Anyone who has looked into setting up a Charitable Remainder Trust (CRT) will tell you that it's complicated. The structure of a CRT varies by the CRT administrator and the trust agreement. Additionally, with a Net-Income Charitable Remainder Trust or NI-CRT, how income is defined by the CRT administrator in the trust agreement will impact the disbursements to you (the donor). If this decision is made hastily, it can result in you being blindsided when you receive the first disbursement and find that it is significantly different from what you expected.
In order to make an informed decision, you and your team of professional advisers, need to understand how income can be defined. Especially if you will be relying on the NI-CRT disbursements, how income is defined in the trust agreement will impact your overall financial plan. In light of this, I have listed 3 common options to define income for a NI-CRT.
NI-CRT Defined
As mentioned above, a NI-CRT is a Net-Income Charitable Remainder Trust. With a NI-CRT, disbursements are made from the lesser of two amounts:
trust income trust payout percentage
To illustrate, if you have a NI-CRT agreement that is set up to disburse 5% of the net income but only sees a 2% gain in net income, you would receive the lesser of the two amounts or 2%. In contrast, if the same NI-CRT sees an 8% gain in net income, you would receive the lesser of the two amounts or 5%.
The first year a NI-CRT disburses income, donors may select how the income is defined and calculated. Keep in mind that this varies by how the trust agreement is set up. As such, it is important for you and your advisers to understand the options before making a selection. Depending on the structure of the trust agreement, this is typically a one-time selection.
3 Income Definition Options
OPTION 1: Income= Dividends & Interest ONLY (No change in value)
Pros & Cons:
Least amount of risk
Conservative payout
Receive earnings not driven by the value of the stock
Preserves principal
Focuses on the long term
The interest and dividends may not be enough in a given year to make a full distribution
OPTION 2: Income= Dividends + Interest + Net REALIZED Gains & Losses (Partial Change in Value)
Pros & Cons:
Medium amount of risk
Higher current payout when market performs well
Lower or ZERO payout when the market performs poorly
Receive earnings based on realized value of the stock
This may increase the temptation to sell off the best performing stock in order to realize gains. It can also lead to avoiding selling poorly performing stock to avoid realizing losses. This leaves the portfolio invested in poor performing stocks.
Focuses on short term payout amounts
High risk of corpus decreasing over time
High risk of distributions decreasing due to diminishing corpus
Ability to “time” distributions by realizing excess loss in years when the donor may not need a distribution
This option is best for donors that have actively involved financial advisers who understand these nuances over time. When donors or their advisers lack the sophisticated knowledge needed to manage this correctly, donors who love this option during years when the market is high, have disliked it more and more over time as their corpus has been impaired.
OPTION 3: Income= Dividends + Interest + Net UNREALIZED Gains & Losses (or FULL change in value)
Pros & Cons:
High amount of risk
Higher current payout when market performs well
Lower or ZERO payout rate when the market performs poorly
Receive earnings based upon value of the stock High volatility due to distributions is solely based upon market performance and value. This means that there is little control on the part of a donor or their adviser to manage CRT distributions.Focuses on short term payout amounts
High risk of corpus decreasing over time
High risk of distributions decreasing due to diminishing corpus
This option is likely to have periods where no distributions can be made. Donors should be careful with this option as they are likely to need distributions the most (due to market turmoil) during years when no distributions can be made under this election.
Also, please note that some CRT administrators use their state's definition of income as a default. Not all the CRT administrators will be open to using an alternative definition. This is something to keep in mind when setting up a NI-CRT.
Key Takeaways
As you can see, each option will have a significant impact on your disbursements and overall financial plan. As a result, it is important to make sure that you and your professional advisers carefully consider each option and its potential impact before making a decision.
Questions about charitable remainder trusts? Email Legacy's Director of Estate & Planned Giving at mike@legacyglobal.org