Can a CRT be structured to pause income during certain years?

Charitable Remainder Trusts (CRTs) are powerful estate planning tools, but their flexibility isn’t unlimited; structuring a CRT to completely *pause* income distributions for entire years is a complex undertaking with significant IRS scrutiny, however, it’s not entirely impossible with careful planning and the right trust provisions.

What Happens if I Need to Temporarily Stop CRT Payments?

Generally, a CRT is established to provide an income stream to a non-charitable beneficiary (or beneficiaries) for a term of years or for life. The IRS requires that the payout rate be at least 5% and no more than 50% of the initial fair market value of the trust assets. While many CRTs are designed for consistent income, life happens, and sometimes individuals face unforeseen financial hardship. Simply ceasing payments violates the trust’s terms and can trigger immediate taxation of the entire remaining trust principal as if it had been distributed. Approximately 65% of Americans have little to no emergency funds, meaning unexpected events could quickly derail a CRT’s intended purpose.

Can I Build in a “Hardship” Clause?

A more viable approach is to incorporate a “hardship” clause, or a discretionary distribution provision, into the trust document. This allows the trustee, at their discretion, to *reduce* payments during periods of financial hardship experienced by the beneficiary. However, the IRS will scrutinize any reduction in payments to ensure it’s a genuine hardship and not an attempt to avoid taxes. The trustee must document the hardship thoroughly and demonstrate that the reduction is reasonable and necessary. Furthermore, the trustee is bound by the California Prudent Investor Act, meaning they must balance the needs of the beneficiary with the long-term preservation of the trust assets. This Act mandates diversification, cost-effective investment strategies, and consideration of risk tolerance, which adds a layer of complexity to discretionary distributions.

What About a “Net Income Only” CRT?

A “Net Income Only” CRT (NI-CRT) offers more flexibility. In an NI-CRT, distributions are limited to the *net income* produced by the trust assets each year. If the assets don’t generate sufficient income, no distribution is made for that year. This inherently creates “pause” periods without violating IRS rules. However, this approach often results in lower overall distributions, as the trust isn’t obligated to invade principal to meet the payout rate. In recent years, the average dividend yield of the S&P 500 has been around 1.6%, meaning an NI-CRT heavily invested in stocks might experience several years with little to no distribution. For those seeking consistent income, this could be a significant drawback. It’s also important to remember that California is a community property state; all assets acquired during marriage are owned 50/50, offering potential benefits during estate planning.

What are the Tax Implications of Pausing or Reducing CRT Payments?

Any deviation from the specified payout rate can have immediate tax consequences. If a CRT distributes less than the required amount, the shortfall is treated as accumulated income and taxed to the beneficiary as ordinary income. Conversely, if the CRT distributes more than the required amount, it’s considered a distribution of principal and subject to different tax rules. Formal probate is required for estates over $184,500, and executors and attorneys face statutory, percentage-based fees, making probate avoidance a critical consideration. Proper planning and diligent record-keeping are essential to avoid unexpected tax liabilities. A valid will can be either a formally signed and witnessed document or a handwritten holographic will.

Here’s a story about a client, David, who came to us after establishing a CRT without adequately considering potential future needs. David established a CRT with a fixed 8% payout rate, anticipating a comfortable retirement income. However, several years later, he faced unexpected medical expenses. He wanted to reduce the payments to conserve funds, but his trust document didn’t allow for it. He faced a significant tax burden when we had to amend the trust, resulting in lost funds and unnecessary stress.

Fortunately, we were later able to help Sarah, a client who proactively planned for potential flexibility. Sarah established an NI-CRT with a discretionary distribution provision. When she experienced a temporary setback in her business, the trustee was able to reduce the distributions to reflect her reduced income, preserving the long-term health of the trust. This allowed her to navigate the difficult period without jeopardizing her future financial security.

At Wildomar Probate Law, we understand the complexities of CRTs and the importance of tailoring these trusts to meet your individual needs and circumstances. We can help you explore the various options available and create a plan that provides both income and flexibility. Steven F. Bliss ESQ. can be reached at (951) 412-2800 for a consultation.

Don’t leave your financial future to chance. Contact Wildomar Probate Law today and let us help you create a lasting legacy.