Win-win way to help out

There is nary a university that doesn’t ask its graduates for a helping hand. But making a charitable contribution doesn’t mean having to forgo income from your assets. One way to keep an alma mater happy and supplement your cash flow is to set up a tax-exempt charitable remainder trust.

With a CRT, a donor gives assets – usually appreciated long-term securities – to an irrevocable trust and re-ceives a lifetime income stream. At the end of the trust’s term, what’s left goes to one or more designated charities. In the process, the donor takes advantage of several tax benefits.

“Charitable remainder trusts are often used to defer capital gains tax,” says Blanche Lark Christerson, a managing director at Deutsche Bank Private Wealth Management in New York. “Suppose you have a concentrated position of a highly appreciated security that you’d like to sell but are reluctant to face up to a 25 per cent haircut because of the federal, state and local taxes you’ll pay on your built-in gain – assuming that you live in a place with state and local taxes.”

Here is how it works: when you set up the CRT you get a charitable income tax deduction (subject to limits based on adjusted gross income) for the present value of the charity’s “re-mainder interest”. The value of the remainder interest the charity will receive must be at least 10 per cent of what you are transferring to the trust, determined at the time of transfer.

The CRT sells the assets and, because of its tax-exempt status, pays no tax on the gain. In turn, the trust reinvests the proceeds and pays you a lifetime income stream, most of which is considered long-term capital gain.

A CRT works best when a donor wants to parlay highly appreciated or low-yielding assets – say closely held stock or real estate – into cash to create a more diversified portfolio or boost liquidity, but doesn’t want to end up with a big tax bill.

For the 79m baby boomers who will soon retire, a CRT may be one way to supplement cash flow during their golden years.

“People do a CRT while they are alive because they still want to get something back,” says Christerson. “The real key here is that it’s appreciated property. If you’ve got a well diversified portfolio there may be less incentive to do this.”

Julia Marie Chu, director of philanthropic services for UBS Trust, says until this year it was possible for a CRT to incur unrelated business taxable income (UBTI) and result in the taxability of all the income of the trust for that year. This could be “quite fatal” if it was in the same year the trust sold the appreciated security. If the CRT had only $1 of UBTI, it would lose its tax exemption for the year and would be taxed as an ordinary complex trust.

That changed with the passage in December of the Tax Relief and Health Care Act of 2006. Now, if a CRT has any UBTI, it won’t lose its tax exemption for the year but will face a 100 per cent excise tax on that income.

“The change in the law means the penalty is not as drastic, although it is still quite harsh, as the UBTI will be effectively forfeited,” says Chu. “It still pays to be careful to avoid the kinds of investments that will generate unrelated business in-come. Anything that is debt-financed is one such area.” This could occur if the trust borrowed funds to buy investments, or held mortgaged property.

When it comes to deciding how to structure a CRT, the available forms are the charitable remainder unitrust (Crut) and charitable rem-ainder annuity trust (Crat).

With a Crut, the payout is adjusted annually based on the value of assets in the trust but a Crat’s payout is fixed. If you are concerned about a hedge against inflation, a Crut is the way to go.

“Most people who establish CRTs are not that dependant on the payout but if a person is conservative and doesn’t want to take a chance, the Crat offers security,” says Julius Giarmarco, a partner at Cox, Hodgman & Giarmarco, and head of the firm’s estate planning and wealth preservation division. Another difference between a Crat and a Crut is that the latter can be structured to allow for extra contributions while the former cannot.

A Crut and Crat are both irrevocable, meaning the donor cannot change the predetermined payout or access the principal. Both can be structured to allow the donor to change his/her mind about the designated charities.

One final point is that when the the donor dies, the remaining assets pass to charity, not the heirs. To counterbalance this, some donors simultaneously create an irrevocable life insurance trust for their heirs – sometimes called a “wealth replacement trust”.

The donor buys life insurance equivalent to the value of the asset transferred to the CRT and uses the tax savings produced by the charitable donation deduction and the income generated by the trust to pay the premiums. The proceeds are payable to the heirs who stand to “lose” from the creation of the CRT. Since the life insurance is bought and owned by the irrevocable trust, the proceeds are free of income and estate tax.

The combination of a CRT and wealth replacement trust is “a win-win-win situation,” says Giarmarco. “The donor gets an income stream, the charity benefits and the children are made ‘whole’.”