I have personally observed in my professional travels that many taxpayers are reluctant charitable donors. However, we you remind a business owner that they only have three choices when it comes to taxes (1) Pay yourself; (2) Pay the Government, i.e. taxes or (3) Donate the money to charity. When you present the options that way, most business owners quickly come to their senses and quickly develop an appreciation for charity albeit reluctantly. Nevertheless, advanced charitable tax planning strategies provide a number of different pathways to “have your cake and eat it too!” For many taxpayers, the issue is not the retention of investment capital for personal spending, but rather retention and control over the investment management and disposition of the assets.
This article focuses on the planning use of a charitable remainder trust as a vehicle to mitigate taxation when a business owner sells his business. It is not uncommon for a business owner (particularly a business that has operated for a number of years) to operate as a regular corporation for federal tax purposes instead of S corporation treatment. In the majority of cases the Buyer will prefer to purchase the assets of the corporation for a combination of tax and business liability reasons. This article will outline the power and utility of the Charitable Remainder Trust (CRT) as a planning vehicle designed to overcome the double layer of taxation inherent in the taxation of corporations. Hence, the CRT is a form of bailout for the Seller from federal and state taxation.
I have encountered recently two different business sale scenarios where the Seller operated his business as a corporation for tax purposes and contemplated the sale of the business through the sale of the business’ assets. Generally, the Buyer would prefer to purchase the assets of the business for business liability purposes and tax planning purposes. In many instance, the assets of the business may be fully depreciated and the Buyer would like a new and higher basis for the business assets for depreciation purposes. Additionally, the Buyer would like to separate himself from any of the past business liabilities associated with the Seller’s company. The negotiation between the Buyer and Seller is a “push and pull” negotiation exercise of how much of the purchase to allocate to goodwill and to equipment. In many cases, the business may also have business real estate that is fully depreciated and owned within the corporation.
The top marginal tax bracket for federal tax purposes is 35 percent. The range of top tax brackets at the state level is four-eight percent. If the corporation pays a dividend to the shareholder, or liquidates the corporation following the sale, the Seller also faces taxation at the individual level most likely creating an additional tax burden of 23.8-30 percent. As a result, the Seller should have a high degree of interest in identifying tax planning strategies that can reduce and defer taxation upon the sale while preserving an income and some degree of management and control over the assets.
What is a CRT?
A Charitable Remainder Trust (CRT) is an irrevocable agreement in which a donor transfers assets to a trust in exchange for an income interest. The trust is known as a split interest trust under IRC Sec 664. The trust is "split" between an income interest and a remainder interest which passes to one or more charities. A qualified charitable remainder trust is exempt from income taxation while allowing the donor to claim an income tax charitable deduction. The arrangement permits the tax-free sale of appreciated assets and irrevocably designates the remainder portion of the split interest for the benefit of one or more charitable beneficiaries, including public charities, donor-advised funds, and private foundations.
In its most basic form, the charitable remainder trust is an arrangement between four parties: 1) a donor (taxpayer); 2) a trustee; 3) an income beneficiary; and 4) a charitable remainder beneficiary. It is possible for the donor, trustee, and income beneficiary to be the same person.
The donor enters into a trust agreement with the trustee to transfer certain assets to be managed and maintained by the trustee. In accepting the assets, the trustee agrees to pay an income stream to one or more designated income beneficiaries for the rest of their lives or a designated period of time (term of years). At the expiration of the trust term, the trustee of the charitable remainder trust delivers the remaining trust assets to the charitable remainder beneficiary.
The donor may be an individual, corporation, partnership, limited liability company (LLC), or trust can be a donor. Alternatively, an individual donor can create a charitable remainder trust during life or at death (testamentary). The transfer to a charitable remainder trust that meets all of the requirements of IRC Sec 664 allows a donor to claim a charitable deduction for income, estate, gift, and generation skipping transfer (GST) taxes.
The trustee of a charitable remainder trust may be to an individual, including the donor, or an institution such as a bank or charity. When the donor serves as trustee, the donor may outsource investment management and trust administration. In most charitable remainder trusts, the donor and the donor's spouse will be named for their joint lifetimes as the income beneficiaries of a CRT. Nevertheless, the Internal Revenue Code and Treasury regulations permit any person to be named as an income beneficiary providing one income beneficiary is not a charitable organization.
