1. Overview: Advantages and Requirements.Generally, charitable remainder trusts (CRT) are created because of the tax advantages that they offer. The grantor may be eligible for charitable income, gift, and estate tax deductions. In addition, a CRT is exempt from income tax and is not taxed on any gain realized from selling appreciated trust assets. Therefore, assets yielding low earnings but subject to high capital gains if sold, may be placed in trust, sold by the trustee, and reinvested. In so doing, the grantor avoids any capital gains tax and may pass on increased earnings to the beneficiaries of the CRT. There are two fundamental requirements that must be met in order for a trust to qualify as a CRT.

    First, a grantor, the trust creator, must designate certain assets to be held in trust for charitable or public purposes. Upon termination of the trust, the remaining trust assets must either be held in continuing trust for charitable purposes or paid to or for the use of a qualified charitable organization. The remaining trust assets must be at least 10 percent of the initial fair market value of the trust assets.

    Second, the grantor must assign one or more beneficiaries the right to receive the income from trust assets. One of the beneficiaries must be a noncharitable beneficiary and payments to the beneficiaries must be made at least annually. The payments may be made for the life of the beneficiary or for a term not to exceed 20 years. If a beneficiary is a corporation or other entity, the term of payment cannot exceed 20 years. Payments to the beneficiaries may not be less than 5 percent or more than 50 percent of the initial fair market value (FMV) of the trust assets. There are various methods used to determine the annual amount paid to the beneficiaries. CRTs are characterized as either charitable remainder annuity trusts (annuity) or a charitable remainder unitrusts (unitrust) based upon the method used to determine beneficiary payments.

  2. Charitable Remainder Annuity Trust.An annuity trust must pay at least annually a sum certain, which may be stated as an absolute dollar amount or as a percentage of the initial net FMV of the trust assets, to one or more beneficiaries. A sum certain is a fixed amount that does not change over the life of the trust. Consequently, an annuity may not receive additional future contributions to the trust corpus. Generally, annuity trusts are created when the trust assets are likely to depreciate or in periods of deflation in order to ensure the best possible return to a noncharitable income beneficiary.
  3. Charitable Remainder Unitrust.Under a unitrust, the beneficiaries are paid a fixed percentage of the FMV of the trust assets, valued annually. The payments to a beneficiary from a unitrust fluctuate with changes in the FMV of the trust property. A unitrust may receive additional future contributions, increasing trust assets. There are various types of unitrusts and choosing the appropriate type of unitrust in part will depend upon the grantor’s individual circumstances. Types of unitrusts include: (i) the standard unitrust; (ii) the income only unitrust; and (iii) the capital gain unitrust.

    A standard unitrust pays the beneficiary a fixed percentage based on the FMV of the trust property, valued each year.

    An income only unitrust pays the beneficiary the lesser of the net income from the unitrust or the fixed percent. This type of unitrust may also include a make up provision. The income only unitrust with a makeup provision allows for a payout to the beneficiary if the income for any year exceeds the unitrust amount for the year (the stated percent) and there was a shortfall in payment in a previous year. In addition, either an income only unitrust or an income only unitrust with a makeup provision may provide that upon the happening of a certain event or date that the trust will covert to a standard unitrust. However, a unitrust may not use more than one type of method for determining payment during any calendar year.

    A capital gain unitrust recognizes capital gains as income. The capital gain unitrust applies only to unitrusts with an “income only” feature and is subject to several requirements. Generally, capital gain may be recognized as trust income if the trust instrument defines trust income to include capital gains and state law does not prohibit it.

  4. Taxation.The IRS requires all CRTs to adopt a calendar year for the purposes of filing taxes. Therefore, a tax return, form 5227, must be filed on or before April 15.

    A beneficiary is taxed on the income receive from a CRT. Payments to a beneficiary retain the same tax character as when it was held by the trust. Therefore, tax-exempt income realized from trust investments and distributed to the beneficiary retains its exempt status in the beneficiary’s hands. The IRS has developed rules for determining the order in which certain types of income are distributed to a beneficiary. Payments from a trust amount are considered to be made first from ordinary income, second from capital gains, third from other income, including tax exempt income, and fourth from trust corpus. Therefore, all trust amounts paid to a beneficiary are treated as ordinary income to the extent of the trust’s ordinary income for that year and any previous years until that category of income is exhausted; payments are then characterized as capital gain and then continue down the scale.

  5. Appointing a Trustee.A grantor must appoint a trustee, a person responsible for the operation of the trust. The grantor may reserve the powers to remove any trustee, to appoint another trustee, and to change the future order of succession of trustees at any time. However, a trust does not qualify as a CRT if the trustee is hindered from investing the trust assets in a manner which could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of trust assets. A grantor cannot require a trustee to invest solely in certain types of property or to otherwise restrict a trustee’s ability to make investment decisions.

    A grantor may serve as trustee of a CRT, however, there are certain limitations. The IRS has outlined circumstances under which a grantor is treated as the owner of a trust. If a grantor is treated as an owner, the trust cannot qualify as a CRT. A grantor is treated as an owner when the grantor retains certain powers including the power to allocate payments among beneficiaries. In addition, because trust assets must be valued annually, if a grantor serves as trustee, all trust assets must have an objective ascertainable market value. Therefore, a grantor serving as trustee should avoid funding the trust with assets that are difficult to value such as real estate, tangible personal property or corporate stocks. A charitable remainderman, institutional trustee, such as a bank or trust company, or an individual, other than the grantor, may also serve as trustee if not prohibited by state law.

    A trustee’s commissions is paid out of the trust assets and cannot be paid out of the annuity or unitrust amount used to pay the beneficiaries. The payment of the fee in an annuity trust does not affect the amount of the annual annuity payment but will reduce the amount ultimately available to the charitable remainderman. The payment of the fee in a unitrust will reduce the net value of the trust assets, thereby reducing the amount of the annual beneficiary payment.

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