Section 664 Trust: What You Need to Know

A Section 664 trust, formally known as a Charitable Remainder Trust (CRT), is a specialized, irrevocable trust. It is designed to achieve two goals: provide an income stream to a designated individual for a specified period, and dedicate the remaining assets to a qualified charitable organization upon the trust’s termination. This structure allows a donor to support a philanthropic cause while retaining a financial benefit for themselves or others. Because its benefits are divided between non-charitable and charitable beneficiaries, it is considered a “split-interest” vehicle that integrates giving into financial and estate planning.

Understanding the Charitable Remainder Trust Framework

A Section 664 trust operates through the interaction of four distinct roles:

• Grantor: Also known as the Donor, this is the individual who creates the trust by irrevocably transferring assets into it. The Grantor establishes the rules of the trust, including who will receive income and which charity will ultimately benefit.
• Trustee: The Trustee is responsible for managing the trust’s assets, which can include cash, securities, or real estate. This involves making investment decisions and handling all administrative duties in the best interests of all beneficiaries.
• Income Beneficiary: This is the individual or individuals designated to receive regular payments from the trust. This income stream can last for the beneficiary’s lifetime or for a set term of up to 20 years.
• Charitable Remainder Beneficiary: This is the qualified 501(c)(3) charity selected by the Grantor. The organization receives the assets remaining in the trust after the income payment period concludes, fulfilling the Grantor’s philanthropic goal.

Annuity Trust vs. Unitrust Structures

Internal Revenue Code Section 664 authorizes two primary forms of charitable remainder trusts: the Charitable Remainder Annuity Trust (CRAT) and the Charitable Remainder Unitrust (CRUT). The difference between them lies in how the income payments are calculated. A trust must be established as either a CRAT or a CRUT from its inception and cannot blend features of both.

A CRAT is defined by its fixed payment structure. The trust pays the beneficiary a specific dollar amount each year, calculated as a percentage (between 5% and 50%) of the initial fair market value of the assets contributed. For example, if a donor funds a CRAT with $500,000 and specifies a 5% payout, the beneficiary receives $25,000 every year, regardless of the trust’s investment performance.

This predictability offers a stable income stream, which can be useful for financial planning. A significant restriction of a CRAT is that no additional contributions can be made to the trust after it has been funded initially.

In contrast, a Charitable Remainder Unitrust (CRUT) provides a variable payment that is recalculated annually. The payout is a fixed percentage, also between 5% and 50%, of the trust’s fair market value as revalued at the beginning of each year. If the value of the trust’s assets increases, the beneficiary’s payment for that year will also increase, and vice versa.

This structure offers the potential for a growing income stream, providing a hedge against inflation. Unlike a CRAT, a CRUT allows the donor to make additional contributions to the trust at any time, making it a more flexible tool for those contributing assets with high growth potential.

Tax Treatment for Donor and Beneficiary

The tax implications of a Section 664 trust are a primary reason for its use, affecting both the donor who creates the trust and the beneficiary who receives income.

Donor Tax Benefits

One of the most immediate benefits for the donor is a potential current-year income tax deduction. This deduction is for the present value of the remainder interest that the charity is projected to receive. The calculation is determined by IRS tables that consider the trust’s term, the payout rate, and federal interest rates. The calculated remainder interest must be at least 10% of the initial value of the assets contributed.

Another advantage arises when contributing highly appreciated assets, such as stocks or real estate. By transferring the asset to the trust instead of selling it directly, the donor can avoid paying capital gains tax on the appreciation. The trust itself is generally tax-exempt and can sell the asset without immediately realizing the gain, allowing the full value to be reinvested.

Beneficiary Tax Rules

The tax treatment for the income beneficiary is governed by a specific four-tier accounting system. This system dictates the character of the income received in each distribution, which determines how it is taxed on the beneficiary’s personal return. The distributions are deemed to come from the trust’s earnings in a specific order.

First, payments are considered ordinary income to the full extent of any ordinary income the trust has earned. Once all ordinary income has been distributed, the payments are then characterized as capital gains. After all capital gains have been paid out, the third tier is tax-exempt income. Only after all three of these income tiers are exhausted is the distribution considered a non-taxable return of the original principal.

The Trust Creation and Funding Process

Establishing a Section 664 trust is a formal legal process that begins with engaging an attorney with expertise in estate planning. The attorney will draft the trust instrument, a legal document that must be irrevocable and contain specific provisions mandated by the Internal Revenue Code to qualify for tax benefits.

The trust instrument must clearly articulate all the terms of the arrangement. This includes naming the trustee, identifying the income beneficiaries, and designating the charitable remainder beneficiary. The document must also detail the payout structure, specifying whether the trust is a CRAT or a CRUT, and define the payout percentage and the trust term.

Once the trust document is signed, the final step is funding the trust. This involves the legal transfer of assets from the donor’s ownership into the name of the trust. For securities, this means working with a brokerage firm to move them to a new account, while real estate requires executing and recording a new deed to transfer the property title.

Annual Compliance and Tax Filing Obligations

Once a Section 664 trust is funded, the trustee assumes ongoing responsibilities to maintain its qualified status. The trustee must manage and invest the trust’s assets prudently, adhering to standards designed to balance the interests of both the income and remainder beneficiaries. For a CRUT, this includes performing a formal valuation of the trust’s assets at least once a year to calculate the required distribution.

A central part of the trustee’s role is fulfilling the trust’s tax reporting obligations. The primary filing requirement is IRS Form 5227, “Split-Interest Trust Information Return.” This return must be filed annually to report the trust’s financial activities, including income earned, expenses paid, and distributions made to beneficiaries.

In addition to filing Form 5227, the trustee must issue a Schedule K-1 (Form 1041) to each income beneficiary every year. This document breaks down the total distribution the beneficiary received into its specific tax characteristics according to the four-tier system. The beneficiary uses the information on the Schedule K-1 to accurately report the trust income on their personal income tax return.