This article provides a detailed comparison of two strategies that are commonly used to tax efficiently diversify appreciated assets: Charitable Remainder Unitrusts (CRUTs) and Deferred Sales Trusts (DSTs).

Key Highlights and Takeaways

• Tax-Efficient Diversification: Both CRUTs and Deferred Sales Trusts allow individuals to diversify out of appreciated assets while deferring capital gains taxes, potentially leading to significantly higher returns compared to outright selling.
• Long-Term Growth: CRUTs provide an income stream and often a significantly higher ROI unless you want all the money distributed in less than eight years. The longer you want to benefit from the tax-deferral benefits of these structures, the higher the relative ROI of a CRUT compared to a Deferred Sales Trust.

What are CRUTs?

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.

How Do CRUTS Work?

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.)

Benefits of CRUTs

1. Tax Deferral: The primary advantage of a CRUT is its ability to defer capital gains taxes. By selling appreciated assets inside the trust, the donor avoids immediate capital gains taxes when selling the asset and can reinvest and grow the assets on a pre-tax basis. The donor doesn’t pay taxes on the sale (or any income) realized inside the trust; instead, the seller (as beneficiary) pays taxes on distributions from the trust. Over a long period of time, this can more than double the post-tax dollars the seller receives from a sale.
2. Charitable Deduction: In addition, the donor receives a charitable deduction that is typically 10% of the value of assets contributed to the CRUT. That deduction can offset ordinary income or capital gains income.
3. Income Stream: The CRUT provides at least annual distributions for the length of the trust, which can be a set number of years or the lifetime of the beneficiary.
4. Asset Flexibility: CRUTs can be used with almost any asset ranging from public stocks to private stocks, crypto, real estate, and collectibles.

Drawbacks of CRUTs

1. Irrevocability of Charitable Gift: Once assets are transferred into a CRUT, the donor can’t claw back the charitable gift.
2. Illiquidity: During the term of the CRUT, the donor is limited to annual distributions from the CRUT equal to a fixed percentage of the trust’s assets. Short of terminating the CRUT entirely, there’s not much the donor can do to access the bulk of the principal during the CRUT term.
3. Income Variability: The income generated by a CRUT can vary depending on the performance of the trust’s investments. If the trust’s assets underperform, the income stream may be lower than expected. The flip side is that if the investments overperform, the income stream may be higher than expected. (You can use our CRUT calculator here.)

What is an Ideal CRUT Situation?

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.

Deferred Sales Trusts

A Deferred Sales Trust is another strategy for deferring capital gains taxes. This strategy allows you to sell an appreciated asset and reinvest the proceeds without paying capital gains taxes immediately. Instead, the sale proceeds are placed into a trust, which can then be reinvested in a variety of assets, such as stocks, bonds, or real estate. DSTs are considered somewhat more aggressive than most conventional tax-minimization strategies.

How Do DSTs Work?

1. Initial exchange. The individual sells the asset to a trust in exchange for a promissory note. The promissory note requires that the trust pay the seller back (plus interest) in installments over a number of years (typically 10 years) as long as the trust has enough money to cover the payments.
2. Taxable payments. The seller pays taxes on the installment payments as they are received, rather than owing all of the taxes upfront. This is the key to the DST’s tax deferral value proposition.
3. Asset sale. Meanwhile, the trust sells the asset to a third-party buyer. This is the buyer who the seller would have otherwise sold the asset to. The buyer pays the same price he or she would have paid anyway, typically the same value as the installment note.
4. Reinvestment. The proceeds from this sale are then reinvested inside the trust in income-generating assets like stocks, bonds, etc.
5. Distributions. The income that the trust generates is distributed to the seller, who pays tax on that income. After the installment note is paid off, the remaining trust assets pass to the trust’s beneficiaries.

Benefits of DSTs

1. Tax Deferral: A DST allows you to defer capital gains tax, giving you more money to reinvest in the short term.
2. Post-Sale Investment Flexibility: You can reinvest the sales proceeds in a wide range of assets, from stocks and bonds to real estate and more.

Drawbacks of DSTs

1. Complexity and Cost: Setting up a DST is complicated and requires professional assistance that is very expensive.
2. Misaligned Investment Incentives: If the trust investments do poorly, the trust may not have enough assets to pay you back the money it owes you (via the installment note). On the other hand, if the trust investments do well, you do not benefit from that investment growth.
3. Legal Risk: A DST is a type of “installment sale.” Installment sales are legal, but they have been under increased IRS scrutiny. The IRS even placed certain types of installment sales, known as monetized installment sales, on the IRS’s “dirty dozen” list alongside things like Conservation Easements.
4. Illiquidity. Once assets are transferred into the trust, a portion of the principal is inaccessible to the seller.
5. Lack of Industry Recognition. Some entities, such as Qualified Intermediaries in 1031 exchanges, may not recognize DSTs as a valid exchange alternative. This can create issues if the Qualified Intermediary refuses to release funds to the DST trustee.

Choosing Between CRUTs and DSTs

The choice between a CRUT and a Deferred Sales Trust often depends on an individual’s financial goals, tax considerations, and philanthropic intentions.

1. Income Stream: If an individual’s primary goal is to use the proceeds of the sale to support his or her lifestyle, a CRUT will have a higher ROI.
2. Risk Tolerance: If you are worried about legal uncertainty, then a Deferred Sales Trust won’t make sense. Deferred Sales Trusts are a type of installment sale, and installment sales have been under IRS scrutiny in recent years. CRUTs are a more conservative approach.
3. Time Frame: CRUTs deliver higher returns the longer the time frame. DSTs perform worse over longer periods. So DSTs will make the most sense if you want tax deferral on the sale and want the proceeds in the next eight years.

CRUT and Deferred Sales Trust (DST) Case Study

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 to support her lifestyle but is concerned about the tax implications of selling her shares.

Assumptions:

• Annual distributions starting in the first year and continuing for 32 years.
• Public market investments grow 10% per year.

Results:

• Both structures are significantly better than doing nothing.
• A CRUT distributes ~100% more after taxes to Jane than a Deferred Sales Trust (the shorter the period Jane lives, the lower this difference will be, while conversely the longer she lives, the higher the ROI of a CRUT on a relative basis).

Conclusion

Choosing between a CRUT and a Deferred Sales Trust 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 to understand the financial trade-offs.

About Valur

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