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Charitable Remainder Unitrust: An Exit Strategy for Closely Held Business Owners

A Charitable Remainder Unitrust ("CRUT") is a great planning tool for charitably inclined proprietors contemplating an exit strategy.  A CRUT is an irrevocable trust in which an income stream is retained by the donor (or another non-charitable beneficiary) for a specified term (usually the donor's life, or for any term up to 20 years).  Upon the expiration of the term, the CRUT's remaining assets are distributed to charitable beneficiaries selected by the donor.  

In order to qualify as a CRUT, the trust must:

1.    Distribute income from the CRUT to the donor (or other non-charitable beneficiary) at least annually for a specified term.  The income is determined based on a fixed percentage (between 5 percent and 50 percent) of the fair market value of the CRUT's assets, which is recalculated each year.

2.    The term must be for the remainder of the donor's life, or a fixed term not to exceed 20 years.

3.    The value of the remainder interest (the portion passing to the charitable beneficiaries at the end of the CRUT term) must be at least ten percent (10 percent) of the initial value of the CRUT.

Benefits of a CRUT

A CRUT is generally considered to be tax exempt (unless it has unrelated business taxable income, not discussed herein).  Thus, a CRUT can be advantageous to a donor who owns highly appreciated property (including small business interests).  The benefit of a CRUT is two-fold:  1) The donor can sell the highly appreciated property within the CRUT and defer (and possibly escape) the income tax on the gain; and 2) the donor is entitled to an income tax deduction in the year the CRUT is initially funded equal to the present value of the remainder interest passing to the charitable beneficiaries.

Example of a CRUT used in The Sale of a Business

Assume that property ("X") owns a business worth $4 million and that his tax basis in the business is $100,000.  X (age 58), a philanthropist, also wants to support the local community that has made his business successful over the years.  X expects to require $250,000 of income per year to support himself during retirement.

If X were to sell his business outright, he would have a capital gain of $3.9 million in the year of the sale.  This gain could easily generate a tax bill in excess of $1 million once federal and state income taxes are paid.  X could substantially reduce his tax burden by contributing his interest in the business to a CRUT.  If X created a CRUT with a 7-percent unitrust amount for his life, then the initial distribution to him would be approximately $280,000 ($4 million multiplied by 7 percent).  X would only incur income taxes on the amount distributed to him ($280,000) in the year of sale, rather than the entire capital gain ($3.9 million).  In addition, X would be entitled to a charitable deduction of $999,360 in the year of the CRUT's creation.

Based on X's life expectancy, and assuming an 8-percent annual return on CRUT investments, X would receive total distributions of $7,094,645 from the CRUT over his lifetime.  At the end of the CRUT term, $4,880,643 would be distributed to the charities of X's choosing.  Thus, X has funded his retirement, while also leaving substantial funds to his community, and has avoided being hit with $1 million in taxes in the year of the sale of his business.

Conclusion

CRUTs can be a great planning tool, but they are not without significant pitfalls.  Proprietors should fund CRUTs with their business interests prior to negotiating the sale of their businesses.  CRUTs are also susceptible to market fluctuations, which could substantially reduce the amount distributed to the donor in years where the CRUT investments perform poorly.  Finally, due to the irrevocable nature of CRUTs, careful planning must be undertaken to ensure the CRUT will meet the donor's needs.

For more information, contact Mike Thomas at MacDonald, Illig, Jones & Britton LLP at 814/870-7717 or mthomas@mijb.com.