Charitable Planning: In the Case of Only Modest Charitable Inclinations

Patrick Gremban, Executive Director, Head of Wealth Analytics and Solutions

Paul Stam, Executive Director, Wealth and Estate Planning Strategist

Chloe Duanshi, CFA®, Vice President, Wealth Analytics and Solutions

 

OVERVIEW OF CHARITABLE REMAINDER UNITRUST

When selling highly appreciated long-term capital gain assets, investors are often concerned about the tax impact of the sale, which will trigger long-term capital gains tax on the appreciation. The tax is generally due by April of the year following the sale. As such, this tax liability can potentially be quite burdensome in both size and timing.

A charitable remainder unitrust (CRUT) is a split-interest trust. That is, it has charitable and non-charitable beneficiaries. The settlor of the trust transfers property to the trust, and typically retains what is called a unitrust interest, either for a fixed term or, more commonly, for her or his life (and sometimes for the life of a surviving spouse as well, if the settlor is the first to die).1 A unitrust payment is the right to receive a fixed percentage of the value of the trust property, valued annually. Thus, if the value of the trust property increases, the unitrust payment will correspondingly increase. If such value decreases, however, the payment will decrease as well. Upon the expiration of the fixed term or upon the death of the relevant person, the then-remaining trust property passes to one or more charitable organizations.

Because the CRUT itself is treated as a charitable entity, it allows investors to sell appreciated assets and enjoy the benefit of diversification without an immediate tax liability.2 The CRUT does not eliminate the tax liability, but it allows for deferral; that is, it allows the investor to pay off the taxes over time. That deferral may have significant value. As a result, while in the real world one would likely not create a CRUT unless one has at least some charitable inclination, the value of the tax deferral means that, from a purely economic perspective, possessing only a fairly modest charitable inclination may be enough to lead one to conclude that a CRUT is a reasonable strategy to employ when seeking to diversify and reinvest where the sale would trigger a substantial capital gain.

In utilizing this technique, the investor first funds a CRUT with the appreciated asset and then the trustee sells the asset. Assuming the sale has not been arranged in advance and thus is treated as a sale by the trust, and not the investor, the sale of the appreciated asset does not immediately trigger a capital gains tax. Following the sale, 100 percent of the sales proceeds (unreduced by the capital gains tax that would have been due if the investor had sold the asset herself or himself) can be reinvested by the trust in a diversified portfolio. The proceeds then flow back to the investor in the form of annual unitrust payments over the term of the trust.3 As the unitrust payments are taxable to the recipient (the investor), the embedded long-term capital gain is realized over time via the annual distributions. This deferral mechanism allows the capital earmarked for future tax payments to be invested in the meantime to potentially generate positive returns. Such additional returns are the tax-deferred benefit.

In exchange for the tax-deferred benefit, and as already noted above, the tax rules to which the CRUT is subject require that the CRUT remainder — the property remaining in the trust at the end of the term — pass to charity. Moreover, in order to qualify as a CRUT, the value of the remainder interest, measured at the time the CRUT is created, must be equal to at least 10 percent of the initial value of the trust’s assets.4 In the year the CRUT is funded, the settlor may claim an income tax deduction equal to the present value of the charity’s remainder interest in the trust. At the end of the CRUT term, the remaining trust assets pass to charity and are no longer available to the investor (or his or her family). As an irrevocable trust, the investor cannot decide to terminate the CRUT and take back the assets after the trust is funded.

While a CRUT is required to leave its remainder to charity, because of the favorable tax treatment, there are some circumstances in which investors with only modest charitable inclinations may improve their financial situations by utilizing a CRUT. As already noted, the tax-deferred mechanism in a CRUT, where tax liability is recognized only up to the amount of the unitrust payment, allows an investor to sell a highly appreciated asset and defer some of the capital gains tax owed on this sale. Further, the upfront income tax deduction that the investor receives for the present value of the remainder interest that will be passed to charity serves to reduce the investor’s total tax liability.

CASE STUDY

Consider an investor who is seeking to diversify a large position of zero-basis stock. The investor can sell the stock outright and pay the capital gains tax upfront, or fund a CRUT with the stock, execute the sale within the trust, and pay the capital gains tax over time.

Using quantitative simulations, we can estimate the potential distribution of the investor’s wealth over time if the investor sells the stock outright. We make the simplifying assumptions that the investor has no other assets and, upon the sale of the stock, reinvests the net proceeds into a diversified portfolio.5 Similarly, we can estimate the alternative value of the investor’s portfolio if the stock is sold within a CRUT. The trust is structured with a 20-year term and a 10 percent charitable remainder interest.6  The investor’s personal portfolio is the recipient of the unitrust payments and is therefore funded over time with the net-of-tax annual distributions from the CRUT. We assume that the capital is invested identically as in the previous scenario.

Of note, due to the correlation between the outcomes of the two strategies, the impact on personal wealth by utilizing a CRUT at different percentiles is not the simple difference between the amounts of personal wealth at the corresponding percentiles.

