Charitable Remainder Unitrust Basics
Prior to the SECURE Act, inherited IRAs for nonspouse beneficiaries could be distributed over the beneficiary’s life expectancy. This strategy was often referred to as a “stretch” IRA. Now, inherited IRAs and other qualified plans must be paid out over a maximum term of ten years to the beneficiaries. There are exceptions for spouses, inheriting beneficiaries with disabilities, minors and beneficiaries who are within ten years of the age of the deceased IRA owner. In light of the changes made through the SECURE Act, many IRA owners are seeking a way to replicate the stretch payments. Many in the estate and gift planning industry are promoting charitable remainder unitrusts (CRUT) as an effective option for stretching the payouts beyond ten years. With the estate planning world giving more attention to the CRUT, it is important to understand a CRUT and how it works. This blog will discuss the basics of a CRUT.
A charitable remainder unitrust is an irrevocable tax-exempt trust. A CRUT pays a fixed percentage to the trust beneficiaries with a vested remainder in one or more qualified charities. After the trust is created, an IRA owner who wishes to direct qualified retirement account funds to a CRUT must submit a new beneficiary designation form. The new beneficiary designation form must reference the trustee of the CRUT as the beneficiary. It is necessary to create an actual trust document first and then to designate the trustee of the unitrust as the beneficiary of the IRA or other qualified retirement plan.
A CRUT may be drafted to make income payments to individual beneficiaries for the duration of a life, multiple lives, a term of years up to 20 years or a combination of a life or lives plus a term of years. After all payments have been made to the beneficiaries named in the trust document, the remaining trust assets are transferred to one or more designated charities. This remainder to charity in many cases is a significant legacy gift. Donors are able to make a transformative gift to charity and benefit their heirs through the use of CRUTs.
A CRUT is a popular planned gift because it produces a charitable income tax deduction in the year (or years) in which the donor transfers assets to the trust and allows the donor to bypass capital gains tax if the trust is funded with an appreciated asset. In addition to the tax benefits, a CRUT also produces an income stream for selected beneficiaries.
A CRUT may be created through a donor’s estate plan, which would produce an estate tax deduction rather than an income tax deduction. The benefits of an estate tax deduction may not be realized by the donor’s estate because the individual lifetime gift tax exemption amount is $11.58 million (in 2020), indexed for inflation in future years. The donor should consult with an attorney to determine if a CRUT is a good fit to meet his or her goals and overall gift or estate plans.
For the CRUT to generate a charitable tax deduction, the trust must meet certain IRS requirements. First, the CRUT must pay out a specified percentage of the trust’s fair market value to the beneficiaries. The payout percentage must be at least 5% and cannot exceed 50%. Second, the CRUT must produce a charitable income tax deduction that is equal to at least 10% of the trust’s funding amount. The maximum allowable payout percentage will be influenced by the 10% minimum deduction test. The donor’s charitable deduction is determined using the IRS’ present value calculation. Most unitrusts select a 5% payout rate to permit potential growth of principal.
Once the CRUT is funded and administered, the trust must file annual tax returns, submit to annual valuations and be managed by a trustee. The donor may choose to act as the trustee of the trust. With a donor-trustee, it is essential to select a capable accounting organization (see GiftLaw Pro Ch. 3.10.5 for potential accounting solutions). If the donor chooses not to self-trustee, the trustee can be an individual, a charity or a private trustee such as a bank and trust company.
There are four different payout types that can be established in the trust agreement. The first is a standard charitable remainder unitrust, which will make payments based on the percentage stated in the CRUT document. Each year, the trustee will determine the annual payment amount by multiplying the CRUT payout percent by the trust value. Because a standard unitrust is straightforward for both the income recipients and the trustee, it is the most frequently selected option.
The second way to structure trust payouts is to draft the trust as a net income plus make-up charitable remainder unitrust (NIMCRUT), which pays the lesser of the trust’s net income or the stated unitrust percentage. This trust type has become quite popular for beneficiaries who desire income control. Through careful selection of either growth or income assets, the trustee may allow growth for a period of time, such as the prime earning years prior to retirement. When the beneficiary desires to start receiving income payments, the trustee can shift from a growth strategy to an income-producing investment strategy and begin making distributions. If there are excess earnings over the unitrust amount, any payout deficit in the initial years can be paid out, or “made up,” in later years.
The third type of CRUT is called a net income only charitable remainder unitrust (NICRUT) and pays out the lesser of trust income or the unitrust percentage, but does not include a make-up provision. This type of trust is not as frequently used.
The final type of trust is a FLIP charitable remainder unitrust. Typically, this trust starts as a NIMCRUT and then “flips” to a standard unitrust on the January 1 following the occurrence of a specified triggering event or date in the future. The trigger event must not be an event in the discretion or control of the trustee or other individuals. Often, the trigger event for a FLIP unitrust will be the sale of a non-marketable asset. The regulations specifically allow certain trigger events such as a birth, death, marriage, divorce or fixed date in the future.
CRUTs must adhere to the four-tier accounting rules contained in Sec. 664 of the Internal Revenue Code. The four tiers are: ordinary income, capital gain, tax-free income and return of principal. The basic rule is that all ordinary income must be distributed before paying out from capital gain. Distributions of tax-free income and principal will only be made if there is no ordinary income or capital gain. Often, trust investments are carefully selected to minimize production of ordinary income and maximize recognized capital gain.
In order to replicate the stretch payments, the IRA or qualified retirement plan assets will be paid directly from the account custodian to the CRUT. Because the CRUT is tax exempt, the full value of the IRA will be available to earn income within the CRUT.
Generally, traditional IRAs and other qualified retirement plans contain untaxed ordinary income. Based on that characterization, the entire IRA distribution will be allocated to the tier-one ordinary income layer of the CRUT for four-tier accounting purposes. Thus, distributions to trust beneficiaries will be taxed as ordinary income.
The passage of the SECURE Act has caused IRA owners and their advisors to seek to replicate the functions of a stretch IRA through other means. A CRUT can be a great option for IRA owners seeking to stretch retirement plan distributions to love ones and also create a lasting legacy gift to charity. CRUTs are subject to certain rules and procedures, which if met will create a charitable tax deduction. The donor’s attorney should be able to discuss and determine if a CRUT is a good fit based on the needs and goals of the donor.