Frequently Asked Questions

1. What is a Charitable Remainder Unitrust?
2. What Formats are available for Charitable Remainder Unitrusts?
3. What are some possible, personal financial benefits for creating a Charitable Remainder Trust?
4. Who are the Candidates for a Charitable Remainder Trust?
5. How is the income tax charitable deduction calculated for a gift to a Charitable Remainder Trust?
6. What are the gift and estate tax consequences of retaining an income interest in a Charitable Remainder Trust?
7. What tax and information returns are required after a Charitable Remainder Trust is created?
8. What are the Annual Valuation Rules for Charitable Remainder Unitrusts? and Why are the Annual Valuation Rules Important?
9. What is a Charitable Remainder Annuity Trust?
10. What Factors Should I Consider When Choosing a Payout Format for my Charitable Remainder Trust?
11. How do I select a measuring term for my Charitable Remainder Trust?

12. What are some methods of income deferral within a Flip Charitable Remainder Unitrust (Flip-CRUT) or a Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT)?

    For many years, charitable planners have considered methods by which income distributions can be deferred from a charitable remainder trust. The annuity trust and standard unitrust are generally inappropriate vehicles because they are required to make annual distributions to the income beneficiaries. The Flip-CRUT during its initial phase and the net income unitrust, with or without a make-up provision, are appropriate because income distributions can be deferred simply by investing in assets that do not produce income as that term is defined in the trust. Following are examples of those methods:

    A. Assets that Produce Capital Gain (e.g., growth stocks)

    One method of shutting off the faucet of distributable net income within a net income or Flip-CRUT involves investing in capital assets that maximize capital appreciation and gain upon sale. For this purpose, the trust instrument should not include gains from the sale of capital assets within its definition of distribute income. Further, in order to maximize income distributions in future years, these trusts should often include a make-up provision.

    Common growth stocks are often selected during the income deferral phase because they frequently produce no dividends, are liquid and easily valued. Assuming the trust has no income, the trustee will record income deficiencies in a deficiency amount.

    When income is desired, the trustee repositions the portfolio in assets that maximize interest, dividends, rents or royalties. These often include government and corporate fixed income instruments, mortgages or trust deeds, or high dividend paying preferred or utility stocks.

    The problem with manipulating asset classes to control income distributions is that such decisions involve personal timing rather than conditions in the investment markets. As a result, the trust may not accomplish the donor's intended goals because a selected asset class may be out of phase with market cycles. For example, a trust may be invested solely in equities during a downturn in the stock market and then, when income is desired, reposition the portfolio in fixed income instruments when prevailing interest rates are at an all-time low.

    Equities also often produce at least a small dividend thereby creating distributable income during the accumulation phase (i.e., the faucet will leak). When this happens, the donor can contribute the income back into the trust, but only after paying taxes on the distribution. Finally, an investment policy of this type could exceed the trustee's risk tolerance and potentially violate the reasonable return requirement of Treas. Reg. §1.664-1(a)(3).

    B. Zero Coupon Bonds

    Another method by which income can be deferred from a net income unitrust involves the purchase of original issue discount (zero coupon) bonds. Using this approach, a Trustor creates a charitable remainder unitrust that includes a net income provision. The trust defines "income" as that term is defined under IRC §643(b) (and local law) and, further specifically provides in the CRT that the discount element of a bond or other evidence of indebtedness purchased at a discount shall constitute income only in the year the bond is redeemed by the issuer or sold by the trust.

    If income is not produced until the bond is sold or redeemed, such sale or redemption by a trust containing a make-up provision can cause a flood of distributable income to the trust, and to the income recipient. This may or may not be a desired result. This result can be avoided several ways: (1) by excluding the make-up provision; (2) by purchasing bonds with laddered maturities; or (3) by allocating the discount element of the bond to principal (if compatible with local law).

