In Canada the charitable remainder trust has, until recent years, been virtually unknown. The United States, however, has been so taken by the concept that the most common form of a planned gift there, with the exception of a bequest, is the charitable remainder trust.
While the legal framework for trusts is complex, the concept is straightforward. When your child asks you to hold some money for safe-keeping, in actuality an informal trust arrangement has been created. Or if you transfer funds into a spousal RRSP, a more formal arrangement has been created. In this instance, you are the settlor, your financial institution is the trustee, and your spouse is the beneficiary.
Valid trusts have three parties: a settlor – who transfers legal title of property, a trustee – who assumes legal title and holds and manages the property, and, a beneficiary(ies) – who will receive benefit from the trust. A formal trust will include a trust agreement which gives instruction to the trustee as to how the property is to be used for the benefit of the beneficiary(ies).
A charitable remainder trust (CRT) is a planned gift whereby a donor makes a gift (usually irrevocable) to a charity through a trust agreement. The donor (settlor) transfers property to a trustee who holds and manages it. If the property is income-producing, the net income will be paid to the donor and/or other named beneficiary(ies). When the trust terminates (either at the death of the beneficiary(ies) or after a term of years, the trust remainder is distributed to the charity. If the trust is irrevocable, the donor is immediately (at the time of the establishment of the trust) entitled to an official tax receipt for the present value of the donated residual interest.
The US experience – from abuse to widespread regulated use
The Tax Reform Act of 1969 was responsible for the birth of modern planned giving and the use of the charitable remainder trust as seen today in the USA. Before 1969 many individuals were using ad hoc trust arrangements to make charitable donations. Unfortunately, there were many perceived and real abuses of the arrangement, which created the impetus for the creation of the Act. While the Act did not introduce a new concept, but rather reformed what was current practice, it did nonetheless give form and a new legitimacy to the use of CRTs.
The Discount Rate – key to the operation of CRTs
The American discount rate was first established at a fixed rate of 6%, and this continued in effect until 1983 when the rate was raised and fixed at 10%. However, as there is an inverse relationship between the discount rate and the tax deduction, this higher rate made charitable remainder trusts less advantaged. In 1989 the rate was allowed to float and was established at 120% of the American mid-term rate.
Among the benefits to the donor, under the American system, are:
- increased income, since the trustee can take appreciated, low-yield property, sell it, and invest the proceeds in higher yield assets;
- tax favourable income, since the payout may be favourably taxed, depending on the nature of the assets transferred to the trust and on the trustee’s investments;
- avoidance of capital gains, since the donor or the estate receives a tax deduction for the present value of the gift, with any capital gains being exempt on the transfer of capital gain property held for more than one year (the trust is tax-exempt and pays no tax on the sale of capital gains property); and
- an immediate charitable deduction, with the donor or the estate receiving a tax deduction for the present value of the gift.
The Unitrust and the Annuity Trust
The Taxpayer Relief Act of 1997 now requires that unitrusts and annuity trusts provide a minimum of a 10% charitable remainder interest and that in addition to a minimum 5% payout rate, the maximum payout rate cannot exceed 50% of the initial fair market value of an annuity trust or 50% of the fair market value at the annual valuation for a unitrust.
- The Unitrust makes a yearly payment of a fixed percentage of the value of the trust assets which must be at least 5%. The payments will vary from year to year, as the assets must be valued each year, and this raises the possibility of increased (or decreased) payouts to the beneficiary.
- The Annuity Trust makes a yearly payment based on the percentage of the initial value of the trust assets which must be at least 5%. The payments will never vary over the life of the trust and the trust is valued only once.
The Charitable Remainder Trust in Canada
The CRT is not as well established in law in Canada as in the United States. Here, the legal framework is provided by Canada Customs & Revenue Agency‘s Interpretation Bulletin, IT-226R which allows for the donation to charity of “an equitable interest in a trust”. CCRA, however, has revisited IT-226R and there is now some uncertainty as to its exact application.
A Canadian CRT can be established in two ways: as a living (or inter vivos) trust established during the life of the donor, or as a testamentary trust established from a donor’s will. Its distinguishing features are two-fold: firstly, that the donor has established an irrevocable gift to charity in return for a discounted tax receipt, and a fully taxable cash flow; and secondly, that the charity has received an irrevocable gift and upon the termination of the trust, will receive the remainder.
In a living trust, the donor funds the trust by irrevocably transferring ownership of their assets (a sum of money, securities, personal or real property) to a trustee, who may be the charity, another individual or a financial institution such as a trust company. Then a trust document is created setting out the rules of the trust and naming the charity as residual beneficiary. This document is signed by the donor and the trustee. The present value of the residual interest is calculated, and the charity gives the donor an income tax receipt for the calculated amount. Income is paid by the trustee to the beneficiary (usually the donor) for life or for a term of years, as outlined in the terms of the trust. Upon the termination of the trust, the trustee pays out the remaining trust assets to the charity.
