“Won’t these heavy taxes quite ruin the country?”
Benjamin Franklin, The Way to Wealth (1758)
What is the Point of a Charitable Remainder Annuity Trust (CRAT)? Let’s break it down.
Assume you are contemplating giving $1,000,000 to your beloved alma mater, Tiger University following their crushing defeat of a pretender to the college football championship.
A Charitable Remainder Annuity Trust (CRAT) allows you to:
- Get an upfront charitable deduction (reported on Schedule A of your personal IRS Form 1040 income tax return) in the year of contribution,
- Manage the charitable trust account yourself as Trustee of the CRAT account,
- Reserve a payment stream (the annuity) for a beneficiary named by you, for example, yourself, your spouse, or a descendant, and
- You can even reserve for the right to let the Trustee of your charitable trust account change the charitable beneficiary of the trust account if Tiger University loses its way in the future!
Sample Case – Tiger University and a Granddaughter in Medical School
Let’s say you were contemplating the following charitable contribution with these details:
- How much are you willing to deposit into the charitable remainder annuity trust account? – $1,000,000.
- Who should receive the annuity payments? – Your granddaughter.
- How much do you want your granddaughter to receive from your charitable remainder annuity trust account? – $100,000 per year.
- How many years of payments do you want your granddaughter to receive? – 5 years of payments, for a total of $500,000 of payments (5 years x 100,000 = 500,000). The first payment starts a year from the date of your contribution.
- What charity gets the remaining amount of the charitable trust account after all the 5 annual payments of $100,0000 are made to your granddaughter? – Tiger University. Go Tigers!
- How are you funding the charitable contribution to your charitable trust account? – For simplicity, assume you have $1,000,000 of cash in a savings account.
How the Cookie Crumbles
You might expect that you get a $1,000,000 deduction in the year you make the irrevocable contribution to the charitable remainder trust. Unfortunately, Uncle Sam does not look at the contribution to the charitable remainder trust this way. Uncle Sam looks at your $1,000,000 contribution as two parts:
- Part 1. Part of the $1,000,000 will end up with Tiger University, so you can deduct that part of the $1,000,000 on Schedule A of your income tax return, subject to limitations below.
- Part 2. The other part of the $1,000,000 contribution is going to a non-charitable entity, in this case, your granddaughter. Gifts to your granddaughter do NOT qualify for a charitable deduction.
So the issue becomes – how much of the $1,000,000 do I get to report as a charitable deduction?
Calculation of Your Charitable Deduction
Usually, you would use computer software to calculate the charitable contribution. You can use Google to find a number of free calculators! The steps below show what the software is doing.
- Find the IRS Section 7520 interest rate. You can use Google to find the IRS website that posts the IRS Section 7520 rate. This is the interest rate that the IRS annuity tables use to “translate” future payments of $100,000 into today’s dollars. Assuming we are doing this calculation for February 2020 the IRS Section 7520 rate is 2.20%.
- Find the applicable annuity factor from IRS Publication 1457, Table B. This is an Excel spreadsheet. Look for the (i) annuity factor that applies for a (ii) 5 Year Annuity at a (iii) 2.20% rate. In our case that annuity factor is 4.6862.
- Find the adjustment factor from IRS Publication 1457, Table K. The adjustment factor changes depending on how we intend to spread out the $100,000 payments to granddaughter. In our case, for simplicity, we are assuming annual payments of $100,000 so the adjustment factor is 1.
- Apply the adjustment factor (paragraph C) to the annuity factor (paragraph B) by multiplying them together. In this case, that product is 1 x 4.6862 = 4.6862.
- The value of the annuity to granddaughter (recall the annuity is an annual payment of $100,000 for 5 years beginning 1 year from now) translated into today’s dollars is the annual annuity amount multiplied by the adjusted annuity factor. In this case that is $100,000 x 4.6862 = $468,620.
What is the Value of This Charitable Deduction to Me?
There are typically two hurdles to getting an income tax benefit from a charitable deduction.
- You must have enough deductions to itemize your deductions. The standard deduction for a married couple in 2020 is $24,800. Remember that for 2020 the state and local tax deduction (e.g., property taxes for Texans) is capped at $10,000 for a married couple.If you do not have enough deductions (e.g., medical, mortgage interest, property taxes, charitable contributions) to qualify to itemize your deductions then the charitable deduction does NOT reduce your federal income tax bill.You can carry forward any unused portion of the charitable deduction for the next 5 years in an attempt to fully utilize the deduction.2. Assuming you have enough deductions to itemize, your charitable deduction may be limited to a certain percentage of your adjusted gross income. In our case, the charitable deduction limit is 50% of your adjusted gross income in the year of the contribution because we have a public charity as the beneficiary of your charitable remainder trust and we contributed cash to the charitable remainder trust.
