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In two recent Kulzer & DiPadova newsletters, we addressed a significant change to the law made by the Further Consolidated Appropriations Act, 2020 (H.R. 1865, P.L. 116-94), the yearend funding measure signed by President Trump on December 20, 2019.  The first article, dated December 30, 2019, summarized the SECURE Act, “Setting Every Community Up for Retirement Act of 2019” and its many provisions.  The second article, dated February 7, 2020, addressed a particular planning idea that has been popular for nearly 20 years called the “Stretch IRA” technique. Under this strategy, a parent could name a child as beneficiary of retirement funds and the child could defer the income tax lability (inherent in an IRA or other tax “qualified” fund) over a significant term.  Subject to a myriad of exceptions, the SECURE Act has now limited the income tax deferral on inherited Individual Retirement Accounts (IRAs) to a ten (10) year term.

The second article addressed some of the planning ideas available for clients with significant wealth in retirement accounts and only touched on one idea that may have merit for the right situation.   This possible technique might be appropriate for a charitably inclined client willing to accept some complexity, called the testamentary creation of a Charitable Remainder Trust.

A Charitable Remainder Trust (CRT) is a trust where one beneficiary receives an interest for a term and, at the end the balance goes to charity. The term interest can be structured either with a fixed annuity (Charitable Remainder Annuity Trust -CRAT) to a beneficiary or a percentage of the fund balance each year, called a “unitrust” (Charitable Remainder Unitrust– CRUT).  The CRAT or CRUT can be structured either for a set term of not over 20 years or, for the life of a beneficiary or beneficiaries.  The beneficiary’s interest can be up to 90% of the actuarial value at the outset. A taxpayer can designate the retirement fund (Individual Retirement Account, IRA) to pass to the CRAT or CRUT as beneficiary at death and, upon receipt of the entire IRA fund by the trustee of the Charitable Remainder Trust, there would be no immediate income tax imposed.  With this plan, immediate income tax is avoided but there are disadvantages, some critical, to consider before a client proceeds.

One problem with funding a CRAT or CRUT with an IRA balance is that the CRT is subject to income tax under the accounting rules called “Worst Income, First Out” rule.  These accounting rules provide that for a CRT, the deferred income tax would be imposed on the beneficiary upon distributions from the CRT to the lifetime trust beneficiary.  The initial receipt is not taxed; however, over time, as distributions are made to the beneficiary, that deferred income (IRA “ordinary” taxable income, the “worst” kind of income), will flow to the beneficiary. Thus, it presents a deferral opportunity, not a forgiveness of the income tax liability, if the beneficiary lives his/her life expectancy.

Let’s look at some examples of how a client could use a CRUT as a retirement account beneficiary.   Over a longer term, a “unitrust” payment (i.e., a percentage of the prior year end balance) to a beneficiary will yield more to the family than a fixed annuity (fixed dollar amount). By using the percentage (CRUT method) in a period when the IRS rates are low, an investment yield over the IRS rate provides more money to the heir.  Suppose the client with a $1,000,000 IRA is considering her plan when the IRC Section 7520 rate (for calculation of the tax benefits) is 2.2% (February 2020). Suppose that the family expects that the fund will grow at 3% and produce 3% of dividends (a 6% yield).  If the taxpayer paid the $1 million-dollar balance to the CRUT, the “optimal” payment to a beneficiary (to minimize the charitable interest to the 10 percent actuarial value), is addressed below. That income would be taxed as “ordinary” income on distribution.

Suppose the testator wanted the fund to be paid over the life of a 62-year-old child.  If an “optimal” unitrust amount was to be paid (i.e., so the charitable actuarial interest is 10%), about 16.6% of the prior year end balance would be paid to the beneficiary for life.  The payments would be made for a 19-year term, the life expectancy of a 62-year-old.  Here, the payments begin around $166,000 per year in early years and, because the balance would be declining, the annual payment would likewise decline. Over time, at five-year intervals, the payments would be:

Year	62-Year-Old
1	$166k
5	$104k
10	$58k
15	$32k
19	$20k
	19-Year Term

Over a 19-year life expectancy, the beneficiary would receive $1,349,000 and, in this example, the charity would receive $109,000 when the term ended if the beneficiary passed exactly on the actuarial lifetime.  Rates of return and actual life terms can change the results, but some families may view this charitable alternative with some, or all, of their IRA as superior to the ten-year fixed term provided by the SECURE Act.