    Using either or both of the first two methods, distributions are triggered upon sale or redemption. In the case of the third alternative, if the discount element of the bond and capital gains are both allocated to principal, the bond will have to be sold or redeemed and the proceeds reinvested in income producing assets before the income recipient can receive any distribution. In application, this takes considerably more time. Under the third method, the CRT's investment in a zero coupon bond creates a high probability of turning off cash flow distributions to the CRT's income beneficiary while the bond is held. However, it also provides almost no flexibility for purposes of making a sizable, future cash flow distribution from the NIMCRUT. If the income beneficiary simply wants the cash flow stream to start in a future known year, the inclusion of zero coupon bond language in a Flip-CRUT along with an investment by the trust of all or most assets in a zero coupon bond portfolio will satisfy these requirements.

    C. Deferred Annuity Contracts

    Private Letter Ruling 9009047 presents a very creative solution to the investment challenges and income deferral possibilities of net income and Flip-CRUTs. In the ruling, two individuals funded a NIMCRUT (net income with make-up unitrust) with common stock. The trustee sold the stock and invested the proceeds in a deferred annuity contract issued by an insurance company.

    The IRS ruled the trust will qualify as a charitable remainder unitrust and will include any annuity contract income in ordinary income for the year under IRC §72(u)(2). The trust will not hold the annuity for a natural person (i.e., an individual).

    1. Application of Deferred Annuity Investments

    The published ruling does not tell the whole story of using the deferred annuity in net income unitrusts. In the trust document submitted with the ruling request, the trust's definition of distributable income was modified to accommodate distributions from an annuity contract. While the IRS did not specifically rule on this issue, such definition was found to be compatible with IRC §643(b) and local law.

    In application, the results of this ruling are quite interesting:

    a. Qualification of Annuity

    The IRS ruled the trust cannot hold the annuity contract for a natural person; therefore, income generated within the annuity contract is taxable to its owner when generated.

    The owner, in this case, is a tax-exempt trust; therefore, no tax is incurred as long as the trust does not become taxable for another reason (i.e., the generation of unrelated business taxable income).

    b. Generating Distributable Income

    The IRS ruled that distributable income is produced only when the trustee makes a withdrawal from the annuity contract.

    Under the annuity rules, distributions from an annuity contract are considered made on a last-in-first-out (LIFO) accounting basis. To the extent such distributions represent gain in the contract, such amounts are considered distributable income to the trust to the extent of the current unitrust amount plus the deficiency amount balance. It is important to note that even though the trust is required to recognize income from the annuity when earned within the contract, it is not considered distributable until it is withdrawn from the contract.

    Planning Note:  CRT trustees who expect to treat withdrawals from the inside buildup of a deferred annuity contract as distributable income should review the trust document and applicable state principal and income law. Optimally, the trust document will be specifically drafted for this purpose. Also, as of January 2004, the principal and income law of 5 states (Indiana, Alaska, Delaware, South Dakota and North Dakota) specifically treat such withdrawals as distributable income. If either the trust document or state law does not include the authority to treat withdrawals as distributable income, the trustee will be unnecessarily placed in a difficult position.

    c. Distribution Planning

    Withdrawals from the annuity contract (and, therefore, distributions from the trust) are voluntary and made at the sole discretion of the trustee.

    During the annuitant's life, this feature provides great flexibility in distribution planning. The planner must be mindful, however, that when an annuitant dies (absent any provisions in the contract to the contrary), the value of the contract must be distributed to its beneficiary, the trust, within five years of the date of death. If there is a surviving income recipient (such as might be the case with a two-life trust created for a husband and wife) and the trust has a large deficiency amount balance, a large amount of income may be distributable if the decedent is the annuitant.

    Planning Recommendation:  This issue can be alleviated by purchasing multiple annuity contracts using different persons as the annuitant. For example, the husband could be the annuitant for one contract and the wife could be the annuitant for a different contract. Another possibility is to name the income beneficiary's child as the annuitant since the child presumably is likely to outlive the parent.

    Caution: IRC §72(s) generally requires that in the event the holder (i.e., the owner) of the annuity contract dies before the starting date of the annuity, the entire interest in the contract shall be distributed within five years of the death of the holder. The section further provides that in the event the holder's spouse is a designated beneficiary (i.e., a co-annuitant) under the contract, the five-year distribution requirement is waived. In this case, however, the trust is the owner of the contract. Therefore, some insurance companies do not feel that §72(s) applies and, therefore, do not force a distribution. Others propose that if the spouse or other party is included as a co-annuitant, the survivor has a contractual right to continue.

    d. Investment Flexibility

    All withdrawals from the annuity contract (in excess of basis) are considered ordinary income regardless of their source.

