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The Four Tier Rules of CRUT Taxation

December 11, 2009

Rob, a “hands on” kind of guy, wanted to learn every detail regarding the charitable remainder unitrust (CRUT) he is planning to establish for the benefit of himself and the American Cancer Society (ACS). Rob was especially interested in how he would be taxed on the payments he would be receiving from his CRUT.

The tax he pays will depend on the type of income earned from the trust investments. Some income, like long-term capital gain, is taxed more favorably than others. Congress has developed a four tier system that causes the ‘worst’ trust income, from a tax standpoint, to be paid to him first:

Tier 1: Ordinary Income (Worst)
•    Interest, rents, royalties, nonqualified dividends (35% maximum rate)
•    Qualified dividends (15% maximum rate)

Tier 2: Capital Gains
•    Short-term gain (35% maximum rate)
•    Collectibles gain (28% maximum rate)
•    Depreciation recapture gain (25% maximum rate)
•    Long-term capital gain (15% maximum rate)

Tier 3: “Other” Income (Tax-Free Interest)

Tier 4: Trust Principal (Also Tax Free)

Every year, the trust income would be totaled up from Tier 1, 2 and 3, including any income that wasn’t paid out from prior years. We would start at Tier 1 and count out that income first, continuing up the tiers until Rob’s unitrust payment (based on the percent payout he chose at inception) is satisfied. Some of his trust income could be taxed as low as 15%, some as high as 35%, and there is the potential for some tax-free payments.

Rob also wanted to know if he, as trustee, could invest in nothing but tax-free bonds and end up with 100% tax-free income.

His question raises several issues.

First of all, if he funds the trust with highly appreciated stocks or real estate, the trust would have a significant capital gain when Rob, as trustee, sells and reinvests in tax-exempts. That gain must be passed through as part of his trust payments before any tax-free income can be considered. Second, IRS rules prohibit donors from requiring the trustee to invest only in one particular type of security. That may not be a practical problem with Rob as his own trustee, but there is an additional hurdle: The Uniform Prudent Investor Act. The Act says that trustees should diversify investments of the trust and that they must act impartially in selecting investments – and with fairness to both the income and remainder beneficiaries.

The CRUT wouldn’t grow very much if it’s all invested in munis – and Rob really does not want to shortchange the ACS, as the remainder beneficiary. But there is a win-win investment plan that would help the war against cancer and also keep his taxes low.
 The trust could be invested to emphasize growth (long-term capital gains) and qualified dividends, meaning that much of Rob’s payment from the CRUT would be taxed at only a 15% tax rate – at least until the tax laws change again. And if the trust needs to sell some securities to make Rob’s annual payment, some of his distribution could be a tax-free return of principal.

Rob found it odd that 15% dividends would be passed through to him before short-term gains because it seems inconsistent with the worst-in-first-out rules. However, this is one of those IRS taxpayer-friendly regulations that is a benefit to anyone who has or is contemplating a Charitable Remainder Trust.

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