A Charitable Remainder Unitrust is a great way to make your assets work for you. In a Charitable Remainder Unitrust, you elect to donate your assets to a charitable organization – or organizations – of your choosing in exchange for income for the remainder of your days – or for the remainder of your beneficiary’s days. You benefit by receiving life income from your charitable gift. The charities benefit by receiving the trust fund at the end of your interest.
The federal government gives tax benefits to encourage you to support charitable organizations through a unitrust. Creating a unitrust – keeping attractive income for life – can save estate taxes and probate costs, as well as substantial income taxes.
How is a unitrust created?
To create a unitrust, a donor irrevocably transfers money, securities, or both to a trustee (often a professional fiduciary), which pays the donor income for life. The trust can also provide income for a survivor (e.g., a spouse) for life. Then the trust assets become the sole property of the charitable organization named as the remainder organization.
A unitrust pays you an amount each year determined by multiplying a fixed percentage (that you select at the outset) times the fair market value of the trust assets each year. You get an immediate income tax charitable deduction, and it is often possible for part of your payments to be taxed more favorably than income you are currently earning on your assets.
In addition, your unitrust can provide income for another–a spouse, parent, child,…etc. You can also have the income paid to you for life, and then to a family member. The charitable deduction is lower for a two-life unitrust, because payments are for a longer time than for a one-life plan. A unitrust created by your will can provide life income for one or more survivors. For a sizable estate, the tax savings generated by the estate tax charitable deduction can be significant.
How is yearly income determined?
The unitrust assets and receipts are managed and invested by the trustee as a single fund. The income beneficiary receives payments based on a fixed percentage of the fair market value of the trust assets, valued each year.
For example, Paul’s unitrust provides that he is to receive 7% of the fair market value of the unitrust assets each year (payable quarterly). Paul funds his trust with $100,000, so he receives $7,000 the first year. One year later, the unitrust assets are worth $110,000. Paul receives $7,700 for the upcoming year ($110,000 x 7%). If the assets are worth $120,000 at the beginning of the succeeding year, Paul will receive $8,400 for that year ($120,000 x 7%). And so on, each year.
What income tax benefits can you earn from a unitrust?
A donor who itemizes their tax return gets a sizable income tax charitable deduction in the year he or she1 creates the unitrust. The deduction is for the value of the charitable organization’s right to receive the unitrust principal (the remainder) after the donor’s life, as determined by official IRS tables.
Your charitable deduction depends on several factors: your age (and the age of any other beneficiary), the unitrust percentage to be paid to the beneficiary, and the amount of money or fair market value of long-term securities placed in trust.
1 Deductible up to 50% of your adjusted gross income when the unitrust is funded with money and the charitable beneficiary is a school, church, hospital or other public charity. Any “excess” is deductible over the five following years – up to 50% of each year’s adjusted gross income.
What are the benefits of funding your unitrust with appreciated securities?
There is no tax when you transfer appreciated securities to fund a unitrust. Furthermore, the charitable deduction for a gift funded with long-term securities is based on the securities’ full fair market value–not their lower cost basis. Gains on sales of appreciated securities by a unitrust aren’t taxed to the trust, nor is ordinary income. The payments made to the income beneficiary are taxed as described below.
How can the unitrust protect against inflation?
The annual amount you receive reflects any increase in the value of the trust’s assets. It also assures you the stated percentage each year, even if the unitrust income is less than the stated percentage. Capital gains or principal can make up any shortfall. If trust income exceeds the stated percentage, the excess is added to the unitrust assets and reinvested for your benefit.
A variation calls for the trustee to pay only the trust’s income if its actual income is less than the stated percentage. Deficiencies in distributions (i.e., where the unitrust income is less than the stated percentage) can be made up in later years if the trust income exceeds the stated percentage.
For unitrusts funded with long-term appreciated securities, the contribution is deductible up to 30% of the adjusted gross income – with a five-year carryover for any “excess.” In some cases, the ceiling can be increased to 50% with a five-year carryover.
How is unitrust income taxed?
The amount paid to you, the income beneficiary, retains the character it had in the trust. Each payment is treated as:
- ordinary income to the extent of the trust’s ordinary income for the year (and any undistributed ordinary income from prior years)
- capital gains to the extent of the trust’s capital gains for the year (and any undistributed capital gains from prior years)
- tax-exempt income to the extent of the trust’s exempt income for the year (and any undistributed exempt income from prior years)
- a tax-free return of principal
The trustee will tell you each year exactly how to report the unitrust payments on your tax return.