Suppose instead the beneficiary was age 50. Under the same hypothetical return, 3% income and 3% increase in capital appreciation in value, the beneficiary would receive $1.7M and at the end of a 29-year term, the charity would receive about $300,000. Again, the annual payment would decline but would begin at $98,000, declining to about $31,000. At five-year intervals, the payments would be:

Year	50-Year-Old
1	$98k
5	$83k
10	$68k
15	$55k
20	$45k
25	$37k
29	$31k
	29-year term

 

For a 30-year old beneficiary, the results are even more dramatic. $2.9M would be paid to the beneficiary over a hypothetical 48-year life term and the charity would get almost $1.3M. In this example, the payments to the beneficiary would actually increase because the yield exceeds the withdrawals. The first payment would be about $54,000 and, by the 48^th year, the payment would be $69,000. At various intervals, the payments would be:

 

Year	30-Year-Old
1	$54k
10	$56k
20	$59k
25	$61k
30	$63k
35	$64k
40	$66k
45	$68k
48	$69k
	48-year term

 

Once again, this approach merely defers the tax over a term longer than the fixed 10-year rule under the SECURE Act.  Because the taxable income would pass out as deferred IRA distributions, the tax is deferred, not eliminated. There are, however, additional concerns.

The second problem is that under the CRT creation rules, at least 10% of the actual value of the trust (valued at the outset) must pass to charity.  That does not mean that 10% must pass to charity, merely that it is expected, under actuarial principles adopted by the Internal Revenue Service (IRS), to occur.  In the event the beneficiary outlives life expectancy, then there may be much less to charity.  If the beneficiary passes away prematurely, then funds in the CRT would be payable to the named charity and there would be more funds passing to charity.  If the CRT fund earns more on investments than the rate prescribed by the IRS (called the IRC Section 7520 rate, set at 2.2% in February 2020, 1.8% in March 2020), there will be more for the family and more for the charity than the beginning actuarial calculation.

A third detriment to this approach is the inflexibility with which distributions could be made to an heir.  The beneficiary is only permitted to have a set amount either calculated as an “annuity” (set dollar amount at the beginning) or as a “unitrust” (percentage of the fund each year).  If the beneficiary needs more support from the CRT fund, no additional distributions (i.e., for health, support and maintenance) are permitted.  This can be a game changing issue in some plans, but perhaps a testator can instead give money to the CRT and provide other resources to the beneficiary, either directly or in trust, so there are resources for the beneficiary beyond the fixed annuity or unitrust payment from the CRT.

Finally, and most important for our New Jersey clients, is that New Jersey does not respect the tax free nature of a Charitable Remainder Trust. Thus, the entire IRA distribution would be subject to New Jersey income tax upon receipt by the CRT. New Jersey law provides that a charitable trust is exempt from income tax only where the trust benefits only charities, not where there are split interests between the life beneficiary and remainder (charitable) beneficiary.

To minimize the New Jersey tax, perhaps the trust could be set up with a non-resident (of New Jersey) trustee, but that approach would increase complexity.  Under New Jersey law, a trust established by a New Jersey resident is classified as a “resident trust” for New Jersey income tax purposes.  However, under guidelines established by the New Jersey Division of Taxation, a so called “resident trust” is not taxable on income if i) the trust has no New Jersey Trustees, ii) the trust owns no New Jersey property, and, iii) the trust has no New Jersey “source” income (e.g., income from a New Jersey business or New Jersey based asset). Thus, a CRT might be established out of New Jersey and if a New Jersey resident names an out of state trustee, neither the asset, nor source of the IRA should cause New Jersey taxation to the trust.

You will note that the residence of the beneficiary of the trust is not a factor in the New Jersey trust taxation rules.  However, if the beneficiary of the CRT is a New Jersey resident, the New Jersey tax will be paid by the beneficiary on distribution, it is just that the tax will not be accelerated into the initial payment from the IRA to the trust.  A trust that distributes income to the beneficiary forces the taxable income to be taxed to the beneficiary receiving the income.

A CRT, and in particular a CRUT, might be a strategy for some families with large IRA accounts to consider in their planning. The approach is not without difficulties but, sometimes, the strategy might have merit.  If the beneficiary of the CRT passes prematurely, before his/her actuarial life expectancy, there may be a more significant amount passing to charity than anticipated and some have suggested that acquisition of a life insurance death benefit might ameliorate the loss of the income stream.  Finally, until the New Jersey charitable trust rules are changed, a New Jersey donor should use an out of state trustee.