When charitable remainder annuity trusts can be worth the risks

With new federal guidance out this month, advisors guiding clients through charitable remainder annuity trusts have been reminded to be careful they are managing these strategies correctly and paying all taxes owed, or they will have to make disclosures to the IRS.

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After a donor transfers assets to a charitable remainder annuity trust, or CRAT, at least one beneficiary can receive income for up to 20 years or for life. Afterward, the remainder, which must be at least 10% of the original net fair market value, goes to at least one qualified U.S. charitable organization. CRATs are a type of irrevocable trust, so assets put in such a trust can’t be removed.

The IRS and U.S. Treasury Department issued final regulations earlier this month to clarify which arrangements purporting to be CRATs are “listed transactions.” For example, one criteria for a listed transaction is when the trust is funded with a property that has a fair market value exceeding its basis. In those situations, material advisors and certain participants must file disclosures, and if they fail to disclose, they will be subject to penalties.

In abusive transactions, property with fair market values exceeding the basis are transferred to purported CRATs, which then sell the property and use proceeds to buy a single premium immediate annuity, the IRS said. Then, if taxpayers or beneficiaries misapply rules for taxing annuities, they underpay taxes on CRAT annuities. 

“The Internal Revenue Service remains vigilant and is watching out for tax avoidance schemes,” IRS CEO Frank J. Bisignano said in a statement. “Taxpayers should not forget that the IRS will continue to combat abusive tax shelters and transactions.”

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Still, there are legitimate ways to use this strategy to avoid capital gains and receive annual payments.

“If you have a family that has a highly appreciated asset, then this can create a win-win for a charity as well as for the taxpayer or the owner of the asset,” said Lawrence Sprung, founder of Hauppauge, New York-based financial planning firm Mitlin Financial. “Then they can use this tool to be a little bit more tax favorable and help a charity at the same time.”

Sprung differentiated what the IRS is cracking down on, saying, “This was more of a tactic by insurance professionals and planners who wanted to kind of circumvent the system,” Sprung said.

READ MORE: The tax advantages of charitable remainder trusts — and the risks

Acceptable CRAT uses

Despite the potential abuses, there are situations when using a CRAT would be acceptable and could be helpful to clients.

“I still feel like there are many, many situations where people were advised in the proper way, and this tool, if you will, was used properly,” so people shouldn’t be deterred from using it properly in the future, Sprung said.

The inappropriate situations involved “a tactic by insurance professionals and planners who wanted to kind of circumvent the system,” he added.

There are “not a lot” of alternative types of transactions, “so that’s why this is so valuable for people with high net worth or highly appreciated assets where, if they sell that asset, like a business, they have a lot of capital gains, so the annuity does make sense for a lot of people,” said Christina Taylor, vice president of tax development and delivery at New York City-based tax planning platform April Tax Solutions. “It’s a valid way to avoid just a huge hit on capital gains in one year.”

The strategy allows distributions to be in the form of ordinary income before capital gains.

“What happens with a traditional CRAT is … the beneficiaries get distributions that first send out ordinary income, then capital gains, then income and then return of principal, whereas the regular immediate annuity is a little bit more favorable to the taxpayer,” Sprung said.

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A CRAT case study

Charles Failla, principal and founder of Sovereign Financial Group in Stamford, Connecticut, gave an example of a client who made a sizable donation to charity, used a charitable remainder trust and took out a single-premium immediate annuity.

“That’s probably one of the best investments we’ve ever made for a client, just because he just crushed the actuarial tables by living so long,” until age 103, Failla said. “There would have been more wealth in his household had he not done this. He could have just bought the SPIA … but he was charitably inclined.”

This strategy might be a relatively efficient way to donate to charity, though in the case of this particular client, “his charities had to wait 33 years,” Failla added.