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Charitable Remainder Trusts: Structural Nuances and Planning Considerations
By: David Roberts
Charitable remainder trusts (CRTs) remain a key strategy in philanthropic and tax planning, particularly for clients facing significant liquidity events or seeking to diversify highly appreciated, low-yielding assets. When structured properly, a CRT can allow donors to support charitable causes while deferring capital gains taxes and generating income for themselves or their beneficiaries. While the foundational mechanics of Internal Revenue Code (IRC) Section 664 are well understood by most practitioners, using CRTs effectively requires careful attention to actuarial testing, income characterization, and compliance requirements.
How a Charitable Remainder Trust Works
At its core, a CRT is an irrevocable split-interest trust. It pays a specified amount to one or more noncharitable beneficiaries for a term of up to 20 years or for life, with the remainder passing to a qualified charity. Practitioners generally utilize two main variations:
the charitable remainder annuity trust (CRAT), which pays a fixed dollar amount, and
the charitable remainder unitrust (CRUT), which recalculates its payout annually as a fixed percentage of the trust’s fair market value.
Because CRUTs permit additional contributions and offer inherent inflation protection as trust assets grow, they are significantly more common in modern planning. Variations such as the Net-Income with Makeup CRUT (NIMCRUT) and the Flip Charitable Remainder Unitrust (Flip CRUT) provide essential flexibility when funding trusts with illiquid assets, such as closely held business interests or real estate. These structures allow distributions to be deferred until a liquidity event occurs.
Key Statutory Requirements
Creating a valid CRT means following specific IRS rules. The trust must pay out between 5% and 50% of its value each year. More importantly, the charity’s projected share at the end must be worth at least 10% of what went into the trust initially. The IRS uses a standard interest rate (called the Section 7520 rate, currently 4.6%) to calculate whether this 10% threshold is met. When interest rates are low, or when beneficiaries are young and expected to receive payments for many decades, meeting this 10% requirement becomes harder — you may need to lower the payout percentage or shorten the trust term.
For CRATs specifically, there’s an additional safety rule: the IRS requires evidence that there’s less than a 5% chance the trust will run out of money before the charity receives its remainder. Using the IRS’s recommended trust language helps avoid disqualification on this point.
Common Compliance Risks
Several operational issues can create problems. One is unrelated business income — money the trust earns from debt-financed property or from running an active business. While this income no longer disqualifies the entire trust as it once did, it now triggers a 100% excise tax on that income. The lesson: keep CRT investments limited to stocks, bonds, mutual funds, and similar passive holdings.
Another trap involves S corporation stock. S corporations can only have certain types of shareholders, and CRTs don’t qualify. Transferring S corporation shares to a CRT immediately terminates the company’s S election, potentially creating significant tax problems for all shareholders. If a client owns S corporation stock, it must be sold or converted before funding the trust.
Hard-to-value assets, like real estate or privately held business interests, require professional appraisals to support the charitable deduction. Finally, the trust cannot engage in transactions that benefit the donor or related parties — no sales, loans, or compensation arrangements except reasonable trustee fees. These “self-dealing” prohibitions are strict, and violations can result in substantial penalties.
Tax Treatment of CRT Distributions
The economic advantage of the CRT relies on its tax-exempt status, which allows the trustee to sell appreciated assets without immediate capital gains recognition. However, distributions to the noncharitable beneficiary are subject to the four-tier accounting system under Section 664(b). Often described as a “worst-in, first-out” system, distributions are characterized first as ordinary income, followed by capital gains, tax-exempt income, and finally, tax-free return of corpus. This effectively defers, rather than eliminates, the tax liability, spreading it over the beneficiary’s lifetime while providing immediate diversification.
Strategic Planning Opportunities
In practice, CRTs are most effective when deployed well ahead of major liquidity events. For clients planning to sell a business, transferring shares to a CRT before signing a binding letter of intent can help avoid the anticipatory assignment of income doctrine and preserve the full proceeds for investment. When paired with a donor-advised fund as the remainder beneficiary, the CRT offers clients enduring control over their philanthropic legacy. When structured thoughtfully, a CRT can help clients meet their wealth transfer goals while taking advantage of meaningful tax planning opportunities, so long as it is carefully administered and maintained.
Considering a Charitable Remainder Trust
If you are considering charitable giving strategies or preparing for a significant liquidity event, a charitable remainder trust may be an effective tool to help achieve both your philanthropic and financial planning goals. Please contact David Roberts or another member of our estate planning team to discuss whether this strategy may be appropriate for your situation.
