✅ A Charitable Remainder Trust is a tax-advantaged account that allows you to exit your winning positions but put off the associated income taxes, thereby growing your money faster with the magic of compounding--kind of like a more flexible IRA. For example, a startup employee or crypto investor with a million-dollar exit could earn an extra $1.5 million over her lifetime with a CRT.
Imagine that you’re an employee of a successful company. Another fundraising round is in the rear-view mirror, and you’re starting to hear whispers about an IPO. You’re excited--and understandably so. You’ve spent four years of your life helping to grow this business, and you’re finally about to be rewarded.
At the same time, though, there’s a cloud hanging over the good news: You know that, whatever you earn from selling your shares, you’re going to have to send a big portion of it to the government--at least 20%, and if you live in a high-tax state like California or New York, as much as 37%. For that reason, even though it makes sense to liquidate your highly appreciated asset (whether to diversify or to reinvest), you might be reluctant to do so because you don’t want to trigger a taxable event.
But what if there were a tool that allowed you to exit your winning positions but also put off those income taxes (state and federal) for 20 years or more so that you can put the proceeds to work pre-tax?
To do that, you can use what’s called a Charitable Remainder Trust (CRT). CRTs, according to Charles Schwab, are a good fit for people who are looking to reduce their personal tax exposure on startup equity and crypto-assets. If done properly, tax deferral can provide massive benefits, and that makes the Charitable Remainder Trust (and, in particular, a Net-Income-with-Makeup Charitable Remainder Unitrust, or NIMCRUT—a specific kind of charitable trust we’ll explain in a bit) a very powerful financial tool.
In this article, we'll explain how Charitable Remainder Trusts work. But before we dive into the mechanics, here is a quick explanation of why these trusts are so valuable.
What is a Charitable Remainder Trust?
A charitable remainder trust is a tax-exempt, irrevocable trust designed to reduce individuals’ taxable income. It distributes income to the trust beneficiaries at least annually for a specified period and, when that period is over, donates the remainder — everything that hasn’t been distributed yet — to your chosen charity.
A charitable remainder trust is the best of all worlds: It allows you to stash your assets in the trust, receive an up-front tax deduction, and defer your taxes on any gains you realize inside the trust (for example, when you sell appreciated assets), but the trust’s income is used for yourself, and then donate a portion of the assets to charity at the end of the trust’s term.
In the words of Charles Schwab, “Charitable remainder trusts are particularly suited for appreciated properties because any capital gains tax will be deferred until the time that it is distributed out to the income beneficiary. Therefore, a donor can contribute highly appreciated concentrated positions to the CRT and diversify his/her position in a tax-effective manner as the tax burden will be spread out over time.”
The Magic of Tax-Free Compounding
There are many benefits to a Charitable Remainder Trust, but the key for our purposes is that they protect your gains from taxes at the exit, and the money you save on taxes is reinvested and continues to grow. For example, if you are a California resident and you have capital gains of $1 million (on a $0 cost basis) when your company goes public, you would typically pay about $360,000, or 36%, in taxes, and you would be left with about $640,000 to invest (or spend!) going forward. If your shares were in a Charitable Remainder Trust, by contrast, the trust would keep the whole $1 million to reinvest.
You will have to pay taxes on that money when you receive distributions—similar to an IRA. But you get to invest those savings in the meantime. It's almost like receiving a 0% interest loan from the government on your taxes.
And think about what happens when you put those savings in the stock market, crypto, or angel investments: your tax savings continue to grow. While it seems obvious that you would rather have $1 million in the market working for you than $640,000, most people don’t appreciate how big of a difference that will make over time. Assuming just an 8% annual return—the average historical return from relatively conservative index investing—that extra $340,000 will turn into more than $700,000 in additional gains over 20 years. Even after you pay the taxes you owe on your gains and leave a gift for the charity of your choice (more on that in a minute), you could come out more than $400,000 ahead on an initial $1 million exit after that same timeframe. That’s the magic of the one-two punch of federal-tax-advantaged trusts and compounding.
The Logic of Tax Smoothing
Another benefit of Charitable Remainder Trusts is that you can keep more of the proceeds from your sale through "tax smoothing," or spreading out your income over time to lower the effective tax rate you pay on your big gain. Imagine you are a California resident who has a $1 million exit coming. If you realize that entire gain in a single year—as you would if you did no tax planning—you will pay around $360,000 in taxes on that big sale. (Plus, the one-time sale could trigger additional tax burdens like the alternative minimum tax (AMT)).
