Exit planning can be complex for startup founders and business owners, particularly regarding effective tax planning. One powerful strategy to optimize your exit outcome and reduce tax liabilities while supporting philanthropic goals is the Charitable Remainder Trust (CRUT).
This article offers an overview of Charitable Remainder Trusts, highlights their benefits, and explores how founders can integrate Charitable Remainder Trusts with Qualified Small Business Stock (QSBS) to maximize exit planning and potentially achieve an additional $10 million tax-free.
Overview of Charitable Remainder Trust (CRUT)
A Charitable Remainder Trust (CRUT) is a type of irrevocable trust that allows you to contribute assets, defer taxes, get an upfront deduction, receive a stream of income, and ultimately benefit a charitable organization. Here’s how it works
- Contribution: The founder contributes appreciated assets (e.g., private stock, public stock, real estate or other assets) to the Charitable Remainder Trust.
- Defer Taxes: Capital gains from the sale of assets within a CRUT are tax-deferred, enabling the entire proceeds to be reinvested and grow tax-deferred.
- Upfront Deduction: The founder will receive an initial deduction equivalent to a portion of the assets contributed to the CRUT.
- Income Stream: The Charitable Remainder Trust pays a percentage of its value to the donor (or other designated beneficiaries) annually, for a specified term, or for the beneficiary’s life or lives.
- Charitable Remainder: Upon the termination of the income stream, the remaining assets in the Charitable Remainder Trust are transferred to one or more designated charities.
The payouts from a Charitable Remainder Trust (CRUT) to the founder or beneficiary fluctuate annually as they are determined by a percentage of the fair market value of the trust’s assets and the income the trust generates.
The Charitable Remainder Trust may also specify that the annual payment is the lesser of a predetermined percentage or the trust’s net income. This particular type is referred to as a Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT), which includes the “makeup” provision to account for any shortfalls in distributions. These shortfalls in distributions can essentially be deferred to future years and taken out when desired.
Benefits of Charitable Remainder Trusts for Founders
- Capital Gains Tax Deferral: By transferring appreciated private stock into a Charitable Remainder Trust, founders can defer capital gains taxes upon the sale, allowing the entire asset value to be invested and grow tax-deferred within the trust.
- Income Stream: Provides a steady income stream, which can be particularly advantageous for founders transitioning out of active business roles. The income will be taxable to the founder.
- Philanthropy: Aligns financial goals with philanthropic objectives, strengthening community impact.
- Estate Tax Reduction: Reduces the taxable estate, potentially lowering estate tax liabilities.
- Potential State Tax Minimization: Founders residing in high-tax states who intend to relocate to states with lower or no taxes can potentially defer their state taxes until they are settled in the new, lower-tax state.
- QSBS Benefits: The Charitable Remainder Trust may achieve its own QSBS Exemption.
Flip CRUT
A Flip CRUT offers additional flexibility by switching from one payout method to another under certain conditions, such as the sale of an illiquid asset. Initially, a Flip CRUT may operate as a NIMCRUT (paying the lesser of net income or the fixed percentage of the trust’s value), which is essentially zero for private stock. The difference is that the NIMCRUT “flips” to a standard Charitable Remainder Trust payout (fixed percentage) following a triggering event.
Triggering events can include but are not limited to:
- Sale of Company or private stock
- Specific date
- Marriage/Divorce
- Death
- Birth of children
- Reaching of a certain age
For example, imagine a founder who expects to have an exit in the near future and decides to contribute a portion of his private stock to a NIMCRUT. The stock does not generate any income, and therefore, there would not be any payout requirements until the company is sold or acquired.
After the exit event, like a company sale, the NIMCRUT could “flip” to a higher fixed-percentage payout if desired.
Advantages of NIMCRUT
- Liquidity Management: Ideal for founders with illiquid assets like private company stock. It avoids the pressure to liquidate illiquid and potentially unmarketable assets prematurely.
- Enhanced Flexibility: Provides flexibility in managing income distributions.
Integrating Charitable Remainder Trusts (CRUTs) with Qualified Small Business Stock (QSBS)
Founders holding QSBS may be able to leverage CRUTs to create additional taxpayers that qualify for their own $10 million QSBS exclusion. This is one way to achieve QSBS stacking. However, this is not typically a strategy we recommend unless a founder has an exit exceeding $10 million, as the first $10 million is excluded from taxation already based on the QSBS rules.
By transferring private QSBS shares into the CRUT, the CRUT can potentially secure its own $10 million QSBS exemption.
When the company is sold, the first $10 million of the QSBS could potentially be excluded from taxation. Any growth beyond this amount is subject to tax, but it is deferred until distributions are made from the Charitable Remainder Trust. This allows founders to delay taxation on post-exit growth until the funds are distributed back to them.
