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Charitable Remainder Trust Distribution Rules

How are your CRTs 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. But to understand Charitable Remainder Trust distrution rules and their impact, it’s important to understand how CRTs trust accounting works and how your distributions are taxed.

The Basics of CRT Accounting

Accounting within Charitable Remainder Trusts, also known as CRTs or CRUTs, can be a complicated and nuanced. There are three areas impacted by these charitable trust accounting rules are:

  • 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?

You can also learn more details on CRTs in our first Spotify podcast episode!

But before we get into the Charitable Remainder Unitrust distribution rules, there are few key principles that will guide the taxation of your charitable remainder trust distributions:

  1. The IRS will only tax you when you receive distributions from the trust
  2. The “Four Tiers” of income (looks more like eight tiers) defines how your distributions are taxed
  3. 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

Understanding the IRS and its general approach to taxing trusts will help you properly grasp the basic aspects of charitable trust accounting.

How Are Distributions From A Charitable Remainder Trust Taxed: 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. So, in simpler terms, Charitable Remainder Trust distribution rules imply 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%)

How Funding A Charitable Trust Impacts Your 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. But to show how Charitable Remainder Trust distribution rules actually work, let’s start with an example:

Chalmers 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 (the 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:

Individual Stocks$120,000$8,000$0$128,000
Total Portfolio$250,000$18,000$2,000$270,000
How Funding A Charitable Remainder Trust impacts your distributions

Because he set up a 20 year term CRUT, Chalmers expects a first year payout to be 11% of the trust value or (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 $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 other income categories first according to charitable remainder trust distribution rules. 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 those assets are distributed from the trust to you.)

More Examples On Taxable Distributions and Accounting

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.

After the first year, her assets have grown about 8% and she’s accumulated some nice income from her crypto, with the breakdown being:

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
Charitable Remainder Trust distribution example

Because she set up a lifetime NIMCRUT, Selena could expect a payout of $17,820 (based on being 38 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.

Next Steps

Charitable trust distribution rules can be complicated. At a high level it is important to remember that income from a Charitable Remainder Trust is taxable when you receive distributions and those distributions are taxed according to CRTs four tier accounting rule. Fortunately working with Valur alleviates all of the stress that comes along with the above items.

Our proprietary approach makes the input from you minimal, all you have to do is tell us if you want a CRT distribution and we’ll tell you how much you can take and when. To learn more, check out our post on how does Charitable Remainder Trust tax deduction work. Use our Charitable Trust calculator to evaluate the potential return on investment given your situation. Or contact us for a meeting!

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.