Family offices and private clients (“Clients”) have complicated investment and estate planning structures that require professionals to understand how to handle the needs from legal, accounting, and tax reporting. One of the planning tools frequently implemented for these Clients is a charitable remainder unitrust (“CRUT”). The CRUT allows for the tax-free liquidation of a highly appreciated asset, the tax-free growth of the assets inside the CRUT, with the income building inside the CRUT only being taxed to the extent of distributions to the lifetime beneficiary. This is a powerful tool if the tax reporting occurs correctly. We have noticed a gap between the estate planning and the tax reporting often resulting in phantom income being taxed to the detriment of the beneficiaries.
As we often preach, this phantom income problem that erodes the benefits of the CRUT is due to professionals siloing themselves into their respective practice areas and not collaborating and coordinating to get the correct result. For the estate planner, they see their work stopping at the signing of the CRUT instrument and are hands off from that point on. For the tax preparer, they see the reporting as a compliance exercise without the extensive knowledge required of the benefits of the CRUT.
One important aspect of the CRUT is that income accrued in the CRUT is only taxed to the lifetime beneficiary to the extent of distributions to the lifetime beneficiary. For example, an owner (“Owner”) of a closely held business (“Business”) contributed $100,000 to start a company that is now worth $10 million. The owner transfers their interest in the Business to a CRUT and then the interest in the Business is sold for $10 million. The $9.9 million of gain is not immediately taxed on the sale.
The lifetime beneficiary of the CRUT, in our case the Owner, will receive annual distributions from the CRUT based on a certain percentage of the annual net asset value of the CRUT. The maximum income that can be allocated to the lifetime beneficiary of the CRUT each year cannot be more than the annual distributions received from the CRUT. In our example, there is $9.9 million of income, let’s assume over the next five years, there is a buildup of an additional $3 million of income or total income accrued of $12.9 million. If in year six the lifetime beneficiary receives a distribution of $750,000, the maximum allocation of income to the lifetime beneficiary cannot exceed $750,000 for the year, i.e., not $12.9 million.
As compared to the immediate taxation on the sale of a highly appreciated asset with after-tax proceeds being subject to tax annually, the CRUT can allow for superior returns where the distributions to the lifetime beneficiary occur over a sufficient period of time even if the remainder is distributed to charity. However, the phantom income issue due to erroneous tax reporting can eliminate the otherwise positive returns that should occur through the CRUT planning and could even end in a worse result.
Too often, we see the lifetime beneficiary being allocated phantom income far in excess of distributions received from the CRUT. This occurs more frequently in the year that the lifetime beneficiary’s interest in the CRUT terminates. This allocation of phantom income to the lifetime beneficiary results in significantly less after-tax return to the lifetime beneficiary and erodes the benefits of the CRUT planning.
Our approach is to get the appropriate professionals with legal, tax, and accounting backgrounds together to ensure the tax reporting is correct and the full benefits of the CRUT are received by the lifetime beneficiary and the charitable remainder beneficiary. This goes to our core competency of having professionals from various professions closely collaborating to achieve the desired results for the client, this is especially important for family offices and private clients.
Praestans Global Advisors is neither a law firm nor a CPA firm.