This presents an appealing strategy for capitalizing on the QSBS tax exemption and, benefiting from the tax-deferred growth offered by the CRUT.
Strategic Utilization of QSBS with CRUTs
- QSBS Tax Benefits: Each Charitable Remainder Trust may qualify for its own $10-million QSBS exclusion ($10-million tax free.)
- Tax-Deferred Growth: Following the sale of private QSBS stock, the resulting proceeds can be reinvested and allowed to grow tax-deferred until distributed back to the founder.
- State Tax Minimization: For residents of California, state taxes can be deferred until distributions are made to the founder since California does not recognize QSBS. Alternatively, if the founder relocates to a tax-free state, these taxes could potentially be eliminated altogether. This can be a strategic approach for those who intend to move out of a high tax state, but are unable to do so before an exit.
- Philanthropic Objectives: This strategy effectively merges the tax advantages of QSBS with philanthropic giving to enhance their impact.
- Asset protection: Assets are protected while inside the Charitable Remainder Trust.
A Specific Example of a Charitable Remainder Trust
Consider a founder with $50 million in Qualified Small Business Stock (QSBS) who plans to transfer $10 million into a Charitable Remainder Trust (CRUT) before a sale. This approach allows the founder to defer and possibly avoid further capital gains taxes on the $10 million transferred.
The founder can then invest the $10 million in the CRUT and defer all tax on the growth until the funds are distributed back to him. This approach not only allows the investment to grow within the Charitable Remainder Trust tax-deferred but also provides an income stream for life while still achieving a $10 million QSBS exemption.
At the end of the term for the Charitable Remainder Trust, the remainder will be directed to a chosen charity(s) that aligns with the founder’s philanthropic goals.
The Final Word on Charitable Remainder Trusts
For founders navigating the complex landscape of exit planning, Charitable Remainder Trusts (CRUTs) serve as a powerful tool. When paired with the tax benefits of Qualified Small Business Stock (QSBS), a Charitable Remainder Trust creates a robust strategy for optimizing tax efficiency, securing income, and supporting charitable efforts.
Typically, this strategy is explored after implementing other tax optimization methods for founders anticipating substantial exits. As always, it is crucial for founders to collaborate with knowledgeable advisors to customize these strategies to their specific situations and improve their overall financial well-being.
FAQs
Are there any limitations on the types of assets that can be contributed to a Charitable Remainder Trust?
Generally, most appreciated assets, such as stocks, real estate, and closely held business interests, can be contributed to a Charitable Remainder Trust (CRUT). However, S-corporation stock is not suitable, and assets that are effectively deemed sold are also not appropriate.
For instance, if your company has reached an agreement to be sold with no contingencies to clear or deal points to negotiate, it may be considered effectively sold. Nonetheless, it is always important to consult with an attorney or tax advisor for specific guidance on your unique situation.
How do taxes work when funds are distributed from a Charitable Remainder Trust?
Typically, taxes on distributed funds follow a tiered tax structure that prioritizes the distribution of the most heavily taxed items first. However, if the Charitable Remainder Trust (CRUT) qualifies for the Qualified Small Business Stock (QSBS) exclusion, an impressive $10 million in gains from the exit could potentially be exempt from taxation when distributed back to the founder.
Can I terminate a Charitable Remainder Trust once it has been established?
No, once a Charitable Remainder Trust is established, it cannot be terminated. However, certain modifications can be made in specific circumstances with proper planning and expert guidance. It’s essential to carefully consider all aspects before establishing a CRUT.
What is a CRUT?
A CRUT is a type of Charitable Remainder Trust that stands for Charitable Remainder Unitrust, a type of trust that provides income to the beneficiary(s) for a set term of years or for life, and then distributes the remaining assets to one or more charities. It can be used as part of an exit planning strategy for founders or business owners who are looking to minimize taxes, secure income, and support philanthropic efforts.
What is the 5% rule for Charitable Remainder Trusts?
The 5% rule is a minimum distribution requirement for Charitable Remainder Trusts (CRUTs). It mandates that the annual charitable distribution must be at least 5%, and no more than 50% of the CRUT’s total assets.
This ensures that the trust has enough funds to provide income to the beneficiary(s) while still leaving a significant amount to be distributed to charity at the end of the trust term. Failure to meet this requirement could lead to penalties and jeopardize your tax benefits. These risks are why it’s always essential to work with knowledgeable advisors when establishing and managing a Charitable Remainder Trust.
Can I modify my Charitable Remainder Trust after it has been established?
Generally, once a Charitable Remainder Trust has been established, it cannot be modified. However, certain changes may be possible with proper planning and expert guidance. It is crucial to carefully consider all aspects before establishing a CRUT to ensure that it aligns with your long-term goals and objectives.
