Saturday April 20, 2024
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8.2.2 CRT Payouts and Four-Tier Accounting
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Four-Tier Accounting for CRT Payments
Payouts from charitable remainder trusts (CRTs) are taxable to most recipients. However, the taxable amount and the tax rate of these payouts may vary greatly from year to year. Because of this uncertainty, it is very difficult to predict the exact amount of tax that a CRT beneficiary will owe each year. In contrast, a charitable gift annuity is very easy to predict because the taxation schedule of gift annuity payouts is predetermined and fixed.
The two most important factors that determine the taxation of CRT payouts are the tax characteristics of the property contributed to the CRT and the trustee's investment choices. These two factors will contribute to and determine an income beneficiary's tax liability each year. While not set in stone, an advisor may estimate an income beneficiary's tax liability, i.e., the effective tax rate on the CRT payout. This estimation will be based upon several factors:
1) The type of property used to fund the CRT, e.g., long-term capital gain property, depreciated.
2) The cost basis and fair market value of the property.
3) The expected trust investments, e.g., stocks and bonds, municipal bonds, rental property.
4) The expected trust return on investments, e.g., 6%, 7%, 8%.
Based upon these factors, an advisor may provide a CRT beneficiary with a projected effective tax rate. In most instances, the taxation of a CRT payout will be part ordinary income and part capital gain income.
Example 8.2.2A
On January 1st, Doug Donor transferred $200,000 of appreciated stocks with a cost basis of $20,000 into a 6% payout CRUT with annual payment frequency. The CRUT trustee sold a portion of the stock holdings and reinvested the proceeds. The trustee would record the sale of the stock holdings in tier two as long-term capital gains. After the proceeds were invested, the investment portfolio consisted of 50% bonds and 50% in equities. By year-end, the $100,000 of bonds produced a return of 4% or $4,000, and the $100,000 of equities grew to $108,000 or by 8%.
The trustee determined that the unitrust payout was $12,000 ($200,000 x 6%). The trustee, therefore, had to distribute this amount to Doug. In addition to the $4,000 of bond income, the trustee sold about $8,000 of equities in order to meet this year's $12,000 payout obligation. The trustee mailed a check for $12,000 to Doug, which left the trust with a fair market value of $200,000. The trustee also mailed Doug a Form 1040 Schedule K-1 that described the $12,000 as $4,000 of interest income and $8,000 of long-term capital gain income.
3.8% Net Investment Income Tax
In the Healthcare and Education Reconciliation Act of 2010, a 3.8% tax on NII was passed. The tax applies generally for married couples with income over $250,000 and for other persons with income over $200,000. Purely charitable trusts and pooled income funds are excluded from the tax.
However, distributions from Sec. 664 charitable remainder annuity trusts and unitrusts (individually a "CRT") may be subject to tax. Proposed Reg. 1.1411-3(c)(2)(i) states that the NII for a CRT beneficiary is the lesser of the total distribution or the accumulated NII of the unitrust or annuity trust. If there are multiple beneficiaries, the trustee is required to apportion the NII pro rata.
Trustees and CRT accountants must track NII as of January 1, 2013. Accumulations of income and gain prior to that date will not produce NII, even if distributed after January 1, 2013. Under Reg. 1411-3(c)(2), NII should be tracked inside the trust and distributed prior to other items. In this regard, the NII distribution is similar to the requirement to distribute all ordinary income prior to distribution of other types of income or principal from a CRT.
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Case Studies on CRT Payouts and 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.
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Private Letter Rulings
PLR
200108035 CRUT with Two-Layer Payout Approved:
Taxpayers propose to create a Charitable Remainder Unitrust with a 7% payout. However, the Taxpayers wish to have a rather unique payout schedule. They intend to pay 50% of the unitrust amount to Child for life, 35% of the unitrust amount to charity for five years and then to Child for life, and 15% of the unitrust amount to charity for the life of Child. Upon Child's death, the trust will distribute remaining income and principal to charity.
PLR
201248011 Trust's Income Excludable from Gross Income:
Employer is a political subdivision of State. Employer intends to establish a Trust to fund a health and welfare plan providing post-employment health care benefits or medical insurance coverage for eligible retirees.
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.
PLR
9240017 Option to Purchase Real Property in a Charitable Remainder Trust:
A taxpayer transferred an assignable option to purchase real property to a charitable remainder trust (CRT) and then sold it to a third party for its fair market value. When the third party purchaser exercised the option, the taxpayer was permitted to take a deduction for the difference between the option price and the fair market value paid by the third party purchaser to the CRT.
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