Posted October 1st, 2009

Driven to Tears by Tiers?

Among the most popular gift plans codified by the 1969 Tax Act are charitable remainder trusts. Their ability to generate income for donors either for life or for a period of years gives them great flexibility valued by donors and gift planners alike.

Though CRTs are popular, the tier structure that determines how distributions are taxed is not. Most donors find the tier structure confusing and frustrating, and many fundraisers do as well. Nevertheless, gift planners should have at least a rudimentary understanding of how a charitable remainder trust’s distribution will be taxed, especially as donors become increasingly vigilant about their finances in today’s economy.

When asked how CRT distributions will be taxed, many experienced gift planners may give donors responses that are less than accurate (taxation depends on the type of income that the trust generates) or unhelpful (taxation of trust payments is governed by the IRS).

According to the IRS

Given these concerns, a short review of the rules governing the taxation of CRT distributions may help you avoid being driven to tears. The basic source of the rules may be found in the Internal Revenue Code section 664(b), which was part of the 1969 Tax Reform Act.

For those not well versed in IRS language, such explanations can shed little light. Suffice it to say that the four-tier payout scheme for CRTs is basically designed to make sure that distributions will generally be taxable at the least favorable applicable tax rate for the recipient. While donors may view this structure as unfair, the system was designed to curtail abuses of these charitable planning tools.

Taxation of CRT distributions can actually be more favorable than taxation of income from other tools such as pooled income funds, which is taxed as ordinary income. CRT distributions are instead taxed as a mixture of ordinary income, capital gains, other income (tax exempt), or distribution of corpus (also tax free).

How is the tier determined?

Practically speaking, most distributions are taxed as ordinary income or as capital gains. However, a variety of factors are considered from an accounting standpoint that affect the treatment of each year’s distributions. What types of property were used to fund the trust? Was the trust funded with cash or highly appreciated property? What are the trust’s investments? Was the income received in the form of interest or dividends? What is the donor’s tax rate? And so on.

Let’s examine how a 5% payout from a $500,000 CRT might be taxed under several different scenarios.

Imagine that the CRT is invested so that it earns income of at least 5%. In such a case, the entire $25,000 will be includable in the taxpayer’s gross income and taxed as ordinary income, or tier (1).

In the event that the trust’s earnings are less than 5%, trust accounting rules will use the four-tier system to determine (1) if there was any undistributed income from previous years and then (2) if any capital gains were generated by the trust that year or carried over in previous years. Any remaining distributions will become (3) tax-exempt income and will (4) finally lead to a tax-free distribution of corpus.

For example, if the trust has interest and dividends totaling 3%, or $15,000, that portion of the $25,000 distribution amount would be taxed as ordinary and qualified dividend income. The remaining $10,000 would be taxed progressively through the other three tiers.

For example, suppose the trust was funded with highly appreciated property. In this case, the $25,000 distribution is funded by interest and dividends totaling $15,000; capital gains on the sale of long-term securities amounting to $7,500; and $2,500 that would be accounted for as previously undistributed capital gain. The tax owed on the capital gains portions of the distribution depends on the type of property, stock, real estate subject to depreciation, or personal property that was sold, as well as the donor’s level of income. As a result, tier (2) income is often taxed considerably more favorably than ordinary income at rates that range from 0% to 28%.

Now suppose that the trust was funded with cash or unappreciated property and has earnings of $12,500 and no capital gains or tax-exempt income. In this case, the $12,500 would be taxable at ordinary income tax rates under tier (1) and the remainder non-taxable under tiers (3) and (4), depending upon the circumstances.

How are most CRT distributions taxed?

According to the annual IRS studies of charitable remainder trusts, most distributions are divided between tier (1) ordinary income and tier (2) capital gain, with relatively small amounts being characterized as tiers (3) or (4). When there is a significant differential between ordinary income tax rates and the applicable capital gains rates, recipients will benefit from receiving tier (2) instead of tier (1) income.

The next time a donor asks how CRT distributions will be taxed, do not be driven to tears! Instead, point to the four-tier system and simply explain that IRS rules and trust accounting require that you work down through ordinary income and capital gains before any of the distribution can be reported as tax exempt or tax free. While complicated in its application, explaining the system can be as simple as 1, 2, 3 . . . 4!

The publisher of Give & Take is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Give & Take may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.

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