In our last post, we told you about the types of assets that are a particularly good fit for Charitable Remainder Trusts--basically any asset that has the potential to grow (or has already grown) significantly. We also flagged a few constraints--prudent investor rule and the prohibition against self dealing--that put some minor constraints on how you can invest in a CRT. Here, we'll dig into those rules and a few other ideas that can help us think through the optimal CRT investing strategy together.
What types of assets are not a good fit for a CRT?The main benefit of a CRT--we'll keep banging on this drum!--is that the assets in the trust get to grow free of capital gains tax. It follows, then, that the main goal when designing an investment strategy for a CRT is to maintain that tax exempt status. Other constraints include the regulations we've already mentioned, plus some basic rules of growth and value investing.
Assets That Risk Tax-Exempt Status
- Assets that are already effectively sold: If an asset is already under contract for sale, the IRS will treat the gift of that property differently because the sale is already effectively completed, and the IRS assumes that any gift to a CRT is being done solely to avoid taxation. (Of course that is one goal of putting money into a CRT, but the government prefers that it not be the only reason.) If the sale is already effectively final, you will have to pay capital gains tax in the year the sale goes through, negating the main benefit of a CRT. Even worse, because the assets are now in the CRT, you wouldn't be able to use the cash from the sale to pay your (potentially large) tax bill. Long story short, you don't want this.
- S corporation stock: This one is more straightforward: By rule, Charitable Remainder Trusts are not "qualified shareholders," and so putting S corp stock into a CRT could disqualify the corporation and all shareholders from receiving the tax benefits associated with that corporate structure (including pass-through treatment of earnings).
- Partnership and LLC interests: Caution should be exercised before donating Partnership or LLC interests because they can create Unrelated Business Taxable Income – income earned from a trade or business that is not substantially related to the Charitable Trust’s purpose. This may result in taxes and penalties to the CRT.
- Real estate with debt: If you donate real estate that has a mortgage on it, the loan may trigger debt-financed income (income produced by assets acquired with borrowed funds), which is considered unrelated business taxable income and triggers taxes and penalties for the CRT.
- Personal residence: Donating your personal residence violates the self-dealing rules if the donor is living in or using the residence. You would also lose your Section 121 capital gains exemption upon sale of the residence.
- Corporate stock redemption: Normally, a transfer of stock to a charitable remainder trust by an owner of more than 35 percent of the voting stock of the corporation followed by a corporate redemption is a prohibited act of self-dealing. However, there are special exceptions that are covered in our self dealing post.
- Tangible personal property: When tangible personal property is transferred into a unitrust, two rules impact the charitable deduction. First, the transfer of assets into a unitrust creates an "intervening interest", which was created to preclude deductions for claimed "gifts" of art in which the donor retained possession of the donated art for a period of time. The charitable deduction is effective after the donor actually relinquishes possession of the art and transfers it to the charity. With a charitable remainder trust, the intervening interest causes the deduction to be delayed until the asset is sold. At that time, there is no longer an "intervening interest," since the asset has been converted to cash.
- US savings bonds: If Series EE or HH savings bonds are transferred to a charitable remainder trust, the trustor may claim a charitable contribution deduction for their fair market value. However, all unrealized income will be taxed to the trustor on the date of contribution.
- Stock subject to right of first refusal: A transfer of stock of a publicly held corporation, subject to a first right of refusal by the corporation, to a charitable remainder unitrust requires any shareholder desiring to sell stock to first offer the shares to the corporation at the same price and terms as offered to any other buyer. (Worth confirming with any agreements that transferral to a charitable remainder trust is permitted.)
- Publicly traded master limited partnerships: The transfer of an MLP to a charitable remainder trust should be considered only after a thorough examination of the partnership prospectus and with specific attention given to possible unrelated business income from acquisition indebtedness or the partnership’s business activities.
- Stock in a professional corporation: Stock in professional corporations such as incorporated legal, accounting, medical, or dental practices may or may not be allowed for transfer to a charitable remainder trust. Determination of suitability will depend on the licensing authority in the state of the corporation’s situs. A transfer may be permissible if the trust is only a transitory holder, pending the sale or other disposition of the practice, or if the trustee holds a professional license compatible with the type of stock being contributed.