Friday December 1, 2023
Unitrust III - Gifts and Taxation
Charitable solutions can create a steady stream of payments for a donor. Professional advisors may provide guidance on retirement planning, investments, tax strategies and charitable giving. Clients are often concerned with maintaining their standard of living, minimizing tax recognition and supporting their favorite charitable organizations. Life income gifts are a great solution for clients who desire a steady source of income for the duration of their lives, while also providing a legacy for charity.
Part three of this article series will provide an explanation of unitrust income as well as gift, estate and generation skipping taxation. It will also cover gifts from CRTs and reformation of trusts. The information should enable a donor to understand how a charitable remainder trust can fulfill his or her philanthropic goals.
CRT Income Taxation
The charitable remainder unitrust (CRUT) donor receives an income tax deduction equal to the present value of the remainder interest. It is calculated using the applicable federal rate for the current month, or one of the prior two months, as permitted under Sec. 7520.
Unitrust payouts are taxed to the recipient under the four-tier taxation structure. Sec. 664(c). Payments will be taxed first as ordinary income, second as capital gain, third as tax exempt or other income and fourth as return of principal.
A charitable remainder unitrust is irrevocably dedicated to charity and therefore is normally exempt from income tax. However, if the trust has acquisition indebtedness or engages in business that is regularly carried on, the trust will recognize unrelated business income (UBI). Sec; 512. Sec. 514. See also Newhall v. Commissioner.
With assets from an active trade or business in the charitable remainder trust, there will be tax on any UBI. The trust will be subject to a 100% excise tax on the unrelated business income. Sec. 664(c)(2)(A). Since a unitrust with unrelated business taxable income does not lose exempt status, an active business asset may be transferred to the trust and quickly sold. If the asset is sold quickly, a donor may receive the capital gains bypass benefit with a modest cost for the 100% excise tax on trust unrelated business income.
CRT Gift Taxation
A gift tax return may be required when there is a transfer of property without full consideration. A donor is allowed to make non-taxable present interest gifts to recipients of an amount equal to the annual gift exclusion amount. If the gift exceeds the annual exclusion amount, the donor is required to file an IRS Form 709 Gift Tax Return but may involve use of the donor's applicable exclusion amount. If the gift exceeds both the annual exclusion and the applicable exclusion, gift tax may be payable. Using the applicable exclusion to reduce gift tax will also affect the estate tax exclusion available at death.
If the donor is the sole income beneficiary of a one-life trust or the trust is a two-life trust with donor and donor's spouse as beneficiaries, there are no gift tax implications. If the donor is the income recipient and retains a testamentary power of revocation for a multiple life CRUT, there is no current gift. The power to revoke the income interest of a successor recipient must be testamentary and not inter-vivos. Reg. 1.664-3(a)(4).
Testamentary Power of Revocation
When a donor sets up a trust to benefit a non-donor, the donor may retain a testamentary power of revocation over the non-donor beneficiary's income interest. This power can be exercised only by the donor's will. The right of revocation renders the gift incomplete with respect to the non-donor. As a result, there is no taxable transfer when the trust is first created.
If the donor does not retain a testamentary power of revocation, the gift to the non-donor beneficiary is complete and there may be a current taxable gift. Taxable gifts will be made when distributions from the trust exceeding the annual exclusion are made to the non-donor beneficiary. However, retaining the testamentary power of revocation may also have estate tax consequences for the donor. The estate tax consequences of a donor retaining a right of revocation are explained below.
1. Donor retained a right of revocation over a non-donor's income interest and did not exercise that power at donor's death. Under Sec. 2038(a), the present value of the income interest over which the donor has retained a right of revocation will be included in the donor's gross estate for estate tax purposes. For example, assume a donor set up a unitrust to benefit himself and his daughter, age 40, as successor income recipient. Donor retains a testamentary power of revocation over the daughter's income interest. At the time of the donor's death, the daughter is age 65 and the current trust value is $100,000. Based on the daughter's age and a current rate of the month of 3.0%, the daughter's income interest is $54,943. Because the donor has retained a right of revocation over this interest, the $100,000 trust is included in his taxable estate. There is a Sec. 2055(e) charitable deduction for $45,057 and $54,943 is a taxable transfer in the donor's gross estate.
