Section 664: Charitable Remainder Trusts

A charitable remainder trust (CRT) is an irrevocable trust that allows an individual to make a substantial gift to a charitable organization while creating an income stream for themselves or others. This arrangement is well-suited for individuals with assets that have appreciated significantly in value who want to support a charity, generate income, and manage their tax situation. The trust holds and manages the assets, making payments to a designated income recipient for a set period. Once this period concludes, the remaining assets are transferred to the designated charitable organization.

Core Concepts of Charitable Remainder Trusts

A charitable remainder trust, as defined by Internal Revenue Code Section 664, is a “split-interest” vehicle because its benefits are divided between two types of beneficiaries. The first is the income beneficiary, who receives payments from the trust for a set duration. The second is the charitable remainderman, a qualified charitable organization that receives the remaining trust assets after the income payment term ends.

The process begins when a donor irrevocably transfers assets—such as cash, securities, or real estate—to the trust. The trust is managed by a trustee, who can be the donor, a third-party, or a corporate entity like a bank. The trustee is responsible for managing the trust’s investments and ensuring payments are made according to the trust document.

The income beneficiary receives payments from the trust at least annually. The term for these payments can be for the life of one or more individuals or for a fixed period not to exceed 20 years. At the end of the specified payment term, the trust terminates and all remaining assets are distributed to the designated charity.

Types of Qualifying Trusts

The Internal Revenue Code authorizes two primary forms of charitable remainder trusts, which differ in how income payments are calculated. The choice depends on whether the donor prefers a stable income or an income stream with the potential to grow. The two structures are the Charitable Remainder Annuity Trust and the Charitable Remainder Unitrust.

Charitable Remainder Annuity Trust

A Charitable Remainder Annuity Trust (CRAT) pays a fixed dollar amount to the income beneficiary each year. This amount, known as the annuity, is determined when the trust is created and is calculated as a percentage—between 5% and 50%—of the initial fair market value of the assets. Once established, this payment amount never changes, regardless of the trust’s investment performance.

For example, if a donor funds a CRAT with assets valued at $500,000 and specifies a 5% annuity payout, the beneficiary will receive $25,000 every year. No additional contributions can be made to the trust after it has been initially funded.

Charitable Remainder Unitrust

A Charitable Remainder Unitrust (CRUT) pays the income beneficiary a fixed percentage of the trust’s fair market value, which is re-valued annually. This percentage must also be between 5% and 50%. Because the trust’s value can change based on investment returns, the annual payment will also fluctuate, offering a potential hedge against inflation.

To illustrate, if a CRUT is funded with $500,000 and has a 5% payout rate, the first year’s payment would be $25,000. If the trust’s assets grow to $520,000 by the second year, the payment for that year would increase to $26,000. Unlike a CRAT, a donor is permitted to make additional contributions to a CRUT.

Tax Treatment for Donors and Beneficiaries

The tax implications of a CRT are a primary reason for its use in financial planning, providing benefits to the donor and dictating how the beneficiary is taxed.

The Donor’s Charitable Deduction

When a donor funds a CRT, they are entitled to an immediate income tax charitable deduction for the year the trust is created. This deduction is not for the full value of the assets transferred but for the present value of the remainder interest projected to pass to the charity. The calculation is based on the trust’s term, the payout rate, and applicable IRS interest rates. The calculated value of the charitable remainder interest must be at least 10% of the initial value of the assets.

Capital Gains Tax on Asset Contribution

A CRT helps manage capital gains taxes. A donor can fund the trust with highly appreciated assets, and the trustee can sell them without immediately triggering capital gains tax. This allows the entire proceeds from the sale to be reinvested within the trust, creating a larger asset base to generate income. As a tax-exempt entity, the trust’s investment earnings can compound without being taxed annually. However, if the trust generates unrelated business taxable income (UBTI), that income is subject to a 100% excise tax.

Taxation of Beneficiary Income

Income payments distributed to the beneficiary from a CRT are taxable, determined by a specific four-tier accounting system. Distributions are taxed in the following order of priority:

• First, as ordinary income to the full extent of any ordinary income the trust has earned.
• Second, as capital gains, using up any capital gains the trust has realized.
• Third, as tax-exempt income, if the trust holds such assets.
• Finally, as a tax-free return of the trust’s principal.

Trust Administration and Reporting

Once a charitable remainder trust is established, ongoing administration is necessary to comply with legal and tax requirements. These duties fall to the trustee and involve asset management, distributions, and annual tax filings.

Trustee Responsibilities

The trustee of a CRT has a fiduciary duty to manage the trust’s assets prudently. This involves making investment decisions that consider the trust’s purpose and the interests of both the income and remainder beneficiaries. A core responsibility is to ensure the correct annual payment is calculated and distributed in a timely manner. For a CRUT, this requires an annual valuation of the trust’s assets. The trustee must also maintain detailed records of all transactions, including income, expenses, and distributions.

Tax Filing Requirements

Charitable remainder trusts are required to file an annual information return with the IRS using Form 5227, “Split-Interest Trust Information Return.” This form reports the trust’s financial activities for the year, including its income, deductions, and distributions to beneficiaries. It also serves to determine if the trust is subject to certain excise taxes. The form is due by the 15th day of the 4th month after the trust’s tax year ends.