Terminating a charitable remainder trust isn’t always possible
Estate Planner July-August 2006
A charitable remainder trust (CRT) allows you to support your favorite charities while providing yourself with current tax benefits and a regular income stream. (See the sidebar “ABCs of a CRT.”) But what if your circumstances change after you set up a CRT? Can you undo the trust? CRTs generally are irrevocable, but it may be possible to terminate one if applicable law permits it and all interested parties consent.
Reasons to terminate
Why would you want to terminate a CRT? Perhaps the trust’s investments have underperformed, causing its value to decline and jeopardizing the charity’s remainder interest. Perhaps you’re short on cash and would like to receive your portion of the trust’s value now rather than later. Or maybe you don’t need the income and would prefer to see the charity enjoy your donation today instead of waiting until you die or until the trust term ends.
Whatever the reason, be sure to plan carefully. Terminating a CRT isn’t always an option – it could be prohibited by state law or by the terms of your trust. And even if termination is allowed, there are specific steps you must take. Any missteps and your CRT may be disqualified retroactively and you’ll lose any previous tax benefits you claimed.
2 ways to terminate a CRT
One way to terminate a CRT is to assign your income interest in the trust to the charitable beneficiary – often referred to as an assignment termination. This may be a good option if you no longer need the trust income. Before taking action, ensure such an assignment is permitted under state law and that the trust document doesn’t expressly prohibit it.
After you assign your income interest, the charity no doubt will want immediate access to the trust principal. Depending on state law, this may happen automatically under the doctrine of merger, which provides for the termination of a trust when one party owns both the income and remainder interests. Otherwise, a court order may be required.
The second method of terminating a CRT – an actuarial split – is to divide the trust assets between yourself and the charity based on the actuarial present values of your respective interests. The IRS has issued several private letter rulings allowing actuarial splits of CRTs in cases where:
· State law permits termination of the trust,
· All of the parties consent to the termination, and
· The income beneficiaries are unaware of any medical conditions that would result in shorter life spans than those set forth in IRS life expectancy tables.
In some states, you’ll need to petition a court for an order terminating the trust. You may also need to notify the state’s attorney general or include him or her as a party to the court proceeding.
To support your actuarial present value calculations, it’s a good idea to have a physician certify that you have no known medical conditions that would result in a shorter-than-normal life expectancy.
The IRS considers the termination of a CRT to be a sale or exchange between the income and charitable remainder beneficiaries, generally resulting in taxable capital gains to the income beneficiaries.
Suppose, for example, that you terminate a CRT and the present values of the income and remainder interests are $50,000 each. Also suppose that the trust assets have a basis of $40,000. Basis is allocated pro rata according to the respective interests of the income and remainder beneficiaries, in this case $20,000 each. If you terminate the trust through an actuarial split, IRS regulations provide that basis is disregarded in calculating your gain, so you’ll be taxed on the entire $50,000.
If you assign your income interest to the charity, however, your gain will be reduced by your share of the basis, resulting in a $30,000 capital gain. You also can claim a $50,000 charitable deduction (subject, of course, to adjusted gross income limits).
There had been some concern that terminating a CRT might be viewed as a prohibited act of self-dealing or as the termination of a private foundation, which could result in penalty taxes or even disqualification of the trust. Fortunately, the IRS has issued several private letter rulings confirming that early termination of a CRT isn’t an act of self-dealing and isn’t subject to termination taxes (so long as the assets are divided actuarially between the beneficiaries and the termination complies with state law).
Explore all angles before taking action
Under the right circumstances, terminating a CRT can be a win-win move for everyone concerned. Be sure to consult a professional to make sure that terminating the trust is permissible and done correctly, and that the benefits of termination outweigh the costs.
Sidebar: ABCs of a CRT
You can contribute assets to a charitable remainder trust (CRT), and the trust pays you an income stream for life or for a term of years and then distributes what’s left to a qualified charity. You receive a current income tax deduction equal to the present value of the charity’s remainder interest. And you shield the contributed assets and all future earnings from estate and gift taxes.
There are two types of CRTs:
1. A charitable remainder annuity trust (CRAT) pays you an annual income of at least 5% of the initial value of the trust assets. After the trust is funded, additional contributions are prohibited. So, the payments you receive remain the same throughout the trust’s term.
2. A charitable remainder unitrust (CRUT) pays you an annual income of at least 5% of the trust assets, valued annually. Additional contributions are permitted. So, the payments you receive will vary from year to year.
Which type to choose depends on your needs and circumstances. A CRAT offers the advantage of a fixed income stream, which protects you in the event the trust’s value declines. A CRUT is riskier because income payments are tied to underlying asset values, but offers greater upside potential. All CRTs must be designed carefully to ensure they preserve a minimum level of benefits for the charitable beneficiary.
A CRT is an ideal tool for converting highly appreciated, low-yield investments into income-producing assets at a minimal tax cost. Suppose you own $200,000 worth of stock with a cost basis of $40,000. You could sell the stock and invest the proceeds in assets that pay, say, a 6% return. After paying $24,000 in capital gains taxes, you’ll have $176,000 left to invest, producing a $10,560 annual income stream.
If you contribute the stock to a CRT, however, the trust can sell the stock tax-free and reinvest the full $200,000, resulting in a $12,000 annual payment. If the CRT is designed to make a 6% annuity or unitrust payment, you’ll enjoy the income on the entire investment without having to pay capital gains taxes.
Sidebar: IRS backs off CRT ruling – for now
Last year, the IRS issued a controversial ruling threatening charitable remainder trusts (CRTs) with disqualification unless the grantor’s spouse waived his or her inheritance rights. The ruling was intended to address state laws that give your surviving spouse a right of election to receive a portion of your estate regardless of your estate plan’s terms.
The new rules – found in Revenue Procedure 2005-24 – disqualified CRTs created on or after June 28, 2005, that are subject to a surviving spouse’s right of election (regardless of whether the right is actually exercised).
After a barrage of complaints, the IRS has suspended the Revenue Procedure indefinitely. In Notice 2006-15, the IRS said that, until further guidance is issued, it will disregard a spousal right of election in evaluating a CRT. For now, a CRT will be disqualified only if a spouse actually exercises that right.