The client has an investment that is about to come to fruition.  It could be family property that is about to be sold for a fortune.  It could be the Coca-Cola stock the client inherited from his or her grandparents.  It could be the aggressive investment that is about to pay off handsomely in the short run.  The client calls the tax advisor to find out how bad it is going to be, and the news is grim.  If the property is sold, the client will take a haircut between 20% and 40%, federal and state. 

The client had hoped to retire on this money, and maybe to create a legacy for a favored charity.  The savvy advisor tells the client about the charitable remainder trust.

The Mechanics

A charitable remainder trust is the mirror image of the charitable lead trust that appeared in the February issue.  The client contributes the appreciated property to the trustee of the charitable remainder trust.  The trustee sells the property and reinvests the proceeds in an appropriate investment portfolio.  With the earnings from this portfolio, the charitable remainder trust pays an annuity for a number of years to the client or to a member of the client’s family.  The annual payment is sometimes a fixed amount, but is usually recalculated annually as a set percentage of the trust’s current value.  At the end of the annuity term, the rest of the money in the trust is paid to a qualified charity of the client’s choice.  The actuarial value of this payment must be at least ten percent (10%) of the value of the contributed property. 

The Tax Treatment

The trust is income tax exempt, so the sale of the appreciated property generates no income tax.  The trustee reinvests the entire proceeds of the sale, unreduced by the 20% to 40% income tax haircut.  This means that the entire value of the appreciated property is available to generate future earnings for the client’s benefit. 

In addition, the IRS allows the client to take a charitable deduction right now for the value of the future payment to charity.  The IRS calculates that value based on prevailing interest rates, the amount of the annuity payments, and the number of years the payments last. 

The Net Income Make-Up Trust

What if the income from the investment portfolio is insufficient to cover the annuity payment in any given year?  Must the trustee dip into the trust’s principal to cover the obligation to the client?  It is possible to set up the trust so that the trustee pays the client the lesser of the trust’s income or the annuity payment amount.  Since this can result in unfairness to the client, additional clauses can be added to the trust agreement which allow the trustee to make up any shortfall.  In years when the trust income exceeds the required annuity payment, the trustee can pay out the “extra” income to the extent of any previous years’ deficits.  This is called a net income make-up trust. 

The Private Foundation

The client need not be satisfied with the payment of the trust’s remaining funds to just any charity.  The client can establish his or her own personal charity, called a private foundation, to receive this money.  The foundation can continue to invest the money as a sort of family controlled charitable endowment.  So long as a reasonable amount of portfolio earnings are actually distributed to charity every year, the private foundation can qualify as a charity.  There are strict rules on such foundations to prevent their funds from being used for the benefit of the client or the client’s family.   

The Disadvantage

The biggest disadvantage of the charitable remainder trust is that it requires a very real dedication of a large sum of money to charity.  The client can keep the earnings for a while, but ultimately this fund is “lost” to the client and the client’s family.  Unless the client’s investment advisors can produce a phenomenal rate of return, consistently, for a long period of time, the charitable remainder trust is not a money making proposition.  It is a helpful technique to make a substantial gift to the community.

The Bottom Line

The most important factor in considering a charitable remainder trust is the client’s intent.  If the client is at all inclined to make a charitable gift, this is an excellent vehicle to shelter a substantial gain, to provide income for a period of time, and to make the world a better place.  If we can help you or your clients in that effort, please give us a call. 

J. Kevin Crain

CRAIN LAW FIRM, LLC

636-G Long Point Road #95

Mt. Pleasant, SC 29464

Phone (843) 735-7602

Fax (843) 735-7002

Email kevin@kevincrain.com

IRS Circular 230 Notice

To ensure compliance with requirements imposed by the IRS, please note that any Federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.