Using Charitable Remainder Trusts to Reduce Capital Gains Rates vs Income Deduction Planning

Charitable remainder unit trusts often are often recommended by professional advisors in situations involving clients who:
1) Are charitably inclined
2) Could use a significant income tax deduction to offset higher than normal taxable income in a given tax year or years.

A typical design for this type of CRT might include:
1) A relatively low payout rate to the income beneficiary (not less than 5%) that would produce a
2) large charitable remainder at the termination of the trust, which would produce an immediate income tax deduction in the year of the gift even though the charitable remainder wouldn’t be paid out to the charity for years or the lifetime of the client(s).
3) Usually a longer term trust which may last for the lifetime of the client(s).

This article will suggest another design for CRUTs, in which the design is primarily for clients who have the following characteristics:
1) Clients who aren’t necessarily charitably inclined
2) Taxable income usually not exposing them to the 20% capital gains tax rate. Taxable income exceeding $457,601 (married filing jointly) or $406,751 (single), but
3) Who will or would have exposure to the 20% capital gains tax rate because of an event like merger deemed an inversion or who simply wish to diversify out of a large position in a single security like a publicly or nonpublicly traded stock.

A typical design for this type of client might include:
1) A relatively high payout rate to the income beneficiary.
a. The highest possible payout rate that satisfies the 10% charitable remainder rule to qualify as a charitable remainder trust that also,
b. Maintains the 15% federal gains tax rate by keeping the combined personal income of the client plus the income from the CRUT below the 20% federal capital gains tax rate, $457,601 (married filing jointly) or $406,751 (single).
c. Maintains the 7.85% or lower state income tax rate by keeping the combined income of the client plus the income from the CRUT below the 9.85% Minnesota state income tax rate. $258,261 (married filing jointly) or $151,951 (single).
2) Minimal charitable remainder at the termination of the trust which satisfies the 10% charitable remainder rule.
3) Usually a shorter term design where the trust will terminate at the end of 10 to 15 years.

In this design the deduction does not drive the design. The smoothing effect of the CRUT payments over time to keep below the 20% capital gains tax rate and possibly even avert the 3.8% Obama care surtax is the primary driver of the design and reason for establishing the CRUT. The deduction simply is the cherry on top that may help incentive the client to decide to act sooner than later and help the professional advisor move the client forward towards the goal of diversifying out of a large undiversified position in a single security or avert higher tax rates than are necessary in a given year because of a taxable event like a merger being treated like an inversion for tax purposes, meaning immediately taxable even though the client isn’t actually selling their position in a security.

If the total income of the client can be kept below $250,000 (married filing jointly) or $151,951 (single) annually it may possible save the client 2% off Minnesota’s income tax rate, 5% of the federal capital gains rate and 3.8% off the Medicare surtax rate or a total of 10.8%. The total tax rate of 15% for federal and 7.85% for Minnesota state capital gains is 22.85% vs. the rate of 33.65% if the client were to be in the highest combined tax rates and subject to the Medicare surtax.

By implementing the CRUT the client may be able to save on income taxes annually, get an immediate income tax deduction and have a larger dollar amount compounding annually than had they simply sold outside of the CRUT and paid the taxes outright. Yes, there is a charitable remainder that is paid out at the end of the trust term that reduces the overall savings of the transaction to the client, but the larger dollar amount compounding returns over time reduces the drag of the charitable remainder and gives the client direction as to how those dollars are used by giving the grantor of the trust the ability to choose and change the charitable beneficiary vs simply leaving it to the government by payment of unnecessary income taxes.

Lastly, it may be helpful to explain to the client that they are essentially moving their position in the security being considered from their right pocket (personal balance sheet) to their left pocket (CRUT). The money will flow in a circular motion from one pocket back to the other. The income payments from the CRUT can even be paid in kind and not sold at all, although the payments themselves will be income taxable regardless of whether they are actually sold or not. That also means that the stock or position transferred from their balance sheet (right pocket) to the CRUT (left pocket) will eventually end up back on their balance sheet, less the statistical 10% charitable remainder and will receive a step up in basis at death.

Hope this is helpful…

Jeremy P. Green CFP, CTFA, CLU, CEBS, MSFS, AEP, EA 
Wealth Strategist & Expert Witness Consultant
Wealth Strategist Designs
Cell: 612-405-0799