Charitable Remainder Trusts (CRT): Tax Traps and Difficult-to-Value Assets
If you are considering establishing a Charitable Remainder Trust (CRT), or already have one established, you’ll need to understand the potential issues and situations that may arise. A Charitable Remainder Trust is a type of trust that specifies distributions to one or more non-charitable beneficiaries for a predetermined period, with the ‘remainder’ value of the trust being paid to one or more charitable recipients.
A prearranged sale is an informal agreement between the grantor and a potential buyer to sell property prior to the establishment of a CRT in which that property is named as an asset. If the property is then sold to that buyer by the trust, the Internal Revenue Service may characterize the sale as being from the original grantor and not from the trust. Therefore, the grantor will be responsible for paying the full capital gains tax out of their own pocket.
In terms of real estate, the solution for this is simple: The grantor should not commit to a binding obligation to sell the property before it is contributed to the CRT. Therefore, the practitioner should ensure that no sale contract or option has been signed prior to the contribution to the CRT.
If the stated property is stock in a corporation, the grantor’s estate and charitable planning advisors often aren’t consulted regarding personal tax and estate planning until after a deal to sell the business has been negotiated. Depending on the situation, a CRT will not be effective to shelter the gain on the subsequent sale of the business. The prearranged-sale issue should not be a problem if the stock is to be redeemed by the corporation rather than purchased by a third party, provided that the trustee of the CRT is under no binding obligation to offer the stock for redemption after the transfer to the trust.
CRTs are subject to excise tax rules against self-dealing, defined as any transaction between a disqualified person and a CRT, and taxable expenditures. CRTs with a charitable beneficiary are subject to prohibitions on excess business holdings and jeopardizing investments.
A gift of residential real property to a CRT poses possible self-dealing problems. For example, if the grantor continues to reside ––even for one second–– in the residence after it is contributed to the CRT, the CRT is deemed to have conferred a direct benefit of the grantor, thereby subjecting the trust and the grantor to the excise tax. The self-dealing tax cannot be avoided by having the grantor lease the property from the trust after the property has been contributed to the CRT. Accordingly, the grantor must move out of the residence before it is contributed to the CRT. Self-dealing carries a penalty of 5% at first offense, but jumps to 200% if steps are not taken to correct the problem.
The sale of C-corporation stock or assets by a CRT to a third party should not trigger the private foundation self-dealing excise tax, unless the third party is a disqualified person. A disqualified person would include the grantor to the CRT, a trustee of the CRT, or of a foundation that is the remainder beneficiary of the CRT, a member of the grantor’s family (defined as a spouse, ancestor, child, grandchild and great-grandchild of the grantor and the spouses of those individuals) and certain entities owned and/or managed by disqualified persons. Thus, a sale of the CRT’s stock or assets to the grantor’s child who expects to take over the family business from the grantor would be a prohibited act of self-dealing, because the child is a disqualified person. In contrast, a redemption of the CRT’s stock by the corporation, rather than a sale to a third party, would not result in a self-dealing tax if the offer to redeem is at fair market value and is made to all shareholders holding the same class of stock. To qualify for this exception, it might be advisable to structure the gift to the CRT as a separate class of stock held only by the CRT. Then, the corporations can redeem only the CRT’s stock while still qualifying for the redemption exception to the self-dealing rules.
The self-dealing rules may make the day-to-day management of a partnership or LLC difficult when a CRT is a partner or member because any transaction between the LLC or partnership and the CRT must be scrutinized to determine whether it violates self-dealing rules.
Unrelated Business Taxable Income
Certain types of assets generate unrelated business taxable income (“UBTI”) when owned by a CRT. A CRT has UBTI in any year in which the trust has income from an active trade or business, or passive income that is debt-financed. This means that contributions of certain types of assets (for example, many partnership interests and most mortgaged real estate) result in UBTI to a CRT. In any year in which a CRT has UBTI, it is taxed at rate of 100% on the UBTI.
Mortgaged property can create a UBTI problem because of the debt-financed property rules, unless a narrow exception applies. However, note that the UBTI problem is not limited to mortgaged real estate. UBTI can sometimes result if the real estate is subject to a lease. Generally, rent payments qualify for the passive- income exception to the unrelated business-income tax. However, if the lease payments look more like an active trade or business, and less like a passive collection of rent by the CRT, then the exception doesn’t apply. For example, this could be so if a commercial lease contains provisions in which the rental payments are tied in some way to the profits of the tenants.
