Wednesday September 27, 2023
Article of the Month
Unitrust I - Duration and Recipients
Part one of this article series will provide an overview of charitable remainder trusts. This article series will provide illustrations of the gift models and practical ways of using a charitable remainder unitrust. The information should help a donor understand how a charitable remainder trust can fulfill his or her philanthropic goals.
Charitable Remainder Unitrust Basics
A charitable remainder unitrust is a tax-exempt irrevocable trust that is funded by a donor and makes income payments to a noncharitable beneficiary. After all payments have been made, the remaining trust assets are transferred to one or more qualified exempt charities. A unitrust is a popular planned gift because it produces a charitable income tax deduction in the year in which the donor transfers assets to the trust, allows the donor to bypass capital gains tax if the trust is funded with an appreciated asset and also produces an income stream for the donor or other selected beneficiaries.
To qualify as a charitable remainder unitrust, the trust must meet certain requirements. First, the unitrust payout percentage must be at least 5% and cannot exceed 50%. Second, the unitrust must produce a charitable income tax deduction that is equal to at least 10% of the trust's funding amount. In addition, the trust must file annual tax returns, submit to annual valuations and be managed by a trustee. The trustee can be a charity, a private trustee or a bank and trust company.
All charitable remainder unitrusts must adhere to the four-tier accounting rules contained in Sec. 664 of the Internal Revenue Code. The four tiers are: ordinary income, capital gain, tax-free income and return of principal. The basic rule is that all ordinary income must be distributed before any capital gain. Distributions of tax-free income and principal will only be made if there is no ordinary income or capital gain. As such, trust investments may be selected to minimize production of ordinary income and maximize recognized capital gain.
A charitable remainder unitrust (CRT) pays a fixed percentage for a life, lives, a term of up to 20 years, or a combination of a life or lives with an additional term up to 20 years. Reg. 1.664-3(a)(5)(i). In most circumstances, the income is paid to the donor for one life or to the donor and spouse for two lives. Alternatively, the unitrust amounts may be paid for a term certain of no more than 20 years.
It is also permissible to combine periods. The unitrust amounts may be paid for one or two lives, with a guaranteed term of years up to 20 years. In effect, this trust pays for the longer of the selected term of years or the two lives. If the life income beneficiaries pass away prior to the term of years, payments for the balance of the term may be transferred to children, nephews, nieces or other family members. Please note, with a two life unitrust that includes a guaranteed term of years, a married couple foregoes the marital deduction under Sec. 2056(b)(8) if one spouse passes away prior to the expiration of the specified term of years.
A trust also may be created for the lesser of a life or a term of years. For example, a trust created for a term of 20 years will terminate if the income recipient passes away prior to the end of the term. At that time, the remainder will be distributed to charity. This duration will result in a larger charitable deduction than a straight term of 20 years, because it is possible that the income recipient will pass away prior to the expiration of the term.
Finally, a unitrust can be created for one or two lives plus an additional term of years. However, for this drafting, all current and successor unitrust recipients must be living at the inception of the trust, and the trust will terminate upon the earlier of the demise of all income recipients or the expiration of the term of years. In effect, the trust is created for one or two lives plus the lesser of the lives of the successor income recipients or the stated term of years. Reg. 1.664-3(a)(5)(ii).
Unitrust Payout Variations
There are four payout types that can be established in the trust agreement. The first is a Standard Unitrust ("STANCRUT"), which will make payments based on the unitrust percentage stated in the trust agreement. Each year, the trustee will determine the annual payment amount by multiplying the unitrust payout percent by the trust value (normally as of January 1 of that year). This type of trust is frequently used for gifts of public stock or other liquid assets.
The second type of unitrust is a Net Income Plus Make-Up Unitrust ("NIMCRUT"), which pays the lesser of trust income or the unitrust percentage. This method has become quite popular for donors who desire income control. Through careful selection of either growth or income assets, the trustee may allow growth for a period of time, such as prime earning years prior to retirement. When the donor desires to start receiving income payments, the trustee can shift from a growth to an income-producing investment strategy and begin making distributions. Note that if there are excess earnings over the unitrust amount, any payout deficit in the initial years can be repaid, or "made up," in later years.
