Avoiding Disasters in Drafting Charitable Remainder Trusts – Stakes are High

Charitable giving is an integral part of society. The government encourages philanthropic activities by way of tax deductions for charitable giving to qualified tax-exempt organizations.

We are all familiar with claiming federal income tax deductions on our annual tax returns for gifts made to eligible entities within the taxable year. However, current and anticipated family financial needs often preclude families from immediately donating assets to charitable causes. Charitable remainder trusts (“CRTs”) are a popular vehicle for charitable giving that permit donors to retain use and control of wealth for personal use for a period of time, in exchange for making an unconditional commitment to future benefit for a charitable cause. CRTs may be drafted as charitable remainder annuity trusts (“CRATs”) or charitable remainder unitrusts (“CRUTs”), the chief difference being in the payments made to the non-charitable beneficiary, which may be either a fixed annuity (CRAT) or a unitrust amount calculated every year as a percentage of the value of the underlying assets (CRUT). If properly drafted, these trusts provide significant present and long-term tax savings. It must be noted that if the drafting attorney sways from the strict and complex rules mandated by the internal revenue code, the trust is disqualified and no tax benefit is available.

The importance of skillful drafting cannot be over emphasized.

Example: Upon his death, Grantor (G) leaves $10 million in trust for his adult daughter (D) to get $500,000 per year from trust for lifetime, and remainder to the University of Miami (UM).

The value of the remainder interest going to UM is deductible both for federal income tax purposes, and for federal gift tax purposes. The trust shall be a tax-exempt entity for federal income tax purposes, and distributions to the daughter shall be taxed under a special statutory scheme, instead of the standard rules for trusts and beneficiaries. Distributions to D are deemed to come first from ordinary taxable income of the trust, then from capital gains realized by the trust, next from tax-exempt income of the trust, and lastly from trust corpus. The character of income distributions only impact the taxation of receipts by D, and a greater distribution is made to UM by virtue of not paying tax on assets retained in the trust.

If D is entitled to “trust income” instead of an annuity of $500,000 per year, no income, estate , or charitable gift tax deduction shall be available. Similarly, if the remainder is left equally to UM and G’s son, no tax deduction shall be available.

The example highlights all the essential features of a qualified CRAT: a certain sum of not less than 5% or more than 50% of the initial fair market value of the property transferred in trust is payable annually to an individual for life, and the remainder is distributable to a qualified charitable organization upon the death of the annuitant. There is a limited menu of permitted variations in qualified CRATs, like the noncharitable beneficiary may receive an annuity for life, or a term of years, not to exceed 20 years. The amount payable to the non-charitable beneficiary is also subject to specific statutory limitations, of not less than 5% and more than 50%, of the initial net fair market value of the trust, and the remainder interest of the qualified beneficiary must not be less than 10% of the of the initial fair market value of the trust.

A CRUT requires an annual distribution to the non-charitable beneficiary of an amount equal to a fixed percentage, of not less than 5% or more than 50% of the value of the trust assets determined on an annual basis. The non-charitable interest may be limited to trust income in any year, and when trust income in any year is less than the fixed percentage amount, the deficiency for such year may be paid in a later year from any surplus trust income of such later year. The trust income ceiling and subsequent funding of deficiencies are options for the drafting attorney, and neither is a requirement for a qualified unitrust.

The standards for identifying non-charitable beneficiaries are fairly lax, and charitable organizations may be included as recipients during the non-charitable period as long as there is a non-charitable recipient that is living and ascertainable. However, including a non-charitable recipient along with a qualified charity as a residuary taker will disqualify the entire trust and no tax deduction shall be available.

While the principal risk of disqualification flows from detailed and complex requirements for noncharitable recipients, precautions must also be taken with respect to the charitable remainder interest. No deduction will be permitted if the designated residuary beneficiary is not a qualified charitable organization under IRC. sec. 170(c). It is best to contemplate the possibility of a qualified recipient ‘s subsequent disqualification at the time of distribution, and either specify an alternative qualified beneficiary at the outset, or grant authority to the trustee to select a qualified alternative donnee.

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