Charitable Remainder Trusts: Effective Planning For Retirement Assets

Sunday, January 1, 2006 - 01:00

Individuals nearing retirement or who have already retired with an investment portfolio consisting of low basis assets may be concerned with the capital gains tax that must be paid on sale of these assets if a sale is necessary or desirable to provide liquidity in retirement or diversify an investment portfolio. To address this concern, consider the transfer of the low basis assets to a charitable remainder trust. A charitable remainder trust will not recognize capital gain on the subsequent sale of the assets and the charitable remainder trust can provide a fixed annuity to the individual for the remainder of his or her lifetime. Further, if someone dies owning retirement assets, such as 401(k) plans or IRA's, Uncle Sam may be the beneficiary of as much as 80% of the value of the retirement assets. The IRS will impose an estate tax on retirement assets at a current rate of approximately 47%. As a result of changes to New Jersey's law in 2001, New Jersey could impose an estate tax as well. In addition, individual beneficiaries other than a spouse will pay income tax on receipt of these assets. To reduce this income and estate tax burden, a charitable remainder trust can be designated as the primary beneficiary of one's retirement assets.

There are two types of charitable remainder trusts: a charitable remainder annuity trust and a charitable remainder unitrust. Section 664(d)(1) of the Internal Revenue Code of 1986, as amended ("Code") provides that a charitable remainder annuity trust must pay to one or more non-charitable or income beneficiaries a sum certain of at least 5% of the initial fair market value of the trust assets on the date the assets were transferred to the charitable remainder trust. Under Code Section 664(d)(2), a charitable remainder unitrust pays to one or more non-charitable beneficiaries a fixed percentage of at least 5% of the net fair market value of its assets valued annually. As an alternative to payment of a fixed percentage, the unitrust may pay the lesser of the fixed percentage or the actual income for the year, with the option of having any shortfall (the amount by which the income of the trust falls below the fixed percentage) made up in subsequent years when the income exceeds the fixed percentage.

Under Code Section 664(d), the non-charitable interest in a charitable remainder trust can be measured by the life (or lives) of the non-charitable or income beneficiaries or for a term of years not to exceed 20 years. When the fixed period ends or the non-charitable beneficiary dies, the remaining assets held in the charitable remainder trust are distributed to one or more charities. Code Section 664(d) further provides that the actuarially determined remainder value of the assets in the charitable remainder trust must be at least 10% percent of the value of the property at the time of the contribution to the charitable remainder trust. A typical charitable remainder trust has the annuity or unitrust interest paid to a married couple for their lives and the remainder interest passing to charity.

In the case of an inter-vivos charitable remainder trust, the grantor is entitled to a charitable income and gift tax deduction for the fair market value of the remainder interest that passes to charity. If someone other than the grantor or the grantor's spouse is the income beneficiary, the grantor is treated as making a taxable gift equal to the value of the income interest given to the non-charitable beneficiary. If the income beneficiary is the grantor's spouse, Code Section 2523(g) allows for a marital deduction with respect to the annuity or unitrust interest given to the grantor's spouse as the sole non-charitable beneficiary other than the donor.

The charitable income tax deduction available to the grantor depends upon the type of property contributed to the charitable remainder trust. Under Code Section 170(b), the charitable deduction generally is limited to 50% of the individual's adjusted gross income, referred to as "contribution base." If appreciated property is contributed to the charitable remainder trust, the amount of the charitable deduction depends upon whether the property is ordinary income or capital gain property. The deduction ceiling for contributions of long-term capital gain property generally is 30% of the individual's contribution base. If the charitable beneficiary is a private foundation, the deduction ceiling generally is further reduced to 20% of the individual's contribution base. If the charitable deduction is limited in a calendar year because of the percentage limits discussed above, any unused charitable deduction may be carried forward for five years.

The income beneficiary of the charitable remainder trust is taxed on distributions from the trust in accordance with a tier system of taxation under Code Section 664(b) as follows:

(1) First, any distribution from the charitable remainder trust is deemed to consist of ordinary income to the extent of the trust's ordinary income for the taxable year of the distribution and any ordinary income from prior years not deemed to have been previously distributed.

(2) Second, if a distribution in a particular year exhausts the current year's income and all prior undistributed ordinary income, the distribution is next deemed to consist of capital gain income to the extent of the trust's capital gain income for the current year and undistributed capital gains from prior years.