2. Donor has retained a right of revocation over a non-donor's income interest and has exercised that power at donor's death. Donor funds a two-life charitable remainder unitrust with payouts to her for one life and names her niece as successor income recipient. The niece later inherits $10,000,000 from her grandfather. Donor elects to revoke by will the successor income interest of the niece. At the death of donor, the trust is distributed to charity. Because the donor has revoked the non-donor's income interest, there is no estate tax consequence. While the trust is included in donor's estate, there is a full Sec. 2055(e) charitable deduction.
An estate tax may be levied on the transfer of property when a person passes away. The taxable estate is valued as of the decedent's date of death and includes the probate and non-probate estate, less costs, debts and administration expenses. With the existing applicable estate tax exclusion, few estates are subject to estate tax.
If the donor retains income, the trust corpus will be included in his or her estate. Sec. 2036(a). With a one-life unitrust, there will be a deduction for the full value of the trust. Sec. 2055. If the trust is funded for a married couple and one spouse passes away, there is a marital deduction. Sec. 2056(b)(8). Only if the successor income recipient is a child, nephew, niece or other family member, will there be a taxable transfer. In this case, the taxable transfer will be the present value of the income interest of the non-spousal beneficiary as of the date of the trust grantor's death. The value of this taxable transfer will be calculated using the Sec. 7520 applicable federal rate and appropriate mortality tables.
If the estate is subject to estate tax, the estate tax may not be payable from an existing charitable remainder trust. Rev. Rul. 82-128. The estate tax will normally be paid from the residuary of the estate.
Tax Apportionment Provisions
With a testamentary unitrust, most state tax apportionment statutes reduce charitable remainder trusts in order to pay taxes in the same manner as other non-charitable transfers. As a result, there is a substantial increase in the total estate tax. If the charitable trust is not to bear a portion of the estate tax, it may be necessary to draft a specific tax apportionment provision in the will or living trust that enables the trust to not be reduced to pay estate tax.
Generation-Skipping Transfer Tax
Generation-skipping transfer tax is levied on direct skips, taxable distributions and taxable terminations. Sec. 2613(a). If the charitable remainder trust makes payments to a grandchild, great-grandchild or other skip person, there may be taxable distributions.
The preferred course of action is to allocate a sufficient portion of the generation-skipping transfer tax exemption to the trust to produce a zero-inclusion ratio. The amount of the exemption allocated will equal the value of the taxable transfer. Sec. 2632; Sec. 2613.
So long as the allocated exemption equals the present value of the transfer to the non-charitable beneficiary, there will be no generation-skipping transfer tax. It should be noted that if there are benefits payable to both children and grandchildren, the entire non-charitable interest may need to be covered by the allocated GSTT exemption.
Calculating Taxable Transfers
A charitable remainder trust consists of a gift of a remainder interest and retention of an income interest. The present value of that remainder interest qualifies for the unlimited gift and estate tax charitable deduction. If a successor income recipient is someone other than the donor's spouse or charity, then there will be gift or estate tax on the value of the retained income interest.
Taxable Transfer Scenarios
The following are several common taxable transfer scenarios and the resulting taxable gift calculations. Each scenario assumes that the donor has not retained a testamentary power of revocation over the recipient's income interest. Trust arrangements more complicated than those detailed below may require an actuary to perform the taxable gift calculations.
1. Donor is sole income recipient. If the donor sets up a CRT to pay income to himself for life with remainder to charity, he has made a gift to charity. The present value of the remainder gift to charity qualifies for the gift tax charitable deduction. The donor's retention of the income interest results in no further gift tax consequences.
