Charitable Remainder Trust: What It Is & How It Works

As a type of irrevocable trust, a Charitable Remainder Trust (CRT) serves as a distinctive financial tool benefitting both individuals and charities. If you're wondering whether one may be right for you, here's some of what you should know. This introduction looks at how CRTs work, discusses their potential advantages and drawbacks and compares a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT).

What Is a Charitable Remainder Trust?

A CRT is a legal and financial arrangement often used for estate planning and philanthropic purposes. It involves transferring assets — typically appreciated ones such as stocks and real estate — into an irrevocable trust.

The trust is designed to provide income to the designated beneficiary or beneficiaries for a specified period — typically the lifetime of the beneficiaries or a fixed number of years. At the end of the income distribution period, the trust's remaining assets then are directed to one or more charitable organizations.

How Does a Charitable Remainder Trust Work?

A CRT works by allowing an individual or donor to transfer assets, such as cash, securities, real estate or other valuable property, into an irrevocable trust. The trust is established for a dual purpose: to provide income for the beneficiaries designated by the donor and to support a charitable organization of the donor's choice.

After the CRT is established, the donor transfers assets into the trust. The provisions of the CRT help provide income to designated beneficiaries.

Types of Charitable Remainder Trusts

The two primary types of charitable remainder trusts are a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). They have different methods of calculating and distributing income to beneficiaries. Both offer unique advantages and considerations.

Charitable Remainder Annuity Trust (CRAT)

With a CRAT, beneficiaries receive a fixed annual income that is determined at the time the trust is established. This income is calculated as a percentage of the initial value of the assets contributed to the trust. The percentage chosen remains constant over the term of the trust, regardless of any fluctuations in the value of the trust's assets.

Here are the key features of a CRAT:

• Fixed income: Beneficiaries receive a set amount of income each year based on the initial trust assets.
• Predictability: Income payments remain steady over time, regardless of how the trust's investments perform.
• Capital preservation: Since the income isn't affected by changes in asset value, a CRAT can be a good option for those looking to preserve the trust's principal for charitable purposes.

Charitable Remainder Unitrust (CRUT)

With a CRUT, beneficiaries receive a variable income based on a fixed percentage of the trust's assets' fair market value, which is revalued annually. This means that if the trust's assets appreciate, the income distributed to beneficiaries increases. Likewise, if the assets decrease in value, the income decreases.

Here are the key features of a CRUT:

• Variable income: Income distributions fluctuate based on the performance of the trust's underlying assets.
• Potential for growth: If the trust's assets increase in value, the income payments to beneficiaries increase as well, allowing them to benefit from asset growth.
• Flexibility: A CRUT can be attractive to those who want their income to potentially keep pace with inflation or changing financial needs.

What Are the Benefits of Setting Up a Charitable Remainder Trust?

Setting up a CRT can offer several potential benefits and advantages, including financial benefits, tax advantages and philanthropic impact, both for the donor and the charitable organizations they wish to support.

Financial Benefits

CRTs can provide a reliable source of income for the donor or other beneficiaries for a specified period — often their lifetime or a fixed number of years. This can be especially beneficial for retirees or individuals seeking regular income. In the case of a CRUT, beneficiaries have the potential to receive increased income if the trust's investments perform well.

CRTs may also offer the opportunity to diversify investments within the trust, potentially improving investment performance and mitigating risks associated with concentrated holdings.

Tax Advantages

Donors can receive an immediate income tax deduction for the present value of the charitable contribution that will eventually go to the designated charitable beneficiary. This deduction can help reduce the donor's taxable income in the year the trust is funded and helps to make a CRT a good estate planning mechanism.

By contributing appreciated assets to the CRT, donors may also avoid paying capital gains tax that would have been incurred if the assets were sold directly. This can be particularly advantageous for assets with substantial appreciation.

