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Friday July 31, 2015

Article of the Month

Charitable Planning With IRAs—Part II

Introduction


Traditional IRAs pose estate planning challenges for an account owner because at death a traditional IRA is income in respect of a decedent (IRD). As a result, the beneficiary must pay income tax on the amount received. Part I of this series discussed the challenges IRAs pose for owners and how basic charitable giving strategies can overcome those challenges and minimize the tax consequences associated with IRD assets. Part II goes further and discusses using an IRA to fund a testamentary charitable remainder unitrust (CRT). A charitable remainder unitrust can be the optimum way to achieve personal and charitable goals using an IRA.

IRA owners may prefer to select a non-charitable trust as the designated beneficiary to protect the IRA assets from creditors, control the distributions to heirs or limit minors’ access to funds. However, there are a number of challenges that come with selecting a non-charitable trust as designated beneficiary. The trust must be drafted carefully to ensure that it qualifies for “look-through” status.1 Otherwise, the trust may receive a taxable distribution of the IRA value, which can thwart the IRA owner’s desire to control income distributions to heirs. As will be seen, a CRT can achieve many of the same objectives as a non-charitable trust but without the need to account for look-through trust status.

Basics of a Charitable Remainder Trust


A charitable remainder unitrust is a Sec. 664 tax-exempt trust that must pay out a fixed percentage of its assets each year. A CRT can last for a life, lives, a term of up to twenty years or a combination of life or lives plus a term of years.2 With a CRT funded at death, the IRA owner’s estate receives an estate tax deduction.3 At the end of the selected CRT duration, the trust assets pass to one or more selected charitable remaindermen.

Because of its tax-exempt nature, any income or gains earned inside the trust are not subject to tax, but payouts from the trust to selected beneficiaries will be taxable to the recipient. This provides a wonderful estate planning opportunity for IRA owners. An IRA can be transferred to a CRT at the owner’s death and cashed out without payment of income tax.4 The IRA value is then reinvested to produce income for the CRT income beneficiaries. The testamentary CRT funded with an IRA will typically last for the life of a surviving spouse plus a term for children or, if children are the only beneficiaries, for a term of years. (Of course, a CRT can also be established to benefit individuals other than family members.)

Using a CRT to Meet a Surviving Spouse’s Goals


If the surviving spouse has other liquid assets, an IRA owner may establish a CRT to benefit him or her along with children. The IRA owner may also have made other provision for the surviving spouse in his or her estate plan. Thus, the surviving spouse may not have an immediate need for IRA income. Consequently, the CRT will be designed to help the surviving spouse achieve three important goals: (1) income control, (2) reduction of income and taxes and (3) preservation of the IRA value for children.

The goal of “income control” can be achieved by transferring an IRA to a unitrust that pays out as a net income plus makeup trust (NIMCRUT). Unlike a standard unitrust, which pays out only a fixed percentage of its assets each year, a NIMCRUT pays out the lesser of either the trust income or the unitrust percentage amount.5 This payout arrangement allows the CRT income beneficiaries to defer taking income from the unitrust until income is needed. As such, the trust may be invested for growth during the times that the surviving spouse or children do not need income. During that time the trust can build up a payout deficit, which is the difference between what the trust would have paid out as a standard payout trust and what the trust actually paid out. This deficit can then be made up in future years to the extent the trust income in future years exceeds the unitrust payout percentage amount.6 A brief example below illustrates the mechanics of a NIMCRUT:

Example 1

Assume a NIMCRUT, funded with $1,000,000, pays out the lesser of trust income or 5.0%. In years 1 and 2, the trust earns 3.0%, in years 3 and 4 it earns 8.0% and in year 5 it earns 6.0%.

Trust IncomePayout at 5%Actual PayoutAccum. Deficit
Year 1$30,000$50,000$30,000 $20,000
Year 2$30,000$50,000$30,000 $40,000
Year 3$80,000$50,000$50,000 + $30,000$10,000
Year 4$80,000$50,000$50,000 + $10,000 $0
Year 5$60,000$50,000$50,000 $0

The above example illustrates how the NIMCRUT works. In years 1 and 2, the trust income ($30,000) is less than an amount based on the 5.0% payout percentage ($50,000). Accordingly, the payout in those years would be $30,000, with $20,000 added to the deficit account each year. In year 3, the trust income is higher than the payout based on the payout percentage so the trust pays out based on the payout percentage ($50,000) and also pays out a “makeup” payment from the deficit account up to the difference of trust income and the payout ($30,000). The same occurred in year 4, but the makeup payment is limited to what is left in the deficit account ($10,000). Finally, in year 5, the trust pays out based on the payout amount (which is less than income) but there is no makeup payment because there is nothing in the deficit account.