2. Donor is co-income recipient with spouse. If the donor sets up a CRT to pay income to himself and his spouse for their lives or for a term of years, then the gift to the spouse will qualify for the Sec. 2523(g) unlimited gift tax marital deduction. The donor will also receive a charitable gift tax deduction for the present value of the remainder interest gift to charity.
If there is another potential non-charitable beneficiary apart from spouse, then the gift to the spouse will not qualify for the unlimited marital deduction. The gift to the spouse and the other non-charitable beneficiary will need to be calculated.
3. Non-donor is sole income recipient. If the donor sets up a CRT to pay income to a non-donor (not his or her spouse) for life with remainder to charity, the donor has made a gift to charity and to the non-donor. The present value of the gift to charity qualifies for both a gift and income tax charitable deduction. The gift to the non-donor is a taxable gift and is calculated as the present value of the income interest. For a charitable remainder unitrust, the taxable gift (present value of the income interest) is equal to the full amount transferred minus the present value of the remainder interest and one annual gift exclusion amount. The donor must file IRS Form 709, Gift Tax Return.
Example: Non-Donor is the sole income recipient. Donor transfers $100,000 to a charitable remainder trust that names his 35-year-old son as the sole income recipient for his lifetime. The unitrust payout percentage is 5% and the AFR is 3.0%. If the one-life remainder value of $14,436 is subtracted from $100,000, the present value of the son's unitrust interest-and the gift-is $85,564. Because this is a vested income stream, the Donor reduces the gift by one annual exclusion amount and the balance is a taxable gift. Reg. 25.2503-3(b). When he or she files IRS Form 709 to report the gift, Donor allocates a portion of his or her applicable gift exclusion equal to the taxable gift.
4. Non-donor is the primary income recipient followed by donor. If the non-donor is the primary income recipient for life followed by the donor, the taxable gift is the same as if the non-donor were the sole income recipient. The value of the taxable gift is equal to the present value of the income interest based on the non-donor's life. The calculation uses a one-life unitrust for the non-donor to determine the life interest. If the non-donor holds a vested income stream, Donor also reduces the gift value by one annual exclusion amount.
5. Donor is the primary income recipient followed by non-donor. If the donor is the primary income recipient followed by the non-donor as vested successor income recipient, then the taxable gift is equal to the present value of the non-donor's survivor income interest. The survivor income interest is equal to the difference between the present value of the income interest based on the donor's and non-donor's joint lives and the present value of the income interest based solely on the donor's life. With a future interest gift, there is no annual exclusion for a present vested income stream. The full value of the future income stream is offset by allocation from the gift basic applicable exclusion.
Example: Donor is the primary income recipient followed by non-donor. Donor, age 60, names himself as the primary income recipient and Son, age 35, as successor income recipient of a $100,000 trust. The unitrust percentage is 5% and the AFR is 3.0%. The value of the son's successor income interest is calculated as follows:
PV of income interest based on joint lives $87,194 (Two Life Calculation)
PV of income interest based on Donor's life $61,733 (One Life Calculation)
PV of son's income interest (taxable gift) $25,461
6. Donor and Non-donor are joint and survivor life income recipients. If the income interest is to be paid to the donor and a non-donor in equal shares for their joint lives with the decedent's portion vested and payable to the survivor, the donor has made two gifts. First, the donor has made a gift to the non-donor of the present value of the non-donor's right to receive a survivor income interest from one-half of the trust. Second, the donor has made a gift of the present value of the income interest for the income recipients' joint lives from the remaining one-half of the trust.
