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How Are My Charitable Remainder Trust Distributions Taxed?

How are your trust distributions taxed? Charitable trust accounting is nuanced and different from how an individual manages their taxes. We include accounting as part of our service to make things simple for you. We generate the necessary trust tax forms andsend you a K-1 annually to capture the personal filing information you’ll need. Still, to see the value of a CRUT, it’s important to understand how trust accounting works and how your distributions are taxed.

Key Takeaways – Charitable Remainder Trust Taxes at a Glance

  • The IRS will only tax you when you receive distributions from the trust
  • The “Four Tiers” of income (looks more like eight tiers) defines how your distributions are taxed.
  • Some income must be distributed each year, including dividends, interest received and dividends.
  • In general this is complicated and tedious and is tough to manage without professional help

Accounting With CRUTs

Accounting within Charitable Remainder Trusts can be a complicated and nuanced. At a high level your distributions are taxed in the same tax category as the income would have been if you had sold it i.e. if it qualified as long term capital gains you would pay long term capital gains when you receive the distribution from the trust however there are some charitable trust accounting nuances that impact the distributions. Thankfully the accounting rules are well defined and follow a set formula. There are three primary areas with CRUTs that are impacted by the accounting rules, which include:

  • How do the assets I use to fund the CRUT impact my future taxable distributions?
  • How are you taxed on income and gains within the trust?
  • How are distributions effected by all of the above?

Before we get into each aspect, illustrated by examples, it’s important to understand the IRS and its general approach to taxing trusts. This fundamental understanding will help you properly grasp the basic aspects of charitable trust accounting.

The Four Tier Accounting Rule

When distributing income from charitable remainder trusts, the IRS uses an accounting method called the “Four Tiers” of income. At a high level this means, the trust distributes income from the highest federal income tax rate category first and ends with the category subject to the lowest federal income tax rate. What does that mean in simple terms? The IRS taxes the highest tax rate items first and foremost!

The Four Tiers along with their sub categories, in the order they are distributed, are as follows: (maximum federal tax rates are in brackets)

Tier 1: Ordinary income (interest on debt / non-qualified dividends) (37%)

Sub category: qualified dividends (20%)

Tier 2: Short term capital gains (37%)

Sub category: Sale of collectibles (28%)

Sub category: Sale of real property that is attributable to depreciation recapture (25%)

Tier 3: Long term capital gains (20%)

Tier 4: Tax free Income (0%)

Sub category: Return of principal (0%)

The Four Tiers really end up looking more like eight tiers with all of the sub categories, so if it’s easier to think about them as individual tiers, they are:

Tier 1: Ordinary income (interest on debt / non-qualified dividends) (37%)

Tier 2: Qualified dividends (20%)

Tier 3: Short term capital gains (37%)

Tier 4: Sale of collectibles (28%)

Tier 5: Sale of real property that is attributable to depreciation recapture (25%)

Tier 6: Long term capital gains (20%)

Tier 7: Tax free Income (0%)

Tier 8: Return of principal (0%)

Funding Your Trust – How It Impacts Your Taxable Distributions

When it comes to funding your trust, the easiest way to remember how you’ll be taxed initially is by the “taxable make-up” of the assets you gift to it. Start with an example of a Standard CRUT:

  • Take Chalmers, he sets up a 20 year term standard charitable remainder unitrust and funds it with start-up equity valued at $250,000 with a cost basis of $10,000. Once he decides to sell the stock, he would realize a gain of $240,000 (value today – cost basis). Since he held his stock for approximately 4 years, his gains qualify as long-term capital gains.
  • From an accounting perspective, his principal is considered to be $10,000 and his capital gain is considered to be $240,000. (For the sake of distributions, you have to distribute the $240,000 before you’re allowed to distribute principal.)
  • Now that Chalmers has sold his stock, he reinvests those proceeds into a diversified portfolio of crypto, ETFs and stocks. After the first year, his assets have grown about 8% from $250,000 to $270,000. With the breakdown being:
 Asset  Invested  Growth  Dividends  Total
 Crypto  $80,000  $10,000  $0  $90,000
 ETFs  $50,000  $0  $2,000  $52,000
 Individual Stocks  $120,000  $8,000  $0  $128,000
 Total Portfolio  $250,000  $18,000  $2,000  $270,000