The benefit of the NIMCRUT is that it allows the surviving spouse and children to unshackle themselves from the IRA required minimum distribution (RMD) rules and gives them control over when and how much income they receive.

Second, a CRT can help the family reduce the income they receive and the taxes paid on the IRA value. Because a surviving spouse may be sufficiently provided for in the estate plan, he or she may not need any payouts from the trust. The deferral aspect of a NIMCRUT allows the surviving spouse to receive income as needed. Conversely, under the IRA distribution rules the surviving spouse would be required to receive income, whether it’s needed or not.

A CRT helps a family reduce the taxes paid on the IRA value in two ways. First, an IRA owner with a taxable estate may receive an estate tax deduction based upon the present value of the charitable remainder interest.7 Second, reduction of income taxes is also a possibility. With a traditional IRA beneficiary designation plan, all of the IRA distributions are ordinary income taxed at ordinary income tax rates. In contrast, a CRT can cash out the IRA and reinvest it, with the possibility that in the future some CRT distributions may be capital gain income taxed at preferential rates.

Third, a CRT arrangement gives a surviving spouse the ability to preserve the IRA value for children if he or she needs little income from the trust. In this situation the NIMCRUT arrangement allows the trustee to invest the CRT assets for growth and defer paying income until such time as the surviving spouse needs it. Such a plan could increase the value of the trust for the children when they need income in the future.

Example 2

Jeff, age 65, and Annie, age 60, have a net worth of $12 million. They have three children, Todd, Isabelle and Megan. Jeff has an IRA worth $3.5 million and Annie has one valued at $600,000. Both Jeff and Annie are regular donors to their favorite charity. Recently they have been updating their estate plan with their attorney, Phil. They have designated each other as the primary beneficiary of their IRAs with their children as contingent beneficiaries. In discussing this plan with Phil, both Jeff and Annie have become increasingly uncomfortable with the IRA distribution rules. They would prefer greater flexibility in using the IRAs to benefit the survivor and family.

Knowing their interest in providing for charity in their estate plans, Phil talked to them about the possibility of transferring their IRAs to a testamentary charitable remainder unitrust. Phil explained that because a CRT is tax exempt the IRA could be liquidated within the trust tax free. The IRA value could then be reinvested to produce income for the surviving spouse and children. If greater income control is desired, Phil explained that the trust could be drafted as a NIMCRUT, which would allow the income beneficiaries to defer income and receive it as needed. Phil also explained that they could receive an estate tax deduction for the transfers to the trust, which could save estate taxes.

In addition, Phil explained that the possibility exists that future payouts from the trust could consist of capital gain income taxed at preferential tax rates. At the end of the trust term, the value of the trust would then pass to Annie and Jeff’s favorite charity. Jeff and Annie liked this plan and decided to create a one-life plus term charitable remainder unitrust to receive their IRAs upon their deaths with the survivor listed as the initial lifetime beneficiary.

Income Control CRUT


Income control is a powerful aspect of designating a CRT as the beneficiary of an IRA. CRTs may be designed to provide income control. Some of these options are complex and may be more appropriate for CRTs containing significant asset values.

NIMCRUT

This article has already highlighted the benefit of a NIMCRUT, but there are two particular ways that NIMCRUTs can be designed to control income. First, after the IRA is liquidated inside the CRT the cash may be used to purchase a commercial annuity. With the annuity the trust will not have distributable income until there is a distribution.8 Second, an LLC or partnership may be created to hold trust investments. The trust will not have distributable income until a cash distribution is made from the LLC or partnership. With both options it is important that the unitrust contain language requiring that distributions be made to trust beneficiaries only after there has been a distribution from the commercial annuity, LLC or partnership.

If the NIMCRUT contains a discretionary power over capital gain, a commercial annuity, an LLC or a limited partnership, then an independent special trustee provision should be included. For any discretionary power that might be exercised by an interested party (for example, with a child as trustee), it is important to have the ability to appoint an independent special trustee with powers limited to that specific purpose.