In most charitable remainder trusts, the donor and the donor's spouse will be named for their joint lifetimes as the income beneficiaries of a CRT. Nevertheless, the Internal Revenue Code and Treasury regulations permit any person to be named as an income beneficiary providing one income beneficiary is not a charitable organization. For example, the income beneficiary could be an individual, corporation, partnership, LLC or trust. The treasury regulations provide that if any non-natural person beneficiary could be an income beneficiary, the payout length of that person's interest may not exceed a term of twenty years. The donor may elect to include one or more charities as co-income beneficiaries in order to provide a currently benefit to the charity.
The charitable remainder interest in a charitable remainder trust may benefit a public charity or a privately-controlled charity (e.g., a private foundation). A third possibility is to split the remainder interest among several charities. The trust may allow a donor retain the power to change the charitable remainder beneficiaries. The donor may choose to name a specific charitable remainder beneficiary immediately, defer the decision until later, name the charitable remainder beneficiary in their will, or grant that power to a child or friend.
CRT distributions to income beneficiaries are taxed using a unique four-tier system of accounting. This system utilizes a "worst -in-first-out" method for characterizing income distributions in the hands of the income beneficiaries. Each item of income earned by the trust must be separately tracked according to type (e.g. interest, dividends, capital gains, tax-exempt interest, etc.). Then each type of income is "used up" starting with items taxed at the highest rate moving to items that are taxed at the next lower rate. The end result is that ordinary income items, such as interest, are passed out first (Tier I), followed by short-term capital gains, then long-term capital gains (Tier II), tax exempt interest (Tier Ill), and finally trust principal (Tier IV).
Any CRT earnings in excess of the income beneficiary distributions are retained in the trust in a tax-free environment and combined with future transactions for characterizing future income beneficiary distributions. Note that while the CRT avoids taxation on capital gains realized from the sale of appreciated assets, such gains may be used to characterize future income beneficiary distributions.
The donor may use several forms of a charitable remainder trust. The principal distinction
between the various forms of charitable remainder trust is the manner in which the trust agreement defines the income interest. The trust must specify that the income interest will be paid as: (a) a fixed amount (annuity) k n o w n as a Charitable Remainder Annuity Trust, or CRAT) or (b) a fixed percentage of the trust's assets revalued annually (a Charitable Remainder Unitrust, or CRUT).
The payout in a CRUT may be structured in three different ways:
Standard Charitable Remainder Unitrust (SCRUT) -The standard version of a CRUT must pay a fixed percentage of the trust's assets revalued annually. The percentage must be at least five percent of the trust's assets. Therefore, as the value of the trust's assets rises and/or falls on the annual valuation date, payments to the trust beneficiaries will rise and fall.
Net-Income with Make-up Charitable Remainder Unitrust (NIMCRUT) - A NIMCRUT differs from a standard version of a charitable remainder trust in two key aspects. First, in determining the amount of the payments to the income beneficiaries, the trustee must compare the fixed percentage unitrust amount to the trust's accounting income as defined under IRC Sec 643 and pay the lesser of these two amounts to the income beneficiaries.
Second, for each year that the trust's accounting income is less than the unitrust amount, the difference (or deficiency) is accumulated as an amount that may be "made up" in the future (i.e., the "make-up amount"). Payments of the make-up amount must be made to the extent that the trust's accounting income in any year exceeds the fixed percentage unitrust amount.
Flip Charitable Remainder Unitrust (Flip-CRUT). The life cycle of a Flip CRUT is generally characterized by two phases. In the initial phase, a Flip CRUT acts like a NIMCRUT and only distributes the trust's accounting income to the income beneficiaries. In the second phase, following the occurrence of a predetermined triggering event, the trust switches, or "flips," to a standard charitable reminder unitrust and pays out a fixed percentage of the trust's annual fair market value.
The trustee has only until the end of the tax year in which the triggering event occurs to make any payments pursuant to the make-up provision. The change in the payout method commences on January 1 of the year following the triggering event. Permissible triggering events include:
The sale of an unmarketable asset;
A date certain;
The birth of any person;
The death of any person;
The marriage of any person;
The divorce of any person; or
An event outside the control of the trustees or any other persons.
The donor's tax deduction allowed for a transfer to a charitable remainder trust is equal to the actuarial present value of the remainder interest. The value of the remainder interest is computed by multiplying a remainder factor times the value of the asset transferred. Many inputs impact the computation of the remainder factor. Among the factors are the expected term of the trust, the payout rate, the prescribed federal rate under IRC Sec 7520, and the frequency of the income payments. The remainder interest must be equal to at least ten percent of the fair market value of the property at the time of transfer to the trust.
