Charitable Remainder Trusts

Posted by   admin on    November 6, 2005

Using Charitable Trusts to Build Family Wealth

There is crispness in the air these days and, to me, this means one thing  the Holiday Season is upon us!

The next several months, for many people, is a special time; a time when people are a little nicer, a little friendlier and a little kinder. Its a time when we focus less on what we dont have and instead find ourselves grateful for what we have. It is a time for family and friends; and a time for goodness and giving. This truly is my favorite time of the year!

Giving is, perhaps, the most basic expression of personal and family values. However, not enough people seem to comprehend the vast benefits that charitable giving can bring to ones self and family. It can be one of the most self-satisfying acts a person can perform and the practice can provide a family much benefit in return for any effort expended. It is the sharing that makes philanthropy a critical factor in the development and preservation of family values  for both their human and intellectual capital.

Philanthropy, or in the original Greek translation philosanthropos, means love of my fellow man. Modern definition would describe a philanthropist as an individual who is a significant supporter of charitable organizations. Yet, Im sure many people associate the word philanthropy as only relating to the wealthy. Well thats just not true! When we focus on the word significant, a person can be defined as a philanthropist whenever he or she is doing what is charitably possible according to his or her individual situation.

Wealthy families, however, have less choice in the matter because almost all practice some form of philanthropy. For wealthy families, philanthropy can be voluntary or involuntary and the choice is quite simple. About half of a wealthy persons estate will go to their heirs. And, the other half can either go to the government as taxes or it can go to charity. When it goes to the government, this type of philanthropy is involuntary.

By contrast, doesnt the voluntary kind seem more rewarding and valuable?

As readers of my newsletters well know, wealth management is the ultimate goal of all that we do at ELF Capital Management. Yes, we promote our services; yet, you will find that we always seek to present thought provoking topics that are relevant to our wide audience.

This months newsletter will reflect how one facet of charitable estate planning can offer affluent families more than mere estate planning. Then, as always, we will finish with a review of the economic and investing climate for the month past, the current market outlook and our investment performance.

Charitable Remainder Trusts

It was 1917 when the US Government first provided an income tax deduction for gifts to religious, charitable, scientific or educational organizations. What was positive about this was that it provided a financial incentive for people to contribute to charitable causes; what made it less than positive was that it became a financial decision from a tax standpoint when and if to give to charity.

Thereafter, it wasnt until the Tax Reform Act of 1969, that Congress gave a clear definition to a tax advantaged arrangement known today as the charitable remainder thrust (CRT).

A charitable remainder trust is a legal arrangement that provides for specified payments to one or more non-charitable entities (the income beneficiary), with an irrevocable remainder interest in the trust property to be paid to a charity or charities (the charitable remainder beneficiary). Ordinarily, one must contribute total ownership in an asset to receive a charitable tax deduction. However, a handful of exceptions may apply and a CRT is one of them. Assuming that the CRT meets all the IRS requirements, contributions to it generally qualify for a charitable deduction for income, estate and gift tax purposes.

There are two basic types of CRTs  charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs). The major difference between the two relates to how the income beneficiaries are to be paid: A CRAT would pay a fixed amount to income beneficiaries, at least annually, of a sum certain that cannot be less than 5% nor more than 50% of the initial fair market value of all property placed in the trust. Whereas, a CRUT provides for a varying payout, at least annually, based upon a fixed percentage of not less than 5% or nor more than 50% of the net fair market value of its assets as valued annually.

In the case of both trusts:

  • There can be to one or more income beneficiaries.
  • The term of the payout can be made as either the life or lives of an individual or individuals living at the time the trust is created, or for a term of up to 20 years.
  • For new trusts, the remainder interest must meet a minimum value requirement. The value of the remainder interest must equal at least 10% of the: (a) initial fair market value of the property placed in the trust, for CRATs; or, (b) net fair market value of the net fair market value of each contribution as of the date the property is contributed, for CRUTs. The IRS Code provides guidance for calculating these numbers.
  • After the term of the payout is completed, the trust principal is irrevocably transferred to the charitable organization 

What Are Some of the Benefits?

Philanthropic. Understanding how to use a CRT in the financial planning process can allow people to create something that lives on long after they are gone. Many people would like to make a charitable gift for various reasons but are not in a financial position to do so or simply do not know how. For a person who has charitable intent, the CRT provides the opportunity to express this desire.

Tax advantages. Since a CRT is a tax-exempt vehicle, it can sell highly appreciated property without being taxed on the capital gain or ordinary income. Also, just like any other charitable contribution, the CRT gives the donor a current income tax deduction in the amount of the present value of the remainder interest and any of that deduction that is not used in the current year can be carried forward to future years. As an estate planning tool, assets placed in a CRT are not included in the estate of the donor, nor subject to gift taxes. Since the assets would be outside of the estate, this could cause the overall estate to be smaller, which could create compounded tax savings.

