Editor’s note: Kristy Meares Sides is a member of the Trusts and Estates Section of Ward and Smith, P.A.

The tech company in which you have a significant interest is about to be sold. You immediately start to wonder how much tax you will have to pay Uncle Sam and if the remaining proceeds will allow you to reach your goal of retiring in the manner to which you would like to become accustomed. Although there are numerous ways to structure the sale of a company, for those with highly appreciated ownership interests and a willingness to be charitable with part of the gain, the use of a Charitable Remainder Trust may be a smart option.

What is a Charitable Remainder Trust?

A Charitable Remainder Trust ("CRT") is an irrevocable trust into which a person, called the "donor," transfers assets for the future benefit of a charity selected by the donor. The donor retains the right to an income stream from the assets transferred to the trust. The right to an income stream can be for a specified number of years, for the donor’s lifetime, for the lifetime of the donor’s spouse, or for the lifetime of some other non-charitable beneficiary. In order to qualify as a CRT and to reap the advantageous tax benefits, the trust’s creation and operation must meet highly technical rules dictated by the Internal Revenue Service.

How a CRT Would Work

Once the donor has donated the highly appreciated ownership interest in the company to be sold, which must occur before the sale, the CRT will receive the proceeds of the sale. The sale by the trust will not be subject to capital gains tax. Thus, conversion of the ownership interest into a liquid asset which, in turn, can be invested in other income-producing assets, occurs without reducing any of its value as a result of taxation.

Furthermore, as discussed below, in the year in which the CRT is created and funded, the donor will receive an immediate income tax deduction for the present value of what is referred to as the "charitable remainder interest," which is the value of the donated assets that is expected, based on actuarial calculations, to remain in the trust when it passes to the charity free of the CRT.

Income earned by a CRT is exempt from federal income tax. However, distributions to the donor are taxable if the distribution includes income passed through from interest, dividends, or other earnings of the CRT. Any additional distribution from the CRT needed to meet the requirements of the trust is deemed to be a return of principal and is not taxable.

Assuming that the income stream is based on the donors’ life, the CRT at the donor’s death will be included in the donor’s gross taxable estate, but the donor will have an equal estate tax charitable deduction. Thus, the assets from the sale of the stock also will not create an estate tax burden for the donor.

The Income Stream

A CRT can take the form of either a Charitable Remainder Annuity Trust ("CRAT") or a Charitable Remainder Unitrust ("CRUT"). With a CRAT, the donor retains the right to receive a fixed payment each year, which payment must be at least 5%, but not more than 50%, of the initial fair market value of the contributed assets. With a CRUT, the donor retains the right to receive an annual payment that will vary in amount based on a fixed percentage, specified in the trust agreement, of the value of the assets remaining in the trust at the end of each year, which percentage may not be less than 5%, nor more than 50%. Thus, the amount of the CRAT’s income stream is fixed for the duration of the trust, while the amount of the CRUT’s income stream fluctuates with the value of the trust’s assets.

The Charitable Remainder

In order to qualify as a CRT, the expected charitable remainder interest, calculated on an actuarial basis, must be at least 10% of the value of the assets transferred to the trust, and there must be less than a 5% chance that the assets will be exhausted before the end of the trust. At the time designated for the income stream to end, as specified in the trust and which may be the death of the donor, the charity receives the remainder of the trust’s assets either outright or in further trust for its benefit.

Illustration

Suppose in June 2008, a 45 year-old contributes stock in a tech company with a fair market value of $2 million to a CRUT, retaining a right to receive an annual payment in the amount of 8.536% of the value of the assets of the trust at the end of the year. The trust sells the stock in the tech company and invests the proceeds in assets with an 8.0% annual return. The donor, over a life expectancy of 38 years, can expect annual payments ranging from approximately $171,000 to $116,000 as the value of the trust’s assets fluctuate. If the donor lives to the donor’s full life expectancy, the annual payments would total approximately $5,380,000, and the chosen charity would receive approximately $1,340,000 at the death of the donor (this is less than the original $2 million contribution because, each year, part of the principal must be returned to the donor as part of the income stream since the 8.536% annual percentage to be paid to the donor exceeds the trust’s 8.0% annual return on assets). The present value of that future amount of $1,340,000 is approximately $200,000, which will be the amount of the donor’s charitable income tax deduction for 2008.

Compare that scenario with one involving the outright sale of the same tech company stock. If the stock had a basis of $100,000, then the shareholder would have a gain of $1.9 million with a resulting capital gains tax (at 15%) of $285,000. The net after-tax income from the sale of the stock would be $1,715,000. After a current gift of $200,000 to the former shareholder’s favorite charity, the former shareholder will be left with $1,515,000 to invest. At an 8% annual return, this would provide an income stream to the former shareholder totaling approximately $4,870,000 over the next 38 years, approximately $500,000 less than the first scenario using the CRUT.

Summary

Using a properly structured CRT to sell timely-contributed ownership in a tech company may provide considerable tax savings. It also can provide a lifetime income stream from the proceeds of the sale of the ownership interest without any reduction of principal as a result of capital gains taxation. And, last, but certainly not least, a CRT supports charity with a deferred gift of the assets remaining after the expiration of the right to the income stream. So, when the time is right for selling your tech company, think of using a CRT to benefit you and your favorite charity rather than Uncle Sam.

© 2008, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Kristy Meares Sides practices in the Trusts and Estates Section, where she concentrates her practice in estate planning and estate administration. Comments or questions may be sent to kms@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.