The third type of unitrust is called a Net Income Only Unitrust (NICRUT), which pays out the lesser of trust income or the unitrust percentage, but does not include a make-up provision. As such, this type of trust is not frequently utilized.
The final type of unitrust is a FLIP Unitrust. This trust initially functions as a NIMCRUT and then switches or "flips" into a Standard Unitrust on January 1 following the occurrence of a specified trigger event or date in the future. The specified trigger event is often the sale of a nonmarketable asset, but it could also be a different event, such as birth, death, marriage, divorce or a fixed date in the future. This type of trust is a popular choice for donors who would like to fund a unitrust with real estate. When real property is transferred to a FLIP unitrust, the trust can pay the lesser of the unitrust percentage or the net income until the property is sold. After the sale, the trust subsequently FLIPs to a standard unitrust on the following January 1.
Normally, the donor is the income recipient for a one-life unitrust, or a donor and spouse for a two-life trust. However, it is permissible to create a trust for another person or persons. Common CRT alternatives include those for a donor and child, nephew, niece or other relative.
If a unitrust is for a term of years, then it is permissible to name a class of individuals as the beneficiary of the trust. Reg. 1.664-3(a)(3)(i). For example, a donor can create a charitable remainder trust with the income distributed among grandchildren. The donor can grant the trustee the power to "sprinkle" among the grandchildren, which allows the trustee discretion to change the amount of the payout between the beneficiaries as circumstances change, so long as there is an independent trustee under Sec. 674(c). Rev. Rul. 77-285.
A charity is also a permissible recipient. The charity may receive a substantial proportion of the income, so long as the non-charitable income recipient receives at least a "de minimus" amount. There is no additional income tax deduction for the value of the CRT income payouts to charity.
Another option is for a trust to be the beneficiary of a payment from a term of years charitable remainder trust. However, if the unitrust is a one-life trust, then any payments to a second trust are deemed permissible only if the single beneficiary is incompetent. PLR 9718030.
The duration of a charitable remainder trust may be shortened by a qualified contingency. Sec. 664(f). It is permissible to shorten the duration of the trust based on an objective event, such as marriage, divorce or a similarly defined event. If the specified event takes place, then the trust may be terminated and the remainder transferred at that time to charity. Since the event is contingent, there is no increase in the income tax deduction, regardless of the nature of the event.
Special Needs Trust
Charitable remainder trusts may be drafted for a life, lives or a term of years. However, if a beneficiary is subject to a disability, then it may be desirable for the trust to have discretionary payment options. Thus, some grantors have preferred to create charitable remainder trusts that makes distributions to a second trust. The second trust is commonly known as a "special needs trust" and permits discretionary distributions for the support and care of an individual with a financial, physical or mental disability.
In Rev. Rul. 2002-20; 2002-17 IRB 794 (29 Apr 2002), the Service set forth guidelines for charitable remainder trusts that make payments to special needs trusts. First, if the charitable remainder trust is for a term of 20 years or less, then it may make distributions to a special needs trust. However, if the charitable remainder trust is payable for a lifetime, then it should meet several requirements. First, the trust must be for one lifetime and the beneficiary must be under a physical or mental disability that renders him or her unable to manage personal financial affairs, as defined in Sec. 6511(b)(2)(A). Second, the special needs trust should follow one of three formats:
I. Flow Through Trust. The trust may be a "Flow Through Trust," in which the unitrust payouts are made to the special needs trust and then are distributed to the beneficiary. Additional distributions may be made under a trustee discretionary power and the remainder will be distributed to the income recipient's estate.
II. Discretionary Trust. Alternatively, the special needs trust may have a discretionary payment provision, which permits the trustee to make payments that would not supplant governmental benefits otherwise available. With a discretionary special needs trust, the remainder of the trust is payable to the estate of the special needs person.
