The economic turmoil that enveloped our country created an unusual set of circumstances for both affluent donors and charitable institutions. On the one hand, after many years of relative ease in raising money, charitable institutions are encountering unprecedented headwinds in reaching their financial goals for their capital campaigns. For the affluent donors that created a Charitable Remainder Trust (“CRT”) they are now feeling significantly de-capitalized as they watch their balance sheets dramatically shrink. Many donors are “feeling poorer” and, in some cases, their purse strings have become hermetically sealed.
But there is a bit of good news that should be considered for those charitable institutions seeking a means to increase the size of their capital campaigns on an accelerated basis and wealthy individuals seeking to put cash back in their accounts.
A Charitable Remainder Trust (“CRT”) is a split interest trust. Generally, a CRT must (1) provide for a specific distribution, at least annually, to one or more persons, at least one of which is a noncharitable beneficiary (the “Income Interest,” which is received by the “Income Beneficiary”) and (2) direct the CRT’s corpus to a charitable organization upon the CRT’s termination (the “Remainder Interest”). A CRT may terminate (1) upon the death of the Income Beneficiary, or (2) within twenty years of formation. The grantor’s income, gift, or estate tax deduction is equal to the actuarial value of the Remainder Interest.
Occasionally, an Income or Remainder Beneficiary wishes to terminate a CRT early. He may wish to terminate the CRT because of market fluctuations, the need for current cash, or an intense capital campaign. One way to achieve a termination is by commutation. A commutation involves the liquidation of the CRT by distributing to the Income and Remainder Beneficiary their actuarial value of their interests directly from the CRT.
In essence, the CRT distributes property to the Income and Remainder Beneficiary (Donor and Charity) equal to their respective interests in the CRT. Thus, the donor receives cash while the charitable institution receives an immediate cash infusion which they otherwise would have to wait for.
Several Private Letter Rulings (“PLRs”) address the validity and taxation of a CRT’s commutation. The IRS has consistently ruled that the transfer is treated as a sale or exchange of each beneficiary’s interest within the meaning of Code Sec. 1001(a). Pursuant to Code Sec. 1001(e), the Income Beneficiary is treated as having a zero basis in his interest, and therefore realizes and recognizes gain on the full amount received.
Despite the apparent simplicity of the technique there is a very complex inter- play of different tax issues. For example, the Code imposes a penalty on “self dealing” between “disqualified parties” and the CRT. If the Income Beneficiary is the CRT’s grantor, he or she is a disqualified party. However, the Income Beneficiary can avoid the self dealing penalty by only receiving the Income Interest’s then cur- rent value. Some commentators believe that the self dealing penalty can only be avoided when the Remainder Beneficiary is a public charity, not a private foundation. Beyond the federal tax rules, state law plays a significant role in a CRT’s termination. Typically, the State Attorney General must be a party to the transaction and a court action is usually involved.
It is important to keep in mind that several different ways to terminate a CRT exist. Each method has its own peculiar tax advantages and disadvantages. Some result in no taxation to the income beneficiary but at a price, to wit: added complexity. However, the complexity is often outweighed by the tax benefits.
Authors: Roy Kozupsky and Douglas Stein