TAX ALERT 2013-11
Year-end Planning Opportunity for Charitable
Remainder Trusts (CRTs)
OVERVIEW
Beginning in 2013, a new 3.8% surtax is imposed on an individual’s “net investment income” to the extent
“modified adjusted gross income” exceeds certain thresholds. In November 2013 the IRS issued regulations,
which address how the surtax will apply to distributions from a Charitable Remainder Trust (CRT). The surtax
does not apply to a CRT itself; however, distributions from a CRT can have surtax consequences to the
recipient/beneficiary. As a result of these regulations, there is a year-end planning opportunity for CRTs:
harvesting capital losses. Even for CRTs that have accumulated mostly long-term capital gains, as in the
examples set forth below, harvesting losses can have a surtax benefit, described below.
TAXATION OF CRTS FOR REGULAR TAX PURPOSES
For regular tax purposes, although CRTs are generally tax-exempt, distributions are taxed to the
recipient/beneficiary under a “tier” system. Under this system, a CRT’s income is categorized into four tiers: (1)
ordinary income; (2) capital gain; (3) other income; and (4) principal. Within each of the first three tiers, a
hierarchy of “classes” of income is created based on the highest federal income tax rate that can be imposed on
each “class.” (The CRT’s losses and deductions are apportioned among these tiers and classes.) Distributions
from the CRT are taxed to the recipient/beneficiary based on the so-called “highest-taxed in, first out” (HIFO)
system. That is, distributions are considered to come from the highest numbered tier until it is exhausted, and
distributions from within a tier are considered to come from the highest-taxed “class” within that tier until that
class is exhausted.
TAXATION OF CRTS FOR SURTAX PURPOSES
The regulations tie into this tier system and extend the HIFO system for purposes of determining the surtax
consequences. For each “class” of income within a tier, the regulations create an additional class: income that
is “net investment income” (NII) for surtax purposes. For purposes of classifying income within a tier, the tax
rate for each class of income that is NII is increased by 3.8%. With that, the usual rules of the “tier” system
apply.
Example 1. Assume you created a Charitable Remainder Annuity Trust in 2012 (before the surtax) and
funded it with appreciated long-term stock with a value of $5MM that was sold by the CRT for long-term
capital gain of $4MM (a common type of scenario for a CRT). Assume your annual annuity payment is 5%
of the initial value, or $250,000. The CRT reinvested the $5MM of sales proceeds, and during 2013 the
CRT received investment income of $100,000 of qualifying dividends, $50,000 of taxable interest, and
$100,000 of long-term capital gain. That would produce the following “tiers” and “classes” of income:
TAX ALERT 2013-11:YEA- END PLANNING OPPORTUNITY FOR CRTS
Tier
Income
Top Rate/Class
Amount
Distributed
Balance
Tier 1
Income
Interest (NII)
43.4% (39.6% + 3.8%)
$ 50,000
$ 50,000
$0
Qualified dividends (NII)
23.8% (20% + 3.8%)
$ 100,000
$ 100,000
$0
Long-term capital gain (NII)
23.8% (20% + 3.8%)
$ 100,000
$ 100,000
$0
Long-term capital gain (not NII)
20% (pre-2013)
$ 4,000,000*
$ 0
$ 4,000,000
Tier 2
Gain
Total
$ 250,000
* This is the capital gain from the sale of the initially-contributed stock. It was sold before 2013 and so the gain is
not NII.
Under the “tier” system, the 2013 distribution of $250,000 would be deemed to consist of (1) $50,000 of
interest received in 2013 (which is NII); (2) $100,000 of qualified dividends received in 2013 (which is NII);
and (3) $100,000 of long-term capital gain received in 2013 (which is NII).
