Testamentary Charitable Remainder Trusts

Many people have expressed concern about possible changes to the federal estate and transfer tax, as tax changes frequently accompany a new presidential administration. Therefore, it is always a good idea to be aware of tax planning strategies such as grantor retained annuity trusts and completed gift domestic asset protection trusts. Another planning option available to individuals with assets that have appreciated significantly in value is the charitable remainder trust (CRT). A testamentary CRT may be a good choice for an individual who wants to benefit not only loved ones, but a favored charity, after death.

What is a Testamentary Charitable Remainder Trust?

If you are familiar with trusts, you know that a trust is a legal relationship among three parties: the grantor or trustmaker, who creates the trust and funds it with assets; the trustee, who manages those assets and distributes income from the trust; and the beneficiaries, who receive income from the trust, and ultimately, the assets in the trust.

With a charitable remainder trust, the grantor places assets that have appreciated in value into the trust, in exchange for a stream of income. Depending on the type of CRT, the trust pays an income stream to someone of the grantor’s choosing for a period of time. When the specified period comes to an end, the assets remaining in the trust are distributed to a charity of the grantor’s choice.

Many CRTs pay that income stream to the grantor for either a term of years, or the rest of his or her life. A testamentary charitable remainder trust is different. With a testamentary CRT, the trust is created by the grantor’s will. Income is usually paid to family members or another individual beneficiary, with the selected charity receiving trust assets at the end of the designated term.

How is a Testamentary Charitable Remainder Trust Used for Tax Planning?

Testamentary charitable remainder trusts can be especially valuable in minimizing capital gains taxes. If an asset has appreciated significantly in value, and could appreciate still more, a recipient of that asset could face capital gains tax upon the sale of an asset.

Take, for example, a farm. Let’s imagine a farmer named Rachel, who purchased her farm several decades ago for $100,000. In the intervening years, the value of the property has grown to $600,000. Rachel is now in her seventies and would like to sell the farm. She intends to give some of the proceeds to her niece and nephew, and the remainder to a local children’s hospital foundation.

If Rachel were to sell the farm during her lifetime, she would have $500,000 in capital gains (the current value of the farm less Rachel’s cost basis of $100,000). At a current federal capital gains tax rate of 15%, Rachel would pay $75,000 in capital gains taxes on the profit from the farm.

She could just leave the farm to her niece and nephew in her will and ask that they make a donation to the charity if and when they sell the property. Under current law, individuals who inherit an asset take a “step up” in basis. Instead of having Rachel’s cost basis of $100,000, their basis would be the value of the property at the time of Rachel’s death. But there are potential problems with this approach.

If the niece and nephew held the property, it would likely appreciate further and they, too, would have to pay capital gains tax when they sold it. What’s more, if the “step up” in basis rule is eliminated as has been proposed, the niece and nephew could have a much higher capital gains tax payment. And there is no guarantee that they would choose to honor their aunt’s wish to benefit the hospital foundation. A testamentary charitable remainder trust could avoid these problems.

The testamentary CRT would be created by Rachel’s will upon her death, and the farm would be transferred into the trust. Her estate would receive a charitable income tax deduction. The trustee could then sell the farm without incurring capital gains tax (a CRT is not subject to capital gains tax). The trustee could then invest the assets, creating an income stream for the niece and nephew for whatever term Rachel specified when she created the trust. At the end of that term, the remaining assets in the trust would go to the charity.

As an added benefit, a testamentary CRT is an irrevocable trust, meaning that assets in the trust are protected from creditors and lawsuits of the beneficiaries.

Is a Testamentary CRT Right for You?

You might consider a testamentary charitable remainder trust for assets valued from $100,000 up to several million dollars. Assets commonly placed in CRTs include stock in certain closely-held corporations; publicly-traded securities; rental property, farmland, or other real estate; and cash.

In addition to testamentary charitable remainder trusts, there are other types of charitable trusts that can pay you an income during your life and distribute trust assets to your chosen charity after your death. To learn more about charitable remainder trusts, we invite you to contact Gudorf Law Group to schedule a consultation.