What are the income tax benefits?
Depending on investments, part of the income paid to the beneficiary can often be treated as capital gain; part may even be a tax-free return of principal. Those benefits can be achieved by a growth- rather than an income-oriented investment policy. The income beneficiary must receive the stated percentage each year; if the unitrust income is less than the stated percentage, capital gains or principal will be distributed.
The following examples show the different tax treatments for growth and income investment policies…
Example 1: Bob funds his 7% unitrust with $100,000 and it earns $7,000 on dividends during the year. The entire $7,000 he receives is taxed as ordinary income. Assuming no increase or decrease in value of the unitrust assets, the assets are worth $100,000 at the beginning of the second year. So Bob is entitled to $7,000 for the second year ($100,000 x 7%).
Example 2: Instead of investing for income, the trustee invests for growth. During the year, Bob’s 7% unitrust appreciates to $107,000, but earns no income. Bob is entitled to $7,000 for the year, so the trust sells $7,000 worth of stock. If the stock sold for $7,000 has a $5,000 cost basis, Bob has $2,000 of capital gain income and a $5,000 tax-free return of principal. Even though capital gain and principal have been distributed, the trust principal is still worth $100,000 at the beginning of the second year. So Bob is entitled to $7,000 for the second year.
Had the unitrust appreciated to $111,000 during the year, the unitrust principal would be $104,000 at the beginning of the second year (after Bob receives his $7,000). Bob would then get $7,280 for the second year ($104,000 x 7%).
Example 3: This example is more detailed to give you a fuller idea of a unitrust’s workings. The trustee advises the beneficiary each year of the amount of income and how to report it properly on his or her tax return.
On the first year, after multiplying the $100,000 fair market value of the unitrust by 7%, it is determined that the beneficiary is to receive $7,000 for Year One. During the year, the trust:
- Received: $2,000 in dividends.
- Sold: a block of stock for $4,000 which had a $2,000 cost basis.
- Received: $2,000 in interest from tax-free municipal bonds.
- The $7,000 the beneficiary receives for Year One is taxed as follows:
- $2,000 is ordinary income.
- $2,000 is capital gain income.
- $2,000 is tax-free interest.
- $1,000 is nontaxable return of principal.
During the second year, after multiplying the $110,000 fair market value of the unitrust by 7%, it is determined that the beneficiary is to receive $7,700 for Year Two. During the year, the trust:
- Received: $8,000 in dividends.
- Sold: a block of stock for $12,000 which had a $9,000 cost basis.
- Received: $1,000 in tax-exempt interest.
- The entire $7,700 received by the beneficiary is taxed as ordinary income.
And finally, in Year Three, after multiplying the $115,000 fair market value of the unitrust by 7%, it is determined that the beneficiary is to receive $8,050 for Year Three. During the year, the trust:
- Received: $3,000 in dividends.
- Received: $750 interest from tax-free municipal bonds.
- The $8,050 the beneficiary receives for the year is taxed as follows:
- $3,300 is ordinary income ($3,000 in dividends received by the trust in Year Three plus $300 of dividends undistributed in Year Two).
- $3,000 is capital gain income (undistributed in Year Two).
- $1,750 is tax-free interest ($750 received by the trust in Year Three plus $1,000 undistributed in Year Two).
How does a unitrust eliminate, or reduce, estate taxes and probate costs?
The unitrust is not subject to Personal Representative’s fees or other probate costs in most states. If your estate would otherwise be subject to federal estate tax, substantial tax savings can be achieved. When the donor is the only beneficiary, the unitrust is not taxed to the donor’s estate.
When U.S. citizen spouses are the beneficiaries of a two-life unitrust, the trust assets are not taxed to either of their estates. For a two-life unitrust in which the donor is the first beneficiary and the second beneficiary is not the donor’s spouse, the unitrust is not taxed to the donor’s estate if the second beneficiary doesn’t survive the donor. If there is a survivor beneficiary (and the donor’s estate would otherwise be taxed), only the value of the survivor’s right to life payments (computed on the donor’s death) is subject to tax in the donor’s estate. The charitable gift–the charitable institution’s right to the trust principal on the death of the survivor–is always completely free from estate tax.
Now that you understand how a unitrust is established and maintained, the toughest decision you’ll need to make now is what organization to donate to.