CRT: Best Tool for Proposed Tax Changes?

There are many current tax proposals. One of the many proposals is an increase in capital gains taxes. 

Currently, federal law taxes capital gains at a maximum rate of 20%, plus a 3.8% surcharge on net investment income, for a total of 23.8%. However, under proposals, to the extent a taxpayer’s income is above $1 million, their capital gains would be taxed at the highest rate for ordinary income. That cap for ordinary income would revert to the law prior to 2017, i.e., 39.6%. The surcharge on net investment income of 3.8% would be on top of that for a total of 43.4%. This assumes no state or local taxes.

Thus, for someone who could keep their income below $1 million, their capital gains would be 23.8% or lower. However, to the extent that income is above $1 million, it would be taxed at a marginal rate of 43.4%. That’s nearly double the rate of taxation. So, if they can spread out taxation of the gain over multiple years, they may be able to reduce their taxable income so it fits under that $1 million threshold and gets taxed at the lower level.

A Charitable Remainder Trust (“CRT”) is just such a tool. With a CRT, the donor gets an upfront deduction for the actuarial value of the remainder interest expected to go to charity. This must be a minimum of 10% of the value of the contribution. The value of the income interest could be as much as 90%. So, if a donor contributes $1 million to a CRT and the actuarial value of the interest going to charity is $100,000, the donor can take a $100,000 charitable deduction in the year of the donation to the CRT (subject to typical AGI percentage limitations).

Perhaps the best attribute of a CRT is that it is a tax-exempt entity. So, if the donor contributes appreciated assets and the CRT sells them (without a prior commitment to do so), the CRT doesn’t pay tax on the gain. However, when distributions go out to the donor or other income beneficiary, those distributions are flavored by the income the CRT has earned.

The impact of this is to defer gains so the donor might pay tax on them at a much lower rate of taxation. The impact of this deferral can be even greater in some circumstances. For example, let’s say your client, Tom Taxpayer, is approaching retirement. Tom has accumulated a great deal of stock at a very low basis. In his final year of employment, Tom contributes $1 million of stock to a CRT. He gets an income tax deduction in his final year of employment when his income is high and the deduction is more valuable. The CRT sells the stock but doesn’t pay tax on the gain because it’s tax-exempt. When Tom receives payments from the CRT in his retirement, he’s in a lower income tax bracket and pays tax at lower rates.

Now is a good time to familiarize yourself with a CRT. This unique tool could be increasingly useful.

Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com