Rising Rates Add to the Appeal of CRTs

If you're philanthropically inclined, have you considered establishing a charitable remainder trust (CRT)? These irrevocable trusts provide a variety of tax and financial perks. Plus, unlike some other tax planning tools and strategies, CRTs can benefit from today's rising interest rates.

How CRTs Work

A CRT is an irrevocable split-interest trust that pays a specific amount as an annuity to one or more income beneficiaries for a fixed term up to 20 years or their lifetimes. The income beneficiaries frequently are the donor and if married, his or her spouse. Payments from a CRT are taxable to the noncharitable beneficiaries.

When the payout period terminates, the remaining assets (or the remainder) in the CRT go to a designated charity or charities, and those assets are removed from the taxable estate. The remainder must be at least 10% of the fair market value (FMV) of the donor's initial contribution to the CRT.

You can transfer a variety of assets to a CRT, including:

• Real estate,
• Artwork,
• Publicly traded securities, and
• Certain closely held stocks.

The trustee typically sells the assets and reinvests the proceeds in income-producing assets. The income beneficiaries pay tax on their distributions. But the investment income is tax exempt. It's important to note that donated assets can't later be taken back by the donor.

CRTs are especially attractive to individuals with highly appreciated assets. By transferring an asset to a CRT, you avoid taxable capital gains and the net investment income tax when the trust sells it—the tax is deferred until the CRT distributes income. In addition, you receive a charitable contribution deduction at the time of the transfer, based on the present value of the remainder that will eventually pass to the charitable beneficiaries. The amount of the deduction is subject to an adjusted gross income limitation and other restrictions.

CRATs vs. CRUTs

The IRS recognizes the following two types of CRTs:

1. Charitable remainder annuity trusts (CRATs). With a CRAT, you can't make additional donations after the initial funding. The trust will make fixed annuity payments in an amount from 5% to 50% of its initial value. This setup assures consistent payments regardless of fluctuations in the trust's value over time.
2. Charitable remainder unitrusts (CRUTs). You're permitted to make additional donations to a CRUT. Further, a CRUT pays out a specified percentage (again, at least 5% but no more than 50%) of the trust's FMV each year. Because the payout depends on current value, CRUTs require annual valuations. The payouts keep pace with inflation. That is, payouts increase as the trust's value increases, but they also decrease if the trust's value declines.

Why Interest Rates Matter

The amount of your charitable contribution deduction when you establish a CRT is based on the remainder interest's present value. The present value is the FMV of the donated property less the present value of the annuity. A variety of factors are part of the calculation, including:

• The initial net FMV of the donated assets,
• The duration of the trust term or, if distributions will be paid for life, the beneficiaries' ages,
• The payout rate,
• The frequency of payments, and
• The IRS interest rate (also known as the Section 7520 rate).

The greater the present value of the remainder interest, the greater your deduction—meaning a higher interest rate produces a larger deduction than you'll get from a lower interest rate. The IRS interest rate has been on the rise. For example, the rate for May 2023 is 4.4%—up from 3.0% in May 2022 and 1.2% in May 2021. You're allowed to choose the Sec. 7520 rate for the month of the contribution or the two previous months, whichever is highest.

Beware of CRAT Scams

The IRS has warned taxpayers that CRATs can be used as part of a "potentially abusive transaction" that's on its "enforcement radar screen." The agency says that dishonest individuals may promote CRATs online, promising tax savings that are too good to be true. It advises taxpayers to rely on reputable tax professionals they can trust to avoid being duped.

Perpetrators of the CRAT scheme wrongfully promise to eliminate taxable gains. After appreciated property is transferred to a CRAT, the scammer advises the taxpayer to improperly claim that the transfer gives the property a step-up in tax basis to fair market value (FMV), as if the property had been sold to the trust.

Based on this faulty advice, the CRAT then sells the property at FMV without recognizing gain, due to the alleged stepped-up basis. Then the proceeds are used to purchase a single premium immediate annuity. The income beneficiary reports as income only a small portion of the annuity and treats the remaining payment as an excluded portion representing a nontaxable return of investment.

Warning: This is a misapplication of the federal tax code that's likely to attract unwanted attention from the IRS.

Seize the Moment

With interest rates on the rise, it's worth considering whether a CRT could help you achieve your financial, estate planning and philanthropic goals. Contact your SSB tax advisor to choose the optimal strategies for your situation.

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