III. Discretionary with Power of Appointment Trust. Finally, a discretionary trust may be created with the income recipient holding a testamentary general power of appointment. If the special needs person does not exercise the general power when he or she passes away, then the remainder may be distributed to family or to charity.
Since unitrust payments may be made for the benefit of an income recipient, rather than to an income recipient, the unitrust may make payments to a special needs trust because the payments are, in effect, received by the special needs person. The above options are also available for an annuity trust.
In addition, it is possible for gift annuity payments to be paid to fund a special needs trust. While the gift annuity provides for fixed payments over the life of the person with special needs, distributions from the gift annuity to the trust must be limited and based on special needs. To avoid disqualifying the individual from receiving government aid, it is best to permit distributions from the trust at the discretion of a special trustee knowledgeable of the federal and state requirements.
Early Termination of a CRUT
It may be possible for a donor to terminate a CRT and cash out his or her interest. There have been several private letter rulings that have allowed a donor to terminate a CRT. The termination may be by gift, sale, conversion to a gift annuity or a combination plan. Both federal and state laws apply to a CRT termination.
With a series of partial terminations, a CRT may function in a manner similar to a donor advised fund. At the end of each year, a donor may designate a vested exempt nonprofit with a fixed percentage of both the income and remainder of the CRT. The trustee may then distribute cash equal to the gifted portion to the designated nonprofit. Some CRT donors consider this plan a "Personal Foundation" and give the CRT growth away at the end of each year. There is a partial charitable tax deduction for this annual gift.
This CRT termination and gift plan is attractive for donors who have sufficient income from other retirement sources. Further, the gift of a unitrust income interest is beneficial because it can reduce the donor's taxable income and create a charitable income tax deduction for the donor in the year of the gift.
1. Gift of Income Interest - A donor may give his or her entire income interest to the remainder charities. The donor will receive a charitable deduction for a gift of a zero-basis capital asset. See Sec. 1001(e)(1). This deduction is usable up to 30% of adjusted gross income because it is an appreciated asset. The gift of the unitrust income is considered a capital asset, even if the CRT was funded with cash. If the donor has retained the right to change charities, he or she will also need to vest selected charities with the remainder and irrevocably relinquish the power to change charities. See PLR 200802024. The selected charities will own vested interests in both the income and remainder of the CRT and under the doctrine of merger, may terminate the trust and distribute the assets. The charity will receive access to use the funds to further its mission. Under state law, there may need to be notice to the state attorney general or approval of the termination by a probate court.
The gift of the unitrust income interest must be an undivided interest in either the entire income interest or an undivided percentage of the income interest. If a donor does not want to relinquish the entire unitrust income stream, he or she can make a gift of a percentage of the income interest. As long as the portion of the interest is undivided, the donor will receive a charitable income tax deduction.
However, a donor should refrain from making a gift of the unitrust interest close in time after creating the unitrust, as the IRS may scrutinize the transaction more closely. Generally, a gift of the unitrust income should not be made within one year of the creation of the trust. Otherwise, the transaction may appear as though it was done to avoid application of the partial interest rules. The partial interest rules are meant to limit abuse of the charitable income tax deductions on certain gifts, prohibiting income tax deductions for gifts of less than the entire interest in the asset.
Example - Gift of Unitrust Income Interest2. Sale of Income Interest - A donor may sell his or her entire income interest to the remainder charities. The donor will not receive a charitable deduction, but may receive cash equal to his or her income interest. If the donor has retained the right to change charities, he or she will also need to vest selected charities with the remainder. The selected charities will own vested interests in both the income and remainder of the CRT and, under the doctrine of merger, may terminate the trust and distribute the assets. Under state law, a probate court may need to approve the termination. With the sale option, the donor will report the full sale price as a capital gain. See PLR 200152018. Under Sec. 1001(e)(1), the basis in the income interest is zero.
Joe and Mary created a two-life charitable remainder trust five years ago. Their estate grew substantially and the donors did not require income from the trust. The trust document permitted them to select the charitable remainder recipient. They irrevocably selected Favorite Charity as the remainder recipient and transferred their current and contingent income interests to Favorite Charity. They received a charitable deduction for the value of the income interest. As a capital gain-type gift, the deduction was limited to 30% of their adjusted gross income, with a carry forward for five years. See PLR 9550026.
