A Charitable Remainder Trust (“CRT”) is a split interest trust wherein you retain the right to receive a certain amount each year (expressed as a percentage of the assets or as a fixed annuity) (“Income Interest”) and whatever remains at the end of the trust passes to charity (“Remainder Interest”). A CRT may terminate (1) upon an individual income beneficiary’s death, (2) within twenty years of formation, or (3) the later of the two. The person who establishes the CRT (the “grantor”) receives an income, gift, or estate tax deduction equal to the actuarial value of the remainder interest.
Occasionally, an income or remainder beneficiary wishes to terminate a CRT early. A beneficiary may want to terminate a CRT early due to market fluctuations that affect the value of the CRT, the need for current cash, or an intense capital campaign by the charitable organization. One way to achieve a termination is by commutation. A commutation involves the liquidation of the CRT by distributing to all the beneficiaries the actuarial value of their interests directly from the CRT.
Several recent 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. The income beneficiary is treated as having a zero basis in his or her interest, and therefore recognizes capital gain on the full amount he or she receives.
Despite the apparent simplicity of the technique, there is a very complex interplay of different tax issues. For example, the Internal Revenue 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 receiving the then current fair market value of the Income Interest and no more. Some commentators believe that the self dealing penalty can be avoided only if the remainder beneficiary is a public charity. It is easiest to terminate a CRT early when the beneficiary is a public charity such as a church or community foundation. If you are uncertain if the charitable beneficiary is a public charity, ask them and they should be able to tell you quickly.
Beyond the federal tax law, 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. Notice must be given to the appropriate parties and all the formalities of a litigated matter must be carefully followed.
Although the PLRs deal exclusively with commutation, there are several other ways to terminate a CRT. Each method has its own peculiar advantages and disadvantages. Some result in no taxation to the income beneficiary but are more complicated. Others are very simple but may result in less money going to the respective parties.
We can help you determine if it makes sense to terminate a CRT and which method is best for you.