If it weren't for a great void of other forms of tax shelter, there wouldn't be nearly as much interest in the tax benefits of the charitable remainder trust (CRT). But ... because of the dearth of other tax saving devices, the CRT has become one of the really HOT financial planning tools for Americans in the 1990s.

Proponents claim it will do virtually everything anyone could ever want. According to the more exuberant advocates, you can use a CRT to avoid income taxes, to avoid capital gains taxes, to avoid estate and gift taxes and to protect your assets from the claims of every form of predatory creditor.

Cooler heads argue that when you examine the details and run the numbers, it's just another of a wide range of financial options. Those who make their living helping taxpayers to establish and administer the charitable trust are the most vocal in arguing that this device is not a tax dodge or tax "loophole". You (or someone in your family) gets an income for life or for a term of years. Later, a charity gets what's left. In many ways, the charitable remainder trust is an alternative to a life income annuity with an insurance company, but with a few extra bells and whistles and with a lot more tax benefits.

Once you make a valid transfer to a charity or a charitable trust, you no longer own the property and it's not available to your creditors. Although the future income you have a right to receive can be attached by future creditors in some states, that problem can be avoided by making your spouse the income beneficiary. Of course, you wouldn't do that if you had any concern about the permanence of your marriage. However, there are some technical hurdles that must be overcome to be sure the asset protection benefits will hold up to a challenge by a determined judgment creditor. I'll discuss those in more detail in the next issue of APS.

The main drawback in exchanging some assets to a charity or charitable trust for a life income annuity is the cost of setting up and administering the charitable remainder trust. Without a significant amount (over $150,000 of deferred gain), the cost may take away the tax and financial benefits. A second major drawback of this financial tactic is the complexity.

In addition, once the charitable trust is in place, the charitable trust can buy and sell investments at a profit without concern for depleting your gains because of the capital gains tax. Of course, the reverse is true in that you can't recover any taxes on capital losses. In this respect, the charitable trust is much like a variable annuity or a retirement savings plan.

Basically, you have to go through a series of calculations, using tables prescribed by the IRS. According to the IRS mortality tables, the remaining life expectancy of either a male or female at age 65 is 20 years. If you contribute $200,000 to a charitable trust in exchange for a 5% annual payment of $10,000 per year, the amount of your tax deduction will be about $100,000. That's the value of the gift minus the present value of the 20 years of income.

If you are in the top federal bracket of 39.6%, you will recover $39,600 in taxes from a contribution of $200,000 to a charitable trust, assuming there are no other restrictions or limitations on the amount of your deduction. The longer the life expectancy of the income beneficiary (or the more beneficiaries there are), the smaller the income tax deduction.

The amount of the tax deduction also depends on the current interest rate on mid-term federal bonds. Actually, it's based on 120% of the "applicable mid-term federal rate" (AFR) for the month of the contribution or either of the two previous months. Thus, if the lowest AFR for the three months is 6%, the rate that must be used to compute the tax deduction would be 7.2%.

Frankly, I believe many commentators and advisors place excessive emphasis on the income tax deduction that's available to the donor. When you run the numbers comparing the charitable trust to other alternatives, you will discover that the tax deferral is a far greater financial benefit than the tax deduction. By leaving some of your money to a charity, you can move your family wealth to your children or grandchildren by using the charitable trust as a conduit. Look at it this way. Would you rather give the IRS up to 55% of your estate or would you rather leave those same dollars to a favored charity?

Even though the income tax deduction is often over-valued, the Congress decided in 1997 that there had to be some minimum amount that would go to the charity in terms of the present value of the funds contributed to the CRT. They set that minimum at 10%. The practical effect of that is that the charity has to get at least 10% of your assets, plus all of the income on those assets. The rest can be paid out to you or other income beneficiaries as annuity payments. The 1997 law also established a maximum annual payout rate of 50% per year.

You can establish a CRT to .....

1. pay you a fixed income for your lifetime,
2. pay you an income for a fixed number of years,
3. pay an income to you and your surviving spouse,
4. pay an income to your children (subject to the 10% minimum to charity)
5. or other combinations.

A substantial charitable contribution

An Alternative To A Deductible Pension Plan

One alternative to that arrangement is to invest after tax money in a tax deferred annuity. When you retire, you can draw out all the money and pay taxes on the deferred income or you can convert the accumulated amount into a life income annuity.

A third alternative is to contribute your money to a "charitable remainder unitrust with net income makeup" (NIMCRUT) provisions designed to permit the trustee to pay out the lesser of the income of the trust or a percentage of the trust assets. When the annual income is less than the "regular" payout, the trust can require that the distribution must be made up in future years, when the trust has sufficient income. Thus, the trustee can invest the NIMCRUT assets to achieve growth instead of current income. When you retire, the trustee can switch the investments to generate income for distribution, including extra amounts to make up for previously deferred distributions. Thus, the NIMCRUT can provide tax deferred accumulations, like an annuity.

In addition, contributions to a NIMCRUT are partly tax deductible, depending on your age at the time of the contribution. The catch is that a substantial amount will end up going to a charity instead of being paid to your heirs. However, your spouse and/or your children can also be an income beneficiary of the CRUT, but that will reduce the income tax deduction that you can take. And, the 10-% minimum present value for the charity sets limits on the number of years that the income can be paid to successive beneficiaries.

