) that's an active trade or business or has debt-financed or debt-acquired property, then any allocations of income, gain, loss, deduction, credit and distributions are attributed to the charity as a partner or member of the entity.

After Dec. 31, 2006, a CRT can maintain its tax-exempt status even if it earned UBTI. However, a 100 percent excise tax is imposed on the entire amount of the UBTI and paid out of trust principal. Not only is UBTI subject to a 100 percent excise tax on the income, but also it's subject to the four-tier CRT income rules. The UBTI will be carried out as taxable income (for example, ordinary or capital gains) to the non-charitable income beneficiary in the current years.9 Therefore, a CRT presumably shouldn't own assets that generate UBTI, but there are times (due to the complexity of the law and nature of holdings) when CRTs may receive UBTI inadvertently. Some private equity and hedge fund managers structure certain funds to avoid UBTI to attract U.S. tax-exempt investors. Trustee and investment advisors should review any specific investment's offering plan that may address the UBTI issue.

CRUTs

CRUTs typically are used more than CRATs. Donors (typically the non-charitable beneficiaries) usually want increased payments over extended periods to keep pace with inflation. The payouts are based on the revaluation of trust assets on the first day of the tax year. Additional contributions can be made to the CRUT (unlike the CRAT) that can provide flexibility to modify asset allocation, increase payouts, reduce future capital gains or meet any capital calls for private equity. CRATs aren't used as often because they have fixed payments over the trust term that don't increase to meet inflation concerns.

How do you choose which type of CRUT to use? If your client needs current income, a CRUT may be suitable. Alternatively, a NIMCRUT or FLIP-CRUT may be more suitable if your client will or may need cash flow in the future. Let's look at each vehicle individually.

A client may choose a CRUT if he wants to receive increased payouts over the trust term. He therefore must consider the propriety of using the minimum 5 percent payout rate versus a larger payout rate (which provides larger distributions initially). The client may want to “optimize” the payout rate allowable under the 10 percent rule — but does a higher payout rate truly “optimize” payouts over time or satisfy your client's charitable inclinations? Remember, the higher the unitrust payout rate, the less that's available for charity. But the less obvious outcome may occur when trust assets diminish — will payouts decrease over the trust term due to higher payout rates on a smaller asset base, instead of lower payout rates on a larger asset base?

For instance, compare the median end wealth value and payouts for a $5 million CRUT with 10 percent, 8 percent and 5 percent payout rates for a 20-year period. (See “CRUT Scenarios,” p. 43.) A CRUT cumulatively distributes less with a 5 percent payout rate than with an 8 percent or 10 percent payout rate. However, the payouts for the CRUT with a 5 percent payout rate are greater towards the end of the trust term because more assets remain in the trust growing tax-deferred and then pass to charity.

Those distributions from a CRUT with a 5 percent payout rate are more likely to maintain or exceed their purchasing power than distributions from a CRUT with an 8 percent or 10 percent payout rate, because the asset base may be increasing more than the CRUT with the 8 percent or 10 percent payout rate (as shown in “CRUT Scenarios”). The inflation-adjusted payout value is more easily met with a CRUT with a 5 percent payout rate than a CRUT with a 10 percent payout rate. Not only will a CRUT with a high payout rate have more difficulty maintaining inflation-adjusted payouts, but also the asset base may fall below the original contribution amount. This situation may be more pronounced if there are downturns in the portfolio early in the trust term. Also, the disparity may be amplified for a CRUT with a high payout rate if the asset allocation is limited to lower growth and more liquid investments.

