Controlling Income Recognition using a Charitable Trust
By: Michael Kirkman & Tyler Wilson
Charitable Remainder Trusts (“CRT”) have long been a staple in the estate and gift planning of charitably minded individuals. A CRT is an irrevocable trust which pays out either a fixed amount (annuity amount) or a percentage of the trust’s yearly asset value (unitrust amount) to the donor and/or other beneficiaries, providing an income stream over the trust term. The trust term can be for a term of years (not to exceed 20) or for the life of the income beneficiary/beneficiaries. In the year of funding, the donor receives an income tax charitable deduction for the remainder value of the trust assets going to charity at the end of the trust term. This remainder amount is calculated using IRS actuarial rates, the trust term, and the value at initial funding of the CRUT. The remainder value must be at least 10% of the Fair Market Value of the donor’s initial contribution to the CRT.
For example, if an individual contributes $1,000,000 to a CRUT in August of 2021. The terms of the CRUT are for 5% of the trust fair market value to be paid each year to husband and spouse (ages 65 and 65) for their lifetimes. At the second death the named charity or charities will receive the remainder value of the trust. In year 2021, the husband and spouse will receive an income tax charitable deduction of $333,210.
One of the greatest strengths of the CRT is its ability to defer capital gains. When appreciated assets are used for funding of the CRT, the trust can sell those assets on a tax-deferred basis. As the trust makes distributions the capital gains are passed out and taxed to the individual beneficiary. However, with the higher ordinary and capital gain tax rate changes looming in Washington, recognition of ordinary and capital gains even over a period of years appears less attractive than it has previously. Given the potential increase in future income tax rates (ordinary and capital gain), options that allow greater flexibility on the timing of how income is recognized becomes extremely attractive. Specialized charitable trusts can provide a method to control how the income is recognition.
Using a specialized CRT to control income recognition is a powerful technique for:
- Immediate charitable deduction
- Deferral of capital gains on the sale of appreciated assets
- Control of when income is recognized by the individual trust beneficiary
- Cash flow planning utilizing joint life beneficiaries
- Cash flow and income recognition with next generation beneficiaries
How to Control the Income Recognition
Instead of gifting the appreciated asset directly to the CRT, you first transfer the asset to a partnership or an LLC. Then you gift the partnership interest or the LLC units to the CRT. The CRT is designed to make a payment to the individual beneficiary based on the lessor of the CRT’s “fiduciary accounting income” or the required annuity/unitrust percentage. Fiduciary accounting income for a partnership/LLC is the actual cash received from the partnership or LLC not the reported Form K-1 income. Therefore, unless the partnership/LLC makes a cash distribution to the CRT there is no requirement to make a payment to the individual beneficiary during that year. The payment amount does not vanish because it was not paid during a given year. Rather, any unpaid amounts are accumulated for future year when actual cash is distributed from the partnership/LLC to the CRT. This is referred to as a “net income make-up” provision.
For example, A CRT with a unitrust payment of 6% (“CRUT”) is established on January 1, 2021, with an interest in an LLC holding real estate. The value of the LLC interest transferred to the CRUT is $1 million. The CRUT is required to pay the lesser of “trust fiduciary accounting income” or $60,000 to the individual beneficiary in year 2021. If the LLC makes $100,000 in income during 2021 but decides not to distribute any of the income to the CRUT, no income is required to be distributed to the individual beneficiary in year 2021. The $60,000 untrust payment is carried over into year 2022.
In 2022, the LLC sells the real estate for $1,500,000 with cost basis of $600,000. The LLC has a capital gain of $900,000 and will issue a Form K-1 to the CRUT for the gain. The LLC decides to distribute cash of $80,000 to the CRUT in year 2022. The CRUT is treated as having current year income of $80,000 based on the actual cash distributed from the LLC. The CRUT is required to pay the prior period accumulated amount of $60,000 plus part of the current year unitrust payment of $90,000 ($1,500,000 FMV * 6%). The current year $90,000 payment cannot be paid because the CRUT only received cash from the LLC to cover the prior period required payment of $60,000 and $20,000 partial payment for the current year payment. The CRUT will have a $70,000 income make up accumulation for year 2023.