(3) After the ordinary income and capital gain tiers are exhausted, distributions are deemed to come from other income, such as tax-exempt bond income.

(4) When the current and accumulated income from the above three categories is exhausted, remaining distributions are considered to have been made as a tax-free return of basis.

A charitable remainder trust may be superior to traditional retirement assets or enhance the value of one's retirement assets. For example, a retiree or individual approaching retirement who has low basis assets in his or her investment portfolio that will result in substantial capital gains tax if sold should consider transferring those assets to a charitable remainder trust. If the trustee sells the low basis assets, the charitable remainder trust will not pay capital gains tax. Consequently, the full sales proceeds will be available to the individual to likely increase the individual's retirement income. The use of a charitable remainder trust for an individual's retirement assets also may provide valuable diversification for the individual's investment portfolio which will now include an asset that provides a fixed annuity for life. Further, the charitable deduction may be available to offset other ordinary income.

In addition to an inter-vivos charitable remainder trust, a testamentary charitable remainder trust provides a variety of tax benefits at death. If an individual designates a charitable remainder trust as the primary beneficiary of his or her IRA or 401(k), no income tax will be due on distribution of the IRA or 401(k) to the charitable remainder trust. Instead, the full amount of the IRA will be held in the charitable remainder trust and available to make the annual payments to the non-charitable beneficiaries. Distributions to the non-charitable beneficiaries are, however, subject to income tax under the tier system of taxation discussed above.

Let's consider an example for use of a charitable remainder trust at death: Assume that you establish a charitable remainder unitrust at your death to be the beneficiary of your IRA on the death of the surviving spouse. The charitable remainder unitrust makes an annual payment of 5% to your children in equal shares for fifteen years. For estate tax purposes, your estate will receive a charitable contribution deduction equal to 46.78% of the value of the IRA at the time of your death. If your IRA has a value of $1 million at your death, your estate will be entitled to a charitable contribution deduction of approximately $468,000, generating federal estate tax savings of approximately $220,000.

At the same time, your children will receive 5% percent of the value of the charitable remainder unitrust each year for fifteen years. If the charitable remainder unitrust grows by 6% percent each year, your children will receive from the IRA over fifteen years a total of approximately $1,122,000. Over the same fifteen year period, the federal estate tax savings of $220,000 would grow at the same hypothetical rate of 6%, to approximately $530,000. In total, over fifteen years, the benefits of the charitable remainder trust would be almost $1,650,000.

In contrast, if the IRA is paid directly to your children in a lump sum following your death and your children are in a 30% income tax bracket, your children will inherit only approximately $200,000 from the IRA. If this amount is invested at 6% for 15 years, your children will receive approximately $480,000, or $1,170,000 less than the amount they will receive from the charitable remainder trust and its tax savings.

The use of a charitable remainder trust (whether inter-vivos or testamentary) is substantially enhanced if the charitable interest belongs to a private foundation. A private foundation is a family business organized for the purpose of making gifts to public charities. Under current law, contributions to a private foundation are deductible for estate, gift and income tax purposes. Under current law, a private foundation is obligated to distribute 5% of the value of its assets each year to one or more public charities. The private foundation is typically managed and controlled by family members, who are entitled to compensation for services they render to the private foundation. The amount of compensation must be reasonable under all relevant facts and circumstances but nevertheless provides an opportunity to continue to provide benefits to the family from dollars that have qualified for deductions for income, gift and estate tax purposes.

As a final note, on March 30, 2005, the IRS issued Revenue Procedure 2005-24. This Revenue Procedure provides that for charitable remainder trusts created on or after June 28, 2005, if under state law, the trust assets are subject to a spousal right of election upon the death of the grantor, the spouse must irrevocably waive the right of election with regard to the assets held in the charitable remainder trust in order to ensure that no part of the trust will be used to satisfy an elective share claim. If this waiver is not obtained, it could cause the charitable remainder trust to lose its tax-exempt status and the donor will lose the benefit of the charitable deduction and recognize immediate capital gains tax if appreciated trust assets are sold. Further guidance on this Revenue Procedure from the IRS is expected.

Rita M. Danylchuk is Counsel with Gibbons, Del Deo, Dolan, Griffinger & Vecchione concentrating in the area of trust and estate planning and estate administration. She is also a Certified Public Accountant in New Jersey. This article was first published in the November 14th issue of the New Jersey Law Journal and is republished here with permission. c. 2005 ALM Properties, Inc.

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