NIMCRUTs and FLIP-CRUTs

NIMCRUTs and FLIP-CRUTs typically are used if the donor wants deferred income for himself or his spouse. The donor uses the CRT as an income tax-efficient deferral vehicle to accumulate wealth inside the trust while deferring or reducing current income and income taxes. The income distribution to the non-charitable beneficiary presumably will be deferred until other sources of income (for example, compensation) diminish or terminate. A common situation is when the donor retires and then uses the distributions from the NIMCRUT or FLIP-CRUT to supplant or supplement his lost compensation. The CRT can be more tax-effective than a traditional qualified plan to help meet cash flow needs because the four-tier income tax structure tends to be more favorable than a traditional retirement plan's ordinary income tax treatment. Planning for deferred income trusts like NIMCRUTs and FLIP-CRUTs generally requires you to perform a greater review and analysis of your donor/client's circumstances, asset allocation, charitable inclinations, timing and amount of desired future distributions than when considering CRUTs.

The NIMCRUT's distributions are based on the lesser of net income or the stated payout rate in the CRT. To the extent net income in a tax year is less than the amount that would be attributable to the payout rate, the trustees credit the amount to a “make-up account.” If the income exceeds the amount attributable to the payout rate in a tax year, the trustee pays out the excess (to the extent of the amount in the make-up account) to the income beneficiary.10 Since the client's objective is to defer income and allow the trust property to grow, the trust property that the grantor donated or trustee invested in the earlier years typically is intended to generate little or no income. At some future time, the trustee can sell and reallocate the trust assets to generate more accounting income for the income beneficiary and receive additional income from the make-up account. The trustee then typically invests a larger portion of the portfolio in fixed income (at the detriment of growth) or dividend-generating stock to increase accounting income to then increase the payouts to the income beneficiary. The NIMCRUT's potential limited investment strategy and asset allocation may be challenging, depending on the investment environment. Yields on fixed income investments can vary significantly based on interest rates, risk tolerance and the investment's creditworthiness. These factors can cause significant reductions and inconsistencies in income from year to year. For instance, during 2009 and 2010, certain fixed income investments provided stronger returns than customarily expected for the asset class. During 2011, advisors anticipate returns to decrease significantly while risk may increase. A NIMCRUT's overweight allocation to fixed income may have significantly less returns and higher risk than a FLIP-CRUT's investment performance.

NIMCRUTs can be extremely flexible as to when the trustee can reallocate assets to provide more income to the income beneficiary. The efficacy of an income deferral feature can, in large part, depend on the definition of “income.” The definition of “income” in the governing trust document or under state law and the property contributed to or acquired by the trust, is pivotal to the planning. The Internal Revenue Service regulations and various state laws (typically under the Uniform Principal and Income Act (UPIA)) expand the definition of traditional accounting income. The regulations and UPIA allow the trust document to define post-contribution realized gain as accounting income11 or allow the trustee discretion to make that determination. Importantly, a client or trustee shouldn't take the decision lightly about how to define income, because a trustee will have to consistently use that definition of income12 during the entire trust administration.

If post-contribution realized gains are considered accounting income, it's more likely that in a given year, income will exceed the amount determined by the payout rate. Additional income then can be distributed to the income beneficiary from the make-up account. Even though a realized gain is considered accounting income, it's considered capital gains under the four-tier tax structure.13

Including these gains as accounting income usually is in the donor/income beneficiary's interest if the donor/beneficiary wants the maximum amount of income in future years. However, this approach reduces growth and income deferral if regular income recognition events will be paid as income. The trustee may determine that post-contribution realized gain shouldn't be considered accounting income based on the trust assets and desired deferral period. This conflict can be addressed by having a donor contribute non-managing member interests in a limited liability company (LLC) that owns underlying investment assets to a NIMCRUT or FLIP-CRUT. The income and gains can remain inside the LLC until the managing member distributes them to the NIMCRUT, and the trustee subsequently pays them out as income to the non-charitable beneficiary. If properly structured, the donor can avoid UBTI and excise tax or problems associated with self-dealing, jeopardizing investments and excess business holdings.

