12. Charitable Remainder Trusts, Part 2 of 4

12. Charitable Remainder Trusts, Part 2 of 4

Article posted in General on 17 May 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 18 May 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

12. CHARITABLE REMAINDER TRUSTS, PART 2 of 4

Links to previous sections of book are found at the end of each section.

We begin with a common financial planning dilemma.  A client holds a low-basis, highly appreciated asset.  Unfortunately, this asset generates little income.  It is often the case that such an asset may be a substantial part of the client’s wealth.  Wealth is often built in the form of entrepreneurial and business-building activity.  A client owning such a business may have a very valuable asset, but one which is difficult to convert into a reliable investment income stream.  This may be true because the business is in a growth phase where it is important to reinvest earnings rather than pay out dividends.  Or, this may be true because getting the business to reliably generate income requires the active participation of an owner who wishes to retire.  Such entrepreneurial businesses have often been built over a long period of years such that the founder has little or no cost basis in the business.

Although business building is perhaps the most common scenario, there are others that can leave clients with low-basis assets the produce little or no income, such as owning farmland that has become developable land due to exurban growth, or highly appreciated artwork or collectibles, or investment property that has been fully depreciated out and is valuable for redevelopment purposes, but generates little current income.  The natural reaction of most financial advisors seeing clients with income needs whose wealth is highly concentrated in such non-income producing assets is to convert them to diversified income-generating investments.  But, such conversion requires a sale, and a sale creates capital gains tax liability.  Such a sale can leave the client with much less wealth.

Suppose a client has a $1,000,000 asset with a zero basis.  We will use a zero-basis scenario to show the most extreme case, but this is certainly not outside the realm of possibility.  For example, a zero-basis asset may be a business built up by the owner over many years without significant up-front cash investment, a completely depreciated asset, or perhaps collectibles acquired or received as a gift where there is no documented purchase price.  Although the owner wishes to convert this non-income producing asset into a diversified income-producing portfolio, that conversion process requires a sale.  The capital gains taxes resulting from that sale significantly reduce the remaining assets available for investment.  Thus, the usually good advice of diversifying investments and matching income needs with income production of investments is thwarted by the tax cost of selling the low-basis asset.  This can keep the owner tied to undesirable investments because any sale would result in the loss of nearly a quarter of the value of the asset, just from the federal capital gains taxes alone.  These federal taxes include the capital gains tax with a top rate of 20% and the 3.8% Affordable Care Act surtax.
Of course, most owners live in states that also impose a state-level capital gains tax.  (Currently, 42 of 50 states impose capital gains taxes.)  Although state capital gains taxes may be deducted from the federal tax return, somewhat softening the impact, the addition of state capital gains taxes can make the prospect of a sale even more disheartening for owners.  As an example, owners at the top tax rates in California will face, even with a full federal deduction, a blended rate of 33.935%.  For the unfortunate owner who cannot take full advantage of the Schedule A deduction for state taxes, this rate could increase to as much as 36.8%.  When capital gains taxes are taking more than a third of the value of any gain, the option of selling even an underperforming highly appreciated asset can become unfeasible.
Beyond this, some assets are subject to even higher capital gains tax rates.  For example, capital gain from the sale of collectibles – such as artwork – has a top federal tax rate of 28% in addition to the 3.8% affordable care act surtax, rising to 31.8%.  Combining this with a 13% state tax in a state like California, if deductible, increases the top rate to 40.87% (or 44.8% if the Schedule A deduction for state taxes could not, for some reason, be used by the taxpayer).
Perhaps the worst capital gains tax result comes from selling a short-term capital gain.  A short-term capital gain results from the sale of an asset held for one year or less.  This is taxed as ordinary income resulting in a top rate of 39.6% combined with the state income tax rate.  For a taxpayer in California this results in a top combined rate of 50.928% assuming the ability to use the Schedule A deduction, or 52.6% otherwise.  Although the prospect of losing more than half of the value of the asset due to a sale may be rare, it shows the potentially dramatic impact of capital gains taxes.  In this particular example, because the underlying asset is short-term capital gain property any charitable gift would be valued based upon the lower of basis or fair market value.  Thus, a zero-basis short-term capital gain asset would generate no deductible charitable gift.  However, the ability to avoid losing more than half of the asset to taxation may be sufficiently attractive, even without the addition of a charitable income tax deduction.