Example: Donor and Non-Donor are Joint and Survivor Life Income Recipients. Donor, age 60, names himself and his Son, age 35, as joint and survivor income recipients of a $100,000 trust. The unitrust percentage is 5% and the AFR is 3.0%. When either Donor or Son passes away, the survivor will receive the entire income interest for his lifetime. The value of the taxable gift to Son is calculated as follows:
Gift 1 Calculation (Using One-Half of Trust Value or $50,000) - Donor and then Son
PV of income interest based on joint lives $43,597 (Two Life Calculation)
PV of income interest based on Donor's life $30,867 (One Life Calculation)
Equals Gift 1 Amount (PV of Son's Future Interest) $12,730
Gift 2 Calculation (Using One-Half of Trust Value or $50,000) - Son and then Donor
One-Half of Trust Value $50,000
PV of remainder interest based on Son's life $7,218 (One Life Calculation)
Equals Gift 2 Amount (PV Income to Son) $42,782
Total Combined Taxable Gift is $55,512.
With the vested income stream in one-half the trust income, one annual exclusion is permitted. The balance is offset by allocation from the applicable gift exclusion amount.
Gifts from a Charitable Remainder Unitrust During Life
Partial Interest Rules
After the unitrust has been funded, it is permissible to use trust corpus to make a current gift. However, the arrangement should not be created to avoid the application of the partial interest rules. Sec. 170(f)(3)(A). For example, it would not be appropriate to create a charitable remainder trust on Monday and then give the income interest to charity on Wednesday of the same week. If the gift of an income interest is contemplated, it should generally be made a year or more after creation of the trust.
Gift of An Income Interest
Under state law, when a CRUT is funded, the donor has made an irrevocable gift of the remainder interest but has retained the income interest. If the donor then transfers part or all of an income interest to a vested remainder recipient, the charity owns both the remainder and the income interest. Under the doctrine of merger, the charity owns the entire interest in that portion and a distribution of principal may be made to the charity.
If a donor transfers part or all of his or her interest in the income to a charity, he or she has relinquished all rights with respect to that portion. Thus, there is a charitable deduction for a gift of his or her income interest in that portion of the trust. Reg. 1.170A-7(a)(2)(i).
If the gift of the income interest is valued at over $5,000, a qualified appraisal will be required or the charitable tax deduction may be denied. Sec. 170(f)(11)(E)(ii). To meet the "qualified appraisal" standard, the appraiser must meet the requirements of Reg. 1.170A-17.
Valuation of UT Income Interest
Unitrust income and remainder interests are valued using the methods of Reg. 1.170A-7(a) and IRS Publication 1458. Based upon the age or ages of the income recipients on the date of the income interest gift, the applicable federal rate, the frequency of payment, the unitrust corpus value and the unitrust amount, the present value of the income interest may be determined. If the entire unitrust income is transferred to charity, then the amount calculated using the Treasury method is usually the deduction value. Section 664(e) of the code provides that the value of the income interest is based on the stated payout percentage.
Prior to 2015, the valuation of the income interest for a net plus makeup unitrust (NIMCRUT) or net income unitrust (NICRUT) was required to use the lesser of the AFR or the stated unitrust payout percent for the unitrust payout percentage. However, with the passage of the Protecting Americans from Tax Hikes Act of 2015, Sec. 664(e) was amended to provide that the valuation of an income interest in a NIMCRUT or NICRUT requires use of the stated payout percent for the unitrust payout percentage.
Gift Tax Deduction
The transfer of the income interest will also qualify for a gift tax deduction. So long as the donor gives an undivided percentage of his or her entire interest, the charitable gift tax deduction will qualify. Reg. 25.2522(c)-3(c).
Gift of Excess Principal
It should be possible for donors to make occasional gifts from a charitable trust to a charity, so long as the amounts and timing of the gift are determined well after the trust is created. For many donors, a gifting strategy would be to give the excess growth to a charity. As the trust corpus grows, donors who do not need the added income may choose to give the growth to charity. In many respects, the unitrust end-of-year grants may function as a low-cost alternative to a private foundation.
