Over the many years that I practiced, the popularity of the charitable remainder trust ebbed and flowed. Though always recognized as a versatile planning tool, CRTs were mainly touted as a vehicle for diversifying a highly appreciated asset on a tax-advantaged basis. Not surprisingly, CRTs were popular when clients had significant appreciation in their portfolios. Otherwise, not.
The Backstory as Told to the Client
In the context of a tax-advantaged diversifier, clients are told that instead of selling that highly appreciated, often low-yielding asset outright and incurring significant capital gains, they can transfer it to a CRT, where the trustee would sell it and reinvest the proceeds in a diversified portfolio. The CRT will pay out an income stream for the client’s life or a certain number of years. Thereafter, whatever remains in the CRT passes to charity.
And the tax advantages? With the caveat that the income, gift and estate tax treatment of CRTs is difficult terrain best traversed with a qualified tax advisor, which I’m not, here’s a decidedly non-technical overview. As a donor to a qualifying CRT, the client is entitled to an income tax deduction for the present value of the remainder interest projected to pass to charity. Then, when the trust sells the asset, the sale doesn’t trigger a capital gains tax at the trust level because the CRT is tax-exempt. So, all of the proceeds can be reinvested. The capital gains tax is, however, recognized by the donor over time as they receive the distributions, all according to a “tiered” system pursuant to Internal Revenue Code Section 664(b). While the CRT doesn’t eliminate the capital gains tax, it defers and spreads it out. When the donor dies and the remainder passes to charity, the estate tax charitable deduction or if the donor’s spouse will continue to receive distributions, a combination of the marital and charitable deductions, will alleviate the estate tax concern. It should go without saying that generalities won’t cut it here. Clients should ask their advisors to apprise them of the tax implications of the specific design they’re considering for their CRT.
Part Art, Part Science
The selection and design of the CRT are part art and part science. The art basically involves the client’s preferences for what they’d like the CRT to do for them over time. The science involves shaping the CRT to meet the technical rules that govern the qualification of the trust as a CRT. Among the many points to be covered with the client are:
- What asset should be contributed to the CRT, and what are the asset’s value and legal, economic and tax characteristics?
- Should you create a charitable remainder annuity trust or unitrust? Is the investment glass half full or half empty?
- Which charitable organization should receive the remainder, and what’s its tax status?
- What’s the term of the income interest, for example, the donor’s life, the lives of the donor and spouse, the lives of the donor and non-spouse or a term of years?
- What’s the payout rate? This depends on what the client is trying to accomplish with the CRT. For example, get their money back as rapidly as the rules permit or generate a lifetime of rising income. Asked another way, how charitable does the client want to be with the CRT?
- Who should be the trustee?
The client and advisors will want to see a comprehensive and detailed model or exhibit that shows the up-front deduction, the amount of the distributions, and their tax characteristics per the tiered system. All numbers and taxes aside, it’s critical that the client understands and acknowledges that the CRT is irrevocable and, what’s more, not their cookie jar! All they’re entitled to is the distributions. They can’t go into the trust for the children’s tuition.
Threshold Concerns
In practice, I found that clients were very interested in the numbers, meaning the CRT’s tax economics, and in seeing variations on the theme of the original design to be sure the CRT would meet their objectives. Eventually, they would sit back and say, “OK, we get it.” The question was whether the “We get it” would be followed by an “and” or a “but.” An “and” was tantamount to “Where do we sign?” Or “Let’s proceed.” More challenging were the “buts,” which generally were attributable to one or both of these concerns:
- “We’re not sure that the up-front tax benefits outweigh the loss of control of the funds.” If they raised that concern, they already knew the answer, meaning they weren’t willing to give up control of that kind of money just to get the deduction and avoid the up-front capital gains tax. The conversation was over.
- “Our children won’t be thrilled with this. It redirects a lot of their inheritance to charity!” That concern invoked the wealth replacement discussion addressed below. The wealth replacement discussion was always technically interesting but could also be laborious, sometimes causing clients to walk away from the project out of frustration.
Approaches to Wealth Replacement
With variations on the theme depending on the facts, circumstances and personalities in each case, a reasonable starting point for the discussion is to determine what the clients want to “replace.” So, clients and advisors will go back and forth about whether to factor in the impact of estate taxes on what the children would actually receive, projected growth in the asset’s value and so forth. Maybe the client sees this as an opportunity to enhance the inheritance for the children, meaning replace the asset and then some. At some point, the client will make the call. Let’s say the client wants to insure for the full value of what would go into the CRT.
The next step might be to take the client back to the cash flow exhibit and highlight how quickly the value of the transferred asset is projected to come back to them, meaning be replaced, through the distributions. Perhaps the client could use the distributions to fund generous annual exclusion gifts to the children. I found that the children liked this approach! But it involves two obvious caveats. First, depending on the CRT’s design, that projection’s just that, a projection. Second, the client has to stay alive long enough for the distributions to complete the replacement.
So, any clients who don’t want to leave the replacement to chance turn or are directed to life insurance. They can direct a portion of the payout to premiums on a policy that will assuredly “replace” the asset’s value for the children’s inheritance. When the client has a taxable estate, the common advice is to hold the policy in an irrevocable life insurance trust, commonly referred to in this setting as a “wealth replacement trust.” At this juncture, the conversation turns to the type of policy.
It’s a Hedge, not a Maze
Proponents of the insured approach will typically show a permanent policy such as whole life having, in our scenario, a face amount at least equal to the full value of the asset contributed to the CRT. But from a purely clinical risk management perspective, the purpose of the insurance is simply to hedge the risk of early termination of the client’s income interest. In that case, depending on the design of the CRT, the donor’s age and other factors, a 15 or 20-year term policy could be all that’s needed. Meanwhile, the client could start those annual gifts, accelerating the replacement process. But, the hedge with term insurance approach is inappropriate when the CRT and the life insurance are intended as parts of a broader, more enduring financial, estate and liquidity plan. That kind of plan calls for permanent insurance, period.
Opportunities
I found that clients appreciated learning about CRTs and how their tax advantages and flexibility of design could enable them to play an important role in their planning, well beyond asset diversification. That’s no doubt still true today. And with some appreciation in clients’ portfolios these days, CRTs could be back on the table.
What’s also true is that CRTs, and charitable planned giving generally, offer advisors outstanding opportunities to develop their technical skills, broaden their service delivery to clients and network with other advisors, including planned giving professionals at local and national charitable organizations.
