How the rich have their cake and eat it too by using trusts to give to charity, collect cash, and save on taxes at the same time

CRTs are recommended for high-net-worth clients who want to give back but are also interested in an income stream, especially if they are asset-rich but cash-poor, according to Katie Sheehan, managing director at SVB Private. Given the amount of administrative work, CRTs generally aren’t worth your while without at least $1 million in assets, she added. 

“It is a fit for folks who are looking to do some good, do some charitable planning, remove some assets from their taxable estate, but not have all of that benefit go to charity,” said Sheehan. “You can use these strategies to have your cake and eat it too.”

The tax-saving tactic is making a comeback after falling out of favor during years of low-interest rates.

With interest rate hikes, the rate that the IRS uses to calculate remainder interest – what goes to charity – has also surged. Grantors get a bigger upfront deduction because a higher rate assumes the trust assets will grow faster and more will be left to charity when the term ends. 

There are two types of CRTs, and this is how they work

There are two primary types of CRTs, each with their own benefits and downsides.

With a charitable remainder annuity trust (CRAT), the annual income is determined at the outset when the trust is funded.

Here is how a charitable remainder annuity trust (CRAT) could work in practice, according to Sheehan:

Consider a couple aged 80 and 81 who decide to fund the trust with $1 million. They select 7% as the percentage payout for a life term. Assuming that the assets in the trust grow at an annual rate of 5%, about $365,000 would be tax-deductible, and the remaining $635,000 would be non-deductible. On an annual basis, the income beneficiary would receive $70,000 for their life expectancy. When the couple passes away, what remains in the trust would pass tax-exempt to charity.  

The second type, charitable remainder unitrusts (CRUT), are more popular in Sheehan’s experience but also more complicated. Unlike CRATs, you can add assets to the trust after it is funded. The income percentage is determined when the trust is set up but the payout is determined using the current fair market value of the trust, which is recalculated every year, rather than the initial value. If assets in the trust skyrocket after the trust is funded, the beneficiaries get a higher income.

Sheehan gave an example of how a CRUT would work with the same couple and a similar trust with $1 million in assets, a lifetime term, and a 7% percentage payout:

In this case, about $480,000 would be tax deductible, and the remaining $520,000 would be non-deductible. The calculations assume a growth and income rate of 5% for the trust assets. On an annual basis, the income beneficiary would receive 7% of the fair market value of the trust assets, recalculated every year for 11 years, (i.e., their life expectancy). In the first year, the couple would receive $70,000 – the same as with a CRAT – but the payments would increase annually as the trust assets appreciate. At the end of that term, the remaining amount would pass tax-exempt to charity. 

There are a few strings attached

The IRS has several requirements for CRTs, including:

• The maximum length is 20 years or the lifetime of whoever funds the trust
• The trust pays an income to at least one living beneficiary
• You cannot withdraw assets from the trust
• The annual payout to the beneficiary (or beneficiaries) must range from 5% to 50% of the trust’s fair market value
• At least 10% of what remains in the trust after the payments must go to a designated charity

The last stipulation is the trickiest one. If you select a payout percentage that is too high, the trust remainder might not be enough to pass muster with the IRS.

If the CRT meets all the requirements, the beneficiary has to pay income tax on the distributions, but there are several tax savings, including:

• The grantor gets an upfront income tax deduction on the estimated amount that will go to charity when the trust ends
• The grantor does not have to pay estate tax on assets put in the trust
• Capital gains tax on assets in the trust is deferred until it is paid out to the income beneficiary.

The last advantage is a big boon for business owners looking to sell in the near future and donate some proceeds, according to Eric Mann, partner at Neal Gerber Eisenberg.

For instance, if a business owner sold a $10 million company that had appreciated by $9 million in value, that increase would be subject to capital gains tax at the time of liquidation. Instead, they can put the company in a CRT before selling it, and since the trust is exempt from capital gains tax, the entire $9 million can be reinvested. The tax burden is spread out over time as the beneficiary only pays capital gains tax on the distributions.

“It allows the clients to invest the entire proceeds instead of the net amount, while also satisfying their charitable goals at the back end when the client dies,” said Mann.

While there are many technicalities, CRTs are actually relatively straightforward compared to other estate planning techniques, said Sheehan.

“These are prescribed by the IRS,” she said. “We know as long as our math works, they will pass muster with the IRS.”