For a testamentary trust, the donor drafts a new will or revises an existing will in which the terms of a testamentary CRT are set out. Here, the will is drafted in the usual way, and provisions for the trust are contained in specific clauses. Although in this case the trustee is not a signatory to the will, the trustee must nevertheless agree to act. Usually the terms provide support to a loved one or other family member for as long as they live, with the trust assets coming to the charity following the death(s) of the beneficiary(ies). The testamentary CRT is irrevocable, and will only be established upon the death of the donor.
Who would be interested, and why
The CRT is a vehicle primarily of interest to upper-income donors 60 years of age or older, with the optimum age being 75+ years of age. The donor has extensive holdings, is in a high marginal tax bracket, has a philanthropic intent and the ability to donate some of their assets. Donors wishing to be free from investment decisions and concerns are ideal prospects. The benefits of the inter vivos CRT are substantial, and include:
- The satisfaction of establishing a substantial gift.
- The provision of lifetime income to the donor.
- An immediate tax receipt.
- [Awaiting clarification from Canada Customs & Revenue Agency] – Beneficial treatment of capital gains.
- Donor is free from investment worries.
- An estate planning tool which avoids probate, is non-contestable and
- provides privacy.
The testamentary CRT, in turn offers its own attractive features:
- Provision of lifetime support to a loved one.
- Provision of a tax receipt to the estate.
- The trust is revocable during life and takes effect on the death of the testator.
Reporting capital gains – The bets are still out
It has been generally agreed that when stocks or bonds, or any appreciated property were used to fund a CRT, not all of the capital gains needed to be reported, and that only that portion of the gain which applied to the residual interest needed to be recognized. In meetings with the Canadian Association of Gift Planners last Fall, however, Canadian Customs & Revenue Agency has clearly rejected this view, and this will be the subject of a presentation to it by a CAGP-headed Task Force later this year.
Choosing a discount rate also a challenge
Determining an appropriate discount rate to use when calculating the present value of the residual interest is problematic. CCRA’s Interpretation Bulletin IT-226R gives no formula for determining the rate, stating only that current interest rates should be taken into consideration. To date, CCRA has not attempted to clarify this issue.
From among the several possibilities, namely
- CCRA’s prescribed rate,
- the prime rate or the prime rate plus 1%,
I recommend using the long term bond rate matching the life expectancy of the beneficiary(ies). Whatever method you use, however, you should seek professional advice and be consistent in your practice.
Choice of Mortality Tables yet another gamble
IT-226R is silent regarding the appropriate mortality table to use when calculating residual interest, and CCRA’s verbal position has been to allow the use of 1990-92 Canada Life Tables. This is yet another aspect of the use of CRTs in need of clarification.
How To Encourage Gifts Through Charitable Remainder Trusts
1. Publicize the benefits.
- That a donor can arrange a significant gift immediately and not lose the cash flow from the gift.
- That a CRT can free the donor from investment concerns and decisions.
- [Awaiting clarification from Canada Customs & Revenue Agency] – That a donor with highly appreciated but low-yield securities can convert them through a CRT and receive a much higher rate of income.
- That a CRT will produce a tax receipt that can be used immediately.
2. Suggest that a CRT is an alternative to a bequest. A CRT may be an important estate planning tool for certain individuals, as it effectively removes assets from their estate.
3. Suggest that a CRT be established through a donor’s will to provide dependable income to a loved one.
Upon passing, the donor has provided financial support to a loved one while at the same time establishing a significant gift for the charity.
Calculation of the Donation Receipt
Canada Customs & Revenue Agency’s Interpretation Bulletin outlines six requirements whereby a gift qualifies for a non-refundable tax credit:
- The gift must vest with the charity at the time of the transfer.
- The transfer must be irrevocable.
- The value of the beneficiary(ies) interest must be ascertainable.
- There must be no encroachment on the capital of the trust.
- The value of the gift at the time of transfer (present value) must be determined.
- The gift must be supported by an official donation receipt.
IT-226R states that the way to calculate the amount of the receipt is as follows:
“The general approach is to value the various interests taking into consideration the fair market value of the property itself, the current interest rates, the life expectancy of any life tenant, and any other factors relevant to the specific case.”
However, bearing IT-226R in mind, the following present value formula is commonly used to calculate the value of the residual interest being donated: The recommended present value formula is as follows:
- pv = p/(1+dr)n, where:
- pv = present value
- p = principal amount
- dr = discount rate
- n = life expectancies of the beneficiaries, or the term of years
Example
Mr. Donor transfers $100,000 cash into a CRT and names ABC Sample Charity as the remainder beneficiary. The donor is 78 years of age, and the charity has determined the discount rate to be 6%.
The donation receipt would thus be: $100,000/(1 + .06)8.1, or $62,377.00
Dr Edward H. Pearce, a member of our Editorial Advisory Board and a frequent contributor to Canadian FundRaiser, is director of development, gift planning at Queen’s University, Kingston, Ontario. For more information, call him at 613-533-2060, fax: 613-545-6599, or e-mail: pearcee@post.queensu.ca.