Example -- Specimen Unitrust Income Interest Gift Language
City, State Zip Code
Re: Charitable Remainder Unitrust ______________
We are currently the income recipients of a two-life charitable remainder unitrust that was created on July 4, 2022, with trust grantors Joe and Mary Jones, 123 Main Street, Anytown, Illinois 00000 and initial trustee Charitable Organization, 456 Main Street, Anytown, Illinois 00000. The unitrust federal ID number is __________________.
As life income recipients, we have retained the power under section ________________ of that trust document to add, remove or modify by name or percentage the qualified exempt charitable remainder recipients. We declare our intention through this signed and dated writing to modify the charitable remainder recipients by irrevocably designating all of our income and remainder interests, whether vested or contingent, to a qualified exempt charity and relinquishing all powers to change charitable remainder interests.
In order to make a charitable gift of this charitable remainder unitrust, I hereby irrevocably designate qualified exempt charity ____________________________, of City, State, as the recipient of 100% of both the income and remainder interests in unitrust number _________________.
The trustee is authorized to recognize that under the doctrine of merger of income and remainder interests, the named exempt charity now owns all interests in this remainder unitrust. Therefore, the trustee may distribute the trust principal to the named exempt charity. Under the law of the state of ____________, this merger of interests may require consent of all trust beneficiaries or order of a probate court.
I understand that this transfer to a charitable organization may qualify under IRC Sec. 170 provisions for a charitable income tax deduction for the present value of the gifted income interest.
____________________________ Date: ____________
Unitrust Income Recipient
3. Convert Income Interest to Gift Annuity - A donor may transfer his or her entire income interest to the remainder charity for a gift annuity. The donor will receive a partial charitable deduction and the right to the annuity for one life. If the donor has retained the right to change charities, he or she will also need to vest selected charities with the remainder. The selected charities will own vested interests in both the income and remainder of the CRT and, under the doctrine of merger, may terminate the trust and distribute the assets. The gift annuity value equal to the income interest will be transferred to the annuity reserve fund. The remainder value in the CRT is transferred to the issuing charity. Under state law, as probate court may need to approve the termination.
4. Combination Plan - A donor may combine a gift, sale or gift annuity for portions of the income interest. With an outright gift or gift annuity, the donor will receive a charitable deduction. If the donor has retained the right to change charities, he or she will also need to vest selected charities with the remainder. Under state law, there may need to be approval of the termination by a probate court.
5. Valuation of Income Interest - With a sale of the income interest, because the donor is not making a charitable gift, the applicable federal rate (AFR) used for the calculation must be the rate that corresponds with the date the donor decides to terminate the trust. With a gift of the income interest or conversion to a gift annuity, one of the prior two-month's rates may be used. For a net income plus makeup trust or a standard unitrust, the income interest is calculated using the unitrust payout percentage. All life income interest calculations require a determination that the income beneficiaries have normal life expectancies. If there are health issues, in order to use the Sec. 7520 mortality tables there should be a written opinion by a medical doctor that a reasonable expectancy exists (at least over the 18-month Reg. 25.7520-3(b)(3) presumption). See PLR 200552015.
6. State Law - State law controls all modifications of irrevocable trusts. A step that may need to be taken in an early termination of a charitable remainder trust is to petition the probate court of the state under which the trust is formed. In California and other states, an alternative may be to terminate with the consent from all income and remainder beneficiaries. In all cases, it is recommended to notify the state attorney general of the early termination. The state attorney general in most jurisdictions oversees all charitable trusts and may be required to sign off on the transaction.
Charitable giving can be crafted to meet the goals of a particular client, whether those goals are financial, familial, philanthropic or a combination of all three. By creating a charitable remainder unitrust, donors will be satisfied that they have created income for life and will enjoy knowing they have made a positive impact through their charitable gifts.