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Selling your Business through a Charitable Remainder Trust – a Win-Win for Taxpayers and Charities – Part 2

March 29, 2016

As discussed last month, Husband and Wife created a Charitable Remainder Trust (“CRT”), contributed their corporate stock valued at $5,000,000 to the CRT and the Trustee later sold the stock.  No capital gains tax was paid because the CRT is a tax-exempt entity.  Once Husband and Wife contribute their stock to the CRT, they are entitled to a current charitable income tax deduction against other income.  But their contribution was valued at $5,000,000, so why is their deduction only $500,100?  Why can’t they deduct the entire $5,000,000 value?  The charitable deduction is limited because Husband and Wife opted to receive annual payments from the CRT for the rest of their lives.

Husband and Wife have two options when creating the CRT and retaining an annual income interest: a Charitable Remainder Unitrust (“CRUT”) or a Charitable Remainder Annuity Trust (“CRAT”).  A CRUT pays Husband and Wife a fixed percentage of the value of the assets of the CRUT each year, and this payment may fluctuate each year based on how the assets of the CRUT perform.  In the alternative, the CRAT pays Husband and Wife a fixed dollar amount each year regardless of how the CRAT assets perform.  For example, assume Husband and Wife create a CRUT with a 5% annual payout and the CRUT assets are $1,000,000 in year 1, $900,000 in year 2 and $1,100,000 in year 3.  In this example, the payout to Husband and Wife is $50,000, $45,000 and $55,000, in each respective year.  On the other hand, if the CRT was a CRAT instead of a CRUT and the payout was 5% based on the value of the assets at the time the CRAT was funded ($1,000,000), the payout to the donor(s) would be $50,000 in years 1, 2 and 3, with no adjustment for how the CRAT assets perform. In the current low interest rate environment that exists today, practitioners prefer to use CRUTs instead of CRATs for two reasons.  The first is for a person younger than the cut off age (approximately age 73), a CRAT for life does not qualify for the current charitable deduction because the present value of the remainder interest payable to charity is not at least 10% of the gift.  Husband is 61, Wife is 60 and the IRS requires that Husband and Wife retain at least a 5% annual payment.  The present value of the remainder of the $5,000,000 gift expected to pass to charity is $82,725.  To qualify for the current charitable deduction, the remainder must be at least 10% of the value of the gift on the date of the gift, or $500,000 in this example.  So CRATs are not available to younger clients who want a lifetime annuity stream with interest rates are low.   Second, the CRUT yields a larger charitable income tax deduction when interest rates are low.

Assume Husband and Wife chose a CRUT because they want an income stream for the rest of their lives and they are younger then the age required to use a CRAT.  Based on current ages and interest rates, the payout rate is 9.332% per year.  So each year for the rest of their lives, Husband and Wife will receive an annual payment of 9.332% of the value of the CRUT.   Using conservative estimates for income and growth, the first year payment is $466,600.  Each successive year, if growth is consistent, the payment is slightly less as the value of the CRUT declines.  If the growth is better then estimated, the annual payments would increase.  However, for discussion purposes and to see how the income stream would change (assuming consistent growth) payouts for years 2, 5, 10 and 20 would be $449,292.62, $401,127.98, $332,051.72, and $227,536.61, respectively.

This planning has many advantages and requires the proper knowledge and expertise to ensure all benefits are realized by both the Taxpayer and the Charity.