A New Dawn for CRUTs?

We may be at the break of a new dawn for charitable remainder unitrusts (CRUTs).

CRUTs exploded in popularity in the 1990s, driven in part by financial advisors who recommended CRUTs as a way to shelter donors from significant capital gains tax while enhancing cash flow and supporting their favorite charity. Then capital gains tax rates dropped, the stock market went south, and CRUT activity soon slowed. Now, stronger incentives for high income donors to contribute appreciated assets to fund a CRUT are back.

  1. Increase in capital gains tax rates. The top federal tax rate on most long term capital gain income has increased from 15% to 20% for high income taxpayers. The new top bracket applies to married-filing-jointly taxpayers with taxable income over $450,000 ($400,000 for single taxpayers).

    What’s more, net investment income earned by these taxpayers is now also subject to the new 3.8% Medicare surtax that is imposed on top of other income taxes. This tax kicks in when modified adjusted gross income is above $250,000 for joint returns ($200,000 for single taxpayers). Net investment income includes capital gain income, so the Medicare surtax effectively increases the top capital gain tax rate to 23.8%.

    But we’re not done. Jointly-filing taxpayers with adjusted gross income (AGI) over $300,000 ($250,000 for single filers) must reduce their itemized deductions by 3% of the amount by which their AGI exceeds this threshold. This is the so-called Pease limitation that expired in 2009, but has been revived for 2013 and beyond. Capital gain income contributes to AGI, so for a taxpayer in the new 39.6% income tax bracket, the loss of itemized deductions can add another 1.2% to his or her capital gains tax rate. Now we’re up to a potential total federal tax on capital gain income of 25%. Last year, this top rate was only 15%.

    And we haven’t taken state capital gains taxes into account yet. For example, Massachusetts taxpayers could face a total tax rate of 29.0% on their capital gains; California taxpayers could face a total rate as high as 35.0%.

  2. Donors holding more appreciation. Many taxpayers have a lot more appreciation to shelter than they’ve had in years. For instance, the S&P 500 is up about 60% since 2009 and recently exceeded the historic high that it had set back in the fall of 2007.

  3. Interest rates remain at historic lows. Furthermore, Ben Bernanke, Chairman of the Federal Reserve, has indicated that interest rates will likely stay very low through at least the end of 2014. This means that donors are receiving low income from their interest-bearing investments and that’s not likely to change soon. Meanwhile, many of these donors own stocks that pay little or no dividends, but have substantial appreciation that will create substantial tax if sold. In short, low interest rates have many donors looking for ways to increase their cash flow without creating a tax problem.

Given the facts recited above, right now may be a perfect time to attract CRUTs. They offer high income donors an opportunity to increase cash flow, avoid substantial capital gains taxes, and make a generous charitable gift all at the same time.

Here’s an example that expresses the benefits of a CRUT in dollars and cents. Imagine a 75-year-old Massachusetts donor who is in the top income and capital gains tax brackets. She has a block of stock worth $500,000 for which she paid $50,000. The stock pays no dividend. If the donor uses this stock to fund a 5% CRUT, she’ll receive a $300,000 income tax deduction, which will save her about $140,000 in taxes. At the same time, her CRUT will be able to sell her stock without incurring any capital gains tax, preserving the entire $500,000 to reinvest for her and the charity’s benefit. If she were to sell the same stock herself, she would owe $157,000 in taxes, leaving just $343,000 to reinvest. If the CRUT sells and reinvests these assets to earn 2% income and 4% appreciation each year over the donor’s 12-year life expectancy, she would receive payments from the CRUT totaling $317,000 during this time period. She would receive just $103,000 over this time if she reinvested in the same assets herself. Meanwhile, the CRUT would have accumulated over $560,000 in principal to leave to the charity.

Of course, the donor must still want to make a substantial charitable gift. She has given her principal away when she funds a CRUT and cannot get it back. In contrast, she would have almost $550,000 in principal at her disposal at the end of 12 years if she were to reinvest the after-tax proceeds from selling the stock herself, as described. Still, a gift arrangement that can triple the cash flow from her asset, save her significant income taxes, and lend significant support to a charity (or charities) she cares about, is hard to beat!