Case Study: Using a Term of Years CRAT to Make a Significant Near Term Gift

Case Study: Using a Term of Years CRAT to Make a Significant Near Term Gift

Case study posted in on 12 May 2008| 6 comments
audience: National Publication | last updated: 20 May 2014


Are charitable remainder unitrusts measured by the life of the trust's income recipients always the automatic recommendation for younger donors? In this case study, we examine how of the challenges of providing dependable cash flow and meeting a capital campaign crediting goal can be met through the use of a term of years charitable remainder annuity trust. 

The Facts:

Martin Grant, age 55, has recently been offered several million dollars in stock to acquire his business. He has worked very hard for twenty years to build the business and he has decided he would like to sell, act as a consultant to the business for a few years, and then retire completely.

After careful thought, Martin has decided that he would like for each of his three children to inherit no more than $5 million from him, as indexed for inflation from the present until the time of this death.  He has put plans in place that should make this possible.

Martin does not believe the federal estate tax will ever be completely repealed, and is assuming it will require significantly more than $15 million in gross assets for his three children to net that much in after-tax dollars. 

In any event, however, he believes that given his financial priorities, he can “afford” to make at least $10 million in charitable gifts. In fact, he has been asked to make a commitment in that range to one of his charitable interests.

While on one level he believes he can afford a gift of $10 million, he is concerned there may be a significant downturn in the economy including major corrections in investment market valuations and that some day he may wish he had waited until later to make such a significant gift.

Martin voices his concern to his investment advisor, who would also prefer to manage Martin’s entire portfolio rather than 70% of it.

After some thought, Martin’s investment advisors suggests he consider a $10 million charitable remainder unitrust that will pay him 5% of the value of the trust assets each year. Utilizing the investment company as trustee, he would transfer stock to the trust prior to the buyout. The trust would then sell the stock as part of the sale of the business. The trust would sell the stock free of capital gains tax at the time of the sale and diversify the sales proceeds in a manner that it is anticipated would yield a total return of 8% per year over his 28 year life expectancy. 

Under this plan, at the end of Martin’s life expectancy there would be a balance of nearly $23 million in the trust.

Martin’s income the first year would be $500,000 and his annual income stream would grow to over $1,100,000 by the end of his life. 

Martin’s charitable deduction would be approximately $3.4 million. Under the campaign guidelines of the charitable donee, that would be the amount with which he is credited.

The Problem:

The chief financial officer of the institution argues that if the trust is to earn 8% (equal to the amount estimated to be earned on the charity’s endowment over the period of time the trust is in existence), then the present value of the anticipated remainder should be discounted at the same 8% discount rate.  (Note the valuation is based on 23 years delay rather than 28 years because Martin would have had 5 years to complete a pledge in any event). That would make the remainder interest worth $3.8 million, more than the charitable deduction amount of $3.4 million. 

From Martin’s perspective, he doesn’t understand why if he transfers $10 million and the charity will ultimately receive $23 million, it is proposed that he be credited with less than $4 million under either the charitable deduction method or under the alternative valuation approach. 

A meeting was held between representatives of the institution and the donor’s advisors. The CFO of the charitable institution asked how the investment advisor planned to achieve an 8% total return for 28 years.  After a lengthy discussion, it was determined that a mix of debt and equity would be used with approximately 40% of the trust invested in high-grade corporate bonds and the remainder in growth stocks of similar quality.  The CFO pointed out that if interest rates spiked up, the value of the bonds could fall, resulting in a reduction in the donor’s income that could take a period of years to reverse. The advisor then pointed out the same risk was present for the assumptions being applied to long-term endowment management. If a higher percentage of the trust were to be invested in equities, there could be significant risk to the donor’s income as well.  Asset allocation issues began to assume tremendous importance in the minds of all concerned.

After this meeting the investment advisor is less sure that he is willing to undertake the challenge of allocation of assets and management of the risk to Martin’s income. He was also concerned that the management fees for a portfolio heavily allocated to debt would be less than with a higher percentage invested in equities. When the investment advisor learns that Martin has been talking to his insurance professional and he is planning to rely on income from the unitrust to purchase a great deal of insurance with annual premiums of $360,000 for the first ten years, he is even less certain the unitrust is the best way to go. Martin’s accountant points out that much of the income Martin receives will be reported as ordinary income under the tier structure of income reporting applicable to charitable remainder trusts. All concerned are further put off when they learn that the standard payout format unitrust amount cannot be less than 5% of the value of the trust assets each year so they can’t “fix” the problem by further lowering the income payout rate. 

The Solution:

The gift planning officer of the charity suggests another alternative. He suggests that Martin place $10 million in a 10% charitable remainder annuity trust that would last for ten years.

Under the terms of the trust Martin can plan on receiving $1 million per year for ten years. If the trust earns the same total return of 8% anticipated under the terms of the unitrust, at the end of ten years, the trust will distribute $7.1 million to the charity.

Martin’s charitable income tax deduction would be $2.1 million. In his tax bracket he will save approximately $735,000 in taxes. At an 8% discount rate, the present value of the remainder interest to the institution would be $4.8 million, significantly more than the present value of the anticipated remainder under the initial plan.

Based on these facts, the CFO of the institution agreed not to oppose a credit of $5 million toward the campaign goal. 

Because Martin will receive $1 million annually regardless of the performance of the trust assets, there is less pressure on his investment advisor to invest aggressively.  If a total return of 8% can be achieved with 60% invested in equities and 40% in debt, much of Martin’s income will be reportable as capital gain under the tier structure of reporting. With a maximum federal capital gains tax of 15%, this means he will have significantly more income in the form of capital gains than he would under the unitrust as originally proposed.