If we assume:
- You are in the 37% tax bracket (taxable income of over $600,000 rounded, married filing jointly),
- You have enough eligible deductions to itemize your deductions, and
- Your charitable deduction is not limited by your adjusted gross income,
Then: the value of your charitable deduction will be in the ballpark of 37% x $531,380 = $196,610. Your particular benefit depends on your particular income tax return.
In other words, by contributing $1,000,000 to the charitable remainder trust and assuming the facts above you would reduce your income tax liability by about $190,000. The value of a charitable deduction depends on your specific tax situation. The example shown above is intended to show a “best case” scenario where you receive the full benefit of the charitable deduction.
To summarize the example above:
- Total contribution to the charitable remainder trust account: $1,000,000
- Amount going to granddaughter = $500,000 (before income taxes paid by daughter)
- Amount going to Tiger University = around $500,000 depending on investment returns inside the charitable remainder trust account.
- Federal income tax reduction to you assuming facts above = $190,000.
Do I Owe Gift Taxes on the Amount Given to Granddaughter?
In the example above your contribution to the charitable remainder trust is a gift of a future interest to your granddaughter that is not eligible for the typical annual gift tax exclusion (which is $15,000 for 2020).
We raise the issue in this blog post simply to point out the possibility of needing to file an IRS Form 709 gift tax return when funding a charitable remainder annuity trust.
The gift tax return may also affect your estate tax/generation-skipping tax planning.
What If I Just Write the Charitable Remainder Annuity Trust to Give All of the $1,000,000 to My Granddaughter?
IRS will not allow a charitable deduction unless at least 10% of the value of your initial contribution (in this case, 10% of $1,000,000 = $100,000) is slated to go the charitable remainder trust beneficiary, in our case, Tiger University.
Furthermore, the smaller the amount of the contribution destined to end up with Tiger University, the smaller your charitable deduction amount.
Does the Charitable Remainder Annuity Trust Entity Owe Income Taxes on the Interest, Dividends, or Capital Gains it Earns on the $1,000,000 It Holds?
Recall that we have a charitable remainder trust account that is holding the $1,000,000 you contributed. Each year that account pays $100,000 to your granddaughter for a maximum of 5 years. Then the charitable remainder trust account liquidates and pays the balance to the charity to Tiger University.
For income tax purposes the charitable remainder trust is its own tax entity with its own tax ID number and annual tax return (IRS Form 5227 Split Interest Return). The name of the return comes from the fact that the ownership of the charitable trust account assets is split between (a) a non-charitable beneficiary, your granddaughter and (b) a charitable beneficiary, Tiger University.
The charitable trust entity typically does not owe income taxes on its IRS Form 5227 tax return.
Does My Granddaughter Owe Income Taxes on Her Distributions She Receives From the Charitable Remainder Trust Account?
Maybe. It depends on if the $1,000,000 in the charitable trust account generates any income.
Reason: the charitable trust entity must file an IRS Form K-1 relating to the annual $100,000 distributions to your granddaughter.
The $100,000 distributions in and of themselves are not taxable income to your granddaughter. Instead, the taxable income is generated for your granddaughter because IRS assigns any income earned inside the charitable remainder annuity trust account to your granddaughter for her to report on her personal income tax return.
The approach is similar to the way a partnership entity “passes through” taxable income from the entity to the partners of the entity via K-1s.
When the charitable remainder trust entity generates the form K-1 for your granddaughter it is required to distribute any income items the charitable remainder trust account earned (e.g. interest, dividends) to your granddaughter for her to report on her personal income tax return (IRS Form 1040).
What If I Want to Structure the Payments to Granddaughter Differently? What If I Want to Arrange Lifetime Payments or an Annual Percentage of the Trust Value?
These arrangements are described as (i) a lifetime annuity or (ii) a unitrust annuity. We can discuss the charitable deduction for these arrangements in another post.
What to Expect Next?
We hope this provides a helpful introduction to calculating the charitable deduction on the contribution to a charitable remainder annuity trust.
If you have charitable contribution questions please feel free to contact our office so we can help!
By Christopher Ha