In 2019, the World Giving Report[i] reported a decrease in charitable donations by the US, despite being in a bull market (March 2009-Feb 2020). The United States did not rank in the top ten for donating money but did rank (5^th) in the top 10 countries for donating time. However, another report[ii] shows that during 2020 there was a 48% increase from 2017 by affluent (defined as ≥ $1M net worth, excluding primary residence, and/or ≥ $200,000 annual income) households, which is probably more related to the 2009-2020 bull market as well as less to spend money on during the 2020 COVID-19 pandemic lockdown.

While giving cash and volunteering time are not complicated and are easy entry points to giving, the bulk of all wealth in the US is tied up in non-cash assets. The total income in the US is $21.3 billion with the US total net worth at $142.1 trillion at the end of 2021[iii] showing that there is greater potential in using non-cash assets, such as marketable securities, real estate, and businesses, rather than cash, for philanthropy.

This is a follow up article to Business Owner Transition and Charitable Planning in Issue 42 – July 2023, and in this article we will focus on business interest gifting using a charitable remainder trust (CRT).

In simplest terms, a CRT allows a donor to donate an asset into the trust and then they receive a lifetime or term-of-years payment stream. There are two types of charitable trusts, an annuity trust (CRAT) or a unitrust (CRUT). The payments are based on an annuity or unitrust calculation, not income. A key difference is that a CRAT has a fixed payment each year based on the initial value of the trust and a CRUT’s payment stream is a percentage of the trust value each year. An advantage of the CRUT over a CRAT is that it can adjust for inflation, since as the assets grow inside the CRT the payment does as well.

The minimum CRT payment percentage is 5%, but can be increased as long as the charitable remainder is calculated to be at least 10%. At trust termination, the remainder in the trust is distributed to charity. By using a CRT for a gift of a business interest, that portion of the business defers capital gains tax when sold and provides the donor an income tax deduction in the year of the gift. It also removes this portion of the business from potential estate tax, although the annual payments to the donor if not spent will be included back in the donor’s estate.

The CRT is ideal for a business that is highly appreciated. When the owner is considering selling their business, they can become concerned about the very large capital gains tax that will come due upon sale. This also applies if the business owns real estate or another asset with low cost basis. The capital gains deferral is a motivator even for those you are not necessarily charitably inclined. Before we get into how the CRT can maximize charitable giving and maximize leaving a financial legacy to heirs, let’s dig into the taxes just a bit.

While capital gains are avoided at the sale of the business, distributions from the CRT each year are taxable based on the gains in the CRT. Any capital gains at sale are tracked and distributed in each payment. Per the IRS^iv, the taxation of a CRT payment has four tiers: ordinary income for the current year or undistributed ordinary income from prior years, capital gain for the current year or undistributed ordinary income from prior years, other income including tax-exempt income, and any remaining part of the payment is considered corpus, or return of principal, which is not subject to tax. Depending on the amount of ordinary income created by the CRT investments, some or all of the payments may be the recaptured capital gains tax that was avoided at sale. (The capital gains tax embedded in the charitable remainder of the trust will be completely avoided).

Let’s take an example of a 70-year-old business owner with a $2 million business that has no cost basis in a state with 5% capital gains tax rate.^v If half of the business ($1 million) was gifted to a CRUT, the capital gains tax avoided would be 23.8% federal plus 5% state for a total of $288,000. Now, with a 5% payout from the CRUT, that would produce $50,000 in the first year. (This payment would change each year going forward based on the performance of the investments in the CRUT).

However, in the year of the gift to the CRUT, the business owner also receives a charitable deduction for the remainder interest which is calculated to be just over $500,000. Multiplying the $500,000 deduction by a 40% tax bracket produces a tax savings of $200,000. Also, the charitable remainder at the CRUT termination could be put into a donor advised fund for the family to use.

To mitigate the loss of resources to the heirs from the gifted half of the business, a portion or all of the $50,000 CRUT payment stream could be used to purchase life insurance, assuming the business owner or their spouse is insurable. This premium amount could easily create a tax-free death benefit to the heirs that replaces the $1 million gift depending on the policy design. For example, a second-to-die universal life policy should be less expensive and work well for this purpose. Also, please note that all of the results discussed above magnify over the course of the business owner’s remaining lifespan, but due to the assumptions necessary to show these projections over another 15 or 20 years, they are left to the reader’s own determination.

Now, compare that result to the sale of the half without using the CRT. First, the business owner would pay $288,000 in capital gains tax that year leaving only $712,000 to invest for income. If invested with a 5% distribution, that would only produce $35,600 in cash flow. Plus, there would be no charitable deduction benefit.

The business ownership gift to a CRT works well for a C-Corp or an asset gift, but S-Corp gifts are not allowed and the CRT cannot have unrelated business taxable income (UBTI). Also, the CRT works best in higher interest-rate environments and uses the AFR 7520 Rate. Further, there is a 30% adjusted gross income (AGI) limitation on the charitable deduction for a business or asset gift, but the deduction can be used in the year of the gift and for five years after. Another side benefit is that the assets in the CRT are protected from creditors.

As you read this article, we hope you have noted all of the types of professional advisors that need to be involved in planning and executing this gift. Attorneys to draft the trust; investment advisors to manage the assets in the trust; accountants to do the tax returns for the trust; charitable advisors to help with the donor advised fund; attorneys, appraisers and real estate agents for the gift and sale; business transition experts to help assure business continuity post-sale; etc.  This is truly collaborative advisor work and another reason for engaging with NAEPC, your local estate planning council and the Accredited Estate Planners® (AEP®) community.

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[i] https://www.cafonline.org/about-us/publications/2019-publications/caf-world-giving-index-10th-edition

[ii] The 2021 Bank of America Study of Philanthropy: Charitable Giving by Affluent Households, BofA Study of Philanthropy (ml.com)

[iii] Households; Net Worth, Level (BOGZ1FL192090005Q) | FRED | St. Louis Fed (stlouisfed.org). 2021 numbers were used to match data released dates.

[iv] https://www.irs.gov/charities-non-profits/charitable-remainder-trusts

[v] This example is inspired by a presentation given by Tiffany A. House, CAP®, CEPA, FCEP and Jeremy Huish, JD, CPA on October 5, 2023 for the Central New York Community Foundation.