Special thanks to Brandon Galvao, Dakotah Flint, and Peter Farrell for their assistance in writing this article.
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The SECURE 2.0 Act of 2022, which was included in the $1.7 trillion omnibus spending bill signed by President Biden on December 29, 2022,[1] has a small gift for charities and individuals over age 70 1/2 who are willing to transfer up to $50,000 to a charitable remainder trust or into a charitable annuity arrangement.
Since 2006, individuals who are required to take annual minimum distributions from their IRA accounts have had the option of transferring up to $100,000 per year directly from one or more IRAs to one or more public charities and/or private operating foundations. This transfer to a public charity is known as a “qualified charitable distribution” (QCD). The Internal Revenue Code (IRC) defines qualified charitable distribution as “any distribution from an individual retirement plan . . . which is made directly by the trustee to [a public charity or private operating foundation] and which is made on or after the date that the individual for whose benefit the plan is maintained has reached age 70 1/2.”[2] Note that this is a younger age than when IRA owners are required to begin taking required minimum distributions at age 72 (73 in 2023).
These qualified charitable distribution rules under IRC § 408(d)(8) have resulted in a great many donations to charities that would not have otherwise occurred. The most effective transfer to charity from a tax-planning standpoint is to take ordinary income subject to federal income tax and to allow that ordinary income amount to go to charity.
SECURE 2.0 indexes the $100,000 annual exclusion limit for inflation beginning in 2024 and provides a second option to take advantage of the exclusion beginning in 2023 for those taxpayers who have reached age 70 1/2 and are required to take minimum distributions.
SECURE 2.0 permits a taxpayer to make a one-time $50,000 distribution directly from an IRA or IRAs to a charitable remainder trust or a charitable annuity and make a one-time election to treat the contributions as if they were qualified charitable distributions made directly to a charitable entity.
Unlike a direct charitable contribution, contributions to a split-interest entity benefit not only the charity but also the individual IRA owner. The overall economic impact is that at least a small portion of what is transferred goes to charity and up to 90% of the economic value of what is transferred (up to approximately $45,000) can be paid out to the individual IRA owner over a selected term of years, not exceeding 20 years, or for his or her lifetime.
However, it is unclear under SECURE 2.0 whether IRA distributions to a charitable remainder trust that pays the IRA owner and/or spouse over a selected term of years will qualify for the QCD election. The new law excludes distributions to split-interests trusts if any person holds an income interest in the entity other than the individual for whose benefit such account is maintained and/or his or her spouse. Under a term-of-years charitable remainder trust, if the non-charitable beneficiary and spouse died before the term ended, their children or another person(s) would receive the remaining payments. Those children or other contingent beneficiaries would have contingent remainder income interests in the trust, and the law appears to exclude such a trust from receiving qualified charitable distributions.
Distributions to three types of split-interest entities qualify for the one-time QCD election: charitable remainder annuity trusts (CRATs), charitable remainder unitrusts (CRUTs), and charitable gift annuities. In addition to the general rules applicable to these entities, SECURE 2.0 places additional rules and requirements in order for distributions to qualify for the election for QCD treatment. These additional requirements are as follows:
Charitable Remainder Annuity Trust (CRAT) IRC § 664(d)(1)
· The CRAT must be funded exclusively by qualified charitable distributions from IRAs.
· A deduction for the entire value of the remainder interest in the distribution for the benefit of a specified charitable organization would be allowable under I.R.C. § 170.
· No person holds an income interest in the CRAT other than the individual for whose benefit such account is maintained, the spouse of such individual, or both.
· The income interest in the CRAT is nonassignable.
· Distributions will be treated as ordinary income in the hands of the beneficiary to whom the payment is paid.
Charitable Remainder Unitrust (CRUT) IRC § 664(d)(2)
· The CRUT must be funded exclusively by qualified charitable distributions from IRAs.
· A deduction for the entire value of the remainder interest in the distribution for the benefit of a specified charitable organization would be allowable under I.R.C. § 170.
· No person holds an income interest in the CRUT other than the individual for whose benefit such account is maintained, the spouse of such individual, or both.
· The income interest in the CRUT is nonassignable.
· Distributions will be treated as ordinary income in the hands of the beneficiary to whom the annuity is paid.
Charitable Gift Annuity IRC § 501(m)(5)
· The charitable gift annuity must be funded exclusively by qualified charitable distributions from IRAs.
· The charitable gift annuity must commence fixed payments of 5% or more than the contribution amount not later than 1 year from the date of funding.
· A deduction in an amount equal to the amount of the distribution reduced by the value of the charitable gift annuity would be allowable under I.R.C. § 170.
· No person holds an income interest in the charitable gift annuity other than the individual for whose benefit such account is maintained, the spouse of such individual, or both.
· The income interest in the charitable gift annuity is nonassignable.
· Qualified Charitable Distributions will not be treated as an investment in the contract for purposes of IRC § 72(c).