  • Because he set up a 20 year term CRUT, Chalmers expects a first year payout of 29,700 (which is 11% x $270,000).
  • Now it’s time for Chalmers to take a distribution, how would that work? Well let’s walk through the individual tiers one-by-one:
  • Tier 1 (Ordinary income): No taxable income
  • Tier 2: Chalmers invested in qualified dividend paying ETFs, and even though the assets haven’t appreciated they paid him $2,000 in dividends that year.
  • Tier 3: No short term capital gains
  • Tier 4: No sale of collectibles
  • Tier 5: No sale of real property
  • Tier 6: So far Chalmers has accounted for $2,000 of his expected distribution but he needs another $27,700 in cash. Even though he only has an additional $18,000 of gains from that year, the remaining entire $27,700 will be taxed as long term capital gains. (You get to decide which assets to sell but ultimately they will be taxed as long term gains.)
  • Tier 7: No tax free income
  • Tier 8: No return of principal (remember, before you can distribute principal you must first distribute all of the initial gain from selling your start-up equity. This goes back to the fundamental aspect of CRUTs that you’re deferring the taxes to allow the assets to grow, but you ultimately still have to pay taxes when taking distributions of those gains.)

Choosing a NIMCRUT – How It Impacts the Accounting and Taxable Distributions

When it comes to choosing a trust, it’s important to understand the distinctions between the accounting rules, as they can determine how much liquidity you have from your trust at any given time.

  • Take Selena, she decides that she would like to set up a lifetime NIMCRUT and funds it with crypto tokens valued at $250,000 with a cost basis of $10,000. Once she decides to sell the stock, she would realize a gain of $240,000 (value today – cost basis). She’s only held her tokens for about 6 months, so all of her gains would qualify as short-term capital gains.
  • From an accounting perspective her principal is considered to be $250,000 and her gain is considered to be $240,000. Now you’re probably wondering, how can that be the case?
  • The trust still realizes a gain of $240,000, but unlike standard CRUTS, NIMCRUTs are unable to distribute principal. They can only pay out income received from gains. Therefore even though there is the initial gain it’s contributed to principal along with the cost basis.
  • Now that Selena has sold her crypto, she reinvests those proceeds into a diversified portfolio of crypto, stocks, and collectible cards. Because she’s a crypto enthusiast she decides to lend her crypto in return for a 3.4% interest rate (floating rate).
  • After the first year, her assets have grown about 8% and she’s accumulated some nice income from her crypto, with the breakdown being:
 Asset  Invested  Growth  Dividends  Total
 Crypto  $100,000  $8,600  $3,400  $90,000
 Collectible Cards  $30,000  $0  $0  $52,000
 Individual Stocks  $120,000  $8,000  $0  $128,000
 Total Portfolio  $250,000  $16,600  $3,400  $270,000

Because she set up a lifetime NIMCRUT, Selena could expect a payout of $17,820 (she’s 38 so her payout rate is ~6.6% x $270,000). It’s important to remember, with NIMCRUTs that the payout is the lesser of Net Income or the standard payout rate, so to receive any distribution (outside of the crypto income that’s forced paid) she would need to sell some assets that have grown.

  • Now it’s time for Selena to take a distribution, how would that work in this example? Well let’s walk through the individual tiers one-by-one:
  • Tier 1 (Ordinary income): In today’s world interest income from bonds, CLOs, crypto, private debt, etc. are all taxed at ordinary income rates. And this is technically realized income, so remember the trust will, regardless of Selena’s desire to take a distribution, pay this out to her each year. So she receives $3,400.
  • Tier 2: No qualified dividends.
  • Tier 3: No short term capital gains
  • Tier 4: No sale of collectibles.
  • Tier 5: No sale of real property.
  • Tier 6: So far Selena has accounted for $3,400 of her desired distribution but she can take up to another $14,420. She can sell up to that amount of any of her assets in order to realize the entire distribution of $17,820. (You get to decide which assets to sell, but ultimately you cannot dip below the principal amount from the beginning of the year.) Thankfully the assets have grown more than you can pay this year, so there’s no concern.
  • Tier 7: No tax free income (generally not worth investing in within a CRUT)
  • Tier 8: With NIMCRUTs you are unable to distribute principal from the trust. You take this trade-off vs. a standard CRUT because of the ability to defer payouts. Even with this caveat the ROI tends to be higher for NIMCRUTs.

Key Takeaways

  • The IRS will tax your highest tax-rate items first and foremost when taking distributions.
  • The “Four Tiers” of income (looks more like eight tiers) is the defining order for which distributions are taxed.
  • Some income must be distributed each year, including dividends, interest received and dividends.
  • In general this is complicated and tedious, so it can be tough to manage it alone with just a spreadsheet.

Working with Valur alleviates all of the stress that comes along with the above items. And we haven’t even scratched the surface of taking all the above and transferring that to the necessary tax filings each year!

Our proprietary approach makes the input from you minimal, all you have to do is tell us if you want a distribution and we’ll tell you how much you can take and when. Your time is valuable and maintaining a trust can be a full time job, trust us we know!

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About Valur:

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