Gifts of C-Corporation stock generally do not raise UBTI problems because the trade or business income of the corporation is taxed at the corporate level. However, if the CRT owns more than 50 percent of the voting power and more than 50 percent of the equity in the C-Corporation, any interest, annuity, royalty or rent (but not dividends) paid from the corporation to the CRT will constitute UBTI.
Hedge funds and other “alternative” investments are often structured as limited partnerships or LLCs. In their investment strategies, these entities frequently utilize debt or derivative products that may look more like debt than equity. Alternatively, if the fund is a venture-capital fund, it may invest directly in operation businesses that are not C-Corporations. As a result, the primary problem presented by gifts of partnership or LLC assets to a CRT is UBTI. If a CRT owns an interest in a partnership or an LLC that operates an active trade or business or has debt-financed property, the CRT will have UBTI because the tax attributes of a partnership or LLC flow through to its partners or members. This result often can be avoided by having the CRT’s investment in the partnership or LLC structured through a C-Corporation which blocks the UBTI from ever reaching the CRT. Many hedge funds and alternative investment funds have established such “blocker” corporations, either domestically or offshore, for the express purpose of attracting tax-exempt investors such as CRTs. Alternatively, it may be possible for the CRT to create its own blocker corporation through which to make such investments.
The single biggest problem with gifts of real estate to a CRT is the mortgaged-property problem. A gift of mortgaged property treated as a “bargain sale” may cause the trust to have UBTI and may cause the CRT to be treated as a grantor trust, thus losing its tax-exempt status. If the grantor remains liable for the debt, the CRT is treated as a grantor trust for income tax purposes. That means it is not a tax-qualified CRT, and the grantor loses the income and gift tax charitable deductions (sometimes the estate-tax charitable deduction, too), plus, the trust loses its tax-exempt status. The grantor will be liable for any capital gains taxes generated when any appreciated trust asset is sold. Our advice to clients is simple: Get rid of the mortgage before funding the CRT.
When a CRT is funded with mortgaged property, the transaction is treated as a “bargain sale” for income tax purposes. This forces the grantor to recognize gain on some portion, or all, of the outstanding mortgage value. This rule applies regardless of whether the mortgage is recourse or non-recourse and regardless of whether the grantor continues to pay the mortgage. Mortgaged property can also create a UBTI problem, because of the debt-financed property rules, unless a narrow exception applies.
Tangible Personal Property
Tangible personal property–such as paintings, sculpture and jewelry–can sometimes be an appropriate asset with which to fund a CRT. While the general tax traps described above must all be considered in the case of a tangible personal-property gift, there are three additional tax problems specific to such gifts. First, the grantor’s income tax deduction is delayed until the property is sold by the trustee. Second the grantor should be informed that his or her income tax deduction for the remainder interest will be based on the lesser of the property’s fair- market value or its cost basis. Third, if the property has been subject to accelerated depreciation (for example, farm equipment), then the charitable deduction may be further reduced.
If the CRT trust instrument allows a private foundation to be named as one of the charitable-remainder organizations, the grantor’s income tax deduction will be subject to the more restricted adjusted gross- income limitations applied to gifts for private foundations, rather than the more generous limitations applied to gifts to public charities. In addition, the grantor’s income tax charitable deduction will be calculated by reference to the grantor’s basis in the contributed property rather than the property’s fair-market value. This basis limitation doesn’t apply if the grantor gives “qualified appreciated stock” to the CRT. Qualified appreciated stock generally means stock in a publicly traded company.
If the grantor has no intention of ever naming a private foundation as one of the remainder organizations and the trust is funded with difficult-to-value assets, the trust instrument should always include a provision limiting the charitable-remainder organizations to public charities. Under most circumstances, this will guarantee that the charitable deduction will be computed based on the contributed asset’s fair-market value rather than its basis. However, practitioners using the IRS-approved forms may unwittingly cause their clients to receive a lower charitable deduction.
The extent to which any of the tax traps discussed will arise in any given CRT depends, in part, on the type of asset involved. While knowing is half the battle, we always advise seeking professional assistance in navigating any form of trust.