Philanthropic Impact

CRTs allow donors to support charitable organizations or causes they care deeply about while also benefiting from the trust's income during their lifetime or the specified period. The assets remaining in the trust after the income distribution period ends are directed to the chosen charitable beneficiary, creating a lasting philanthropic legacy.

What Are the Potential Drawbacks of a Charitable Remainder Trust?

While CRTs offer numerous benefits, they also come with potential drawbacks and considerations. It's important to be aware of these drawbacks before deciding to establish a CRT.

• Irrevocability: CRTs are irrevocable, meaning that once you transfer assets into the trust, you cannot reclaim them. This lack of flexibility could become an issue if your financial circumstances change significantly after the trust is established.
• Complexity and costs: Setting up and managing a CRT can be complex and involve legal, financial and administrative costs. Professionals are typically required to create and oversee the trust, which can lead to upfront expenses.
• Minimum funding requirement: CRTs typically require a minimum amount of assets to be established. If you lack a significant amount of assets to contribute, a CRT might not be a feasible option.
• Income limitations: While CRTs provide income to the beneficiaries, the income generated might not match the potential income from other investment options, especially in the case of a CRAT, where the income is fixed.
• Potential for investment risk: The performance of the trust's investments can impact the income distribution to beneficiaries. If the investments underperform, it could lead to lower income than expected, especially in the case of a CRUT.
• Ongoing management: CRTs require ongoing management, including investment decisions and income distribution calculations. This can be time-consuming and will likely require the involvement of professionals.
• Charitable intent: CRTs are primarily intended for individuals who have both philanthropic goals and a need for income. If you're solely focused on charitable giving without the need for income, there might be more straightforward ways to achieve your philanthropic objectives.

How to Set Up a Charitable Remainder Trust

Here's a step-by-step explanation of how to set up a CRT.

1. Establish the trust: The donor works with legal and financial professionals to establish the CRT and determines the terms of the trust. This includes specifying the charitable beneficiary (or beneficiaries) that will ultimately receive the remaining assets, as well as designating the income beneficiaries who will receive income from the trust for a specific period of time.
2. Transfer assets: The donor transfers assets, often appreciated assets such as stocks or real estate, into the CRT. By doing so, the donor avoids immediate capital gains tax on the appreciated assets.
3. Distribution of income: The CRT provides income to the designated income beneficiaries per the terms of the trust.

Case Study: Successful Use of a Charitable Remainder Trust

Let's consider a simple example of how a CRT could be successfully used to achieve both philanthropic and financial goals. This case study scenario is for "John," who is a retiree and owns a substantial amount of appreciated stock.

John is concerned about the capital gains taxes he would have to pay if he sells the stock. He also wants to help secure a steady income stream for his retirement years and help make a lasting impact on a charitable cause he cares deeply about, which is education.

Here are steps that John could take to successfully use a CRT to meet his goals:

1. Setting up the CRT: John consults with legal and financial professionals to set up a CRT. He decides to create a CRUT to benefit from potential income growth.
2. Transferring assets: John transfers $1 million worth of appreciated stock into the CRT. By doing this, he avoids immediate capital gains taxes on the appreciated stock.
3. Generating income: The CRT's terms specify that John will receive a variable annual income equal to 5% of the trust's fair market value, revalued annually. In the first year, the trust is valued at $1 million, so John receives an income of $50,000 (5% of $1 million).
4. Receiving income and tax benefits: John receives an immediate income tax deduction for the present value of the charitable remainder. He also benefits from the tax-free nature of his income from the CRT since it's considered a return of principal.
5. Supporting education: John designates a reputable education-focused nonprofit organization as the charitable remainder beneficiary. The CRT's remaining assets will go to this organization after John dies.
6. Providing income and impact: Over the years, the trust's investments perform well, leading to increased trust value. John's annual income also increases as the trust value grows, providing him with a steady income stream.
7. Leaving a philanthropic legacy: When John dies, the remaining assets in the CRT, which have appreciated significantly due to wise investments, are directed to the education-focused nonprofit. This substantial contribution makes a meaningful impact on the organization's initiatives, aligning with John's philanthropic goals.

