The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
This article provides a detailed comparison of two strategies that are commonly used to tax efficiently diversify appreciated assets: Charitable Remainder Unitrusts (CRUTs) and exchange funds.
A CRUT is an irrevocable trust that mitigates capital gains tax on the sale of appreciated assets like stock, crypto, real estate, or privately held businesses and then generates income for a beneficiary (or beneficiaries) for a specified period, after which the remaining assets are distributed to a designated charity.
The basic idea is that a person (the “grantor”) transfers appreciated property to a CRUT and, in return, the CRUT pays the grantor (or another beneficiary) a fixed percentage of the assets in the trust each year for either a set number of years or the beneficiary’s lifetime. When the appreciated assets are sold inside the CRUT, there is no immediate federal or state capital gains tax on the sale; the trust can reinvest and grow the assets pre-tax. Instead, the capital gains tax will be paid by the beneficiary (probably the grantor) when the beneficiary receives distributions from the CRUT. While the capital gains tax is eventually paid, in the meantime the grantor is able to reinvest any untaxed amount inside of the CRUT, generating returns on that entire amount. At the end of the term, anything left over in the trust passes to a charity of the grantor’s choice. In addition, the grantor gets a charitable deduction typically equal to ~10% of the assets they contributed to the trust in the first place. The amount that passes to charity is roughly equal to the 10% charitable deduction the grantor receives adjusted for the growth of the assets over time.
Thanks to the combination of this tax deduction and the powerful tax deferral described above, the grantor typically ends up with significantly more post-tax money than he or she would have had without the CRUT — and a charity gets money, too! That’s a win-win. (You can learn more about CRUTs here and you can estimate the potential returns here.)
Imagine that Bob, a 40-year-old California resident, has a $1,000,000 asset with a cost basis of zero. He wants to sell the asset in a tax-efficient way so he can receive some of the sales proceeds every year to support his lifestyle. If he contributes that asset to a standard CRUT that is designed to last for his lifetime, he’ll get annual distributions from the CRUT equal to about 7% of the value of the CRUT’s assets. So, in Year 1, he’ll get a $70,000 distribution (7% of $1,000,000), in Year 2 he’ll get a distribution equal to about 7% of the value of the CRUT’s assets at that time, and so on. In the meantime, Bob, as Trustee of the CRUT, will generate returns investing the ~$350,000 that would have been taxed immediately without the CRUT. Over his life, Bob will be able to receive about $1,400,000 more after taxes (a 124% additional return) by using the CRUT than he would have been able to generate without it.
An exchange fund, also known as a swap fund, is a financial vehicle designed to help investors diversify their concentrated stock positions without incurring immediate capital gains taxes. The process begins when multiple investors, each holding a significant position in a single stock, contribute their shares to a collective pool.
When a person decides to participate in an exchange fund, they typically start by contributing a significant portion of their concentrated stock position to the fund. This process is similar to making an in-kind transfer to a brokerage account. The investor doesn’t sell their shares on the open market; instead, they transfer ownership of the shares directly to the exchange fund. In return, the person receives an equivalent value of units or shares in the exchange fund itself. Once the investor’s shares are in the fund, they become part of a larger, diversified portfolio. From this point on, the investor’s investment performance is tied to the overall performance of the fund rather than being tied to the performance of their original stock.
During the mandatory seven-year holding period, the investor may receive periodic reports on the fund’s performance, but they typically can’t make withdrawals or changes to their investment.
The tax benefits and returns materialize in different ways. Most important, the initial exchange of shares into the fund doesn’t trigger any immediate tax consequences for the investor. So instead of facing a large capital gains tax bill at that point, the investor pays capital gains tax as they liquidate the position over time. Additionally, if the person holds their fund shares until death, their heirs may benefit from a step-up in basis, potentially eliminating a significant portion of the capital gains tax liability.
Imagine that Sara, a 70-year-old California resident, is an investor in a publicly traded technology stock and that she will pass away in 19 years (based on IRS actuarial estimates). The stock has a cost basis near zero and a fair market value of $1,000,000. She wants to diversify because the stock has appreciated so much, but she doesn’t want to pay capital gains tax on the sale and she doesn’t need the cash. If she uses an exchange fund, she will be able to diversify without selling the asset. When she dies, the cost basis of her assets will be stepped up to fair market value. Thanks in part to the resulting tax savings from the basis step-up, Sara will be able to pass on $2.8 million to her children, about double what she would have been able to pass on if she had just sold the assets without an exchange fund and paid the capital gains tax upfront.
The choice between a CRUT and an exchange fund often depends on an individual’s financial goals, tax considerations, and philanthropic intentions.
Sometimes, the choice is less clear cut. What if an individual is looking to sell an appreciated asset, but isn’t sure if they’ll need the income stream or to what extend they’ll need it? Here are two other factors to consider:
Consider Jane, a tech entrepreneur with a $5 million concentrated public stock position in a successful company she co-founded. Jane is 55 years old and has plans for retirement, with a strong desire to contribute to environmental causes. Her stock has appreciated significantly, and she wants to sell it but is concerned about the tax implications of selling her shares.
Imagine that Jane wants to use the proceeds to support her lifestyle.
Assumptions:
Results:
| Exchange Fund | CRUT | Nothing | |
|---|---|---|---|
| Distributions | $22,611,071 | $29,311,737 | $10,938,782 |
| Capital Gains Taxes | $8,366,096 | $10,750,439 | $3,186,148 |
| Charitable Donation | $0 | $5,491,394 | $0 |
| Net distributions (to donor) | $14,244,975 | $18,561,298 | $7,752,634 |
Choosing between a CRUT and an exchange fund requires careful consideration of various factors, including tax efficiency, income needs, philanthropic goals, and control over assets. Both strategies offer unique advantages and potential drawbacks, making it essential to align the chosen approach with the individual’s broader financial objectives. You can use our Comparison Calculator here.
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