This is the sixth and final part of our charitable giving series. In our last article, we met the Joneses, a successful couple with a significant net worth. Their priorities are exclusively focused on legacy. However, they have such a disdain for paying taxes, they are willing to adjust their goals to avoid tax. We previously learned how the Joneses used a charitable lead trust to avoid estate taxes. In this article, we will see how the Joneses can use a charitable remainder trust to defer income taxes, thereby increasing their personal wealth.
So let’s revisit the Joneses. Ed, 60, and Ruth, 56, own a business that they are in negotiations to sell. Ed and Ruth also personally own the underlying business’ real estate. The real estate has a cost basis of $50,000 and the buyers have offered the Joneses $2,500,000.
The “Typical” Plan
The Joneses love that price and have decided to sell the real estate. They understand that, when they sell, the difference between the $2,500,000 proceeds and their $50,000 basis will be taxed at a combined (federal and state) 25% capital gains rate. After paying a $612,500 tax bill, they will have $1,887,500 to reinvest.
The Joneses have met with their advisors and understand that they could defer the taxation on the real estate by reinvesting the proceeds in new parcels of real estate in a tax-free exchange. While that tax deferral is attractive, they have no interest in real estate as an ongoing investment. So, the question becomes, within the context of their goals of providing for themselves and their family, is there another planning tool that provides similar tax deferral (and thereby more wealth for themselves and less taxes for the government)?
Using a Charitable Remainder Trust as a Wealth Maximization Tool
As we learned in the last article, the tax code provides charitable planning tools to donors that can be used not only to benefit charity but as a way to enhance personal and family wealth. One example of such a tool, as we learned in the last article is a charitable lead trust. Another is a charitable remainder trust (CRT).
What Is a Charitable Remainder Trust?
Simply put, a CRT is “split interest trust,” meaning that both charities and human beings have economic interests in the trust. With a CRT, people (generally the donor and the donor’s family) have the first economic interests. The charity, in turn, has an interest in what is left over when the family interests terminate. The family interest could be for a period of years or for one or more lifetimes. Generally, the family interest requires the trust to make annual distributions to the family beneficiary. Those distributions are either a set amount (what is known as a charitable remainder annuity trust or CRAT) or a set percentage of the trust’s assets (what is known as a charitable remainder unitrust or CRUT). The advantage of the CRAT (the annuity type) for the family beneficiary is certainty, whereas the advantage of the CRUT (the unitrust type) is the possibility of growth.
When the donor transfers property to a charitable remainder trust, there is a tax deduction equal to the value of the charity’s remainder interest; the larger the value of the family interest (i.e., larger payments, longer duration or both), the lower the charity’s interest and thereby the lower the tax deduction. Critically, the CRT is income tax exempt. When the CRT engages in what would be taxable transactions, the CRT owes no income tax. Rather, the family beneficiary incurs that tax as annual distributions are made.
These somewhat complex relationships are best illustrated with an example, so let’s return to the Joneses.
How a CRT Helps Attain the Joneses’ Goals
As highlighted above, the Joneses could sell their real estate and have almost $1.9 million available to invest to help meet their goals. Or the Joneses could create and contribute the real estate to a CRT. If they did so, the CRT would be able to invest the entire $2,500,000 of sales proceeds.
- Assume the Joneses create the CRT to be a 10% unitrust and invest the sales proceeds in a balanced portfolio.
- Assume between interest, dividends and capital appreciation, the CRT grows in value to $2,625,000 by the end of the year (a 5% growth rate).
- Mr. and Mrs. Jones would receive a first year unitrust payment of $262,500, taxed at ordinary income rates first for any interest income and capital gains rates for the remainder.
- This continues each year with the Joneses receiving 10% of the end of year trust value.
After twenty-five years, assuming the sales proceeds grow at 5%, the Joneses will end up with $1.2 million more than if they just sold the real estate AND the charity of their choice will receive $700,000. Like the testamentary CLT highlighted in the last article, the Joneses can use the tax code to give more and get more.
Clients are happiest when their assets and income are used to meet their wishes, hopes, dreams and desires. For the Howards, that meant using a portion of their wealth to meet important philanthropic objectives. For the Joneses, that meant using the tax code to give more in order to maximize the ability to meet independence and legacy goals. For both clients, it was important that their planning team understood that financial success is a blend of behavior, tax minimization and investment performance. It is critical that you engage a team with a similar mindset and skills.