THE ROLE OF “HARVESTING LOSSES” AFTER THE SURTAX
Example 2. Assume the same facts as Example 1, except the CRT’s portfolio also has an accrued, but
unrecognized, capital loss of $100,000. If that loss is “harvested” in 2013, that will affect the surtax
results of the distribution. For surtax purposes, that $100,000 capital loss harvested in 2013, when
combined with the $100,000 capital gain recognized in 2013, would cause the CRT to have “net gain” of
$0 in 2013. In that case, the 2013 distribution of $250,000 would be deemed to consist of (1) $50,000 of
interest (still NII); (2) $100,000 of qualified dividends (still NII); and (3) $100,000 of long-term capital gain
that is not NII because it would now be considered to come from pre-2013 capital gain. The chart below
summarizes.
Tier
Tier 1
Income
Tier 2
Gain
Income
Top Rate
Amount
Distributed
Balance
Interest (NII)
43.4%
$ 50,000
$ 50,000
$0
Qualified dividends (NII)
23.8%
$ 100,000
$ 100,000
$0
Long-term capital gain (NII)
23.8%
$ 0*
$0
$0
Long-term capital gain
(pre=2013; not NII)
20%
$ 4,000,000
$ 100,000
$ 3,900,000
Total
$ 250,000
* This is the $100,000 of long-term gain net of the $ 100,000 loss that was “harvested.” That
loss reduces the 2013 net gain, which is NII, to $0.
Thus, by harvesting enough capital loss to offset 2013 gains, the “net gain” that is considered to be NII (and
therefore distributable as NII) is reduced to $0, allowing distributions to be deemed made from pre-2013 capital
gains, which are not considered NII to the recipient.
HARVESTING EXCESS LOSSES AFTER THE SURTAX
What if there was more than $100,000 of capital losses that could be harvested? Should excess losses be
harvested? The result of that is not clear under the regulations. It is very possible that in Example 2, harvesting
more than $100,000 of capital losses would not be a good idea.
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TAX ALERT 2013-11:YEA- END PLANNING OPPORTUNITY FOR CRTS
In general, for surtax purposes “net gain” for a year cannot be less than zero. So, in Example 2, if $150,000 of
capital losses were harvested by the CRT, that would still fully offset the $100,000 of 2013 capital gain and make
the 2013 “net gain” be $0, but it is unclear whether the excess $50,000 (i) would reduce the pre-2013 capital
gain, or (ii) could be carried forward (for surtax purposes) to offset 2014 capital gain. It is clear that for an
individual, excess capital losses can be carried forward to the next year for surtax purposes. It is not clear,
however, how that rule operates for purposes of the CRT tier system; the regulations do not address that issue.
Therefore, the more prudent course would seem to be to harvest enough losses to offset the current year’s
gains, but no more.
FURTHER LOSS PLANNING
The examples above apply only to a certain set of circumstances. Depending on the distribution provisions of
the CRT, its funding and the portfolio performance, it might also make sense to harvest capital losses for other
reasons.
For example, so far we have considered only long-term capital gains. If short-term capital gains were recognized
by a CRT (e.g., it invested in hedge funds), those are subject to a top federal tax rate of 39.6% for regular income
tax purposes, plus a potential additional 3.8% for surtax purposes. If those short-term gains would be
considered the source of the CRT’s annual distribution under the tier system, ahead of long-term capital gain, it
could make good sense to harvest short-term capital losses to offset those short-term capital gains. Even if that
would mean the source of the CRT’s distribution then became long-term capital gain recognized in 2013, that
would still be a better result because 2013 long-term capital gains are federally taxed at 23.8% at the highest,
whereas 2013 short-term capital gains are federally taxed at 43.4% at the highest. In fact, even before the
surtax (prior to 2013) it made good sense to offset a CRT’s short-term capital gains with harvested short-term
capital losses.
This type of loss harvesting remains sound and is the basis for U.S. Trust’s capital-loss harvesting program, Tax
Efficient Structured Equities (TESE). If you would like more information on TESE, please contact your U.S. Trust
representative.
— National Wealth Planning Strategies Group
Note: Any examples are hypothetical and are for illustrative purposes only.
Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial
situations.
Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any
financial decisions. If any information is deemed “written advice” within the meaning of IRS Regulations, please note the following:
IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is
intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another
party any transaction or matter addressed herein.
While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America,
N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.
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