Taxation of CRT Income Payouts:
This tax discussion raises an important point
constantly to be kept in mind: cash distributions to
beneficiaries of a CRT are taxable under a special
three-tier income tax provision: first, as ordinary
income to the beneficiary, if the trust has ordinary
income; second, as a capital gain to the extent the
trust has such a gain not taxed previously to the
beneficiaries; and, third, as tax-free income, or a
return of principal, if the distribution is in excess
of ordinary income or capital gain.
Imposition of these beneficiary payout taxes
suggests there may be an advantage to selling an
appreciated asset first, then donating the cash
proceeds to the CRT, thus assuring all future trust
income will be tax free to the donor. When a CRT sells
appreciated property, every subsequent annual
distribution to beneficiaries in excess of ordinary
income will be taxed as a capital gain, until the
entire amount of the beneficiaries' original capital
gain is paid. This means you may not escape some of
the capital gains tax, but any payments are delayed and
on the installment plan, and contingent on the type and
amount of income the trust has.
The obvious solution is to fund the CRT with cash
or non-appreciated assets allowing the trustee to
invest in municipal bonds or securities that provide
little or no current income, so there will be no
immediate capital gains tax.
As you shall see in discussion that follows, there
are several ways of structuring trust investments and
income to minimize the beneficiary's income tax on
annual payouts.
