Understanding Charitable Remainder Trusts

Preserving and transferring wealth can involve multiple strategies, depending on your personal situation and intentions.  Some of the tools used in these strategies, however, may not be widely known or easily understood.  

One strategy is a Charitable Remainder Trust (CRT), which can provide significant benefits to you, your beneficiaries, and charitable causes you care about. However, CRTs can be complex, costly to set up, and carry certain financial risks. As a result, they are typically most suitable for high-net-worth individuals. 

In this article, we explain the different types of CRTs, explore how they are structured, and highlight why they might be a valuable addition to your financial plan. 

What is a Charitable Remainder Trust? 

A Charitable Remainder Trust is a type of “split-interest” trust. It provides income for you or your beneficiaries for a set period of time, after which the remaining assets are donated to charity. A trustee, either an individual or an organization, manages the trust and oversees the distribution of assets. 

There are two main types of CRTs: the Charitable Remainder Annuity Trust (CRAT) and a Charitable Remainder Unitrust (CRUT). The key difference between them lies in how they calculate and distribute the income payments. 

How Charitable Remainder Trusts work 

Charitable Remainder Trusts are irrevocable trusts, meaning once a donor establishes and funds a CRT, it cannot be revoked or undone. 

There is no legal minimum contribution required to create a CRT. However, due to setup costs and administrative complexity, it is usually best to start with at least $100,000.  

CRTs are commonly funded with cash, appreciated stocks, or real estate, which can grow over time through strategic investing. Contributing appreciated assets to a CRT can provide a significant tax benefit, as the CRT can sell the assets tax-free. The resulting capital gain is taxed to the income beneficiary as annual payments are received, thus deferring the capital gains tax over the duration of the CRT. 

CRTs can be created to last for a specified term of years, up to a maximum term of 20 years, or for the lifetime of one or more income beneficiaries. However, naming younger beneficiaries may cause the CRT to fail either or both of the 5% and 10% threshold tests discussed below, since the income payments over the beneficiaries’ actuarial life expectancy would leave little or nothing for the charity. 

Income distribution from a Charitable Remainder Trust 

You can choose how the trust pays out income to you or your beneficiaries, depending on the type of trust you establish.  

• Charitable Remainder Annuity Trust (CRAT): Funded with a one-time contribution, this trust pays a fixed annual amount based on the percentage you select. The payout is designed to be consistent with the performance of the investments. Charitable Remainder Unitrust (CRUT): Allows for additional contributions over time. The annual payout is a fixed percentage of the trust’s current value, so the income can vary year by year.  

Example:  

If you fund a CRAT with $500,000 and choose a 5% payout, you’ll receive a fixed annual amount, which is 5% of the initial investment, regardless of how the trusts investments perform. If you fund a CRUT with the same amount and a 5% payout, your income would be 5% of the trust’s value each year. Therefore, if the trust grows to $600,000, you’d receive $30,000 that year. 

Charitable distribution requirements 

The IRS requires that a Charitable Remainder Trust must reasonably be expected to have assets remaining for charity at the end of the trust term. Different tests apply to a Charitable Remainder Annuity Trust versus a Charitable Remainder Unitrust. These tests vary depending on factors such as the income beneficiaries’ ages, the applicable 7520 rate, and the annuity amount (CRAT) or payout percentage (CRUT).  

For example, a CRAT that will last for the income beneficiary’s lifetime must have a less than 5% chance of being exhausted and leaving nothing to charity. CRATs that last for a term of years, or that have certain IRS-approved provisions, are not subject to the 5% test.  

All CRTs, both CRATs and CRUTs, must also satisfy a separate test which requires the present value of the charitable remainder interest to be at least 10% of the amount funded into the CRT. The present value of the remainder interest is computed using published IRS actuarial tables and the applicable 7520 rate.  

Both of these tests are performed prior to creation of the CRT. This allows all controllable variables, such as the selection of income beneficiaries, duration of CRT, payout rate, and payment frequency to be adjusted and optimized during the drafting of the document. The IRS allows the grantor to choose the 7520 for the month the trust is created, or the 7520 rate for either of the two preceding months, thus allowing for further optimization.  

The present value of the charitable remainder interest must be calculated not only for purposes of performing the threshold tests described above, but also for purposes of determining the charitable deduction, as discussed below.  

