Monday April 29, 2024

3.10.2 Four-Tier Accounting

Four-Tier Accounting

CRT Payouts:   Unitrust payouts are one of the most important areas for the advisor to communicate to the recipient.

Four-Tier Accounting:   Approximately 80-90% of the CRTs in the future will be straight unitrusts or FLIP unitrusts that become straight unitrusts.

CRT Payouts

Unitrust payouts are one of the most important areas for the advisor to communicate to the recipient. With a charitable remainder trust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.

This distribution sounds reasonably simple. However, the options and the accounting can be fairly complex. The challenge for the advisor is to explain these rather complex options and concepts in simple terms to donors and clients.

Four-Tier Accounting

Approximately 80-90% of the CRTs in the future will be straight unitrusts or FLIP unitrusts that become straight unitrusts. This is, in part, because of ease of understanding and administration, but also due to the desire of donors to receive capital gain payouts.

Unitrust distribution rules are set forth in Reg. 1.664-1(b). Distributions from unitrusts are first ordinary income, then capital gain, then tax-free income and finally corpus. The distribution method is commonly described as the "Four-Tier" structure. In truth, the distribution rules have been made somewhat more complex by the different capital gains rules. The capital gain tier is further subdivided into the four levels for capital gain. The actual final structure is as follows:

CategoryTax Rate
 Ordinary Income 37%
   - Dividends 15%/20%/23.8%
 Capital Gain -  
   - Short-Term Gain 37%/40.8%
   - Tangible Personalty Gain  28%
   - Depreciation Gain 25%
   - Long-Term Gain 15%/20%/23.8%
 Tax-Free 0%
 Return of Principal 0%

The trust accountant must also track post-2012 Sec. 1411 passive income. While the CRT is exempt if there is no unrelated business income (UBI), the distributions to the income recipients must track the four-tier amounts and the Sec. 1411 amounts. There is a 3.8% federal tax on the Sec. 1411 amounts.

The process and accounting can be complex, but the concept is simple. The distribution to the recipient will require payment of tax at the highest possible rate. Thus, all ordinary income earned by the trust must be distributed before any capital gain is paid out.

Since the goal for most trusts is to distribute capital gain, the trust investments are carefully selected to minimize production of ordinary income and maximize recognized capital gain. Of course, creation of capital gain return involves inherent risk-return issues that will be addressed in subsequent chapters.

Case Studies on Four-Tier Accounting

In-Kind Distributions to Donors, Part 1 of 2:   Jim Thompson, a retired engineer, and his spouse Logan Thompson, a retired nurse, are currently considering funding a term-of-years charitable remainder unitrust with Americans for the Arts charity. Americans for the Arts is raising money for the construction of a new building which would house a state-of-the-art theatre and museum. The Thompsons, while retired, are active investors and have amassed quite a fortune over the past few years. In particular, they have investments in numerous established technology companies that have quadrupled in value over the past two years. They would like to use $800,000 of stocks with a cost basis of $100,000 to fund a five-year CRUT with a 15% payout. However, they believe these companies are great investments with acceptable risk and prefer that the trustee of the CRUT not sell these stocks. Furthermore, the Thompsons would like their CRUT payouts to be the actual stock - an in-kind distribution - as opposed to cash payouts. Thinking creatively, the Thompsons then wonder if such a distribution would avoid capital gain since technically the stock has never been sold.

In-Kind Distributions to Charity and the Reverse Four-Tier, Part 2 of 2:   Jim Thompson, a retired engineer, and his spouse Logan Thompson, a retired nurse, are currently considering funding a term-of-years charitable remainder unitrust with Americans for the Arts charity. Americans for the Arts is raising money for the construction of a new building that would house a state-of-the-art theater and museum.

Stock Unitrust Payouts to Donors:   Jim Thompson, a retired engineer, and his wife Janet Thompson, a retired nurse, are considering funding a term-of-years charitable remainder unitrust (CRUT) to benefit their favorite charity. Their favorite charity is raising money for the construction of a new building which would house a state-of-the-art theatre and museum. The Thompsons are active investors and have amassed quite a portfolio over the past few years. In particular, they have an investment in a medical services company that has quadrupled in value. They would like to use $800,000 of stock with a cost basis of $200,000 to fund a five-year CRUT with a 15% quarterly payout. However, they believe this company is a great investment with acceptable risk and prefer that the trustee of the CRUT not sell this stock. Furthermore, the Thompsons would like their CRUT payouts to be the actual stock – an in-kind distribution – as opposed to cash payouts. Thinking creatively, the Thompsons then wonder if such a distribution would avoid capital gain taxation since technically the stock has never been sold.

Can the Thompsons accomplish their goal of a tax-free 'in-kind' distribution of their technology stock? What are the tax consequences to the CRUT and to the Thompsons with this transaction?

Private Letter Rulings

PLR 8405005 Municipal Bonds in Charitable Trust:   Under the four-tier structure of IRC Sec. 664, payments are first ordinary income, then capital gain, then other or tax free and then return of principal. In this ruling, the taxpayer desired tax-free income and planned to obtain that by funding the trust with municipal bonds. Since the trust would have no ordinary income and recognize no capital gains, the distributions would be third-tier tax-free income. While the Service did not expressly approve the plan to distribute tax-free income, it stated that this would be a qualified trust, even though it invests in tax-free bonds. Trustees should also note that state prudent investor laws can impact this investment strategy.

Related Topics on Four-Tier Accounting

3.1.2  Four-Tier Accounting:    Payouts are one of the most important areas for the advisor to communicate to the recipient. With a charitable remainder annuity trust, the payout rule is that the annuity trust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.

3.10.4  Types of Unitrust Payouts:    Payouts are among the most important areas for the advisor to communicate to the recipient. With a charitable remainder unitrust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.

      Quiz-Basic



© Copyright 1999-2024 Crescendo Interactive, Inc.