In my July column, I commented on recently released reports indicating that there’s been significant growth in the number of charitable remainder trusts (CRTs) and similar deferred gifts created for the benefit of higher education institutions.
I noted that this surge was due in part to the recovery of the economy, particularly investment markets, but that much of the increase could also be traced to the arrival on the philanthropic scene of over 75 million baby boomers, now aged 48 to 67.
While studies indicate that the average age range of individuals entering into CRTs for lifetime terms is late 60s to early 70s, and the bulk of baby boomers haven’t yet reached that age threshold, there are also a number of interesting planning opportunities available through the use of these vehicles that can appeal to relatively younger donors who wish to create such trusts for a specific purpose that may not require the trust to last for the remainder of the settlor’s lifetime.
A Flexible Tool
Many personal planning issues can seem to preclude individuals from making six and seven figure charitable gifts during midlife and in later years due to a number of other financial responsibilities.
For example, donors may need to provide for: (1) additional income in pre-retirement years, (2) temporary assistance for children or other loved ones, and, increasingly, (3) financial support to cash-strapped aging parents or other loved ones of advanced years for the remainder of their lives.
By way of background, it’s important to note that CRTs can, under the terms of the Tax Reform Act of 1969, be created for the lifetime of one or more individuals or for a period of time not to exceed 20 years. It’s also possible, under Internal Revenue Code Section 664, to create CRTs for a combination of lifetimes and terms of years. For example, a trust can be created for the lifetime of one or more individuals or 20 years, whichever period is longer.
One other limitation that can affect the structure of CRTs is the fact that, since 1993, it’s necessary for the charitable remainder portion of a CRT to not be less than 10 percent of the amount placed in the trust. In the case of charitable remainder annuity trust (CRAT), there may also not be more than a 5 percent probability of the trust corpus being exhausted over the term of the trust under Internal Revenue Service tables.
Accelerating a Bequest
With estate tax exclusions of $10.5 million in 2013 for a married couple or $5.25 million for an individual, it’s important to note that many individuals who would otherwise leave a charitable bequest through a will or other testamentary plans might wish to accelerate their bequest through a lifetime transfer that results in current income tax and capital gains tax savings, in lieu of a testamentary gift that may or may not generate any estate tax savings due to the increased exemption levels.
For example, take the case of a 60-year-old individual with teenage children who are approaching college age. The individual may own highly appreciated securities that he wishes to liquidate and devote to funding education and/or living expenses for his children for a period of time adequate to see them through college and early adulthood, before they are on their own financially.
In that case, the individual may wish to create a CRAT, which will generate a fixed income for a period of time, funded with the securities. The securities can be sold inside the trust with no taxable capital gains tax payable at the time of the sale. As the children receive the payments from the trust, much of what they receive will be taxed at lower capital gains tax rates under the tier structure of income reporting that applies to income from CRTs.
Assume this individual places $1 million worth of appreciated securities with a $200,000 cost basis in a CRAT that specifies fixed payments of 7 percent, or $70,000, per year, to be split between two children for 10 years. The immediate charitable deduction for the gift would be $366,000, generating significant income tax savings over time. The children would each receive $35,000 per year for the 10-year period the trust is in existence.
If the trust earns a 7 percent net total return over that period, the amount remaining in the trust would still be $1 million at the end of the 10-year term. If the net total return on the trust assets was instead 5 percent, the remainder of the gift would be just under $750,000.
The $634,000 difference between the amount placed in the trust and the charitable deduction would be reportable as a taxable gift to the children. This amount could be offset against the new higher unified estate and gift tax exemptions.
An additional benefit would be the avoidance of federal capital gains tax of as much as 20 percent, taking into account new higher federal capital gains tax rates. The Medicare contribution tax of 3.8 percent of passive income would also be bypassed at the time of the gift. The combined savings could amount to $190,000 or more, depending on state tax rates and other factors. What will be accomplished, in effect, is making a large gift that might not otherwise be received by the charity, except as a bequest through a will or other long-range plans, while providing a tax-favored source of income for children for a period of time and an immediate, capital gains tax savings for the donor.
A Bridge to Retirement?
Take the case of another 60-year-old, who’s facing expenses, such as education, weddings and other financial needs from age 60 to 70, when he plans to begin taking significant withdrawals from his qualified retirement plans. He may wish to create a bridge to retirement by funding a trust similar to the one described above with the income instead being paid to the donor himself for the 10-year period of time prior to retirement. During that time, the funds in his qualified retirement plan can continue to build on a tax-free basis.
The donor may take the $1 million in securities and place them in a CRAT that would pay 10 percent for 10 years. The charitable deduction would be just over $100,000 and thus qualify under the IRC’s 10 percent minimum deduction requirement.
The donor would receive payments totaling $1 million over 10 years, the same amount placed in the trust. If the trust earned 6 percent and paid 10 percent, there would be over $470,000 remaining at the termination of the trust. The donor would benefit from avoidance of the capital gains tax at the time the trust is funded, while the $100,000 annual payments would then be taxed primarily as capital gains and/or return of principal on a tax-free basis.
Charitable Elder Care?
In another case, a 55-year-old donor finds himself responsible for the financial support of a substantially older parent, perhaps age 83. The donor may wish to use securities worth $1 million to fund a CRAT or charitable remainder unitrust for the parent’s benefit.
In the case of a 6 percent CRAT that paid $60,000 a year for the life of an 83-year-old parent, the charitable deduction would be $600,000. The parent would receive the income for the remainder of his life, estimated at just under eight years, followed by a significant charitable gift at the parent’s demise. The remainder might be used to fund an endowment or other gift in memory of the deceased parent. As in the case of the income for children described in the first example, there would be a taxable gift to the parent amounting to $400,000 that could be offset by a relatively small portion of the donor’s lifetime gift tax exemption.
This type of gift results in using the donor’s assets and the older parent’s life expectancy. From a charitable recipient perspective, the remainder of the trust can be expected to be received much sooner, an outcome that’s vastly preferable to the estimated 28 years that the charity would have to wait for the remainder of a trust funded for the life of a 55-year-old.
Creativity is Key
The examples discussed above show how CRTs for a term of years or the life expectancy of older individuals can be used to make significant and valuable gifts for the benefit of charitable recipients, while first meeting financial benefits of the donor and others that could otherwise preclude the completion of the gift.
Planners working with financially inclined individuals of all ages should be increasingly aware of the extensive flexibility possible in the case of split-interest charitable gifts in today’s environment.
If smaller amounts are involved, similar results may be achieved with other types of gift vehicles using amounts that are significantly less than would be required to fund a free-standing CRT.
For many reasons, I believe that CRTs structured in creative ways will increasingly be a vital component of the toolbox available to estate and financial planners as they consider how best to serve their clients in increasingly complex financial times.