The Charitable Remainder Trust provides an alternate path for an owner to be able to sell and earn payments from the highly appreciated asset.  Critically, this path results in no reduction of the investment asset due to its sale.  The ability to convert the asset into a diversified, income-producing portfolio while leaving the full value of the asset completely undiminished by capital gains taxes is potentially quite attractive.

Whether capital gains taxes would cause the owner to lose a quarter, a third, or more than half of the value of his or her asset, avoiding this reduction can result in a much higher level of investment income.  The Charitable Remainder Trust offers the attractive option of being able to sell and reinvest a highly appreciated asset with no reduction by capital gains taxes.  At a minimum, these capital gains taxes will be deferred to future years, often spreading across the lifetimes of one or more recipients.  However, in many cases, the capital gains taxes are not simply deferred, but are completely avoided.  Thus, the use of the Charitable Remainder Trust can produce a much higher level of income than would otherwise be available to the owner of a highly appreciated non-income producing asset.
The advantages to using a Charitable Remainder Trust include receiving an immediate income tax deduction, avoiding capital gains taxes on the transfer or sale of underlying assets, and the enjoyment of lifetime payments based upon the full value of the investment asset, undiminished by initial capital gains taxes.  These advantages do come with one primary cost.  That cost is the requirement that any remainder amount is transferred to a charity.  For a donor who already had the intention of leaving assets to charity at death, this result is perfectly appropriate.  However, some donors may be particularly concerned about their surviving family members losing the ability to inherit the remainder interest.  This might be addressed by giving heirs a lifetime payment stream from the Charitable Remainder Trust.  Aside from this, there is another option that will provide the heirs with a lump sum inheritance to replace some or all of the asset that they will no longer be inheriting.
It is common to combine a Charitable Remainder Trust with an Irrevocable Life Insurance Trust as a means to replace the inheritance of the wealth being donated to the charity.  The use of the Irrevocable Life Insurance Trust is a method to make the life insurance death benefit pass to the heirs with no estate taxes.  In this way, the heirs may lose the rights to inherit an asset which would have been subject to estate taxes but in replacement they receive a tax-free life insurance benefit.  Consequently, even a smaller life insurance benefit may be more attractive to the heirs because it passes free from estate taxes.  The Charitable Remainder Trust transaction conveniently generates two potential sources to pay for the purchase of life insurance.  First, the Charitable Remainder Trust creates an immediate income tax deduction.  This allows the donor to take the value of this deduction (i.e., the taxes the donor would have had to pay but for the deduction) and use it to purchase life insurance.  Additionally, the Charitable Remainder Trust creates a regular income stream, part of which can be dedicated by the recipient to pay for the purchase of life insurance.  This method also allows the donor to transfer a much larger asset to charity, but then use proceeds from the Charitable Remainder Trust to satisfy the needs of heirs through “wealth replacement” by life insurance.  Thus, even the primary disadvantage of Charitable Remainder Trusts to the heirs can be softened or eliminated through the use of a combination Charitable Remainder Trust – Irrevocable Life Insurance Trust (CRT-ILIT).
As with Charitable Gift Annuities, the taxation rules for Charitable Remainder Trusts can become complex.  This is due to the multi-faceted tax dimensions of a Charitable Remainder Trust transaction.  The Charitable Remainder Trust creates an immediate charitable income tax deduction as well as a stream of payments that can be treated as ordinary income, capital gain, and/or return of principal.  With the exception of the valuation process for a fixed annuity, the tax treatment of a Charitable Remainder Trust is different than for an otherwise similar Charitable Gift Annuity.  The Charitable Gift Annuity rules will not apply to payments received from the Charitable Remainder Trust.
