The donor funds a qualifying trust under Code §664, providing a fixed annuity (minimum 5% of the original value of the principal, maximum 50%) for one or more individuals. The trust may last for the lifetimes of the beneficiaries or a term of years (maximum 20 years). When the trust ends, the principal passes to one or more qualified charities. No additional contributions are permitted to the trust.
Income Tax Deduction
The present value of a charity's remainder interest (10% minimum required) is deductible, based on the ages of income beneficiaries (or a fixed term up to 20 years), applicable federal rate (§7520 rate) and an unvarying dollar amount to be paid each year. A 5% probability test limits the maximum payouts.
Capital Gains Consequences
No capital gains are recognized upon a transfer of appreciated assets to the trust, or upon a sale by the trustee. Part of the beneficiary's income may be taxed at low capital gains tax rates under the four-tier tax reporting system.
Charitable remainder trusts are tax-exempt. Payments are taxable to income beneficiaries under a four-tier, worst-in-first-out system: (1) any current and accumulated ordinary income ( dividends taxed at 15% or 20% are considered last); (2) capital gains, beginning with short-term gain, then 28% gain (collectibles), 25% gain (recapture of depreciation), and finally 20% or 15% gain; (3) "other" (tax-exempt) income; (4) corpus (tax free). Trust income earned and distributed after 2012 may be subject to 3.8% net investment income tax. The trust pays a 100% tax on its unrelated business taxable income.
One-life trust for donor: corpus is included in the gross estate, but a 100% charitable deduction is available. Two-life trust for donor and spouse: gift and estate tax marital/charitable deductions eliminate tax; adding additional beneficiaries voids the marital deduction. A trust for a non-spouse creates a taxable gift for income interest. The donor can retain the right to revoke, by will, the income interest of the survivor beneficiary, avoiding a taxable gift, but the survivor's interest is taxable in the donor's estate. The value of the testamentary trust is included in the donor's gross estate, but remainder interest gives rise to an estate tax charitable deduction.
Donors must file gift tax returns (Form 709) for all lifetime trusts, even where a donor is the sole income beneficiary [Code §6019(3)]. Form 8283 is needed with the donor's tax return except for cash transfers. The trustee must file Form 5227 annually and Form 4720 is required if the trust is liable for excise taxes.
Best Funding Assets
Appreciated property, generally, and cash work best. Transfers of mortgaged real estate will disqualify the trust. Unproductive, hard-to-sell assets may be unsuitable for annuity trusts if the trustee is unable to make the required annuity payments. S stock is prohibited.
Annuity trusts are most appealing where the income beneficiaries are in their mid-70s and older and prefer the security of a fixed income. Low §7520 rates (AFR) limit deductions and payouts for annuity trusts.