Example: Gift of 20% of Trust
A married couple created a charitable remainder trust. The trust had grown substantially and the donors did not require income from the entire trust. They requested and received approval to give an undivided 20% of their income interest in the trust to the vested remainder charity. They received a charitable deduction for the value of the income interest. Because transfer of a trust income interest has a zero basis, this gift was a transfer of appreciated property. As a capital gain-type gift, the deduction was limited to 30% of adjusted gross income, with a carry forward for five years. PLR 9550026.
Specimen Unitrust Income Interest Gift Language
City, State Zip Code
Re: Charitable Remainder Unitrust ______________
I am currently the income recipient of a one life charitable remainder unitrust that was created on July 4, 2021 with trust grantor George Washington, 123 Main Street, Anytown, Illinois 00000 and initial trustee Charitable Organization, 456 Main Street, Anytown, Illinois 00000. The unitrust federal ID number is __________________.
As life income recipient, I have retained the power under section ________________ of that trust document to add, remove or modify by name or percentage the qualified exempt charitable remainder recipients. I declare my intention through this signed and dated writing to modify the charitable remainder recipients by irrevocably designating a percentage of both income and remainder interests to a qualified exempt charity and retaining the balance of the income interest and the right to modify the charitable remainder recipients for the balance of the trust.
In order to make a charitable gift of part of this charitable remainder unitrust, I hereby irrevocably designate qualified exempt charity ____________________________, of City, State, as the recipient of _____% of both the income and remainder interests in unitrust number _________________.
The trustee is authorized to recognize that under the doctrine of merger of income and remainder interests, the named exempt charity now owns all interests in the specified percentage of this remainder unitrust. Therefore, the trustee may distribute that portion of the trust principal to the named exempt charity.
I understand that this transfer to a charitable organization may qualify under IRC Sec. 170 provisions for a charitable income tax deduction for the present value of the gifted income interest.
____________________________ Date: ____________
Unitrust Income Recipient
Sec. 2055(e) Reformations
Due to the complexity of the mandatory and optional CRT provisions and the difficulty of drafting charitable remainder trusts, Congress created a provision for the reformation of charitable remainder trusts. The reformation provision is intended to facilitate the proper creation and operation of charitable remainder trusts. There are two main categories of trusts that may be reformed -- the "intent to comply" trust and the trust with a charitable remainder but little or no other language in compliance with the Code and Regulations.
The "Intent to Comply" Trust
If a trust mandates a fixed percentage payout to a noncharitable beneficiary and distribution of the remainder to a qualified exempt charity, then it may be qualified for reformation under the "intent to comply" provisions. Sec. 2055(e)(3). With a trust that includes the basic charitable remainder trust language, there is no time limit on the reformation. Therefore, counsel who draft unitrusts that include the basic fixed percentage language may be confident that they could amend, as required, to comply with existing or future Treasury requirements.
The "Little or No Compliance" Trust
There are many trusts, particularly testamentary trusts in wills drafted by counsel who are not estate planning experts, that pay all income to a non-charitable beneficiary with a remainder to charity. These trusts may be reformed within 90 days of the date the estate tax return is due (with extensions). Since a six-month extension is now permissible, in addition to the normal nine-month period, there is a period of eighteen months after the date of death to reform non-complying testamentary unitrusts.
The reformation must be qualified under local law. Normally, the reformation will be approved by the probate court in the appropriate jurisdiction. The agreement must be reformed into a charitable remainder unitrust with the appropriate language. In addition, the charitable interest must not vary more than 5% from the actuarial value of the charitable interest under the previous trust.
After the trust has been reformed, the estate will qualify for a charitable deduction in the amount of the remainder interest determined under Sec. 7520. Sec. 2055(e)(3).
Charitable giving can be crafted to meet the goals of the client, whether those goals are financial, familial, philanthropic or a combination of all three. By creating a charitable remainder unitrust, donors will be satisfied that they have created income for life and will enjoy knowing they have made a positive impact through their charitable gifts.
Published December 1, 2022
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