When selling highly appreciated assets, an investor who does not have any charitable intent may still come out financially “better off” by utilizing a CRUT if the combined benefit of the tax deferral and the charitable deduction outweighs the value of the remainder interest that will be passed to charity. Of course this strategy is not without drawbacks. First, we assume that the investor survives the term of the trust. If the investor dies before the term, the CRUT is terminated and a greater-than-anticipated amount passes on to charity via the remainder, as opposed to the investor’s family. In fact, in the case study above, the investor would need to live 16 of the 20 years in order to be financially indifferent between selling inside or outside of a CRUT. Second, utilizing a CRUT limits an investor’s access to the sales proceeds. Selling assets outright means that the investor has full access to the liquidity generated from the sale at any time. Whereas when selling within a CRUT, the investor’s liquid wealth is limited to the cumulative installments received from the CRUT. By the same logic as above, the investor in the case study would need to wait 16 years to have an equal access to liquidity. For these reasons, in the real world, where mortality and other factors need to be taken into account, one might hesitate to employ a CRUT where there is truly no charitable intent. But the financial analysis demonstrates that only modest charitable inclination may be enough to support use of the technique.

OTHER CONSIDERATIONS

Cost Basis

The primary benefit of utilizing a CRUT is the deferral of tax payments over multiple years when selling highly appreciated assets. Intuitively, the higher the cost basis, the smaller the embedded tax liability, and the less attractive a CRUT may be as an income tax planning technique. Investors with only modest charitable intent should only consider utilizing a CRUT when the amount given away to charity is justified by the combined benefit of tax deferral and charitable deduction — for example, only when the cost basis is low enough.

Tax Rate

The case study above assumes that the investor is a New York state resident and pays the highest marginal tax rate. All else being equal, the higher the tax rate, the greater the embedded tax liability on the same amount of appreciation, and thus the greater the tax-deferred benefit.

Term Length

Given the same amount of remainder interest held by charity (minimum 10 percent), the maximum annual unitrust percentage that an investor may elect to receive decreases as the term of the CRUT increases.9 The longer the term, the less the CRUT distributes each year, and the more deferral of the embedded tax liability. However, the investor should be mindful that a longer term increases the risk of the investor dying before the term, and smaller annual distributions restrict the investor’s access to liquidity.

Investment Decisions

As the unitrust payment fluctuates from year to year based on the performance of the investment portfolio, the investor participates in the market risk of the investment portfolio held within the

CRUT. Further, although a CRUT is a tax-exempt entity, the annual unitrust payments are taxable to the recipient (the investor). As a result, the investments within the CRUT should be aligned with the investor’s risk preference and return objective, with return evaluated on an after-tax basis. The tax efficiency of the investment portfolio, along with other considerations, is relevant to the long-term growth potential of the investor’s personal wealth.

Section 664 (d) (2) of the Internal Revenue Code of 1986, as amended from time to time (the “IRC”).

IRC § 664 (c) (1).

The investor will likely receive only a portion of the funding principal. This is discussed in the next paragraph in the text.

The unitrust rate is a fixed percentage elected by the investor at the inception of the trust. Because the investor must give away

10 percent of the trust’s initial value to charity via the trust remainder, there is a maximum limit on how high the unitrust percentage may be.

Additionally, the fixed percentage must be at least 5 percent but not more than 50 percent. IRC § 664 (d)(2).

The portfolio is assumed to be 50 percent Global Equities, 35 percent Fixed Income, and 15 percent in Liquid Real Assets and Hedge Strategies.

The investment performance is based on Morgan Stanley Global Investment Committee’s capital market forecast.

Based on a discount rate of 3.4 percent pursuant to IRC § 7520 (the October 2018 rate), the maximum annual unitrust percentage that the

investor may elect and still satisfy the 10 percent remainder requirement is 11.245 percent.

The comparison is based on the simulated portfolio values at the end of Year 21. This is to account for the fact that the tax liability

associated with the unitrust payment in Year 20 is paid in the following year.

See footnote 5.

The maximum term of a CRUT is 20 years. A lifetime CRUT may extend beyond 20 years, as it terminates when the individual dies.

Disclosures:

This material, including all charts and graphs, has been prepared for informational purposes only. It does not provide investment advice or any advice regarding the purchase and/or sale of any investment. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. It is not a recommendation to purchase or sell artwork nor is it to be used to value any artwork.

 Investors must independently evaluate particular artwork, artwork investments and strategies, and should seek the advice of an appropriate third-party advisor for assistance in that regard as Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide advice on artwork. Investing in commodities entails significant risks. These are speculative investments and, as such, their value can be subject to declining market conditions. The value of commodities markets may fluctuate widely based on a variety of factors, including, but not limited to, price volatility and lack of liquidity. Investing in physical commodities, such as art, exposes the investor to other risk considerations such as potentially severe price fluctuations over short periods of time; storage and insurance costs that exceed the custodial and/or brokerage costs associated with the investor’s other portfolio holdings; lack of a fundamental pricing model for art; absence of an income stream compared to other investments; challenges to authenticity and ownership; and lack of regulation.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning, and their attorney for matters involving trust and estate planning, charitable giving, philanthropic planning and other legal matters.

Morgan Stanley Smith Barney LLC is not implying an affiliation with, or sponsorship or endorsement with, or the third parties named within this presentation.

Past performance is no guarantee of future results.

© 2019 Morgan Stanley Private Wealth Management is a division of Morgan Stanley Smith Barney LLC. Member SIPC.

CRC 2274738 01/19