Optimum CRAT Payouts
Payouts are one of the most important areas for the advisor to communicate to the recipient. With a charitable remainder annuity trust, the payout rule is that the annuity trust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.
This distribution sounds reasonably simple. However, the accounting can be fairly complex. The challenge for the advisor is to explain these rather complex concepts in simple terms to donors and clients.
This annuity trust plan has several advantages. It is fairly easy for the donor to understand, it is quite easy for the CPA or attorney to explain to the client, and it is fairly easy to distribute capital gain. For these reasons, the annuity trust is preferred by donors who desire a fixed return.
Four-Tier Accounting for Remainder Annuity Trusts
CRAT distribution rules are set forth in Reg. 1.664-1(d)(1). Distributions from charitable remainder trusts are first ordinary income, then capital gain, then tax-free income and finally corpus. The distribution method is commonly described as the "Four-Tier" structure. In truth, the distribution rules have been made somewhat more complex by the different capital gains rules. The capital gain tier is further subdivided into the four levels for capital gain. The actual final structure is as follows:
| Category | Tax Rate |
| Ordinary Income | 37% |
| - Dividends | 15%/20%/23.8% |
| Capital Gain - | |
| - Short-Term Gain | 37%/40.8% |
| - Tangible Personalty Gain | 28% |
| - Depreciation Gain | 25% |
| - Long-Term Gain | 15%/20%/23.8% |
| Tax-Free | 0% |
| Return of Principal | 0% |
Related Topics on Four-Tier Accounting
3.1.9
Education Annuity Trust:
An excellent application for an annuity trust is to provide for the college education of a child, nephew, niece, grandchild or other person. The education trust typically will pay a fairly high annuity amount for a term of four or five years.
3.10.2
Four-Tier Accounting:
Unitrust payouts are one of the most important areas for the advisor to communicate to the recipient. With a charitable remainder trust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.
Palumbo:
In
Estate of Antonio J. Palumbo et al. v. United States; No. 2:10-cv-00760 (8 Mar 2011), the District Court upheld a charitable deduction for a bequest to a testamentary trust.
Gerhardt:
In
Gladys L. Gerhardt et al. v. Commissioner; No. 11127-20; No. 11128-20; No. 11129-20; No. 11146-20; 160 T.C. No. 9, the taxpayers and their children donated low-basis real estate to multiple charitable remainder annuity trusts (CRATs). The CRATs sold the property and the proceeds were used to purchase single premium immediate annuities (SPIAs). The tax preparers claimed that the basis was stepped up on the transfer to the CRAT and a high percentage of the annuity payouts were not taxable.
The taxpayers had been engaged in farming for six decades. As they considered retirement, they learned about a CRAT strategy where they could sell their appreciated farm assets, retire and receive substantial payouts – all with little or no taxes.
The taxpayers transferred farm assets to multiple annuity trusts for both parents and their children. All CRATs were audited by the IRS. While the tax preparers claimed on the IRS Form 5227 trust tax return and the Schedules K-1 sent to annuity recipients the payments were over 95% corpus and nontaxable, the IRS disputed that. Because the farm assets were ordinary income under Sec. 1245, the IRS issued a notice of deficiency and increased the income of Albert and Gladys Gerhardt by $307,656 in 2016 and 2017.
There were similar results for the CRATs for children Alan and Audrey, Jack and Shelley and Tim and Pamela. Taxpayers claimed all CRATs distributed more than 95% nontaxable payments, but the IRS determined that 100% of distributions were ordinary income.
A CRAT is qualified under Sec. 664 of the Code. The transfer of an appreciated asset to a CRT does not trigger recognition of gain. Therefore, a CRAT that complies with Sec. 664(c)(1) may receive appreciated property and sell without paying tax on the sale.
However, under Sec. 1015(a) and (b), the basis of the property in the hands of the donor or grantor is transferred to the CRT. Therefore, the CRT may sell the property without tax, but the CRT accountant will record as gain the amount of the sale that exceeds the adjusted basis.
Under Sec. 664(b), CRAT distributions to recipients will be Tier 1: ordinary income, whether current or previously undistributed, Tier 2: capital gain, whether current or previously undistributed, Tier 3: other income or Tier 4: nontaxable distribution of corpus. The full amount of each category must be distributed before moving to the next category. Income recipients receive a Schedule K-1 that describes the tax character of the distributions.
Taxpayers claimed there was an increase in basis and "all taxable gains disappear and the full amount of the proceeds [is] converted to principal to be invested by the CRAT." The Tax Court stated, "The gain disappearing act the Gerhardts attribute to the CRATs is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations or caselaw."
Under Sec. 1015(a), the basis of the property transferred to the CRAT "shall be the same as it would be in the hands of the donor." Sec. 72 does not change this rule. Distributions by the CRAT are governed by Sec. 664(b) and Sec. 72 does not override that rule.
Because the property was used for farming and the raising of hogs, the Commissioner determined that they fell under Sec. 1245(a)(3)(A) and (D) as a single-purpose agricultural structure. The recapture of depreciation on Sec. 1245 property is ordinary income. Therefore, the sale of the property used for raising hogs produced ordinary income inside the CRAT. Because the CRAT is required under Sec. 664(b) to distribute all ordinary income prior to moving on to Tier 2 for capital gain, Tier 3 for other income or Tier 4 for principal, all distributions from the CRATs were to be paid out as ordinary income.
There also was an accuracy-related penalty under Sec. 6662(A) for children, Tim and Pamela Gerhardt. The accuracy penalty is not applicable if there is reasonable reliance on professional advice. The standard is that the advisor was a competent professional, the taxpayer provided the necessary and accurate information and the taxpayer relied on the advisor in good faith. Because the taxpayers were not able to provide evidence of compliance with the reasonable cause defense, the penalty was applicable.
Editor's Note: Your editor has assisted numerous farm families with successful retirement plans. Typically, the parents have built substantial equity over six decades and now are prepared for retirement. They are family and charitably oriented. Often, a portion of the farm is transferred to a two-life charitable remainder unitrust (CRUT) for parents, a portion is transferred to a 20-year term of years CRUT to distribute substantial income to children and a portion is sold for cash. There are no net taxes to pay when the plan is created because the tax on the cash out is offset by the charitable deductions. While the distributions are taxable, all family members receive substantial income and the parents enjoy a relaxed and fulfilling retirement.
