Exit and Growth Strategies for Middle Market Businesses

The CRT Strategy – Charitable Remainder Trusts

By David DuWaldt | Jan 29, 2010

Suppose you own a valuable asset that does not earn any income or it earns very little income.  Let us assume that this property has substantially appreciated in value such that, if you sold it today, you would realize a substantial gain and resulting tax on the gain.  So how can you turn this valuable property into an income producing source without erosion to principal due to taxation?

Answer:  By conveying the property to a Charitable Remainder Trust (CRT).

Here’s how it works:  After the trustor/donor transfers property to the CRT, the property is sold by the trustee.  There is no tax on the sale since the CRT is exempt from income tax under Section 664(c)(1) of the Internal Revenue Code.  The proceeds from the sale are invested into income producing property.  The trustee distributes income to the trustor during his or her lifetime.  Upon death of the trustor, the remaining property (corpus) is transferred to a designated charity.

Besides the benefit of avoiding tax from a taxable sale, in the year of transfer to the CRT, the trustor receives a charitable contribution deduction for the computed value of the charitable remainder interest.  The charitable remainder interest computation is based upon the value of the property transferred to the trust, the type of trust, the payout rate, frequency of payments each year, the mortality table, the applicable federal interest rate, and the age of the trustor.

There are two types of charitable remainder trusts – the annuity trust and the unitrust.  The difference between these two types of trusts has to do with the determination of the amount paid to the trustor each year.  Subject to some restrictions, an annuity trust pays a fixed amount to the trustor each year.  Also subject to some restrictions, a unitrust pays a fixed percentage of the value of the trust assets each year.

In the context of an exit strategy, the stock of a closely held company can be the appreciated property conveyed to the CRT.  One disadvantage of a CRT is that the trust is irrevocable.  So once the transfer of property to the CRT takes place, the property cannot be returned to the trustor.  In planning a transfer of stock in a closely held company to the CRT, one would assume that a buyer will need to be in place to purchase the stock from the trustee after transfer of the stock to the CRT.  This is a delicate issue under federal tax law and competent tax counsel needs to be involved with such a plan.  The Internal Revenue Service generally frowns on a preplanned stock sale before a transfer to the CRT.

Another exit strategy involving the use of a CRT, with less risk than a transfer of closely held stock, has to do with qualifying replacement property that is acquired in an ESOP rollover (see the blog article of January 15, 2010).  The qualifying replacement property will usually have a fair market value that is greater than the tax basis in such property.  If the qualifying replacement property is sold, generally a taxable gain will result.  What if some portion of the qualifying replacement property is transferred to a CRT?  If the replacement property includes stock in a publicly traded domestic corporation, which does not pay dividends, the transfer of such property to a CRT can effectively convert this asset into an income stream, and, as described above, create a charitable contribution deduction as well.

The CRT is also a useful tool in estate planning.  Since the property of the CRT is transferred to a designated charitable organization upon the death of the trustor, the value of such property is not included in the measure of the taxable estate of the trustor.

Before considering any type of strategy that includes the use of a CRT, it is important to seek competent tax counsel who is experienced with transactions involving a CRT.

posted by David DuWaldt

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