To appreciate the benefits of this new election for QCD treatment, it is necessary to understand the basic structure of these split-interest entities.
Charitable Gift Annuities
Under a charitable gift annuity, a charity receives a donation of cash or other assets and agrees to make an annual lifetime payment to the donor. Usually this is for a fixed annual amount for the donor’s lifetime, and the value of the stream of payments is typically one half of the value of the total amount transferred to the charity by the donor/payee.
The donor/payee typically receives an income tax deduction of approximately half of the value of the donation and then receives a stream of payments that are partly taxable and partly considered to be a return of principle.[3]
The American Council on Gift Annuities identities three types of charitable gift annuities based upon when the annuitant(s) starts to receive payments:
· Immediate (“annuitant(s) start(s) receiving payments at the end (or the beginning) of the payment period immediately following the contribution”),
· Deferred (“annuitant(s) start(s) receiving payments on a date chosen by the donor at the time of the contribution that must be more than one year after the date of the contribution”), and
· Flexible (“donor does NOT have to choose the payment starting date at the time of the contribution[, but instead] agrees to a range of possible payment start dates from which the annuitant can later choose”).[4]
In a typical transaction, a donor with one of more IRAs can transfer $50,000 to a charity and receive an immediate life annuity that may pay a 73-year-old donor $2,850 per year for his or her lifetime and may pay a 76-year-old donor $3,050 per year for his or her lifetime.[5]
Charities are permitted to pay more, but the suggested maximum rate schedules that are issued by the American Council of Gift Annuities (ACGA) and are followed by most charities, provide for the 50% ratio.
Many charities keep or spend half of the money donated and use the other half to buy a life annuity on the individual. The charity receives the moneys that it owes to the individual each year from an insurance company to make sure that the charity stays solvent.
Because the self-dealing rules under IRC § 4941 apply to all private foundations, private operating foundations set up by a donor or parties related to the donor cannot enter into an annuity contract with a disqualified person. The Code imposes an excise tax on the disqualified person of up to 210% of the amount involved in the self-dealing transaction.
Charitable Remainder Trusts
SECURE 2.0 permits a donor over age 70 1/2 or a charity to establish a charitable remainder unitrust that will receive up to $50,000 from the donor’s IRA or IRAs and will then pay annual distributions to the donor and/or the donor’s spouse for a term of years or the non-charitable beneficiary’s lifetime. Unlike the annuity arrangement, the charitable remainder trust may delay payments or limit payments based upon the NIMCRUT and Flip NIMCRUT rules described below.
There are two kinds of charitable remainder trusts: charitable remainder annuity trusts (CRATs) and charitable reminder unitrusts (CRUTs).
A charitable remainder annuity trust pays a fixed dollar amount that is determined upon inception of the arrangement to the donor each year, regardless of the performance of the trust assets.[6] Charitable remainder annuity trusts are subject to the “5% probability exhaustion test” whereby there must be less than a 5% chance according to IRS actuarial tables that the trust assets will be exhausted before the end of the term.[7]
A charitable remainder unitrust makes payments to the donor and/or spouse that are based upon the value of the assets each year. These payments must be of a fixed percentage of the net fair market value of the trust assets. There are two other types of CRUTs: a Net Income Makeup Charitable Remainder Unitrust (NIMCRUT) and a Flip Net Income Makeup Charitable Remainder Unitrust (Flip NIMCRUT). A NIMCRUT “allows the payment to the non-charitable beneficiary to be the lesser of the unitrust amount or the accounting income, however any deficiencies must be repaid when income allows.”[8] A NIMCRUT typically includes a “make-up” provision that provides that if the payout from a particular year is less than the fixed percentage payout, then the difference can be paid out in a future year to the extent that future year exceeds the fixed percentage.[9] Flip NIMCRUTs allow a CRUT to convert once from one of the income exception methods, such as a NIMCRUT, to the fixed percentage method following a trigger date or event.[10]
Charitable remainder annuity trusts are safer if the values go down, and charitable remainder unitrusts are better if the investments within the trust do well.[11]
Normally, payments received from a charitable remainder annuity trust are partly taxable and partly tax free. If the charitable remainder annuity trust had a capital gain from the sale of an appreciated asset then the income comes out as capital gain income. The income comes out “worse first.” The income taxation of a charitable remainder unitrust is essentially the same.
Under the new SECURE 2.0 rules, 100% of all payments received by the IRA owner or owner’s spouse must be considered ordinary income.
For this reason, it is expected that existing charitable remainder trusts will not be used to receive IRA payments, because most existing charitable remainder trusts make payments that do not constitute 100% ordinary income. In addition, SECURE 2.0 requires that CRUTs and CRATs be funded exclusively by qualified charitable distributions.
Example
An example of how a CRUT, NIMCRUT, and a Flip NIMCRUT can work is as follows:
John is 75 years old and wishes to transfer $50,000 directly from his IRA to a charitable remainder trust.