The longer the charity must wait, and the greater the income payments to the income beneficiaries, the lower the amount of the charitable deduction. This computation is complex and is generally performed using specialized software. The amount of the deduction of the gift of the charitable remainder interest is generally limited to thirty percent of the donor's adjusted gross income for most long term capital gain property for public charities and twenty percent to private foundations. Deductions that are denied because of the deduction limitations, may be carried over for the next five tax years.
Charitable remainder trusts are subject to complex rules dealing with self-dealing and unrelated business taxable income (UBTI). The UBTI rules are designed to prevent tax-free treatment to investment income that is unrelated to the charitable purpose of the public charity.
The consequences of UBTI treatment are severe for a charitable remainder trust. Previously, even a dollar of UBTI within a charitable remainder trust would disqualify the trust. IRC Sec 664(c) now imposes a 100 percent excise tax on any UBTI within a charitable remainder trust.
A good example is an ideal strategy to illustrate the benefits of the planning approach.
Julio and Maria, both age 60, own a company in California that manufactures and distributes Raspado machines and accessories. In case, you did not know, a “Raspado” is a Latin American delicacy, a snow cone with shaved ice and exotic fruit flavors topped off with sweetened condensed creme on top.
They plan to sell the company and the Buyer would like to purchase the assets of the Company. The Company operates and is taxed as a regular corporation. The sales price is $9 million. As part of the negotiation, three million dollars has been allocated to goodwill and five million dollars of fully depreciated equipment and one million of fully depreciated real estate. The company’s combined marginal bracket is 44 percent. A liquidation of the company would be taxed to Julio and Maria at a 35 percent rate considering both federal and California taxation.
The Company should create a new limited liability company (LLC) and contribute Company-owned assets to the new LLC. The Company serves as the managing member of the LLC. The Company makes an election to be taxed as an S corporation. In spite of the Built-In Gain (BIG) tax rules that apply to S corporations that were previously taxed as regular corporations for federal tax purposes, LLC membership units may be contributed to a new CRT designed for the payment of income with a makeup provision. The remainderman of the CRT is the client’s donor advised fund – The Raspado Foundation.
The CRT is designed to provide an income on a joint and survivor basis. The joint life expectancy is twenty seven years. The IRC Sec 7520 rate is 2.2 percent. The CRT provides for a five percent distribution. The projected investment portfolio assumes five percent income and three percent growth.
The CRT provides an income tax deduction in the year of contribution equal to $2.469 million or 27.5 percent of the contribution. The deduction would flow through to the S corporation on a pro rata basis to the shareholders. The deduction would be limited to 50 percent of each shareholder’s adjusted gross income (AGI) with a five-year carry forward to future tax years.
The LLC units in this case are short term capital gain property in which the tax deduction threshold is 50 percent and the contribution is based on the basis of the LLC units and not the fair market value of the equipment and real estate and goodwill.
The CRT is tax-exempt and would not be taxed on the sale of the equipment from the LLC when purchased by the Buyer. The funds would be held for reinvestment and would provide an income for the joint lifetime of Julio and Maria. Income would only be taxed when received by the income beneficiary. The projected income in Year 1 is $442,000. Based upon the investment assumptions, the income distribution would increase by approximately three percent per year.
Corporate level taxation would be avoided using this strategy. The income tax deduction would offset the income received personally by Julio and Maria. The assets would be outside of their taxable estate.
The strategy would avoid any immediate taxation at the corporate level and would only be taxed to you personally as CRUT distributions are received. The assets would be outside of your taxable estate. The donor advised fund – The Raspado Foundation – can be selected to receive the CRUT funds following the death of you and your wife. Assets passing to the donor advised fund can be replaced tax efficiently using life insurance owned with an irrevocable life insurance trust.
The proposed strategy would eliminate $3.96 million in taxation using the CRT strategy based upon the Sale. The initial tax deduction would provide an additional $1.086 million of economic benefit. Additionally, Julio and Maria who can afford to defer income for some time, would accrue investment income within the CRUT on a tax-deferred basis. The projected remainder interest passing to the donor advised fund in Year 27 is $20 million. The projected income in Year 27 is $969,000.
The CRT is a well-known and accepted strategy by professional advisors and planned giving professionals. The planning nuances where the CRT might fit are less well known particularly where corporate assets within a regular corporation or even an S corporation might make the planning cumbersome. The strategy is robust for the owner of a regular corporation who finds himself in the snare of double taxation. The strategy provides for a solid tax deduction on the contribution; tax elimination on the sale; and control over the flow of the assets being distributed from the CRT. At the same time, federal estate taxes can be avoided and assets replaced for the family in an irrevocable life insurance trust.