Charitable Remainder Trust Cuts Taxes by 38% for Client

Charitable Remainder Trust Cuts Taxes by 38% for Client

Executive Summary

A high-net-worth client of Luminary Wealth faced a substantial capital gains tax liability after selling a significant portion of their real estate holdings. To address this challenge, Luminary Wealth leveraged a Charitable Remainder Trust (CRT), allowing the client to donate the appreciated assets to charity, receive an income stream over time, and significantly reduce their tax burden. The CRT strategy ultimately reduced the client’s capital gains taxes by 38% and facilitated a meaningful charitable donation, demonstrating the power of strategic tax planning.

The Challenge

John Miller, a 68-year-old client of Luminary Wealth, recently sold a commercial property he had owned for over 20 years. The sale price was $2.5 million, and his original cost basis was $500,000, resulting in a capital gain of $2 million. This gain was subject to a federal capital gains tax rate of 20% and a state income tax rate of 5% (assuming the state taxes capital gains). This meant John faced a combined capital gains tax liability of $500,000 (federal) + $100,000 (state) = $600,000.

John was also philanthropically inclined and had a long-standing desire to support his alma mater's scholarship fund. He wanted to contribute a substantial amount but was hesitant to do so because of the hefty tax bill he was facing. A direct cash donation, while tax-deductible, wouldn't fully offset the capital gains tax. John expressed concern that the tax liability would significantly reduce the funds available for both his philanthropic goals and his retirement. His primary goal was to minimize his tax impact while making a significant charitable contribution and potentially receiving an income stream. The challenge was to find a strategy that could accomplish all three objectives efficiently. Furthermore, John preferred a structure that could provide him with some income over the next ten years.

The Approach

Sophia Rodriguez, the lead financial advisor at Luminary Wealth, proposed establishing a Charitable Remainder Trust (CRT). The core strategy revolved around donating the appreciated asset – in this case, the cash proceeds from the sale of the commercial property – to the CRT. This donation would trigger an immediate charitable income tax deduction, potentially offsetting a significant portion of John’s capital gains. The CRT would then provide John with a stream of income over a predetermined period (in this case, 10 years), after which the remaining assets would pass to his designated charity, his alma mater.

Sophia's decision framework involved several key considerations:

• Tax Benefits: The CRT allows for a charitable deduction based on the present value of the remainder interest that the charity is expected to receive. This deduction could be used to offset the client's current income, including capital gains.
• Income Stream: The CRT could be structured to provide John with a fixed annuity payment (Charitable Remainder Annuity Trust - CRAT) or a variable percentage payout (Charitable Remainder Unitrust - CRUT) based on the trust's assets. Given John’s desire for some income for 10 years, this was a crucial component.
• Charitable Goals: A CRT aligns with the client's philanthropic objectives, providing a way to support their favorite causes while optimizing their tax situation.
• Asset Management: The assets within the CRT would need to be managed prudently to ensure they generate sufficient income for John while preserving capital for the ultimate charitable beneficiary.
• Legal and Compliance: Setting up and managing a CRT requires specialized legal and accounting expertise. Sophia decided to partner with an experienced estate planning attorney specializing in CRTs and utilize a platform that provides ongoing administrative support.

After discussing both a CRAT and CRUT with John, they opted for a CRUT due to its flexibility. A CRUT allows for additional contributions to be made to the trust in future years, and its payout is based on the current value of the trust assets, providing potential for growth. Sophia selected a 7% annual payout rate, deemed reasonable considering the investment strategy to be employed within the trust.

