Wealth Transfer 301: The Family Charitable Remainder Trust

Executive Summary

  • For clients with large and highly-appreciated stock holdings, the FCRT provides an opportunity to diversify the position, defer the associated tax liability and pass substantial wealth to successive generations.
  • The complexity of the FCRT makes it most appropriate for clients who are likely to have taxable estates (over $10 million, under current law).

After successive years of strong gains in equity markets, many clients' investment portfolios have large unrealized capital gains. For the charitably inclined, an outright gift of these appreciated securities to charity produces great income tax results (see article on the benefits of using appreciated assets to fund philanthropic goals), but what if you want to pass your wealth primarily to your children instead of charity?

Giving appreciated securities outright to your children is an option, and for estates under $5 million (or $10 million for couples) the gift would be covered by the unified credit, and no gift tax would be due. Larger estates would benefit from techniques that preserve the unified credit for future use, but many of these strategies don't work well with appreciated securities, since the securities often must be sold, thereby generating immediate income tax consequences. One strategy, the Family Charitable Remainder Trust (FCRT), combines the income tax benefits of charitable planning with the estate tax benefits of standard estate planning techniques.

The FCRT allows a client with appreciated securities and a desire to both diversify his portfolio and pass wealth to successive generations to achieve both goals without immediate income tax or gift tax consequences. Additionally, the FCRT provides an immediate income tax charitable deduction and a significant benefit to the client's favorite charity, which can even include the client's own private foundation.

While the structure is novel, it combines three well-established techniques:

  • a family limited partnership,
  • a charitable remainder trust, and
  • a sale to a defective grantor trust.

Understanding the FCRT requires a basic understanding of these three techniques.

Family Limited Partnership

Family limited partnerships (FLPs) facilitate wealth transfer without loss of control. A client will typically create the partnership (which can hold real estate, securities or other assets) and later transfer or sell the limited partnership interests to family members (while holding on to the general partnership interest). Because the transferred limited partnership interests have no right to control the underlying assets, the transfer garners a discount that reduces the overall value of the interests for gift tax purposes. While the IRS has sometimes challenged fractional interest discounts, to date these efforts have been unsuccessful in eliminating their use for properly maintained entities.

Charitable Remainder Trust

A charitable remainder trust (CRT) allows a client to defer recognition of income tax on the sale of appreciated securities for several years while simultaneously receiving an income stream and benefitting charity. The client contributes appreciated property to the trust in exchange for the right to receive a fixed percentage of the trust assets for life or for a period of years. Once the income stream ends, the remaining assets in the trust are transferred to charity.

The charitable component makes the trust tax-exempt. As a result, selling the appreciated securities does not result in immediate income tax; rather, the client recognizes income only upon distributions from the trust. Moreover, the client receives an up-front income tax deduction typically equal to about 10% of the contributed assets. The CRT's income tax benefits only partially offset the often large remainder passing to charity, making CRTs appropriate only for clients with significant charitable intent.

Sale to Defective Grantor Trust

A "defective" grantor trust is merely an irrevocable trust containing certain provisions that cause the trust's income to be taxed to the grantor (the creator of the trust). A sale of appreciated securities to the trust in exchange for a promissory note does not result in any income or gift tax. As a result, all appreciation on the securities (in excess of the low interest rate on the note) accumulates in the trust and is excluded from the grantor's estate, thereby reducing the grantor's estate tax. The appreciated securities are eventually sold (incurring a large capital gain) and the sale proceeds used by the trust to repay the interest and principal on the promissory note. For this reason, the technique is not ideal for taxpayers with appreciated securities who are averse to selling the securities and recognizing gain.

Family Charitable Remainder Trust

The Family Charitable Remainder Trust (FCRT), in its most simple form, combines the three techniques outlined above to achieve tax-efficient diversification and effective wealth transfer to family, with a meaningful benefit to charity in the future.

Step 1 — Establish trust. The client establishes a defective grantor trust, usually for the benefit of their children and grandchildren, and seeds it with a cash gift.

Step 2 — Asset identification. The client creates a family limited partnership and adds highly appreciated securities that need to be diversified.