Just as with any bargain sale or quid pro quo transaction, the charitable deduction is simply the value of what the donor gave less the value of what the donor received back.  In this case, what the donor receives back are the payments from the Charitable Remainder Trust.  (This is still the process for valuing the gift, even if the donor chooses to have the payments made to someone else.)
Consider a the simple example, using numbers identical to the Charitable Gift Annuity example from that chapter, of a donor who gives $100,000 of cash to his Charitable Remainder Trust and, in exchange, receives the right to collect $4,000 per year for life from the trust.  Just as with a Charitable Gift Annuity, the charitable income tax deduction is the amount gifted less the value of the annuity payments.  In this case, the fixed annuity amount is $4,000 per year.  However, the same concept applies if the donor were receiving a fixed percentage payment of, say, 5% of trust assets per year.  The charitable income tax deduction is still the difference between what the donor gave and the value of what the donor received back.  The only difference between the Charitable Remainder Annuity Trust and the Charitable Remainder Unitrust is the calculation process for valuing the payments.
So how do we value the payments that are scheduled to come from the Charitable Remainder Trust?  Naturally, we do not know in advance how long the annuitant might live.  Nor do we know what the future returns of the Charitable Remainder Trust will be.  But, we cannot wait until after the death of the donor (or some fixed period of years) before we calculate the value of the charitable income tax deduction.  Consequently, the value of the payments are based upon the premise that the annuitant will live to his or her life expectancy as of the date of transfer, and that the investments in the Charitable Remainder Trust will always return exactly the §7520 interest rate as of the date of the transfer.  Of course, if the annuitant lives longer or shorter than expected or the investment returns differ from the initial §7520 interest rate, the actual payments to the annuitant may vary widely.  This ultimate reality does not affect the valuation of the payments for purposes of the charitable income tax deduction.
The process of valuing payments from a Charitable Remainder Annuity Trust is identical to the process for valuing payments from a Charitable Gift Annuity.  The first step is to find the §7520 rate, which is available at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Section-7520-Interest-Rates and at a variety of other planned giving websites.  With this rate, the one-life or two-life annuity tables can be used to identify the appropriate annuity factor (tables are located at www.irs.gov/Retirement-Plans/Actuarial-Tables ).  Multiplying this annuity factor times the payment (with a possible adjustment from Table K for payments starting earlier than, or given more frequently than 12 months) gives the valuation of the annuity for purposes of the charitable income tax deduction.
As with Charitable Gift Annuities, the donor is allowed to choose the current §7520 rate or either of the previous two months for the annuity calculation.  Additionally, because the next month’s §7520 rate is released towards the end of the previous month, the donor may have a choice among four different rates if the transaction can be briefly postponed.  In our example of a Charitable Remainder Annuity Trust where the age 55 donor contributes $100,000 and receives a $4,000 per year annuity on January 31 of 2015, the available rates were 2.0% and 2.4%.  On that date, the donor would also have known of the upcoming §7520 rate for February and could have postponed the transaction if that rate had been more advantageous.  In either case, the donor in this example has the choice of using the 2.0% or 2.2% §7520 rate.  Which is preferable?
The theory is the same as that used with Charitable Gift Annuities.  As interest rates increase, the value of a fixed dollar annuity decreases.  Because the charitable tax deduction is the difference between the $100,000 transfer amount and the value of the fixed dollar annuity, the donor will want the highest interest rate as this produces the lowest calculated value for the annuity.

