What Is a Unitrust and How Does It Work?

A unitrust is a specialized financial arrangement designed to provide a flexible income stream to individuals for a set period or their lifetime, with remaining assets ultimately benefiting a charitable organization. It is a type of charitable remainder trust, allowing donors to make a significant charitable contribution while retaining income from gifted assets.

Understanding the Unitrust

A unitrust is characterized by its unique payment mechanism, where beneficiaries receive a fixed percentage of the trust’s fair market value, revalued annually. This annual revaluation means the dollar amount of income distributed can fluctuate, adapting to the trust’s investment performance. Unlike an annuity trust, which provides a fixed dollar payment, a unitrust offers a variable income stream.

The primary purpose of a unitrust is to provide income to non-charitable beneficiaries for a specified term. After this period concludes, the remaining assets are distributed to the designated charitable organization. Key parties include the donor, income beneficiaries, and the charitable remainder organization.

How a Unitrust Operates

The operational mechanics of a unitrust center on its annual valuation process. Each year, the trust’s assets are revalued to determine their fair market value. This valuation dictates the unitrust payment for the upcoming year, calculated as the fixed percentage of the updated asset value.

Payments are typically distributed quarterly or annually. If assets experience growth, the annual payment will generally increase. Conversely, if the asset value declines, the payment will decrease, reflecting the trust’s performance. If investment income is insufficient, the trustee may need to draw from the trust’s principal to meet the required payment.

Common Unitrust Structures

Various unitrust structures exist, each offering distinct payment mechanisms.

The Standard Charitable Remainder Unitrust (CRUT) pays a fixed percentage of the trust’s annually revalued assets to the non-charitable beneficiary. This payment occurs regardless of the trust’s actual income, potentially drawing from principal if income is insufficient.

A Net Income Charitable Remainder Unitrust (NICRUT) limits payments to the lesser of the fixed percentage or the actual net income earned by the trust. If the trust’s income is low, the beneficiary receives less than the stated percentage, and any shortfall is not recoverable.

The Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT) operates similarly to a NICRUT, but it includes a “makeup” provision. If the trust’s income is less than the fixed percentage, the shortfall is tracked and can be paid out in future years if the trust earns more income.

A FLIP Unitrust begins as a NICRUT or NIMCRUT. Upon a specified triggering event, such as the sale of an illiquid asset, it converts to a Standard CRUT, allowing for regular percentage-based payments thereafter.

Establishing a Unitrust

Establishing a unitrust involves several preparatory steps to ensure the trust aligns with the donor’s financial and charitable objectives. The process begins with the donor identifying assets to transfer and selecting the parties involved. These parties include the trustee, income beneficiaries, and the charitable organization that will receive the remainder.

A formal trust agreement must be drafted to outline the unitrust’s terms. This agreement specifies the chosen payout rate, which must fall within Internal Revenue Service (IRS) guidelines, generally between 5% and 50% of the trust’s value. It also defines the trust’s term, which can be for the life of the income beneficiary or for a period not exceeding 20 years. Legal and financial professionals are commonly engaged to ensure the trust is structured correctly before it is funded.

Tax Implications of a Unitrust

Unitrusts offer several tax considerations for donors and beneficiaries. When a donor establishes and funds a unitrust, they may qualify for an immediate income tax deduction. This deduction is based on the present value of the charitable organization’s remainder interest, calculated using IRS actuarial tables. The deduction is subject to adjusted gross income limitations and can be carried forward for several years if not fully utilized.

Distributions received by income beneficiaries are taxable, following a “tier system” established by the IRS. Payments are first considered ordinary income, then capital gains, followed by tax-exempt income, and finally, a return of principal, which is typically tax-free. For estate and gift tax purposes, assets transferred to an irrevocable unitrust are generally removed from the donor’s taxable estate. However, if a non-charitable beneficiary other than the donor or their spouse is named, a portion of the transfer may be subject to gift tax.