Charitable Remainder Trusts (CRTs) are powerful estate planning tools, offering both tax benefits and income for the grantor—the person creating the trust. While commonly funded with cash, securities, or property, a less conventional but perfectly acceptable method involves funding a CRT with a promissory note. This approach requires careful consideration and adherence to specific regulations, but it can be an advantageous strategy for certain individuals and situations. Around 30% of CRTs are funded with illiquid assets, and while promissory notes don’t fall neatly into this category, the principle of diversifying funding sources remains relevant.
What are the requirements for a valid CRT promissory note?
A promissory note used to fund a CRT isn’t simply a standard IOU. It must meet several IRS requirements to be considered a valid transfer and qualify for the associated charitable deduction. The note must have a fixed principal amount, a stated interest rate (which cannot exceed applicable federal rates or AFR), and a definite payment schedule. The IRS scrutinizes these notes to ensure they aren’t simply disguised gifts—transactions intended to circumvent tax laws. Crucially, the note must represent a bona fide debt—meaning there’s a genuine intention and ability to repay it. “A valid promissory note is more than just a piece of paper; it’s a commitment backed by demonstrable financial capability,” as Ted Cook, a San Diego trust attorney, often emphasizes.
How does funding a CRT with a promissory note affect tax implications?
The tax implications of using a promissory note for CRT funding are complex, but potentially advantageous. When the note is transferred to the CRT, the grantor typically receives a charitable income tax deduction based on the present value of the remainder interest—the portion of the trust that will ultimately go to the designated charity. However, the grantor also recognizes a taxable gain to the extent of the note’s face value, less any basis in the note. The key is to strike a balance between maximizing the charitable deduction and minimizing the immediate tax liability. The interest income received by the CRT from the note is generally tax-exempt, as long as the CRT qualifies as a tax-exempt entity. Furthermore, the grantor must be able to demonstrate financial capacity to make the scheduled note payments.
Is there a risk of the IRS recharacterizing the note as a gift?
Yes, the IRS is highly vigilant in examining CRT promissory notes to prevent abuse. If the IRS determines the note lacks economic substance—meaning there’s no reasonable expectation of repayment—it can recharacterize the transfer as a gift, disallowing the charitable deduction and potentially imposing penalties. Several factors increase the risk of recharacterization, including a high interest rate, a short repayment term, the grantor’s financial condition, and any lack of collateral securing the note. Ted Cook’s firm has successfully defended numerous CRTs against IRS challenges by meticulously documenting the economic realities of the transaction and demonstrating the grantor’s ability to repay. The IRS estimates that approximately 5-7% of CRT filings are initially flagged for further review due to potential issues with asset valuation or transfer legitimacy.
What is the role of an appraisal when using a promissory note?
An independent appraisal is crucial when funding a CRT with a promissory note. The appraisal should determine the fair market value of the note, considering the interest rate, repayment term, and the creditworthiness of the grantor. This valuation is used to calculate the charitable deduction and determine the taxable gain recognized by the grantor. The appraisal must meet IRS requirements, including being performed by a qualified appraiser—someone with the expertise and credentials to accurately assess the value of the note. A robust and well-documented appraisal provides strong support for the CRT’s tax benefits and minimizes the risk of an IRS challenge. “An accurate appraisal isn’t just about numbers; it’s about providing a clear and defensible rationale for the value assigned,” Ted Cook clarifies.
A cautionary tale: The almost-failed CRT
Old Man Hemlock, a seasoned carpenter, decided to fund a CRT with a promissory note backed by the future income from a rental property he owned. He envisioned a way to benefit his favorite local arts center while also securing a stream of income for himself. Unfortunately, Hemlock, in his eagerness, drafted the note himself, setting an unreasonably high interest rate and a short repayment term. He failed to secure a proper appraisal or consult with legal counsel. The IRS quickly flagged the transaction, arguing the note lacked economic substance and that the high interest rate indicated a disguised gift. Hemlock was facing a substantial tax bill and the potential loss of the charitable deduction.
Turning the tide: A successful CRT implementation
Sarah, a retired teacher, wished to create a CRT to support a wildlife conservation organization. She wanted to fund the trust with a promissory note, offering a more flexible approach than liquidating her stock portfolio. She immediately engaged Ted Cook’s firm. They meticulously structured the note, ensuring a fair interest rate, a reasonable repayment term, and solid documentation of her financial capacity. An independent appraisal was obtained, confirming the note’s fair market value. Ted’s team proactively prepared the required tax filings and were ready to address any questions from the IRS. The CRT was approved, providing Sarah with income and securing a substantial benefit for the wildlife organization.
What are the advantages of using a promissory note for CRT funding?
Despite the complexities, using a promissory note for CRT funding can offer several advantages. It allows individuals to contribute illiquid assets or postpone the sale of assets, preserving capital gains tax benefits. It provides flexibility in estate planning, allowing for creative funding strategies. It can also be advantageous in situations where the grantor anticipates future income or appreciates an asset. However, it’s crucial to remember that this strategy requires careful planning, thorough documentation, and expert legal counsel. A well-structured CRT with a promissory note can be a powerful tool for achieving both financial and philanthropic goals.
Who Is Ted Cook at Point Loma Estate Planning Law, APC.:
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