In exchange for his contribution to the charitable remainder trust, he wants to receive annual payments for his lifetime and the lifetime of his wife, Amy, who is 70 years old.
John makes the transfer in January 2023 when the IRC § 7520 rate is 4.6%.
Based upon the IRS tables, he and Amy will receive an annual payment based upon 22.19% of the value of the trust assets, as measured every year until the death of the survivor of them, and for no less than 10 years in the unlikely event that both die within 10 years.
If they wanted to receive the maximum percentage amount for life without a 10-year minimum payment then this would be 15.52%.
If this were just for Tom’s life, it would be 34.67% per year.
If it were for only 20 years (assuming you can do this on a term-of-years basis, as discussed above), it would be 10.875% per year.
Based upon an assumed rate of return of 4.6%, a charity selected by Tom and named in the trust agreement has a remainder interest initially considered to be worth $5,000 to satisfy the 10%-upon-inception remainder interest calculation.
The investments in the trust grow at 7% per year, so that in 10 years the trust has $60,413 (pre-tax) of assets under the first scenario, $53,254 (pre-tax) in assets under the second scenario, $63,402 (pre-tax) in assets under the third scenario, and $44,940 (pre-tax) in assets under the fourth scenario.
The distributions that Tom (and Amy) would receive each year and the amounts remaining to pass to the charity (assuming that Tom dies in 20 years and Amy dies in 25 years) under each scenario are as follows:
Scenario overview.
Alan Gassman
Potential Issues with Taking Advantage of the Election for QCD to a Split-Interest Entity
The major issue from an economic standpoint with taking advantage of this new QCD election is the legal fees incurred when setting up a split-interest entity. It can easily cost $2,000 to set up a decent charitable remainder trust and the charity will typically only receive about 10% of the initial contribution if the charitable remainder trust is designed to maximize payments to the grantor. If the grantor is healthier than average, the charity will probably receive less than 10%. This is why many well-advised charities, other than the American Cancer Society, may consider giving packages of cigarettes and bottles of grain alcohol to their lifetime-payment charitable remainder trust donors each year in recognition of their contributions. This is also why well-advised unhealthy donors are unlikely to set up lifetime payment charitable remainder trusts or to accept packages of cigarettes or bottles of grain alcohol.
A charitable trust also has to file an annual return with the IRS, Form 5227, Split-Interest Trust Information Return, which can be expensive and time consuming.
As previously mentioned, the requirements that the trust must be funded exclusively by qualified charitable distributions and that 100% of all payments received by the IRA owner or owner’s spouse have to be considered ordinary income make it disadvantageous to use an existing split-interest entity.
Online legal services companies like LegalZoom may be able to more inexpensively set up these entities or provide templates for doing so, but there is a risk that they will be drafted incorrectly, potentially disqualifying the donor from taking the election to treat the distribution as a QCD.
It is also essential to ensure that the trust be managed properly, with payments being made on schedule. Failure to adhere to the required formalities could cause disqualification of the charitable remainder trust back to the date of formation. This result occurred in the 2002 Eleventh Circuit case Estate of Atkinson v. Commissioner,[12] where the taxpayer did not make payments and the IRS succeeded in asserting that the trust could not qualify as a charitable remainder unitrust, regardless that it was properly drafted, signed, and funded. This resulted in the taxpayer losing her charitable deduction and requiring her to pay taxes on the charitable remainder trust income, as if she kept the charitable remainder trust assets that were sold and received the income that was received by the charitable remainder trust.
If not for these ongoing management requirements and setting aside consideration of legal fees, taking advantage of what is essentially a new $50,000 income tax deferral opportunity would otherwise be a no-brainer from a business standpoint for many taxpayers. Even if a wealthy taxpayer is not charitably inclined, SECURE 2.0 permits the donor to defer paying income tax on $50,000 of income by spreading that amount out over his or her lifetime or a term of years.
Other Notable SECURE 2.0 Act Provisions
The SECURE 2.0 Act includes close to 100 additional provisions aimed at enhancing Americans’ ability to save for retirement. There are too many to cover in this article, but a few stand out:
Sec. 107. Increase in Age for Required Beginning Date for Mandatory Distributions: Under current law, as set in place by the SECURE Act of 2019, IRA owners are required to begin taking required minimum distributions at age 72. Section 107 of SECURE 2.0 Act will increase this amount in 2023 to age 73 and again in 10 years to age 75, allowing taxpayers to hold money in their retirement accounts for a longer period.
Sec. 115. Withdrawals for Certain Emergency Expenses: Section 115 allows for an early distribution without being penalized once every calendar year up to $1,000 for the purpose of meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.
Sec. 302. Reduction in Excise Tax on Certain Accumulations in Qualified Retirement Plans: If the amount that is distributed from a taxpayer’s retirement plan is less than the minimum required distribution amount, the current law imposes an excise tax equal to 50% of the amount by which the minimum required distribution exceeds the amount actually distributed. Section 302 reduces the tax rate from 50% to 25%.