FLIP Unitrust

A CRT can also be designed to contain a FLIP provision wherein the trust can “flip” or convert from a NIMCRUT to a standard payout unitrust on the occurrence of a trigger event. The trigger event is usually the death of the surviving spouse or a specified date, such as when the youngest beneficiary reaches a certain age. The NIMCRUT allows accumulation of resources during the life of the surviving spouse while the FLIP to the standard payout trust then facilitates a significant distribution to children. It is important to note that with this plan the make-up aspect of the NIMCRUT goes away with the FLIP. However, since the distribution is frequently over the lives of the children, the economic value of retaining the assets in the trust and using those to increase income is perhaps equal to or greater than the value of distributing the deficit account and paying much larger income taxes at an earlier time.

Finally, it may be appropriate to consider a “Flex-FLIP” unitrust. With this plan, a relatively inexpensive real estate asset, such as a vacant lot in a small community, is included as a trust asset. The trust trigger event is the sale of this real property. Since the trustee may, within reasonable bounds, choose when to sell this asset, there is control over when the FLIP occurs. This can provide greater flexibility to the surviving spouse or family members on determining when to receive income from the trust.

Example 3

Let’s return to the example of Jeff and Annie. Phil, their attorney, helped them establish a plan where the IRAs would go into a charitable remainder unitrust upon their deaths. The trust would last for the life of the survivor and then pay income to their children Todd, Isabelle and Megan. The trust would be created as a FLIP unitrust where it would “flip” to a standard payout trust upon the death of the lifetime beneficiary. At that time a fixed percentage of the trust’s assets would be paid to the children for the remaining duration of the trust.

When Jeff was 80 and Annie was 75, Jeff passed away. His $3.5 million IRA went into the FLIP unitrust while other assets of his estate were set aside to benefit Annie and his three children. During Annie’s life the unitrust will operate as a NIMCRUT. Because Annie has other assets to provide support, the NIMCRUT trustee will invest in growth assets. Only in the event that Annie needs income will the trustee allocate trust assets to produce income. To give the trustee greater flexibility to produce income as needed, the trustee has discretion to allocate all post-contribution realized capital gains to income.

Fortunately for Annie, she does not need to receive any distributions from the NIMCRUT during her life. She was thankful the NIMCRUT provided her with income control. When she passed away ten years after Jeff, the trust then “FLIPPED” to a standard payout trust. The 5% unitrust amounts were paid to Todd, Isabelle and Megan. Over the next twenty years the three children received a little over $8 million in income with $8.9 million passing to Jeff and Annie’s favorite charity at the end of the twenty years.

CRT Funding Options


A CRT will be funded with an IRA at the IRA owner’s death. Three possible methods exist to transfer the IRA to a CRT at death.

Funded Unitrust

A parent or couple with children could create a trust for one-life plus a term of years or two lives plus a term of years. The IRA beneficiary form designates the CRT trustee as recipient under provisions of the charitable remainder unitrust. A one or two-life plus term trust is permissible if all recipients are named and living when the trust is created and there is a termination provision that requires the trust to terminate if all named beneficiaries pass away prior to the expiration of the term of years. For example, a unitrust for a married couple with three children for two lives plus twenty years is in effect a trust for the lesser of the five lives or the period of two lives plus twenty years. Note that if children are named as beneficiaries, the Sec. 2056(b)(8) marital deduction will not apply.

With a one or two-life plus term of years trust, the parent or couple may receive unitrust income distributions during life. For a married couple, it is possible that the survivor will be the IRA beneficiary and will receive normal IRA distributions for his or her lifetime, plus the income payouts from the unitrust. However, it is possible for the CRT to be the beneficiary of the IRA after the death of the first spouse, though local law may require that the surviving spouse sign and notarize a consent form to ensure the IRA safely passes to the CRT. After both parents pass away, the IRA designated beneficiary is once again the trustee of the trust. This trustee will then receive the IRA distribution, add the IRA proceeds to the unitrust and make payments to children for the term of years.

With a funded unitrust, an addition may also be made from a profit sharing or 401(k) account. However, in these cases a spouse must sign a consent form for the beneficiary designation. As a practical matter, since spouses may either live in or move to a community property state, it is good practice for both spouses to sign consents to the plan to create a charitable trust that will later receive IRA or other deferred compensation distributions.