In this example, John successfully achieves his goals of generating a reliable income stream for his retirement years, avoiding capital gains taxes and leaving a significant charitable legacy to support education. The CRT allows him to combine his financial and philanthropic aspirations while optimizing the use of his appreciated stock assets.

It's important to note that the specifics of CRTs can vary based on individual circumstances. Consulting with financial professionals is crucial to ensuring that the trust is structured and managed in the best possible way.

Comparing Charitable Remainder Trusts to Other Charitable Giving Strategies

CRTs are just one of many charitable giving strategies available to individuals who wish to support charitable causes while potentially deriving financial benefits. Let's compare CRTs with a few other common charitable giving strategies.

Charitable Remainder Trust (CRT)

• How it works: Assets are transferred to an irrevocable trust. Beneficiaries receive income for a specified period, and the remaining assets go to a charitable organization at the end of the trust term.
• Benefits: Provides income for beneficiaries, an immediate income tax deduction, the avoidance of capital gains tax, the potential for growth and a philanthropic legacy.
• Considerations: Complexity, irrevocability, administrative costs and potential impact on your beneficiary's inheritance.

Donor-Advised Fund (DAF)

• How it works: Donors contribute to a fund held by a sponsoring organization. Donors can recommend grants to eligible charities over time.
• Benefits: Immediate tax deduction upon contribution, flexibility in timing of grants and simplicity.
• Considerations: Limited control over investments, not suited for income generation and administrative fees.

Direct Cash or Asset Donation

• How it works: Donors give cash, securities or other assets directly to a charitable organization.
• Benefits: Potential for tax deduction, simplicity and direct support to chosen charity.
• Considerations: No income generated and there are capital gains tax implications for appreciated assets.

Charitable Gift Annuity (CGA)

• How it works: Donors give assets to a charitable organization in exchange for fixed annual payments for life.
• Benefits: Fixed income for life, immediate tax deduction, potential for partially tax-free income and support for charity.
• Considerations: Limited control over assets, less flexibility compared to CRTs and potential tax complexities.

Charitable Lead Trust (CLT)

• How it works: Assets generate income for a charitable organization for a certain period, after which the assets revert to the donor or other beneficiaries.
• Benefits: Reduced estate or gift taxes for beneficiaries, and philanthropic impact during the trust term.
• Considerations: Complexity, potential reduction of inheritance for beneficiaries and less focus on income generation for the donor.

Legacy Giving (Bequests)

• How it works: Donors include charitable gifts in their wills or estate plans.
• Benefits: Flexibility during lifetime, potential estate tax reduction and lasting philanthropic impact.
• Considerations: No immediate tax deduction, assets tied up until donor's passing and no income generated for donor.

Frequently Asked Questions (FAQs)

What are the tax benefits of a charitable remainder trust?

A CRT offers several potential tax benefits to donors who establish the trust as part of their estate and philanthropic planning. They include income tax deduction, avoidance of capital gains tax on appreciated assets, tax-free income and a potential estate tax reduction.

Can I change the beneficiary on a charitable remainder trust?

In most cases, once a CRT is established and funded, you cannot change the designated charitable beneficiary. The choice of charitable beneficiary is a fundamental aspect of the trust's structure and purpose, and changing it could potentially violate the irrevocability of the trust.

What assets may be donated to a charitable remainder trust?

A variety of assets can be donated to a CRT, depending on the terms of the trust agreement and applicable laws. Some common types of assets that may be donated to a CRT include cash, investment securities, such as stocks and bonds, real estate, life insurance and artwork and collectibles.

The Bottom Line on CRTs

It's important to note that while there are potential benefits to establishing a CRT, there are also complexities and considerations to take into account. The specific advantages will depend on individual circumstances, financial goals and the assets involved. Consulting with tax, legal and financial professionals is essential to ensure that a CRT is set up in a way that aligns with your intentions and maximizes its benefits.