If, for example, Martin nets $760,000 per year after tax, he will be assured of $400,000 beyond the $360,000 necessary for the payment of insurance premiums. If his investment advisor invests this for a total return of 8%, at the time the trust terminates and the charity receives its $7.1 million, Martin will have built up a “side fund” of some $5.8 million. 

The balance in the side fund would be sufficient to yield $464,000 per year at 8%, an amount equal to the amount he was investing each year during the ten years the trust was in existence. This side fund could then serve to largely “replace” the income he would have been receiving from the unitrust had that option been pursued.

As a result of structuring the gift in the alternative manner, the following has been achieved:

  • Martin avoids $1.5 million or more in capital gains taxes at the time of the gift.
  • He recovers $730,000 in the form of income tax savings.
  • He receives guaranteed income totaling $10 million over a ten-year period of time.
  • This income is taxed largely at lower capital gains tax rate.
  • He is assured that the income will be available to purchase the life insurance policy he wishes to put in place.
  • He is able to rebuild a significant asset base from net income in excess of the premium amounts.
  • His advisor can manage the trust and any amounts Martin accumulates from excess payments he receives for ten years and is left with the side fund to manage when the charitable trust terminates.
  • The charitable remainder is deferred for 10 years instead of 28.
  • The present value of the charitable remainder is over 25% higher and it is received in less than half the time. The charity knows EXACTLY when the funds will be received.
  • This plan is not dependent on the age of the donor and is actually more effectively utilized with younger persons due to the ability to purchase more insurance.
  • Significantly more is credited toward the campaign goal than would the case under the unitrust for life.
  • In Martin’s mind, the annuity trust is more likely to be seen as a way to fund a special gift to a campaign than his ultimate gift of a lifetime. He may live to see the gift come to fruition at age 65 whereas he would never see the results of the unitrust gift that is finally completed only at his death.

Final Thoughts:

The charitable remainder annuity trust in coming years may prove to be as attractive to younger donors as the charitable gift annuity will be for older persons.  The certainty of a generous income for a period of years, whether used for insurance premiums, education expenses, elder care, or to build a nest egg for the future, may prove increasingly attractive to younger persons and their advisors who may not be willing to take the risks inherent in a unitrust invested for total return in today’s environment.

Disclaimer: This case study is intended to provide information of a general nature only and is not intended to provide legal, accounting, investment or other professional advice. Persons mentioned within this case study are fictional with any resemblance to real persons, living or dead, coincidental. Tax law rates and federal discount rates used in examples are based on those rates in effect at the time of publishing. Those viewing this case study should always check for latest tax and other relevant state and federal laws and regulations prior to completing charitable gifts.

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another way

Yes, the CGA is another way, but if I'm Martin, I'd much prefer the security of my own FUNDED trust (i.e., the CRAT) than I would being an UNsecured creditor of the charitable institution I'm favoring with the gift, ESPECIALLY if the institution is going to "cannibalize" part of the gift up-front. Naturally, this all hinges on the financial strength of the institution. Having said that, I think the CRAT is, by and large, the safer economic choice for Martin.

Security of CRAT vs. CGA

As one who makes a living doing tax work for CRTs, I should be biased in favor of the CRAT vs. a CGA. However, I take some issue with Peter's comment that "the CRAT is, by and large, the safer economic choice". I would bet that there have been many more cases where CRATs have run out of assets, compared to charities who were unable to meet the terms of CGA obligations. I see the advantage of the CRAT more in the nature of retaining flexibility over the ultimate charitable beneficiary.

another way

Great case study! :-) Although I know the facts indicate that one of the motivations if for the investment advisor to retain the portfolio, I would also suggest that perhaps another solution would be to use a CGA instead of a CRT. The taxation of the annuity payments is certain (typically more favorable than CRTs), the security of the payments is also assured (a general oblgation of the charity) and the charity may even be able to use a portion of the funds immediately as oppsed to waiting for the trust termination (in California the excess over the reasonably commensurate value that is set aside in a seprate account). Whether or not the charity could still use the investment advisor to manage a part of the endowment fund to make up for the loss of the trust is not certain (probably would be difficult) but sometimes the CGA makes more sense than any CRT. Just a thought...

Martin has an offer.

The first paragraph says that Martin has an offer. This may cause difficulty, since as I understand it there cannot be a pre-arranged sale, a contract or agreement that the stock transferred to the CRT will be sold to a particular company or individual, yet the purchaser of Martin's company may require sale of all stock as a condition.

Martin has an offer

Kathleen, Thanks for your perceptive comment. You are of course correct it is not permissible for Martin to have an enforceable agreement to sell the stock prior to donating the stock to the trust without triggering a realization of his capital gain, nor can he require the trustee to enter into an agreement with a proposed buyer prior to the transfer of the stock to the trust. In this case, it is contemplated that Martin only has a preliminary offer that he has not accepted and there is no binding agreement. If Martin transfers the stock at this point, he is taking the risk the buyer will not be able to negotiate acceptable sale terms with the trustee of the trust. That being said, the trustee would presumably be holding a minority interest in a company and be exposed to lack of diversification and there may be few if any other purchasers on the horizon. Thanks again for bringing up this important point as I think it adds to everyone's learning experience. Robert

Thank you

This illustration is excellent. Thank you. --Robin Trozpek

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