Charitable Remainder Annuity Trust (CRAT)

A charitable remainder annuity trust, or “CRAT,” is an irrevocable trust which pays to the grantor (i.e., the creator or settlor of the trust), or beneficiaries selected by the grantor, or both the grantor and beneficiaries, a fixed dollar amount each year. At the end of the trust, the remaining assets of the trust go to one or more charities.

Why Use It?

The usual reason for creating a CRAT is that the grantor wants to make a gift to charity at his or her death, but wants a present charitable income tax deduction for the future gift. A CRAT can carry out that goal even though the CRAT is irrevocable because the grantor retains an income-like interest in the assets transferred to the trust, and so continues to have the benefit of the assets during lifetime.

Another reason for a CRAT is that the grantor wants to provide an income for a child or other relative, or a friend, but wants the trust assets to go to charity following the death of the beneficiary.

A third reason for creating a CRAT is that CRATs do not pay federal income tax, although income and gains that are earned by the trust become taxable to the beneficiaries of the trust when they are distributed. If a person who wishes to make charitable gifts has a valuble asset that has appreciated in value and is about to be sold, it may be advantageous to donate the asset to a CRAT before agreeing to the sale, so that the income tax on the capital gain is deferred until the gain is actually distributed in the future.

How Does It Work?

A gift to a CRAT results in a charitable deduction because section 170 of the Internal Revenue Code allows a charitable income tax deduction for the present value of the future charitable remainder in a trust described in section 664, which includes charitable remainder annuity trusts. The same present value is also a federal gift tax deduction, so only the noncharitable interests are subject to gift tax. If the CRAT is created at death, then the present value of the charitable remainder is a federal estate tax deduction, so only the present value of the noncharitable annuity payments is subject to estate tax.

Section 664 of the Internal Revenue Code also says that a CRAT is not subject to income tax, and that the income and gains of CRAT are taxable to the noncharitable beneficiaries of a CRAT only when they are distributed.

The present value of the charitable remainder is difference between the value of the property transferred to the trust and the present value of the annuity payments that must be distributed each year. When a CRAT is for a term of years, the future payments are discounted back to present value based on the income it is assumed the payments could have earned if received immediately. When a CRAT is for the life or lives of the noncharitable beneficiaries, the value of the future annuity payments is discounted for both interest that could have been earned and for the probabilities of the beneficiaries dying before the payments are to be made.

The Internal Revenue Code and regulations impose a number of restrictions on CRATs, the most signficant of which are the following:

• The payout percentage (the annuity amount as a percentage of the value of the property transferred to the trust) must be at least 5%, and cannot be more than 50%.
• The present value of the charitable remainder must be at least 10% of the contribution to the trust.
• The duration of the trust cannot be more than 20 years or until the deaths of the noncharitable beneficiaries.
• When the annuity payments are more than the assumed interest that would be earned by the trust, so that annuity payments will be made from principal as well as income and the trust might be entirely depleted by the annuity payments, the probability of the noncharitable beneficiaries outliving the principal of the trust must not exceed 5%.
• The trustees of CRATs are subject to many of the rules that apply to private foundations, such as the prohibition on self-dealing.

Benefits

The primary benefits of a CRAT are:

• The donor/grantor of the trust gets an immediate income tax deduction (or estate tax deduction in the case of a CRAT created at death) for the present value of the future remainder payable to charity.
• Because the distributions to the grantor or other noncharitable beneficiaries are a fixed dollar amount, the distributions will not go down even if the investments of the trust decrease in value.
• The income and gains of the CRAT are not subject to income tax until they are distributed to the noncharitable beneficiaries.

Costs

The primary costs of a CRAT are:

• There may be a gift tax (or estate tax) cost for the present value of annuity payments to be made to beneficiaries other than the donor/grantor. (Although the gift tax cost of payments following the death of the grantor can be postponed if the grantor retains the right to revoke the interests of those beneficiaries.)
• Because the payments to the grantor or other noncharitable beneficiaries are a fixed dollar amount and not dependent on future investments, the trust can be depleted if the payments exceed the income and gains of the trust, so that the charities named as beneficiaries receive nothing.
• Because the CRAT can only distribute the annuity amounts, and not any additional amounts, the grantor or other noncharitable beneficiaries will be unable to withdraw funds that might be needed for medical or other emergencies, or for other purposes which would be permitted for other kinds of trusts.
• There are also possible transactional costs:
• The legal fees or other costs of preparing the CRAT trust document.
• The costs of valuing the charitable and noncharitable interests in the CRAT for income tax and gift tax purposes, or for estate tax purposes, which costs would include the costs of valuing the assets being transferred to the GRAT and the costs of calculating the value of the remainder interests based on the values of the assets transferred to the CRAT. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the CRAT, appraisals might be needed for those properties.
• The costs of preparing any gift tax returns that may be needed to report the creation of the trust and the present value of the charitable noncharitable interests in the CRAT.
• The other costs (if any) of administering the trust. The investment costs of the CRAT should be the same as what the grantor would have paid for investment advisors if the CRAT had not been created, so the creation of the CRAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the CRAT.

CRAT or CRUT?

