Individuals and businesses can create a charitable remainder annuity trust to receive a reliable income stream from their assets through a tax-advantaged arrangement. After the trust term ends and income payments cease, the remaining balance is donated to a tax-exempt entity.
A charitable remainder annuity trust can last a set number of years, or it can last for the lifetime of one or more individuals. The IRS considers the trust itself as a tax-exempt entity, so any income gained within the trust does not automatically trigger a tax bill.
Instead, taxes are paid on distributions to beneficiaries. These taxes are assessed according to the type of income generated by the trust.
With this arrangement, the trust’s creator could conceivably defer taxes on gains for years—or entirely, if the trust generates enough income to pay for all of the distributions made during each year.
Because of their tax-exempt status and ability to defer or avoid certain taxes on the sale of appreciated assets, charitable remainder annuity trusts can be highly desirable. You can discuss the opportunities one might offer and consider your options for starting one when you book a no-obligation consultation appointment at New Mexico Financial & Family Law.
Schedule your consultation and portfolio review with an Albuquerque charitable remainder annuity trust lawyer today when you call our firm at (505) 503-1637 or contact us online.
All charitable remainder annuity trusts must be irrevocable. Accordingly, you should think carefully about how you want the trust to be structured and how you want to make certain decisions based on your goals and your unique financial situation.
Factors you can consider with the help of an Albuquerque charitable remainder annuity trust attorney include:
During your consultation with an Albuquerque charitable remainder annuity trust lawyer, they will help you understand the implications of each decision, along with the opportunities and risks of certain strategies. For example, if your goal is to reduce your tax burden on highly appreciated assets, your attorney may recommend specific guidelines for managing the trust’s investment portfolio, along with a strategy for deciding the amount and the frequency of distributions the trust pays out.
Reach out to our law offices in Albuquerque today to begin the discussion. Our guidance will help you create a trust that’s capable of helping you fulfill all of your long-term financial and philanthropic goals.
Like other trusts, a charitable remainder annuity trust is a legally recognized entity that can assume ownership of cash accounts and other assets. The trust is formed when the trust creator (called a grantor, settlor, or trustor) transfers these assets into the trust.
Assets that can be placed into a trust include:
Note that a charitable remainder annuity trust cannot hold equity shares in an S corporation or certain other types of business-related assets.
The trust is then managed by a trustee, who will operate the trust according to the guidelines set by the grantor. With a charitable remainder annuity trust, the grantor can act as sole trustee or a co-trustee alongside other parties.
Also like other trusts, a charitable remainder annuity trust will pay distributions to a beneficiary or beneficiaries. The “annuity” designation means that the payments must be arranged in advance as a set amount that the beneficiary will receive.
The IRS sets rules governing the distributions of a charitable remainder annuity trust. Namely: there must be at least one distribution made annually, and the annual distributions must total to at least 5% of the trust’s principal value.
A charitable remainder annuity trust can be set up to last a predetermined number of years, or it could persist for the duration of one or more named individuals’ lifetime, or some combination thereof.
When the term of the trust has expired — either because the allotted time has transpired or because all designated individuals have passed on — then the remainder balance of the trust is distributed to the charity (or charities) initially selected by the grantor.
If all beneficiaries die before the full term period has elapsed, then the remaining distributions are combined with the remainder and set aside until the term expires.
One of the major benefits afforded by a charitable remainder annuity trust is that taxes are only assessed on income when it is distributed to beneficiaries. The beneficiaries then pay the appropriate taxes, as if they had generated the income themselves.
When the charitable remainder annuity trust is first formed, the grantor must calculate the present value of the remainder balance. This calculation is performed by subtracting the sum total present value of all annuity payments from the principal value of the trust (see IRS Publication 1457, Table S, Single Life Factors for more).
The present value of the remainder is calculated using the IRS’ Sec. 7520 rate in the month that the trust is funded. Alternatively, the grantor can use the Sec. 7520 rate for one of the two months that preceded the funding date.
Grantors are able to use this calculated amount to deduct from their income (or their estate) that year, up to the allowable amount. The maximum amount allowed is typically 50% of the grantor’s adjusted gross income (AGI) that year, but certain factors could limit this amount to as little as 20%.
Unlike a charitable lead trust, the grantor typically wants to transfer assets into the trust during a period when the Sec. 7520 rate is high. That way, they can maximize the assessed value of the charitable deduction.
Distributions from a charitable remainder annuity trust are taxed in a very different scheme from most other trusts or investment vehicles.
The goal of the IRS is to make the beneficiary pay the appropriate taxes in relation to the income generated by the trust each year. However, if the beneficiary does not withdraw an amount equal to the taxable income generated, then they are not required to pay taxes on any remaining taxable interest left in the trust until a later date.
The balance of income earned then carries over to the next year (or years).
Distributions from the trust count towards the appropriate taxes, in the following tiered order:
As an example, a generous grantor named Jennifer might fund a charitable remainder annuity trust with $2 million in mixed assets. Over the following year, the trust generates $50,000 in ordinary income and $350,000 in short-term capital gains, along with $200,000 in long-term capital gains.
Jennifer must take an annuity payment of at least 5% of the value of the $2M principal by the end of that year. This equals a minimum annuity of $100,000. She will then pay taxes on the entirety of the $50,000 of ordinary income along with $50,000 of short-term capital gains.
The remaining $300,000 interest generated from short-term capital gains carries over to the next year. It may be possible for some of this amount to convert to long-term capital gains as well, if the short-term gains were not fully realized that same year.
In this way, Jennifer can potentially reduce her tax burden by only withdrawing enough income to trigger a portion of the taxes she might otherwise owe. Alternatively, she can seek to withdraw a higher annuity payment (or pay a higher annuity sum across multiple beneficiaries) so that she can withdraw all of the taxable income, along with as much tax-free proceeds from the trust’s principal balance and tax-exempt income as possible each year.
Her strategy will depend on her goals, her portfolio, and the expected performance of the trust’s portfolio over its term.
To deter abuses of charitable remainder annuity trusts, the IRS has formed rules that cause certain income to be taxed at a 100% excise rate. This rate applies to income that is generated from business activities, rather than investments, and which is unrelated to the charitable purpose of the trust or the charitable foundation that it intends to support — AKA: unrelated business taxable income, or UBTI.
In the past, generating any UBTI could have invalidated the charitable remainder annuity trust’s tax-exempt status. However, after rule changes made in 2008, the UBTI will instead effectively be recaptured in its entirety by the IRS.
This rule is created to actively discourage the generation of UBTI within a trust. Accordingly, grantors should take care not to place businesses or other ventures into the ownership of the trust if their proceeds could be seen as UBTI.
Refer to an attorney to learn more about what could count as UBTI.
New Mexico Financial & Family Law has decades of experience helping individuals and businesses with planning their charitable giving while helping reduce their tax burden. You can talk to our knowledgeable Albuquerque trust lawyers during a confidential consultation to discuss your options for forming a trust of your very own.
Call (505) 503-1637 or contact us online to schedule your no-obligation appointment today.
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