Investment advantages. From the perspective of managing ones investments, an individual may own highly appreciated assets in the form of real estate or a closely held business. Often an investor may be reluctant to sell some of their investments in order to diversify or to generate more income because they do not want to recognize a capital gain. If you knew that the value of your assets would drop 20% or more the moment you sold, wouldnt you think twice about selling? Historically, it has been shown that a lack of diversification increases the risk of a portfolio more than the character of the actual investments. Using a CRT allows one to reposition the portfolio without loss due to taxes.

Of course, if taxes and portfolio diversification were the only objectives, a person could employ other strategies that would not involve surrendering ownership of the assets to a charity. However, the CRT makes good sense for the individual who wants to make a charitable gift and has appreciated assets.

Wealth Replacement Example

More often than not, life insurance is purchased to provide financial relief to dependents in the event that a familys breadwinner(s) prematurely dies. This is the most significant use of that product. Yet, in the following example, well review an effective planning tool in which the income and/or tax savings from establishing a charitable remainder trust can be used buy life insurance to replace the asset given away. Also, life insurance, when held in an irrevocable insurance trust, allows the death benefit to pass to heirs free of estate taxes.


Mr. and Mrs. Smith, both age 55 and in excellent health, were recently offered $2 million for their closely held company and an additional $1 million, each year, for a 2 year consulting agreement. Their cost basis in the stock is almost zero and even at a reduced rate of 15%, for federal taxes, and 5.75%, for Virginia state taxes, the tax on capital gains portion would be $415,000. On top of that, they can expect to pay another $450,000 in taxes on the ordinary income generated from the consulting agreement. In addition, they care for their community and would like to make a substantial gift to their favorite charities to support some community needs they feel passionate about.

Their creative thinking financial advisor suggested that they look at a charitable remainder trust to alleviate the tax burden and support their philanthropic wishes. They decide to establish a $2 million charitable remainder unitrust and, using their after-tax income, buy a $2 million second-to-die life insurance policy naming their heirs as beneficiaries.

The suggested action steps look like this:

  1. The Smiths create a CRT and transfer their company stock to the trust. At the same time, they arrange for an independent trustee and money manager.
  2. When the company is sold, the trust receives $2 million in cash for the company stock.
  3. The money manager conservatively invests the cash in a portfolio designed to preserve capital and generate returns to pay the Smiths 7.5% annually.
  4. The Smiths contribute approximately $22,000 each year to a wealth replacement trust in order to fund a $2 million second to die life insurance policy.
  5. After Mr. & Mrs. Smith are deceased, the remainder interest will be transferred directly to the charities or to a private family foundation designed to assist with the communitys charitable needs. And, at the same time, the heirs will receive $2 million on life insurance proceeds tax free.

And, the expected tax and cash flow benefits look like this:


Concluding Thoughts

One of the first axioms of financial planning states, "It's not how much you make that counts; it's how much you keep." In charitable gift planning that phrase could be modified to, "It's not how much you give that counts; it's how much it costs you to give!" This is not to suggest that charitable giving is motivated primarily by tax considerations; however, it does suggest that to be good philanthropic stewards, donors should take full advantage of the tax laws to optimize their gifts.

ELF Capital Management Investment Performance Update

How much have we been impacted by oil prices? And, are we immune from these effects? Ive read and heard arguments that the US and most non US economies have been able to absorb the huge rise in energy prices without much pain. This may be so, yet, we are now approaching winter season and consumers are about feel another pinch from increased costs to heat our homes. So, why do the economists think we havent felt much pain?

US Gross Domestic Product (GDP), one of our broadest measures of economic activity, was reported to be 3.8% for 3Q 2005. And, given the expectation from higher oil prices and hurricane season, the markets looked at this number as very bullish. Increases in spending by consumers, business and the federal government  hurricanes Katrina and Rita related  contributed to the higher than expected increase in GDP. What is significant is that people kept spending! Spending didnt slow down!

One word of caution in the GDP estimate, however, was that expanding business inventories also contributed to the increase. While inventory increases can signal strength in an economy, it can also signal weakness as well. It can signal weakness when increases in inventories are due to slowing turnover and business hasnt gotten the message yet.

Also this month, the Consumer Price Index (CPI)  including energy and food prices  for September registered up 1.22%. This is its largest monthly increase in over ten years and the measure and is now up 4.47% on a year to date basis. CPI is the most widely cited inflation indicator and is the basis for calculating cost of living adjustments for most US government programs. Inflation is the result of too many dollars chasing too few goods!

For the month ended October 31, 2005, our one-month performance is down 0.26%, our three-month return is up 0.95% and our one-year return is up 4.48%.

For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

ELF is an independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities. ELF may also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for both individual and business clients.

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF. Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less. There is no minimum account size for inclusion into ELFs ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

The performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELFs ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any. ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter. 

Copyright 2005 ELF Capital Management, LLC. All rights reserved.