Skip the Surtax: A Tax-Saving Strategy for CRTs

Daniel B. Eagan, Steve Schilling and Tara Thompson Popernik

A special provision buried deep in a recent set of proposed US Treasury regulations opens the door for charitable remainder trusts (CRTs) to protect gains from being subject to next year’s 3.8% Medicare surtax. Here’s how CRTs can reduce their beneficiaries’ tax burden. 

The new 3.8% Medicare surtax will apply to investment income (including capital gains) generated inside a charitable remainder trust from January 1, 2013, onward, but not to income generated in 2012. This is hardly surprising, since the same rule applies to all taxable accounts.

But CRTs have a complex tax structure. While the trusts themselves are tax exempt, ordinary income, capital gains and qualified dividends generated inside them are tracked, and trust beneficiaries become responsible for paying the relevant tax in whatever year they receive the money as a distribution. So if a CRT books a capital gain in 2012, the Medicare surtax will not apply to it—even if the beneficiary receives the money in 2020. 

While professionals managing CRT investments have no way to accelerate ordinary income or qualified dividends, they can accelerate long-term capital gains, thereby helping beneficiaries to avoid the surtax. For every $1,000 of unrecognized income realized before the end of 2012, CRT beneficiaries may save $38 in Medicare surtax charges. 

Short-term gains are another story, because they are taxed at a substantially higher rate. Avoiding the 3.8% surtax by harvesting short-term gains in 2012 would actually result in higher taxes than would holding the securities far enough into 2013 for the gains to be subject to the long-term capital gains tax. 

A portfolio manager who wants to retain a position in a security can harvest the gain and then immediately repurchase it (thereby establishing a new—higher—cost basis). Before taking action, managers should carefully analyze whether the benefit of harvesting is greater than the transaction costs.

For example, when we looked at CRT accounts holding municipal bonds with unrealized long-term gains, we found that in most cases, the cost of selling and then repurchasing the bonds was greater than the tax savings. That’s because the bid/ask spread for municipal bonds is wider than it is for stocks.

Of course, regulations could still change before the end of the year, and future tax policy is impossible to predict. Even so, we believe that in many cases, harvesting long-term gains in CRT accounts today is likely to result in tax savings for beneficiaries over time.

Bernstein does not give tax or legal advice. Taxpayers should consult professionals in those areas before making any decisions.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Steve Schilling, CFA, is a Director and Tara Thompson Popernik, CFA, is Director of Research in the group.

Daniel B. Eagan

Daniel B. Eagan is a Managing Director and the Head of Bernstein’s Wealth Management Group; he assumed his current role in 2011. A member of the Private Client Investment Policy Group, Eagan joined Bernstein in 2001 as a senior portfolio Manager; in 2003 he assumed the leadership of Bernstein’s private client practice in the Northwest. Prior to joining the firm, Eagan was a senior portfolio manager and managing director with BlackRock for seven years. From 1986 to 1994, he worked in investment consulting, most recently with Mercer Investment Consultants. Eagan earned a BS in finance from the University of Illinois and an MBA with distinction from DePaul University.

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