Protection From A Government Pension Grab

As a result of this concern, I've had a number of phone calls from my subscribers who have asked for my advice on how to get their money out of a pension plan or IRA with the minimum tax burden. Those who choose to take some or all of their money out of a pension plan or who stop putting money into the plan, will end up paying more taxes. The fear of a government pension grab will cause a lot of people to respond in a way that will result in more tax revenue for the government. Do you suppose our elected officials are so diabolical that they would engage in disinformation in order to create an hysteria that would result in early distributions from pension plans that would produce a short term windfall for the government?

It's beyond the scope of this article to dwell on the extent to which the government may or may not resort to some sort of "pension grab". But, if you are concerned, one partial solution is to move your money out of the public pension system into a private "pension" system, via a charitable remainder trust.

At age 50, a single taxpayer can deduct about 29% of the money put into a U.S. CRUT with a 5% annual payout rate. That would reduce the tax bite on any money that you don't put into a deductible retirement plan. At age 65, a single taxpayer can deduct about 50% of any money that is drawn out of an existing retirement plan and contributed to a CRUT. The trustee of a CRUT can invest the assets so that there will be no current income to distribute until you are ready to retire - meaning when you need the income.

Provide Funds For College Expenses Of Children Or Grandchildren

Some advisors claim a CRT can be used to secure all of these benefits. To do this, the charitable remainder trust is set up for a term of years. It can be funded with appreciated assets, thereby avoiding the capital gains tax. The income is distributed for the years the children are in college. However, all of the money will not be available for college expenses. Some of it must be left in the trust for the charity at the end of the selected term of years. So, unless you have a genuine desire to help a charity, the tax benefits of this arrangement won't be enough to make this attractive. Other alternatives for tax favored education would result in having more money available for education.

Avoid Or Reduce Future Estate And Gift Taxes

At the very least, the real cash cost to your heirs may be very small compared to the money you can provide to a charity. For example, if you are in the 60% estate tax bracket, any gift to a charity is only "costing" your family 40% of the amount left to the charity. If you sell appreciated property, the federal and state capital gains tax might take 33% of your gain. If the IRS gets 60% of the rest, your children end up with only 27% of the unrealized gain. By giving the appreciated assets to a charity, the real cost to your children is 27% to 40% of the value of the donation.

Of course, if you live out your life expectancy, the after tax proceeds from selling your property can be invested and will most likely add to your total estate. Here's an example that compares a charitable gift to a sale, where the donor lives another 20 years.

If you sell $100,000 of appreciated stock that cost $10,000 and you are in the 20% capital gains tax bracket, you would end up with $80,000 after taxes. If you then invest that in 6% bonds, your after tax return would be 4%, if you are in the 33% federal and state tax bracket. After 20 years, the accumulated income would be $95,280. The $80,000 bond plus accumulated income would increase your estate by $175,280. If the estate taxes were 50%, that would leave $87,640 for your children and grandchildren after all taxes.

By giving the stock to a charitable trust, investing it at 6% and paying out 6%, you would begin with a fund of $100,000 instead of $80,000. Your annual income would be $6,000 before taxes, and $4,000 after taxes. Your accumulated income would be $119,100 instead of $95,280. In addition, if you were 60 years of age and the only income beneficiary of the CRT, you would get an income tax deduction of about $35,500, which would save you about $12,000 in income taxes. If that were invested for 20 years at 4% after tax, it would equal $26,300. That would leave $145,400 for your estate and $72,700 for your children. Your $100,000 charitable gift has actually cost your children only $3,985, based on these assumptions.

Protection From Tax On Inflationary Income

With a charitable remainder unitrust (CRUT), you make an initial decision about the percentage of assets to be distributed to you each year. The minimum percentage is 5%, but you can select a higher payout rate if you wish (up to a maximum of 50%.) To secure the maximum protection from inflation, you should select a payout rate equal to an inflation free rate of return on a portfolio. (A moderate risk rate of return without inflation would be about 4% to 5%.)

Assume you put $100,000 into a CRUT and you selected a 5% rate of payout. If the CRUT earns 8%, you will get $5,000 after the first year. The extra $3,000 stays in the CRUT - tax free - and increases the value of the assets. In the next year, your 5% payout will be based on an asset value of $103,000. Your 2nd income payment will be $5,150. If the CRT makes 9% in the second year, the total income would be $9,270 and the balance in the CRUT after two years would be $107,120. Then, if the rate of inflation pushes interest rates up to 10%, the CRUT will make $10,712 in the third year. The third payment would be 5% of $107,120. The balance after five years would be $124,004. The key to this arrangement is that the extra $24,004 of income is not subject to income taxes. If you adjust the numbers to eliminate the effect of the inflation, your annual payments would be very close to $5,000 per year.
 

Continued Investment Management

But, if you want the trust to permit the trustee to defer distributions by investing in growth type assets, I've been told you can't be the trustee. And, it's doubtful if you are qualified to do what a CRT trustee is required to do. Even many bank trust departments aren't qualified to be trustees of a CRT. However, there is a company that provides technical support to donors who want to be trustees of their CRT. They market their service through a national network of advisors with special training in the use of charitable trusts and other charitable gift instruments. The name of the organization is Renaissance Inc. Their address is 11595 N. Meridian Street, Suite 250, Carmel, Indiana, 46032. (317-843-5400)

Use Life Insurance To Replace Assets For Your Heirs

Further details about protecting your assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.
 

About the author:

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant. He is also the author of The Jacobs Report on Asset Protection Strategies, writes Vern Jacob s' Tax Solutions and serves as the Tax Editor for The Offshore Journal. He  sponsors and moderates a free discussion group on asset protection and offshore topics.   He can be reached by phone at (913) 362-9667.