Step 3 — Charitable gift. The appreciated securities, now housed in the FLP, are transferred to a charitable remainder trust in exchange for a twenty year annuity equal to approximately 11.5% of the annual value of the trust.

Step 4 — Sale. The client sells a 99% interest in the FLP to the grantor trust in exchange for a promissory note. The grantor trust now owns the FLP, which is the beneficiary of the charitable remainder trust.

Step 5 — Diversification. The charitable remainder trust sells the securities income tax-free, purchases a diversified portfolio, and uses the proceeds to make the annuity payment to the FLP

Step 6 — Repayment. Each year for 20 years, the charitable remainder trust makes annuity payments to the FLP, which subsequently distributes them to the grantor trust. These payments are taxable to the clients, primarily as long-term capital gain. The grantor trust then makes interest and principal payments to the clients, retiring the note, often in about ten years. Distributions from the FLP in years 10-20 accumulate in the grantor trust, to be held for the client's heirs, gift-tax free.

Step 7 — Termination. At the end of the charitable remainder trust's twenty-year term, any assets remaining in the CRT pass to charity.

Flow

Case study — the FCRT in action

An example will clarify the type of situations where a FCRT is most effectively used.

Lauren Smith has $10 million of Apple stock acquired in 2004 for $1 million. She wants to diversify her holdings but doesn't want to immediately recognize the entire $9 million capital gain. She has a family foundation and some charitable giving goals, but she prefers to pass the majority of her estate to her children and grandchildren; consequently, giving the shares outright to charity is not a good option.

Instead, Lauren deposits the Apple stock into a family limited partnership and sells 99% of the partnership to a defective grantor trust, which Lauren had established for the benefit of her heirs and seeded with an initial $750,000 gift. The partnership garners a 25% fractional interest discount, so Lauren receives a low interest rate note back for approximately $7.4 million. The partnership donates the Apple stock to a charitable remainder trust, which sells the stock income tax free. Lauren receives an immediate $1 million income tax charitable deduction.

The charitable remainder trust, now holding a $10 million diversified investment portfolio, pays an annuity of approximately 11.5% of the CRT account balance each year ($1.1 million in the first year, assuming the portfolio returns about 8% per year). The grantor trust uses this income to pay interest and principal on the $7.4 million note, retiring it in as little as eight years. The remaining 12 years of distributions accumulate in the grantor trust for eventual distribution to Lauren's heirs gift tax-free.

Distributions accumulate in the grantor trust income tax-free (Lauren is responsible for any income tax), so the trust could accumulate as much as $13.5 million by the end of the 20 year term.

Lauren's private foundation receives the balance of the charitable remainder trust after 20 years, which could be as much as $5.2 million.

In summary, Lauren has:

  • Diversified a $10 million concentrated stock position with no immediate tax consequences,
  • Obtained a $1 million income tax charitable deduction,
  • Transferred as much as $13.5 million to her heirs over 20 years,
  • Transferred as much as $5.2 million to her family foundation, and
  • Received proceeds from the stock sale totaling $7.4 million,

While simultaneously:

  • Using only $750,000 of her lifetime gift credit (preserving $4.25 million to be used in the future) and
  • Potentially saving $5 million of estate taxes and another $5 million of generation-skipping transfer tax savings.

This all assumes an 8% pre-tax rate of return on the diversified investment portfolio. A return higher than 8% would result in even greater benefits for the children and charity.

Other considerations

While the FCRT combines several well-tested techniques, it is not a simple strategy and involves additional risks. The most likely challenge arises from the fractional interest discount taken on the limited partnership, but the strategy itself has passed IRS scrutiny in our office. However, it's generally appropriate only for large transactions and situations where the client is likely to be subject to estate tax liability. In the right situation, the FCRT can be a powerful tool, allowing a client to diversify an appreciated stock position without immediate income tax, transfer a significant amount to heirs, and provide a material benefit to charity.

Clay Stevens, JD
Director - Strategic Planning, Principal



Lifetime unified credit — The amount one can give away during lifetime or at death free of estate and gift taxes. Currently, the credit is $5 million per person ($10 million per couple).


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