Charitable Remainder Trust Tax Tips

In 1969, Congress passed IRS Section 664. Section 664 created a trust designed to help charities and not-for-profit organizations. At the same time, it can help individuals increase retirement income, avoid capital gains and estate taxes. It can also decrease current income tax liability while passing on an estate to heirs and make a substantial gift to a family foundation or charity. This type of trust is known as a Charitable Remainder Trust (CRT).

The basic premise is easy. If you have a substantial stock portfolio that you intend to leave to heirs upon your death, the capital gains and estate taxes could feasibly consume two-thirds of the proceeds. That can add up to a huge check for the IRS.

Instead, set up a CRT and donate the portfolio to the trust. Designate yourself as trustee. The investment income from the portfolio can still be paid to you, and you would report it as taxable income on your personal tax return. In fact, the IRS requires the CRT to make a distribution of at least 5% of the net fair market value (FMV) of its assets. The good news is if you don’t need the income in one year, you can defer the income to a future year, but in the end, net distributions must bet at least 5%. This is one reason a CRT is often used as a retirement plan. During the pre-retirement years, income can be deferred until you retire.

If the trust does not earn a current income, you would not be paid, and the trust would continue to grow tax deferred. This type of tax-deferred trust is often used to fund employee retirement plans.

Additionally, you can take the donation as a charitable deduction on your tax return, reducing your tax liability for the year in which the donation is made. Upon your death, the trust balance would go to the charity, which can then sell the stocks, capital gains free.

Another option is to set up a family foundation and pass on the trust proceeds to it rather than an outside charity or not-for-profit organization. The advantage to this approach is it would allow the family more control over how the funds were distributed on charitable projects. There is also a certain amount of prestige that can be passed on from generation to generation in this type of arrangement.

Concerned the family will not directly reap the rewards of your portfolio? Consider a $1 million portfolio. When the IRS collects capital gains and estate taxes, your legacy could be reduced to roughly $310,000. A more prudent move might be to purchase a life insurance policy for that amount, which can be structured to escape estate taxes. By handling the situation this way, most of your portfolio would remain in tact. When you set up a CRT and take the charity deduction, your personal deduction would come close to matching the $310,000.

All told, you have saved $600,000 in capital gains and estates taxes, plus gained a $310,000 charitable deduction. For the price of a life insurance policy, your heirs break even monetarily, and the charity of your choice comes out the biggest winner, having received a $500,000 donation.

Now that you know the facts, you can make the choice. Pay the IRS or make a charitable contribution.

Before you do anything, check with your accounting professional to ensure a Section 664 works for you specific situation.