Unfunded Unitrust

Some individuals desire to create a plan for transfer of an IRA to a charitable remainder trust, but do not want to fund and administer the trust during life. For the person who does not wish to operate the trust during life and prefers that the unitrust is available to receive the distribution from an IRA, an unfunded unitrust may be created.

Under the laws of some states, it is permissible to create a trust with no or nominal funding. For example, in California, an unfunded trust is valid under state law. The IRA owner may easily sign an unfunded trust and select the trustee as the IRA beneficiary. In other states, the applicable trust law may require nominal funding of $10 or $20. In those states, the typical practice is to create and sign a trust and staple a $10 or $20 bill to the trust instrument. Finally, the trust should be created prior to signing the beneficiary designation form and filing it with the IRA custodian.

This unfunded trust has the advantage of validity under state law, but does not require administration under federal statutes until it is funded at the death of the IRA owner. Since no investment or activity is required, the U.S. Treasury has not objected to this practice. In order to achieve this objective, it is quite important that the trust be structured as a net income trust, net income plus makeup trust or FLIP unitrust. Most counsel also require capital gains to be allocated to income. Although the income paid to children will be ordinary income under the Sec. 664 four-tier structure, the allocation of capital gain to distributable amounts gives the trustee flexibility in selecting trust investments.

Will or Revocable Trust

The final option is to include a trust document in a revocable trust or a will. The trust will generally be a one-life trust for a spouse, a term of years trust for children or a one-life trust for a child. It should be clearly identified within the revocable trust or will as a separate charitable remainder unitrust effective only at the death of the testator or trust grantor. It should have a specific number or Article designation.

After the living trust or will document has been signed by the trust grantor or the testator, it is then possible to designate that testamentary trust as the beneficiary of the IRA. Because IRA beneficiary designations may affect large sums of money, it is very important for attorneys, CPAs and gift planners to make certain that a client’s beneficiary designation is done correctly. If not done correctly then the door is opened for a distant relative petitioning the probate court to declare the designation void. This adverse result could cause unnecessary payment of substantial income and estate taxes, as well as disruption of the IRA owner’s distribution plan.

Other CRT Options


As discussed in Part I, the largest asset of many clients may be their IRA. For these individuals, they may want to use the IRA to provide a double inheritance to their children. To do this, they may use the IRA to fund an irrevocable life insurance trust (ILIT), which can provide children an income and estate-tax-free inheritance while still using the IRA to benefit charity. In Part I, this strategy resulted in charity being the outright beneficiary of the IRA. However, an IRA owner could instead designate a charitable remainder unitrust as the IRA beneficiary.

The ILIT strategy will generally work the same way as described in Part I where part or all of the RMD could be contributed to the ILIT to pay the premiums on the life insurance policy, except this time the IRA value will first pass to a charitable remainder unitrust upon the IRA owner’s passing. The trust may be designed to operate as a NIMCRUT or in any way as described earlier in this article. Upon the end of the trust term, the remaining value of the trust then passes to the charitable remainderman.

Conclusion


A charitable remainder unitrust can be a wonderful solution to the negative aspects of passing on IRAs to family. Many IRA owners dislike subjecting their family to the distribution rules for IRAs. These individuals may prefer to give their family more income control and, potentially, lower-taxed income from a charitable remainder unitrust. Of course, it is recommended that IRA owners work with professional advisors to ensure the charitable remainder unitrust plan is properly structured for optimum benefit. Successfully implemented, a charitable remainder unitrust allows an IRA owner to provide family with income control, reduced taxes and greater financial benefit.

Footnote


1 Treas. Reg. §1.401(a)(9)-4.
2 Treas. Reg. §1.664-3(a)(5)(i).
3 I.R.C. §2055(e)(2)(A).
4 PLR 9634019.
5 Treas. Reg. §1.664-3(a)(1)(i)(b).
6 Treas. Reg. §1.664-3(a)(1)(i)(b)(2).
7 I.R.C. §2055(e)(2)(A).
8 PLR 9825001.

Published July 1, 2015


Previous Articles

Charitable Planning With IRAs—Part I

Gifts of Farms

Contributions of Mobile Homes and Fixtures

Donating Real Estate Part II

Donating Real Estate

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