Technical Implementation

The technical implementation involved several steps:

1. Legal Documentation: Luminary Wealth partnered with an estate planning attorney specializing in CRTs to draft the legal documents establishing the trust. These documents outlined the terms of the trust, including the charitable beneficiary (John's alma mater), the income beneficiary (John), the payout rate (7%), and the term of the trust (10 years). The documents also specified that the trust was a CRUT.
2. Asset Transfer: The cash proceeds of $2.5 million from the sale of John's commercial property were transferred directly into the newly established CRUT. This transfer was structured as a charitable donation.
3. Charitable Deduction Calculation: The estate planning attorney calculated the present value of the remainder interest that the charity was expected to receive. This calculation depended on several factors, including the payout rate (7%), the term of the trust (10 years), and an IRS-prescribed discount rate (Section 7520 rate), which at the time was 4.0%. The attorney determined that John was eligible for a charitable deduction of $1,085,000. This deduction could be used to offset his adjusted gross income (AGI) up to 50%.
4. Platform Management: To streamline ongoing administration, Sophia chose to manage the CRT through the Fidelity Charitable platform. This platform provides tools for managing charitable donations, tracking distributions, and generating tax reports. Fidelity Charitable provided John with a dedicated account representative and access to a range of investment options suitable for CRT management.
5. Investment Strategy: Sophia crafted an investment strategy for the CRUT that aimed to generate sufficient income to meet the 7% payout rate while preserving the principal balance. The strategy included a diversified portfolio of stocks, bonds, and real estate investment trusts (REITs). The asset allocation was customized to John’s risk tolerance and income needs.
6. Income Distribution: The CRUT paid John 7% of the trust's assets annually. The distributions would be taxed to John as ordinary income to the extent that the distributions were derived from ordinary income earned by the trust, then as capital gains, and finally as tax-exempt income, retaining the character of the income generated by the trust.
7. Tax Reporting: Fidelity Charitable handled all the tax reporting requirements associated with the CRT, including the issuance of K-1 forms to John and the preparation of the trust's annual tax return (Form 5227).

Results & ROI

The implementation of the CRT yielded significant financial benefits for John:

• Capital Gains Tax Reduction: The initial $1,085,000 charitable deduction substantially reduced John's capital gains tax liability. He was able to use the $1,085,000 deduction to offset 50% of his AGI. He elected to carry the deduction forward for up to 5 years.
• Tax Savings: Based on the $1,085,000 deduction and using a combined federal and state tax rate of 25%, John saved $271,250 in taxes. This represents a 38% reduction of the original $600,000 liability ($271,250/$600,000 = 0.38 or 38%).
• Annual Income: John received an annual income stream of approximately $175,000 (7% of $2.5 million) from the CRUT.
• Charitable Impact: John made a significant contribution to his alma mater's scholarship fund, providing opportunities for deserving students. The estimated value of the remainder interest passing to the charity at the end of the 10-year term will depend on the performance of the trust investments.
• Cost Basis Step-Up Avoidance: By donating appreciated assets, John avoided the potential for future estate taxes on the property.

Before CRT:

• Capital Gains Tax Liability: $600,000
• Charitable Donation: $0
• Annual Income from Asset: $0

After CRT:

• Capital Gains Tax Liability: $328,750 (estimate, depends on AGI and carryforward rules)
• Charitable Donation (Present Value): $1,085,000
• Annual Income from CRUT: $175,000 (7% of $2.5 million)

Key Takeaways

1. CRTs can be a powerful tool for clients facing significant capital gains tax liabilities. They provide a way to reduce taxes, support charitable causes, and generate income.
2. Careful planning and collaboration with legal and tax professionals are essential for successful CRT implementation. The legal documents must be drafted correctly, and the charitable deduction must be calculated accurately.
3. The choice between a CRAT and a CRUT depends on the client's individual needs and circumstances. A CRAT provides a fixed income stream, while a CRUT offers more flexibility.
4. Investment management within the CRT is crucial. The asset allocation should be designed to generate sufficient income while preserving capital for the charitable beneficiary.
5. Leveraging platforms like Fidelity Charitable can simplify CRT administration and tax reporting. These platforms provide tools and resources to help advisors manage CRTs efficiently.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify tax planning opportunities, like CRT strategies, for their clients, personalize investment recommendations and automate portfolio rebalancing. Visit our tools to see how we can help your practice.