If, instead, you put those shares into a Charitable Remainder Trust and take distributions over time—say, $100,000 per year—you would pay taxes only when the money comes out, and that could mean a tax rate as low as 24%, because the smaller, piecemeal withdrawals keep you in a lower tax bracket. That's the logic of tax smoothing, and it works so long as you spread your withdrawals out even a little bit.
How Does It Work?
A simple example will be helpful. Take Olivia, an employee of a successful startup who joined the company around Series B. Her shares are worth about $250,000 according to the 409a valuation, but she got them when they were worth almost nothing. She expects the company to go public at the end of the year, at which point she will sell her shares for about $1 million.
Olivia works with us to put her shares into a lifetime trust today. She’ll get a tax deduction this year of approximately $25,000. (You can trust us on the math—that's 10% of the current 409a value when Olivia put her shares into the trust—but here’s an article on Charitable Remainder Trust deductions that explains the calculation in more detail.)
Then, when her company goes public, she will sell the shares, just like she would have if she had been going it alone. But because her shares are in the trust, she won’t pay any taxes—state or federal—now. So instead of sending $360,000 to California and the federal government this year, she will get to invest her $1 million and let it grow.
Then, she'll decide over time how much income she wants to withdraw every year. Say she elects to pull out $100,000 every year. By taking advantage of tax smoothing, she'll end up paying about $24,000, or a (much lower) 24% total tax rate on those annual distributions.
Why Is This Allowed?
When we explain the magic of Charitable Remainder Trusts, most people ask a good and important question: Why does this work? In short, the government has decided that it’s willing to allow people to get tax-free growth in exchange for a promise that they’ll give some money to charity in the future. This is also why these trusts are called a “charitable remainder” trust; a Charitable Remainder Trust (CRUT) is a trust where whatever is left at the end of the term —the “remainder”—goes to a tax-exempt entity such as a charity. And since the assets that are left in the CRUT will go to a tax-exempt entity, the trust doesn't pay taxes on its capital gains (and you won't pay taxes until you withdraw your money).
This charitable giving is great—you get to reap the benefits of tax-free growth, you get to give some money to charity and take a deduction, and, because of the way the trust is structured, you still come out ahead in the end. How? Because of the aforementioned tax-free compounding and tax smoothing. Plus, you’re not actually committing a huge portion of your assets to charity; the IRS sets the payout rates so that the trust will leave behind at least 10% of the net present value of the initial donation to charity, and the government gives you an up-front charitable deduction for the present value they estimate will go to charity at the end of the trust term.
You Decide When To Cash Out
There are some additional requirements for a Charitable Remainder Trust. Assuming Olivia sells her stock for a big gain in year 1, she’ll be entitled to receive an annual payment from the trust every year after that. Critically, though, she doesn’t have to take much money out. Because most of our charitable trusts are classified as “net income” Charitable Remainder Trusts, our customers need only cash out the income their assets actually earn in a given year.
And that amount is more or less in Olivia's control. If she wants to cash out some of her gains in year 5—say, to buy a house—she can do that. If she wants to leave her money in the trust for the full 20 years, she can do that too, subject to the rules of NIMCRUT distributions. (Why would she do that? To maximize her investment returns; the more money she leaves in the trust, the more grows tax-free.) Then, at the end of the term, Olivia can cash out most of the rest of her accrued gains, again according to NIMCRUT rules, and she'll leave the rest for the charity of her choice. How much will that be? It depends. The IRS sets maximum CRUT payout rates to ensure that at least 10% of the net present value of the trust principal is left for charity, but the amount varies based on the length of the trust, the type of trust (standard, NIMCRUT, or Flip CRUT), and the growth rate of trust assets.
Due to the magic of compounding and income smoothing, Olivia's money will grow much faster in a tax-free trust. Taking the numbers we gave you above—most importantly, a $1 million exit. Using a lifetime Charitable Remainder Trust instead, Olivia's gains would be striking: She could keep about $4.6 million v. $3.1 million after taxes if she just left her shares in a taxable account. That's about a 50% additional return! Plus she’d get to give $2.1 million to her chosen charity to boot.