A FLIP-CRUT provides more investment flexibility than a NIMCRUT during the payout phase to the non-charitable beneficiary. Initially a FLIP-CRUT is a NIMCRUT that then “flips” to a standard CRUT on a triggering event stated in the trust document. The event can be a specific date, birth, death, retirement, marriage or sale of an unmarketable asset.14 The triggering of the event can't be at the discretion of the trustee, grantor or beneficiary.15 The grantor must be committed to a plan at the trust's creation. In contrast, the NIMCRUT allows for more flexibility regarding terminating the income deferral period.

The FLIP-CRUT becomes a standard CRUT on the first day of the tax year following the triggering event.16 When a FLIP-CRUT becomes a CRUT, the trustees have the benefit of investing for total return under modern portfolio theory to increase the portfolio's value, payouts to the non-charitable beneficiary and charity's remainder interest. The trustees and investment managers no longer are hampered by investing for returns and making payouts based on the definition of accounting income.

The make-up account is forfeited when the FLIP-CRUT becomes a standard CRUT.17 However, the period from the triggering event to the first day of the following tax year (when the trust becomes a CRUT) may provide an opportunity for additional income payouts to the non-charitable beneficiary. These payouts depend on the amount of the make-up account, whether post-contribution realized gain is accounting income (and if so, the amount of the gain), the nature of the trust assets and the non-charitable beneficiary's desire for a then-increased income payment, rather than greater accumulation of trust principal for growth and larger income payouts in future years.

Trustees and investment advisors should coordinate the asset allocation and specific investments with the definition of income to optimize the plan and be consistent with the grantor's intent. As with a NIMCRUT, it may be effective for a FLIP-CRUT (in the income deferral phase) to own non-managing interests in an LLC.

Trustees of NIMCRUTs and FLIP-CRUTs also may be interested in investing in certain alternative investments that are illiquid or non-income-producing assets. These illiquid investments typically are intended to have good long-term performance because they aren't managed to provide short-term liquidity for short-term payouts. As with all investments, trustees should be mindful of prudent investor standards. These investments — with certain limitations due to possible UBTI — can optimize the deferral strategy. However, some alternative investments (other than closely held business or real estate interests) require a trust to have at least $5 million in assets to satisfy the accredited investor and qualified purchaser rules.18

If a client is willing to commit to the “triggering event” in a FLIP-CRUT, then the trust typically will provide greater payouts to the non-charitable and charitable beneficiaries than a NIMCRUT. For example, “NIMCRUT vs. FLIP-CRUT,” this page, and “Asset Allocations,” p. 46, compare asset allocations, median cumulative payouts and median end wealth values of a NIMCRUT and a FLIP-CRUT (over a hypothetical 20-year period) funded with $5 million with a 5 percent stated payout rate. For the first 10 years, both trusts can invest for long-term growth resulting in minimal accounting income (around 1 percent) from the portfolio. (See Column B, “Asset Allocations,” p. 46.) The trusts can have post-contribution realized gains not deemed accounting income or investment assets owned by an LLC with minimal distributions made to the trust. At the end of the tenth year, an asset allocation overweight in fixed income (and less growth) and high-dividend paying stocks can be implemented for the NIMCRUT to increase accounting income and payouts to the income beneficiary. (See Column C, “Asset Allocations,” p. 46.) The FLIP-CRUT can invest for growth, total return and liquidity. (See Column D, “Asset Allocations,” p. 46.)

Other Considerations

Advisors (legal and investment) have growing concerns regarding concentrated positions in investment portfolios in fiduciary and non-fiduciary contexts. Courts are holding fiduciaries liable for failing to diversify in a timely and prudent fashion consistent with the Prudent Investor Act. There's a trend for investment advisors to create investment policy statements for clients (in fiduciary and non-fiduciary contexts) that clearly contemplate implementing a plan to diversify concentrated positions. CRUTs, NIMCRUTs or FLIP-CRUTs can be well suited to accomplish that objective in an income tax-efficient manner.

