In this month’s article, we will delve a bit deeper into the design of a Charitable Remainder Trust (CRT) and how some of the design elements can customize your trust more specifically to your needs. We see in our little chart above that the CRT would provide a future gift to charity, it is a complex strategy and can have both Income Tax as well as Transfer Tax advantages. As mentioned in last month’s article, there are strict IRS regulations that govern how a CRT must be drafted and designed. However, there are some nuances that can be built into trust documents to provide some flexibility and to customize the trust to your specific needs. We’re reminded of that complex IRS calculation that must be done when the trust is established to determine that its design meets the criteria to be valid as a CRT and therefore provide the tax advantages the donor is seeking. Under IRS rules, the CRT must be designed to pay out income to a non-charitable income recipient (frequently the donor) at least annually during the term of the trust. The percentage amount the trust pays out annually must be between 5% and 50% of trust value. When determining the payout percentage amount for your trust, the first thing to keep in mind is that IRS calculation that is going to tell you whether what you are designing meets regulations. There is calculation software available that legal, tax, and trust services professionals use to do this calculation. One variable that goes into the calculation is the payout percentage amount. Another is the term of the trust – how long it is going to last before paying the remainder amount out to the charity. The third variable is an interest rate that is set monthly by the IRS and is related to the current prevailing interest rates.
The term of the trust is frequently tied to the lifetime of the income recipient, so it would pay income to that person (frequently the donor) during the term of the trust and then pay out the remainder to the charitable beneficiary at the death of the income recipient. It is also possible to create a trust that has a term of a specific number of years, not to exceed 20 years. When you have a younger donor with a lifetime payout to himself (a longer trust term) that could impact how high you could push the payout percentage amount – and in fact, it may not be possible to design a valid trust for a younger income recipient with a lifetime payout. Typically, an older donor/income recipient (shorter life expectancy) may be able to design a valid CRT with a higher annual payout than one for the younger person. When you are working within a low interest rate environment, as we have now, that third variable (the monthly IRS-established rate) is also going to drive down the amount you can choose for your annual payout.
As mentioned last month, this calculation arrives at how much the donor can claim as an income tax charitable deduction when a gift is made into the trust. Remember, the IRS is looking out for the charity here. Depending on interest rate conditions, it may be possible to design a valid trust with a higher payout percentage amount (as an example a 10% annual payout) and a relatively long term, however that’s going to drive down the amount of Income Tax charitable deduction that may be claimed. And, if your trustee is paying out 10% of the trust value every year to the income recipient, you need to also consider whether the investment performance of the trust portfolio is going to be able to keep up with that payout amount. The trustee has a fiduciary mandate to manage the trust portfolio prudently and in the best interest of the trust. If, as an example, a trust is paying out 10% annually, but with prudent management of the trust portfolio, it is only earning a net 5% annually, the trust is going to be depleting through its term. This may be something that the donor is perfectly happy to experience. However, in many instances, the donor who is also the income recipient is counting on that trust income to help fund retirement income needs. Having trust income that depletes each year may present a serious concern for the donor/income recipient. In my years of working as a trust services professional and collaborating with attorneys and CPAs designing CRTs, I was typically comfortable with a CRT designed to pay out something in the range of 5% - 6% annually. Taking into consideration that the trustee needs to prudently manage a trust portfolio that may hopefully show slight growth each year, therefore a little increase in income, something in the range of a 5% - 6% payout seemed prudent. Obviously, donors need to work closely with licensed tax and legal advisors who are well versed in working with these specific strategies, and engaging a professional trustee to administer this complex trust is highly recommended. And, of course, in a fluid investment market, the performance of a trust portfolio cannot be guaranteed.
To recap our lesson for this month, when working with licensed tax and legal counsel to design a Charitable Remainder Trust that best meets your individual needs, there are some nuances that can be built into a trust document. Keep in mind that it must be designed such that it meets IRS regulations. In the current low interest-rate environment, you have less flexibility in designing a specific valid CRT and it is possible, given the terms of the trust you want, that the trust would not successfully pass that IRS test – the calculation that determines it is a valid CRT. Next month, we will continue to delve into some more design considerations when creating a CRT.
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Bonnie Lane, Verde Volunteer
Member, Board of Directors
NAZCCA is not licensed to give legal or tax advice and any planned giving strategies you choose to pursue should be discussed with licensed tax and legal counsel