Charitable Remainder Trusts (CRTs) are powerful estate planning tools, but it’s a common misconception that they are entirely tax-free once established.
What Happens When a CRT Receives Non-Charitable Assets?
While CRTs are designed to minimize taxes on the transfer of assets and provide income to beneficiaries, they can indeed generate unrelated taxable income (UTI). This occurs when the trust receives or generates income from sources that aren’t directly related to its charitable purpose. For instance, if a CRT receives stock in a C-corporation and that stock pays dividends, those dividends are generally taxable as ordinary income to the trust. According to IRS guidelines, a CRT is still subject to income tax on any income that is not used to fulfill its charitable remainder beneficiary’s income stream. In 2023, the CRT tax rate, mirroring corporate tax rates, was 21% for any unrelated business taxable income (UBTI). This is a crucial point, because many assume all income within a CRT is shielded from taxation, which isn’t always the case.
Could a CRT Accidentally Trigger UBTI?
One of the most common ways CRTs generate UBTI is through investments that fall under the definition of an “unrelated trade or business.” This could include actively managed rental properties, or even certain types of partnerships where the trust is considered to be a “limited partner” engaging in a business. Imagine old Mr. Abernathy, a retired carpenter who gifted stock in a small family-owned construction company to his CRT. The stock consistently paid dividends, but the company also had a side business – operating a small gravel pit. The income from the gravel pit, considered an unrelated business, triggered UBTI for the CRT. This meant Mr. Abernathy’s trust had to file a separate tax return (Form 990-T) and pay taxes on that income, diminishing the amount available for his designated charitable beneficiary. “Ignoring the potential for UBTI within a CRT is like building a beautiful house on a shaky foundation – it may look good at first, but it could crumble under pressure.”
What if a CRT Owns a Small Business?
If a CRT directly owns and operates a small business, the income generated is almost certainly considered UBTI. Even seemingly passive activities can trigger UBTI if the trust is deemed to be actively involved in the business. This happened to Eleanor Vance, a widow who placed shares of her family’s vineyard into her CRT. While the vineyard had been run by generations of her family, the IRS determined that the trust’s active management of the vineyard, including decisions about grape varietals, marketing, and sales, constituted active participation in a trade or business. The income from the wine sales was subject to UBTI, eating into the funds intended for the local art museum. The IRS provides a de minimis rule – if the gross income from UBTI is less than $1,000, it’s exempt from taxation, but this is rarely enough to avoid the issue entirely.
How Can a CRT Avoid Unrelated Taxable Income?
Fortunately, there are steps you can take to minimize the risk of generating UBTI. Careful planning and asset selection are key. Steve Bliss, an estate planning attorney in Escondido, always advises clients to conduct a thorough review of all assets being transferred into a CRT. “We look at the potential for UBTI before anything is transferred, ensuring the trust’s investments align with its charitable purpose.” Another option is to utilize a “split-dollar” strategy where the trust invests in life insurance, potentially shielding some income from taxation. After Mr. Abernathy’s issue was discovered, he worked with legal counsel to restructure his investments, moving the stock into a different type of trust that was better suited to handle potentially taxable income. Following these procedures enabled Mr. Abernathy to maintain his original plan to financially support his favorite local charity while remaining compliant with IRS regulations. In Eleanor’s case, she reorganized the vineyard’s management, delegating daily operational decisions to a third-party management company. The art museum once again received the full amount designated, and she could rest assured her gift was making the intended impact.
Remember, proactive planning is essential to maximizing the benefits of a CRT and minimizing the risk of unexpected tax liabilities.
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About Steve Bliss at Escondido Probate Law:
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