Differences in types of trusts 

The chart below shows the differences between a CRAT and a CRUT. 

Feature	CRAT (Annuity Trust)	CRUT (Unitrust)
Payout Structure	Fixed dollar amount annually	Fixed percentage of trust’s value, recalculated annually
Income Predictability	Predictable, stable income	Variable income based on trust’s annual value
Additional Contributions	Not allowed after initial funding	Allowed at any time
Best For	Donors who want steady, predictable income	Donors comfortable with market fluctuations and potential for growth, or anticipate making additional contributions
Valuation	No annual valuation needed	Revalued annually, more complex administration
Flexibility	Less flexible	More flexible for future contributions and income adjustments

Tax benefits of Charitable Remainder Trusts 

Charitable Remainder Trusts provide important tax benefits. They are appealing for people who want to support charitable causes while enhancing their financial and estate planning strategies. 

These trusts can be structured to provide either fixed income (CRAT) or variable income (CRUT), helping supplement retirement income and improve tax efficiency through strategic timing of payouts. 

Key tax benefits of CRTs 

1. Income tax deduction

A contribution to a Charitable Remainder Trust provides the donor (or in the case of certain Charitable Remainder Annuity Trusts, the trust itself) with a charitable deduction in the year of the contribution.  

The deduction will only be a portion of the total amount contributed, since income payments will be coming back to the noncharitable income beneficiaries. The deduction amount is equal to the present value of the charitable remainder interest. This calculation depends on factors such as the income beneficiaries’ ages, the applicable 7520 rate, and the payout amount or percentage. 

The amount of the deduction that can be used will depend on the type of asset donated (cash or other property), the charity’s classification (public charity or private foundation), and the grantor’s adjusted gross income (AGI). The deduction for a cash donation is limited to 60% of the grantor’s AGI if the charitable beneficiary is a public charity, or 30% if the charity is a private foundation.  

For contributions of appreciated property, the deduction is limited to 30% of the grantor’s AGI if the charitable beneficiary is a public charity, or 20% if the charity is a private foundation. 

2. Capital gains tax deferral

If you put valuable assets like stocks or real estate into a CRT, the trust can sell them. This way, it won’t trigger immediate capital gains taxes. This allows investors to reinvest the full value of the asset, ideally into a diversified portfolio. It can also provide a potentially larger income stream for the donor or other beneficiaries. 

You can spread the tax liability over time as you recognize income. The income beneficiary reports and pays income tax each year, on a “worst first” basis. The beneficiary will treat the amount received each year as ordinary income to the extent the CRT had ordinary income, then as capital gain to the extent of the CRT’s capital gain. Any unallocated ordinary income or capital gain rolls over to the next year.  

When a large capital gain position is sold, this creates a large reservoir of capital gain in the CRT which is distributed little by little each year, thus allowing for deferral of capital gains tax over the term of the trust. Establishing the CRT before a sale could also create a powerful strategy when selling a business. 

3. Estate tax reduction

Assets placed in a CRT are removed from your taxable estate, which can reduce or eliminate estate taxes. This is especially helpful for individuals looking to leave more to their heirs while also creating a lasting charitable legacy.  

If the grantor or their spouse is the income beneficiary, this would result in some of the contributed assets returning to the gross estate. This may be necessary based on cash flow considerations but, if not, you could consider naming children or other family members as the income beneficiaries to provide for them and to prevent the income payments from increasing your gross estate. 

Is a Charitable Remainder Trust right for you? 

Charitable Remainder Trusts can be powerful tools for retirement planning, estate planning, and charitable giving. However, they are not suitable for everyone. Potential risks include: 

• Loss of control due to the irrevocable nature of the trust 

• Income variability, especially with Charitable Remainder Unitrust 

• Administrative complexity and setup costs 

That’s why it’s essential to work with a comprehensive wealth management team. At Mercer Advisors, we offer an integrated approach to financial planning, investment management, tax planning and preparation, estate planning, insurance solutions, and more. 

The team can advise you on choosing the right CRT based on advantages and trade-offs, as well as selecting the right trustee and charity. Our wealth advisors and specialists know the details of CRTs. They can help you decide if setting one up will improve your tax situation or match your values. 

If you’re not a Mercer Advisors client and want to learn more about CRTs or how we can help you with wealth management, let’s talk. 

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