    The most important and unique benefit of using a deferred annuity contract within a net income or Flip-CRUT is the trustee's ability to separate the investment management of trust assets from its requirement to distribute income. In application, a variable deferred annuity can be invested in equity, fixed income or guaranteed sub-accounts during periods of accumulation or distribution. Most other deferral methods require investment within specific asset categories (i.e., stocks or zero coupon bonds). In the case of the annuity, asset allocation within the contract can consider the trustee's risk tolerance, return goals and investment horizon, not the distributable income requirements of the trust.

    e. Application of Pre-59 1/2 Penalty Tax

    IRC §72(q) provides that amounts received by a taxpayer under an annuity contract prior to the taxpayer attaining age 59 1/2 are subject to a penalty tax equal to 10% of the portion of such amount which is includible in gross income.

    The 10% penalty tax should not, however, apply because the annuity is already taxable to its owner (the trust) under IRC §72(u). Even if the penalty does apply, it is in the form of an additional tax and the trust is tax-exempt.

    f. Use of "Make-Up Provision"

    If the trust contains a make-up provision and the deferred annuity has gain in the contract over its original acquisition cost, the trustee can at any time withdraw from the contract and distribute the unitrust amount for the current year plus the entire deficiency amount.

    Unlike a traditional deferral plan, the trustee does not have to change investments from growth to income and then wait for income to be generated. The annuity can, in essence, store income. This not only provides for immediacy of income distributions, it can also provide very substantial lump-sum distribution amounts.

    g. Valuation

    Private Letter Ruling 9009047 also stated, "The annuity contract shall be valued at its account value, i.e. the value on which interest earnings are computed, for purposes of determining the annual net fair market value of the trust assets under the terms of the trust instrument."

    As a result, the annuity's full value (as compared to its cash surrender value) is used to determine the annual unitrust amount. No discount for possible withdrawal is taken into consideration.

    h. Guaranteed Benefit for Charity

    In a fixed annuity, principal is guaranteed by the issuing insurance company. Therefore, regardless of market conditions at time of surrender, the charitable remainder beneficiary will receive the full market value. Also, most contracts waive all surrender penalties at the death of the annuitant.

    Variable annuities handle this issue differently. Some contracts provide a death benefit that goes beyond the original investment in the contract by guaranteeing the original investment plus a stipulated compounded rate of return as a death benefit (regardless of actual account value at death).

    CAVEAT: With a "fixed" annuity, the term "guarantee" should be viewed with the understanding that a guarantee is only as good as the insurance company making it. Variable sub-accounts are required by law to be held in segregated accounts in trust. Careful consideration of carriers and contract provisions should be made prior to investing.

    2. Independent Special Trustee

    When using some income deferral methods, the Trustor is advised to consider utilizing an independent trustee or Independent Special Trustee to oversee all elements of investment management, income deferral and income distribution. Because of the flexibility regarding income distributions, a Trustor who serves as the sole trustee runs the risk the trust will be deemed a grantor trust.

    The danger of a grantor trust scenario increases in direct proportion to the grantor's increased flexibility to influence distributions via the income deferral method. For example, the trustee of a CRT that owns a deferred annuity contract has complete discretion as to both the timing and the precise withdrawal amount (assuming the annuity contract's value has sufficiently increased in value).The tremendous flexibility of making that determination leads many attorneys and planners to recommend that the grantor either not serve as trustee for such a CRT or to appoint an Independent Special Trustee to determine both the timing and amount of withdrawals from a deferred annuity contract.

    3. Implementation Considerations

    A full discussion of the administration and implementation of a deferred annuity as a trust investment is included in other Renaissance materials. While the concept creates a very compelling case for the use of a deferred annuity, and while in operation this technique may seem simple, as with most areas of charitable trust planning, care must be taken to implement the program correctly.

13. What is a Flip Charitable Remainder Unitrust (Flip-CRUT)?
14. What are the Typical Responsibilities of a Trustee of a Charitable Remainder Trust?
15. What is an “Independent” Special Trustee (IST)? When is an IST used in Charitable Remainder Trust Planning?