In this case, the donor is benefited by choosing the highest interest rate available, which is the 2.2% §7520 rate from January.  This higher rate results in a relatively lower valuation of the annuity payment stream and consequently a relatively higher valuation of the charitable income tax deduction. 

Although the higher interest rate results in a larger charitable income tax deduction it also results in a lower total investment portion, which will be counted as tax-free return of capital when returned.  In cases where the charitable tax deduction could not be fully used, this could lead to a circumstance where the lower rate would be preferred.  Such a scenario is much less likely with Charitable Remainder Trusts than with Charitable Gift Annuities.  A Charitable Gift Annuity donor who lives to his or her life expectancy will receive all of his or her investment back as tax-free portions of the annual payments.  In contrast, the tax characterization for payments to a Charitable Remainder Trust donor is quite different.  It is quite possible for a donor not to receive any of his or her investment back as tax-free repayment of principal in a Charitable Remainder Trust, which makes this strategy far less attractive for Charitable Remainder Trusts than for Charitable Gift Annuities.  The rules for counting payments as return of investment will be discussed in more detail later in this chapter.

Once the §7520 rate has been selected, we can now move to the appropriate section of the single-life Table S.  Once we are in the section of the single-life table S for a 2.2% interest rate, we see that the annuity factor for an age 55 donor is 18.6808.  Multiplying this annuity factor times the $4,000 per year annuity payment gives the valuation for the annuity payments of $74,723.20.
If this annuity payment were to be made annually on the anniversary of the initial transfer, the $74,723.20 valuation would be correct.  If the annuity made its first payment prior to the anniversary of the initial transfer, or made payments more frequently than annually, the valuation would have to be increased by an adjustment factor taken from Table K from the same website.  In that case, the annuity would be worth less (more) if the annuitant would receive the payments later (earlier) because payments received earlier could presumably be invested to earn additional interest.
Just as with a Charitable Gift Annuity, the calculation of the charitable income tax deduction is simply the amount of the transfer, $100,000, less the value of the annuity, $74,723.20, for a total deduction of $25,276.80.

Now suppose the donor is receiving not a fixed dollar payment, but rather receiving 5% of all assets inside the Charitable Remainder Trust as of the anniversary date of the initial transfer.  This is a unitrust, not an annuity trust.  The process for calculating the charitable income tax deduction resulting from a transfer to a Charitable Remainder Unitrust differs slightly from the calculation for a Charitable Remainder Annuity Trust.  The concept, however, is identical in that the deductible gift is the difference between the transfer and the value of the payment stream promised to the annuitant.

There are actually fewer steps for calculating the charitable deduction for a Charitable Remainder Unitrust than for a Charitable Remainder Annuity Trust.  To calculate the deduction for the age 55 donor receiving a 5.0% payout rate, simply multiply the initial transfer amount by the remainder percentage found in table U of the same website (www.irs.gov/Retirement-Plans/Actuarial-Tables).  This remainder interest is .31450 which, when multiplied by the $100,000 initial transfer, results in a charitable deduction of $31,450.

            Notice that we did not use the §7520 interest rate in the calculation of the charitable income tax deduction for a Charitable Remainder Unitrust.  How is this possible?  As interest rates rise, the amount remaining at the expiration of the annuitant’s initial life expectancy would also rise.  But, the present value discounting of that larger future value also increases due to the higher interest rate and this difference exactly offsets the increased remainder amount in present value terms.  Let’s look at an example.  Suppose an annuitant had a 20 year life expectancy and received 5% of the value of the trust at the end of each year.  If we used a 0% interest rate, then the amount remaining in 20 years would be $35,849.  Because the interest rate was 0% the present value of that amount would also be $35,849.  If instead we used a 10% interest rate, then the amount remaining in 20 years would be a much larger $241,171.  But, the present value of $241,171 received in 20 years using a 10% interest rate is the same $35,849.  Because the charitable income tax deduction is based on the present value of the predicted transfer to charity, changes in the interest rate have no effect on this deduction.

The standard calculations for valuing the tax deduction for gifts to a Charitable Remainder Unitrust are based on the assumption that payments to the annuitant will be made immediately each year after the annual valuation.  When the payments are postponed, for example by being paid out monthly over the course of the following year, the annuitant receives a reduced benefit.  For annuity trusts and Charitable Gift Annuities the valuation of this change in benefit due to intra-year timing of the distribution is calculated using table K.  For unitrusts this adjustment is made using table F (linked at the same website at www.irs.gov/Retirement-Plans/Actuarial-Tables), which generates an adjusted payout rate.  For example, a 6% payout rate, if paid quarterly beginning with the first payment immediately after the annual valuation when the §7520 rate is 2.4% generates an adjusted payout rate of 6% x .991168 or 5.947008%.  This creates a problem because Table U contains remainder factors for 6.0% and 5.8%, but not for 5.947008%.  Calculating the remainder factor (i.e., the charitable tax deduction) requires interpolating between the factor for 6.0% and the factor for 5.8%.  The formula for this interpolation, where APR is the Adjusted Payout Rate is

Factor above APR – [(factor below APR – factor above APR) X (APR-rate below APR)/.002 )]. 

So, if the annuitant were age 55 in the previous example (where the adjusted payout rate was 5.947008%) then the present value of the charity’s remainder interest would be

.26791-[(.26791-.25768) X ((.05947008-.058)/.002)] = .26039. 

As expected, this remainder interest factor (.26039) for the 5.947008% rate is between the factor for the 6% rate (.25768) and the 5.8% rate (.26791).

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