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IRS Proposes Changes to Charitable Remainder Trusts

Charitable Remainder TrustsCharitable Remainder Annuity Trusts (also known as CRATs) have been blessed by IRS since 1970.  So why is the IRS now proposing to make CRATs reportable with your individual tax return with hefty penalties for not reporting?  The short answer is due to the abuse of this income tax and estate tax planning tool.  The long answer is a bit more complicated. 

What is a CRAT? A CRAT allows an individual to transfer assets to a trust in return for an annual income stream for a defined period.  At the end of the trust’s term, the remaining assets must go to a designated charity. The income stream must be distributed to a person or non-charitable entity. The trust is irrevocable, meaning the person creating it cannot change its terms after the trust is formed.  The CRAT must also have a charitable purpose.  The taxpayer gets a charitable deduction at the time that the assets are transferred to the trust.

What makes these trusts so popular?  The key is delaying income.  If appreciated assets go into a trust, the income will come trickling back out over a number of years. That delays and cuts into smaller, more manageable pieces the income from those assets.  Otherwise, a sale of the assets could trigger a large tax bill in the year the taxpayer sells the asset.  In addition, this gets the asset out of the donor’s estate, which can mean reduced estate taxes while still receiving that income stream, often during retirement.

There are an almost endless variety of CRATs and its close cousin, the charitable remainder unitrust, or CRUT, including trusts that distribute net income only (NICRUT) and trusts to make up income for bad years in the good years (NIMCRUTs), along with other variations.  CRATs and CRUTs can also minimize the taxes on the sale of a business to a third party or the transfer of a family-owned business to the younger generation or to an employee stock ownership plan (ESOP).

IRS is targeting the abuse of these types of trusts.  Some promoters claim that using a CRAT along with a specialized annuity will permanently avoid ordinary income and capital gains from being recognized and taxed. IRS claims that the individual donating the assets to the trust is actually making a gift at that time.  If true, then the trust must use the original price at which the taxpayer bought the asset, not the fair market value. 

What is the IRS trying to accomplish with these new regulations?”  Clearly, to close these “loopholes.” If these transactions are not reported on an income tax return, penalties would apply to the taxpayer for each year that the taxpayer participates in these transactions.  These are not slap-on-the-wrist penalties but rather can be up to 75% of the unreported income.  In addition, misstatement or gross misstatement penalties may apply; they start at 20% of the unreported income.  IRS also proposes to penalize advisors who promote and prepare these abusive types of tax avoidance schemes.

Does that mean you need to avoid all CRATs and CRUTs?  No, the technique is blessed by the law and has been used successfully for many years.  However, you should seek reliable advisors and carefully follow all of the requirements. For more information about charitable trusts, please contact Kathleen D. Adcock at McMillan Metro Faerber, P.C. (301) 251-1180 or