Too often clients, their advisors and trustees are averse to selling a low basis concentrated position in a short time frame because of capital gains tax consequences. The income tax consequences of divesting a CRT asset under the four-tier tax structure are less onerous and easier to accomplish than with traditional income tax treatment. When advisors are considering creating or funding various trusts on behalf of a client, it may be wiser to donate a concentrated position into a CRT rather than a traditional grantor or non-grantor trust. Not only can one avoid significant immediate income tax consequences, but also potential fiduciary liability.

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 increases the gifting opportunities of CRTs to non-spouse family members. Gifting a unitrust interest in a CRUT to a child without necessarily triggering a gift tax — due to the significantly increased gift tax exclusion and charitable deduction for the remainder interest — can be an effective gift to meet a child's cash flow needs with property ultimately distributed to charity.

The author thanks his colleague, Neil P. Murphy, senior vice president and investment strategist at U.S. Trust in New York, for his assistance and input.

This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. The content represents thoughts of the author and does not necessarily represent the position of Bank of America. U.S. Trust Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.

Endnotes

  1. Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, enacted Dec. 17, 2010.
  2. Internal Revenue Code Section 664(d)(2)(D) for charitable remainder unitrusts; IRC Section 664(d)(1)(D) for charitable remainder annuity trusts (CRATs); Revenue Ruling 77-374, 1977-2 CR 329 for the 5 percent CRAT rule (that is, there's more than a 5 percent probability that the trust property will be depleted before the property passes to charity).
  3. IRC Section 664(c).
  4. IRC Sections 1361(b)(1)(B) and 1361(c)(2)(A).
  5. IRC Section 4941.
  6. IRC Section 664(b).
  7. Treasury Regulations Section 1.664-1(d)(1)(iv).
  8. IRC Sections 512, 513 and 514.
  9. Treas. Regs. Section 1.644-1(d)(2).
  10. IRC Section 664(d)(3)(B); Treas. Regs. Section 1.664-3(a)(1)(i)(b)(2).
  11. IRC Section 643(b), Treas. Regs. Sections 1.643(b)-1 and 1.664-3(b)(3).
  12. Treas. Regs. Section. 1.664-3(b)(3).
  13. Treas. Regs. Section 1.644-3(a)(1)(i)(b)(3); IRC Section 643(b); Treas. Regs. Section 1.643(b)-1.
  14. Treas. Regs. Section 1.644-1(a)(7)(iii).
  15. Treas. Regs. Section 1.664-3(a)(1)(i)(d).
  16. Treas. Regs. Section 1.644-3(c)(2).
  17. Treas. Regs. Section 1.664-3(c)(3).
  18. An “accredited investor” is defined under Rule 501(a) of Regulation D under the Securities Act of 1933 and “qualified purchaser” is defined under Section 2(a)(51) of the Investment Company Act of 1940 and the rules thereunder.

Douglas Moore is a managing director of the Family Office of U.S. Trust, Bank of America Private Wealth Management in New York and co-chair of the Trusts & Estates Estate Planning & Taxation committee

CRUT Scenarios

Distributions with a lower payout rate are more likely to maintain or exceed their purchasing power

Scenario 1 2 3
Description CRUT CRUT CRUT
Term 20 years 20 years 20 years
Beginning assets $5,000,000 $5,000,000 $5,000,000
Annual payout formula 5% of portfolio 8% of portfolio 10% of portfolio
  value as of Jan. 1 value as of Jan. 1 value as of Jan. 1
Payout frequency Annually Annually Annually
Payout date End of year End of year End of year
Median end wealth value $8,110,954 $4,462,462 $2,966,943
Median cumulative payout $6,357,259 $7,586,147 $7,892,905
Median payout in 2011 $250,000 $400,000 $500,000
Median payout in 2020 $310,856 $380,052 $395,289
Median payout in 2030 $397,834 $360,828 $305,711

Assumptions:

  1. The investment strategy is designed to achieve long-term return opportunities through an allocation to equities, fixed income, real estate and commodities. The average annual anticipated rate of return for the strategy is 7.9 percent. See Column A, “Asset Allocations,” p. 46.
  2. No income tax is payable by CRUTs.
  3. Data as of April 2011.

