An asset or property can be divided up in many ways. We can divide if geographically by putting a fence down the middle. We can dividing it over time by renting or leasing it. A split interest gift divides property into two parts. One is gifted, and the other is retained. The most common way of dividing property for Split Interest Gifts is to separate the income interest from the residual value at death. In most instances, the income interest is retained, and the residual value at death is gifted. There are many variations on this theme. Each has its own particular application.
Split Interest Gifts can be structured in more than one way. The two most common ways are as Trusts, which are generally called Charitable Remainder Trusts (“CRT”), or as Annuities, which are called Charitable Gift Annuities (“CGA”). A very powerful combination is to have the charitable beneficiary be the Family Foundation or a Donor Advised Fund.
Spit Interest Gifts are creatures of the US Tax Code. Although professional advisors who do not use them regularly may be unfamiliar with the nuances, there is nothing edgy or aggressive or abusive about them. Split Interest Gifts are powerful devices routinely used by skilled professionals to assist their clients. Like any other tool, they can be mis-applied or abused. So it is important to make sure that the right structure is used, and used correctly, to suit the goals and concerns of the particular application.
CRUT — Standard Charitable Remainder Unitrust
A CRUT is the most common and the most basic CRT. Sometimes it is called a “fixed percentage CRT” because the payout is a set percentage determined at the time the CRUT is formed. The payout can occur for life or for a term of years (not to exceed 20). The amount of the payout is calculated based on the fixed percentage of the Fair Market Value of the assets held by the CRUT each year. This requires an annual valuation of the CRUT assets. The CRUT pays the income to what the regulations call the “recipient”, which is typically the Donor or a member of the Donor’s family. Married couples can be be joint recipients, with the survivor on the first passing receiving the entire payout. The payout percentage cannot be less than 5% or more than 50%. At least 10% of the initially contributed value must go to the charitable beneficiary. This means that as a practical matter the maximum payout is an actuarial determination based on part on the recipient’s age.
One of the hazards of the standard CRUT is that the payout amount is a fixed percentage regardless of the income earned. This means that in a year where the market is down, principal can be depleted, which would then reduce payouts even further in future years.
NI-CRUT — Net Income CRUT
A NI-CRUT is the same as a regular CRUT except that the payout to the recipient is the standard payout OR the actual income, whichever is less. There is no make up for payouts below the standard rate in subsequent years. This has the effect of preserving the principal of the Trust. It has the risk of lower payouts in years where the income is less than the standard payout rate. It is useful for situations where the recipient is not dependent on the income, and preserving the principal is one of the objectives. Preserving the principal can be important when the Donor wants to protect the CRUT from future payout reductions resulting from down markets and/or when the Donor wants to preserve the amount that ultimately goes to charity.
NIM-CRUT — Net Income with Makeup CRUT
A NIM-CRUT is the same as a regular NI-CRUT with the very important distinction that if there is a reduced payout in one year, it can be made up in future years when the income is sufficient. This is particularly useful for situations where the asset initially gifted is not going to produce an income (such as bare land), and will produce income in the future (when the land is sold and the proceeds reinvested).
A FLIP-CRUT starts out as either a NI-CRUT or a NIM-CRUT, and then “flips” to a standard CRUT on a qualified triggering event. The qualifying triggering event can be the sale of a property or a birthday or a variety of other events. A FLIP-CRUT can be structured so that it is very flexible in when, if ever, the flip will happen. The timing and trigger of the flip is a crucial planning point. A FLIP-CRUT is sometimes referred to as a “combination of methods trust”.
A FLIP-CRUT is useful when the Donor wants the best of both worlds of reduced payouts while the CRT is not producing income (to avoid depleting the CRT or to deal with lack of liquidity), and standard payouts once the CRT has a regular income stream.
In certain instances, it is possible to treat capital gains occurring after an asset is transferred to the CRT (sale of an appreciated asset) as either “principal” or as “income”. Whether such gain is principal or income will, of course, determine the payout amount. This creates planning opportunities to customize the payout to the particular needs of the client and the nature of the investment assets held by the CRUT. This is in large part made possible by the specifics of the “principal and income act” adopted under state law where the CRUT is situated. Obtaining these benefits may require the CRT to be situated in or based on the laws of states which permit such flexibility in whether or not gain is allocated to income or principal.
This can be very useful, for example, when the recipient does not need income in early years of the CRUT and wants to grow the principal, and then wants or needs more income in later years. This requires coordinated planning with the Donor, the attorney, the investment advisors, and sometimes the charitable beneficiary.
CRAT — Charitable Remainder Annuity Trust
A CRAT is a CRT where the income is NOT recalculated each year based on the value of the assets, and does not change with ups or downs in the market. The income is simply a fixed amount, calculated as a percentage of the initial contribution to the CRT.
A CRAT is attractive in situations where the recipient needs or wants a guaranteed fixed income, and does not want to be at risk of market fluctuations on investment returns.
A CRAT must meet what is called the “5 percent probability test” under applicable regulations, which means requires that the probability that the qualified remainder beneficiary will not receive any property be no more than 5 percent. This can be accomplished with a “safe-harbor” provision that terminates the CRAT and distributes the balance to the charitable remainder beneficiary if the assets ever fall below the prescribed limit. Some CRUT’s also employ such safe harbor provisions just to make sure that they do not inadvertently fail the 10% rule. Of course, to gain the benefit of avoiding inadvertent loss of the CRAT advantages, the Donor also gains the additional risk of an untimely termination of the CRAT income just as the market goes down and the income is most needed.
Charitable Gift Annuity — CGA
A Charitable Gift Annuity differs from CRT’s in several significant ways. Most notably, a CGA is NOT a Trust. It is an annuity. An annuity is a contractual income stream for a specified term. The payout can be immediate or deferred.
A CGA also differs from a commercial annuity purchased from an insurance company. Annuities issued by insurance companies are regulated as securities. CGA’s are not regulated as securities under the Philanthropy Protection Act of 1995. Annuities issued by insurance companies have payout rates based on the market. The payout rates of CGA’s are typically below market rates, and are generally but not necessarily determined by the American Council of Gift Annuities.
One of the benefits of a CGA over a CRAT is that the risk of the untimely termination is avoided.
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