Trim Steep New Taxes with a Charitable Trust

High-income taxpayers face escalated effective tax rates as a result of new tax laws. Moreover, the higher rates are not limited to athletes, entertainers, and corporate CEOs who regularly collect substantial paychecks and bonuses. Taxpayers who ordinarily are in moderate tax brackets may trigger the new premium rates, surtaxes, and deduction phaseouts in any year when they sell a business, sell investment property, or take portfolio profits. One strategy can defer these extraordinary gains for years or even decades. This tactic allows you to spread the gains over many years, so you may be able to keep your annual income down and, thus, avoid the extra taxes aimed at the top earners. If you might face such a situation in the future, consider setting up a charitable remainder trust (CRT) for the asset sales.

Convert gains into income

With a CRT, you transfer assets you own into an irrevocable trust. Often, you’d transfer appreciated assets that you plan to sell. For a CRT, you name an income beneficiary or beneficiaries, who will receive cash flow for a specified time period. The beneficiaries could be yourself and your spouse, for example. You also name one or more charities to receive the remainder interest in the trust—the assets left in the CRT after the income payout period. Example 1: Matt Reese is about to sell investment property he has owned for many years. He expects to sell the property for $1 million and owe around $350,000 in various federal and state taxes, leaving him $650,000 to invest in securities for his retirement. Instead, Matt transfers the property to a CRT he has created, and the CRT sells the property for $1 million. As a charitable trust, the CRT will owe no tax on the sale. Thus, the CRT has the full $1 million to reinvest in securities.

The 5% Solutions

When creating the CRT, Matt names himself and his wife, Janice, as income beneficiaries; he instructs the attorney drawing up the trust to have the CRT pay out income as long as either of them is alive. Matt can choose between two modes of payments:

• Matt can select an annuity trust, which will pay out a fixed amount each year. That amount must be at least 5% of the initial trust fund. If Matt sets up the CRT with $1 million of real estate, the trust can pay out at least $50,000 a year to Matt and Janice or to the surviving spouse. When they both die, the assets still in the trust will pass to charities Matt has named.

• Alternatively, Matt can structure his CRT as a unitrust, which will pay out a fixed percentage of the net fair market value of the trust’s assets, valued annually, each year. Again, the minimum is 5%.

Example 2: Suppose Matt decides on a unitrust with a 6% payout rate. The first year, Matt and Janice will receive $60,000: 6% of $1 million. In future years, the CRT payout will be more or less than $60,000, depending on whether the trust’s assets have appreciated or lost value. Thus, the unitrust structure offers the potential for more income, over time, but also the risk of reduced income if the CRT value falls.

Deducting the donation

Besides future cash flow, the creator of a CRT also will receive an upfront tax deduction. The deduction will be the present value of the remainder interest in the trust donated to charity after all the payouts to the income beneficiaries. This calculation is based on several factors, including the ages of the income beneficiaries and the CRT payout rate. Under federal law, for a CRT to be treated as a charitable trust, the value of the expected donation must be at least 10%. If Matt Reese funds a CRT with a $1 million asset transfer, his deduction (the present value of the remainder interest in the trust) must be $100,000. This provision effectively caps a CRT’s income payout—Matt might be able to stipulate a 6% or 7% unitrust lifelong payout for himself and Janet but not a 12% lifelong payout, if the larger payout leads to a projected remainder interest under $100,000.

Tax relief

If Matt and Janice Reese receive $50,000 a year from their CRT, that’s the amount of income they will report. Such a relatively modest payout may keep this couple below the annual thresholds for higher taxes, whereas selling the investment property for $1 million in their own names might trigger a much more painful tax bite on the sale. How will the CRT payout be taxed? That depends on how the money is invested inside the trust. If the trustee buys corporate bonds, for example, the taxable interest income will pass through to the trustee, taxed at high rates. On the other hand, if the trustee invests in growth stocks that generate no income for the trust, the taxable payout will retain the favorable capital gains tax treatment of the investment property sale.

Copyright AICPA

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