New Rules for Charitable Remainder Trusts

I am not sure I can properly condense this information from Forbes, so best for those interested in the changes to Charitable Remainder Trusts (CRTs) and CRUTs and CRATs to read through and digest. In any event the CRT is a way to defer taxes and can be used with fine art.

Forbes reports

Art and collectibles are subject to a 28% long-term federal capital gains rate, compared to a top rate of 20% for stocks and other investments assets.  Add on the 3.8% Net Investment Income Tax and state and local income taxes, and a New York City collector can end up paying up to 44% on gains; a California collector could pay up to 45%.

So understandably, collectors are always looking for ways to mitigate this tax burden. A new IRS Revenue Procedure  makes using certain charitable remainder trusts (CRTs) as vehicles for tax deferral more viable for art and collectibles.  Moreover, this change comes at an opportune time, what with the Federal Reserve expected to increase interest rates later this year. (Charitable remainder trusts are most effective in higher interest environments.)

The dual benefit of CRTs

The name “charitable remainder trust” suggests a charitable component, and not surprisingly, CRTs are typically used by those who are both charitably inclined and want to sell a highly appreciated asset without paying a big capital gains tax bill. If appreciated art is sold outright by an art collector, the collector would owe income tax on the gain in the year of the sale.  By contrast, if a CRT sells the appreciated art, the gain is taxed over time as distributions are made from the CRT. Meanwhile, the CRT, which is itself generally exempt from state and federal income taxes, can reinvest the full amount of sale proceeds unreduced by taxes.  Additionally, in the year the CRT sells art, the collector can take a charitable deduction on his individual income tax return — a deduction based on the remainder value of the CRT that is projected (based on formulas dictated by the IRS) to be left for charity.

How a collectibles CRT works

Typically, a collector transfers art to the CRT and the CRT’s trustee sells that art, reinvesting the proceeds in a portfolio of stocks and bonds.  As noted above, the initial transfer of art to the CRT and the subsequent sale of the art will not result in a current capital gains tax bill for either the art collector or the CRT.

The CRT then makes a series of annual payments to a non-charitable beneficiary, usually the art collector who created the trust (or a family member) for his or her life or for a term of years.  The annual payments to the art collector or family member will be made from the CRT’s portfolio of assets, and the amount will vary depending on the structure of the CRT.

A CRT structured as a unitrust (or CRUT) pays an annuity equal to a fixed percentage of the net fair market value of the trust’s assets, as valued annually. (The percentage paid must be at least 5% but not more than 50%  of the trust’s value.)  If the value of the assets increases, the annual payments from the CRT will increase, and if the value of the assets decreases, the annual payments from the CRT will decrease.  By contrast, a CRT structured as an annuity trust (or CRAT) pays a fixed dollar amount equal to at least 5% but not more than 50% of the initial appraised net fair market value of the art or collectible transferred to the trust.

At the end of the CRT term, all remaining trust assets are paid to a charity or charities, chosen by the art collector who created the CRT, and the trust terminates.  By law, when the CRT is formed, the projected actuarial value of the remainder interest (that is, what’s being left to charity) must be at least 10% of the initial net fair market value of the trust.  Thus CRTs end up being a win for both charity, which receives at least 10% of the initial net fair market value of the art, and the collector, who receives tax benefits.

The key rule change by the IRS

Prior to the release of IRS Revenue Procedure 2016-42 in August, low interest rates have made qualification of a CRT with an annuity trust structure (a CRAT) difficult, if not impossible, for those under the age of 74 to create.  This was due to a rather arcane IRS rule referred to as the Probability of Exhaustion Test.  Under that test, if the probability of exhausting the entire trust fund before the charity receives it’s share is greater than 5%, the CRAT would not qualify.  (By definition, a CRUT, which pays only a percentage of what’s in the trust each year, can be designed so it won’t run out of assets.)

But the new Revenue Procedure opens the door to long-term charitable remainder annuity trust planning for those under age 74 by providing an alternative test.  A CRAT isn’t subject to the Probability of Exhaustion test if it contains a provision that triggers the early termination of the CRAT and an immediate distribution of all trust assets to the charitable remainder beneficiary if the total value of the trust’s assets falls below a certain level. In other words, under the Revenue Procedure, the CRAT would have to maintain a minimum amount of funds for charity.  If the trust assets fall below this amount, the trust must terminate.  That minimum amount is equal to 10% of the starting value of the trust, increased at the IRS assumed rate of interest (currently 1.4%).

Federal interest rates matter

As state and federal tax rates for art and collectibles remain high and adjustments to federal interest rates are being considered, it is an opportune time for charitable remainder annuity trusts to surface as an option for collectors.  CRTs are tax-exempt so the tax deferral benefit is greater when tax rates are high.  Additionally, charitable remainder annuity trusts for art and collectibles become a more attractive structure as interest rates rise.  That’s because higher interest rates translate into a larger tax deduction for donors, which increases the tax benefits of using a remainder trust.  As we wait to see what happens with federal interest rates in the coming months, it is worth keeping this new IRS Revenue Procedure in mind.

Source: Forbes