There is another form of charitable remainder trust, and that is a charitable remainder unitrust, or "CRUT." A CRUT is similar to a CRAT, except that a CRUT pays out a percentage of the value of the trust assets, revalued each year, while a CRAT pays out a fixed dollar amount each year, regardless of the value of the trust assets.

A common question is, which is better, a CRAT or a CRUT? The answer depends on the goals and motives for creating the trust.

• The charitable deduction will be different for a CRAT and a CRUT even if they have what looks like similar payouts, so that the percentage payout from the CRUT is the same as the CRAT annuity as a percentage of the transfer to the CRAT. For example, there may be a significant difference between the charitable deduction for a $100,000 CRUT with a 5% payout and the charitable deduction for a $100,000 CRAT paying a $5,000 annuity, even though the annuity amount is 5% of the value of the CRAT. This is because of the differences in the ways that CRATs and CRUTs operate, and the different ways their charitable remainders are valued:
• The charitable remainder from a CRUT is valued based on the percentage payout, and the current and future assumed income yields, represented in other present value calculations by the §7520 interest rate, is almost irrelevant. So the remainder for a CRUT with a 5% payout may be pretty much the same regardless of whether current interest rates are 4% or 8%.
• The charitable remainder from a CRAT is valued based on the assumption that the trust will earn the current §7520 rate, and the present value of the remainder will vary greatly based on the difference between (a) the annuity payment and (b) the income that will be earned by a trust earning the §:7520 rate on investments. So the present value of the remainder for a CRAT that pays an annuity that is 5% of the initial value of the trust will vary a great deal depending on whether the §:7520 rate is 4% or 8%.
• The distributions from a CRUT will increase if the value of the trust increases, because the trust has been able to produce income and gains that are greater than the percentage payout, and the distributions will decrease if the investments yield less than the percentage payout. However, a CRAT will always payout the same amount until the trust ends, whether due to its terms or because the trust fund has been depleted by the noncharitable distributions. The choice between a CRAT and a CRAT may therefore depend on (a) expectations of future investment returns and (b) the grantor's goals for the noncharitable and charitable beneficiaries.
• Optimism about future investment yields, together with a desire to benefit the noncharitable beneficiary, might lead to the choice of the CRUT in order to give the noncharitable beneficiary the potential for an increasing income. However, if the goal is to maximize the future remainder to charity, and a fixed income for the noncharitable beneficiaries is acceptable, then a CRAT may be the better choice.
• Pessimism about future investment yields would lead to the opposite conclusions. A desire to benefit the noncharitable beneficiary would lead to the choice of the CRAT in order to give the noncharitable beneficiary the fixed income even though it might reduce (or eliminate) the future charitable remainder. However, if the goal is to preserve the future remainder to charity, and a reduced income for the noncharitable beneficiaries is acceptable, then the CRAT may be the better choice because the noncharitable distributions will decrease if the value of the fund decreases.

Other considerations:

• If the property contributed to the trust, or the initial trust investments, will produce little cash income (e.g., interest, dividends, or rents), a CRUT may be desirable because CRUT distributions can be limited to the actual net income of the trust, but the annuity payable by a CRAT cannot be limited to income.
• It may not be possible to create a CRAT for the entire lifetime of a relatively young noncharitable beneficiary (or beneficiaries), because the probability of the trust being exhausted by the annuity payments, and the charitable beneficiaries receiving nothing, can't be more than five percent. A CRAT must pay an annuity of at least 5% of the initial value of the trust, but the §7520 rate has been less than 5% since 2008, so it is assumed that a CRAT will have to distribute principal as well as income and will be depleted eventually. For beneficiaries below a certain age (the exact age will depend on the current §7520 rate), a CRAT will not be possible unless either (a) there is a term limit on the CRAT (i.e., the CRAT is not for the life of the beneficiary but for the shorter of a term or life), or (b) the trust document provides that the trust ends and distributes its assets to the charitable beneficiaries when the value of the trust assets fall to a certain level determined by a formula created by the IRS.

Webcalculators can produce economic projections of both CRATs and CRUTs so that the results of different payouts and investments assumptions can be illustrated for both kinds of charitable remainder trusts.

Decisions

Because the terms of a CRAT are restricted by the Internal Revenue Code and regulations, there are usually only a few decisions to be made when a CRAT is created:

• Who are the noncharitable beneficiaries?
• Who are the charitable remainder beneficiaries? Are they named now, or will the grantor name them in the future? Or can the trustees of the CRAT name the charities to receive the remainder at the end of the trust?
• What is the duration of the trust? A term of years? The lifetimes of the noncharitable beneficiaries? Or a combination of the two (such a trust for the lifetime of the grantor and the grantor's spouse, or a term of twenty years, whichever is shorter). It may be necessary to limit the number of noncharitable beneficiaries, or the number of years the trust can continue, in order for the present value of the charitable remainder to be at least 10% of the transfers to the trust, or for the probability that the trust will be exhausted to be less than 5%.
• What is the annuity amount to be paid by the CRAT? The payout percentage must be at least 5% of the transfer to the trust, but can be more than that (although larger percentages will reduce the present value of the charitable remainder). (Webcalculators can calculate the largest payout that will still result in a 10% charitable remainder and not result in a probability of exhaustion that is more than 5%.)