Over the many years I practiced, the popularity of the charitable remainder trust ebbed and flowed. While always recognized as a versatile planning tool, CRTs were primarily valued as a means of diversifying a highly valued asset on a tax-advantaged basis. Not surprisingly, CRTs were popular when clients had significant appreciation in their portfolios. Otherwise, no.

The back story as told to the customer

In the context of a tax-advantaged diversifier, clients are told that instead of selling that highly valued, often low-yielding asset and making significant capital gains, they can transfer it to a REIT, where the manager of the trustee will sell it and reinvest the proceeds in a diversified portfolio. KRRT will pay an income stream for the life of the customer or a certain number of years. After that, whatever remains in the KRRT goes to charity.

And the tax advantages? With the caveat that the income, gift and estate tax treatment of IRCs is a difficult terrain best traversed by a qualified tax advisor, which I am not, here is a clear summary of non- technical. As the donor of a qualifying CRT, the client is entitled to an income tax deduction for the present value of the remainder interest that is intended to pass to charity. Then, when the trust sells the asset, the sale does not trigger a capital gains tax at the trust level because the CRT is tax-exempt. So all income can be reinvested. However, capital gains tax is recognized by the donor over time as they receive distributions, all under a “tiered” system pursuant to Section 664(b) of the Internal Revenue Code. While the KRRT does not eliminate capital gains tax, it defers and spreads it. When the donor dies and the remainder passes to charity, the estate tax deduction, or if the donor's spouse continues to receive distributions, a combination of the marital and charitable deductions, will alleviate the estate tax concern. It goes without saying that generalities won't cut it here. Clients should ask their advisers to inform them of the tax implications of the specific design they are considering for their CRT.

Part Art, Part Science

KRRT selection and design is part art and part science. Art basically involves the customer's preferences for what they would like the CRT to do for them over time. Science involves shaping the KRRT to meet the technical rules governing the trust's qualification as a KRRT. Among the many points that must be covered with the client are:

• What asset should be contributed to the KRRT and what are the asset's value and legal, economic and tax characteristics?
• Should you set up a charitable annuity or unitrust? Is the investment glass half full or half empty?
• Which charity should receive the remainder and what is its tax status?
• What is the term of the income interest, for example, the life of the donor, the life of the donor and the spouse, the life of the donor and not the spouse, or a term of years?
• What is the payment rate? It depends on what the customer is trying to achieve with the CRT. For example, return their money as quickly as the rules allow or generate a lifetime of increasing income. Asked another way, how charitable does the client want to be with KRRT?
• Who should be the trustee?

Clients and advisors will want to see a comprehensive and detailed model or exhibit that shows the initial deduction, amount of distributions and their tax characteristics for the tiered system. All numbers and taxes aside, it's important for the customer to understand and accept that the CRT is non-refundable and, furthermore, not their cookie jar! All they are entitled to is distributions. They cannot enter the trust for the education of the children.

Threshold concerns

In practice, I found that clients were very interested in the numbers, meaning the tax economics of the KRRT, and to see variations on the original design theme to ensure that the KRRT would meet their objectives. Eventually, they would sit down and say, “OK, we get it.” The question was whether “We understand” would be followed by an “and” or a “but.” An “and” was equivalent to “Where do we sign?” Or “Let's move on.” Most challenging were the “buts,” which were generally attributed to one or both of these concerns:

• “We're not sure the first tax benefits outweigh the loss of control of the funds.” If they raised that concern, they already knew the answer, meaning they weren't willing to give up control of that kind of money just to get the deduction and avoid upfront capital gains tax. The conversation was over.
• “Our kids are not going to be thrilled with that. He redirects much of their inheritance to charity!” This concern prompted the discussion of asset substitution discussed below. Discussing asset replacement was always technically interesting, but it could also be troublesome, sometimes causing clients to walk away from the project out of frustration.

Approach to asset replacement

With the subject matter varying depending on the facts, circumstances and personalities of each case, a reasonable starting point for the discussion is to determine what the clients want to “replace”. So clients and advisors will go back and forth on whether to factor in the impact of estate taxes on what the children would actually receive, projected growth in asset value, and so on. Perhaps the client sees this as an opportunity to increase the inheritance for the children, which means replacing the asset and then some. At some point, the client will make the call. Let's say the client wants to insure for the full value of what would go into the CRT.

The next step may be to return the client to the cash flow statement and highlight how quickly the value of the transferred asset is expected to be returned, ie replaced, through distributions. Perhaps the client can use the distributions to fund generous annual exemption gifts for children. I found that the kids loved this approach! But it includes two notable caveats. First, depending on the design of the KRRT, that projection is just that, a projection. Second, the client must remain alive long enough for the distributions to complete the replacement.

So any customer who doesn't want to leave replacement to chance turns to or turns to life insurance. They can direct a portion of the premium payment into a policy that will surely “replace” the asset's value for the children's inheritance. When the client has a taxable estate, the usual advice is to hold the policy in an irrevocable life insurance trust, commonly referred to in this setting as an “asset replacement trust.” At this point, the conversation turns to the type of policy.

It's a fence, not a maze

Proponents of the insurance approach will typically point to a permanent policy, such as having, in our scenario, a nominal amount at least equal to the full value of the asset contributed to the KRRT. But from a purely clinical risk management perspective, the purpose of insurance is simply to protect against the risk of early termination of the client's income interest. In that case, depending on the design of the KRRT, the donor's age, and other factors, a 15- or 20-year term policy may be all that is needed. In the meantime, the customer can initiate those annual gifts, speeding up the replacement process. But hedging with a term insurance approach is inappropriate when KRRT and life insurance are intended as part of a broader, more sustainable financial, wealth and liquidity plan. This type of plan requires permanent insurance, period.

OppORTuNiTy

I found that clients appreciated learning about CRTs and how their tax advantages and design flexibility could enable them to play an important role in their planning, far beyond asset diversification. This is undoubtedly true even today. And with some appreciation in customer portfolios these days, CRTs may be back on the table.

What's also true is that CRTs, and planned charitable giving in general, offer advisors tremendous opportunities to develop their technical skills, expand their service offerings to clients, and network with other advisors. , including planned giving professionals to local and national charities.