This example is hypothetical and doesn't reflect specific strategies that may have been developed for actual clients. Charts are for illustrative purposes only. They aren't intended to serve as investment advice since the availability and effectiveness of any strategy are dependent upon individual facts and circumstances. Results will vary. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
— U.S. Trust

NIMCRUT vs. FLIP-CRUT

A comparison of these strategies

Scenario 1 2
Description NIMCRUT FLIP-CRUT
Term 20 years 20 years
Beginning assets $5,000,000 $5,000,000
Annual payout Lesser of prior year net Lesser of prior year net
formula: Years 1-10 income or 5% of income or 5% of
  portfolio value as of Jan. 1 portfolio value as of Jan. 1
Annual payout Lesser of prior year net 5% of portfolio
formula: Years 11-20 income or 5% of value as of Jan. 1
  portfolio value as of Jan. 1  
Payout frequency Annually Annually
Payout date End of year End of year
Median end wealth value $12,270,563 $13,472,995
Median cumulative distributions $5,789,408 $6,836,100

Assumptions:

  1. The investment strategy in the first 10 years for both CRTs is designed to optimize appreciation through an allocation to equities. The average annual anticipated return for the strategy is 9.0 percent. See Column B, “Asset Allocations,” p. 46.
  2. The investment strategy in Years 11-20 for the NIMCRUT is designed to optimize current income through a large allocation to fixed income. The average annual anticipated return for the strategy is 6.4 percent. See Column C, “Asset Allocations,” p. 46.
  3. The investment strategy in Years 11-20 for the FLIP-CRUT is designed to achieve long-term return opportunities through an allocation to equities, fixed income, real estate and commodities. The average annual anticipated return for the strategy is 7.9 percent. See Column D, “Asset Allocations,” p. 46.
  4. No income tax is payable by NIMCRUTs and FLIP-CRUTs.
  5. Post-contribution realized gain isn't deemed accounting income.
  6. Data as of April 2011.

This example is hypothetical and doesn't reflect specific strategies that may have been developed for actual clients. Charts are for illustrative purposes only. They aren't intended to serve as investment advice since the availability and effectiveness of any strategy are dependent upon individual facts and circumstances. Results will vary. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
— U.S. Trust

Asset Allocations

Compare the anticipated rates of return over a 20-year period for CRUTs, NIMCRUTs and FLIP-CRUTs

Asset Allocation A B C D
CRUT NIMCRUT/ NIMCRUT FLIP-CRUT
Years FLIP-CRUT Years Years
1-20 Years 1-10 11-20 11-20
U.S. large caps 30.0% 51.0% 10.0% 30.0%
U.S. mid caps 4.0 8.0 1.0 4.0
U.S. small caps 3.0 5.0 1.0 3.0
International developed 13.0 25.0 5.0 13.0
Emerging markets 6.0 11.0 2.0 6.0
Investment grade fixed income 29.0 0.0 61.0 29.0
International bonds 3.0 0.0 6.0 3.0
High-yield bonds 4.0 0.0 8.0 4.0
Real estate 5.0 0.0 4.0 5.0
Tangible assets (commodities) 3.0 0.0 2.0 3.0
Total 100.0% 100.0% 100.0% 100.0%
Anticipated rate of return 7.9% 9.0% 6.4% 7.9%

Data as of April 2011.

This example is hypothetical and doesn't reflect specific strategies that may have been developed for actual clients. Charts are for illustrative purposes only. They aren't intended to serve as investment advice since the availability and effectiveness of any strategy are dependent upon individual facts and circumstances. Results will vary. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
— U.S. Trust