This letter is in response to our previous discussion concerning your desire to establish a charitable remainder trust under your will. You indicated that your spouse will be the life beneficiary and that Alma Mater College will be the recipient of the remainder interest. I indicated to you that, to qualify for the estate tax charitable deduction, a remainder trust must satisfy specific statutory criteria. I noted that you have two choices: a charitable remainder annuity trust and a charitable remainder unitrust. You asked me to identify the differences between these trusts. Although there is another alternative, the pooled income fund, you rejected this alternative, since you want your designated trustee, rather than Alma Mater, to have control over the funds during your spouse's life.

Both trusts require that a specified percentage of the trust assets must be paid to the income beneficiary at least annually. That percentage cannot be less than 5% or more than 50%. The annuity trust requires this percentage to be applied to the net fair market value of the trust assets at the time the trust is established. This amount will not change regardless of any subsequent appreciation or depreciation in the value of the trust assets.

The unitrust, however, requires the fixed percentage to be applied annually against the fair market value of the trust assets. Accordingly, if the trust assets have depreciated in value, the net cash amount to be distributed would be reduced. However, if the assets have appreciated in value, the net cash amount to be distributed will be increased. The anticipation is, of course, that assets will appreciate in value and, accordingly, the annual payments will increase. The objective of the unitrust is to enable the life tenant's payments to reflect increases for inflation, thereby enabling the life tenant to retain purchasing power.

The value of the assets in a unitrust may increase merely because the annual percentage distribution is less than the amount of income being received. For example, if the annual payment is on a 5% basis, but the trust assets are in an investment which yields 10%, the 5% differential will accumulate each year and, therefore, constitute a larger base against which to apply the 5% distribution factor in subsequent years. On the other hand, if the annual payment is based on 10% and the trust is invested in growth stocks which are only yielding 3%, the additional 7% of the distribution must come from principal and will reduce the base against which the 10% is applied in subsequent years. However, this reduction of the principal by the amount of the distribution might be offset by appreciation in the value of the underlying assets.

The value of the estate tax charitable deduction for either type of trust depends upon the amount of the annual percentage distribution. The distribution of a higher percentage to the life tenant will reduce the value of the remainder interest to be received by charity. Therefore, ordinarily this means that a higher amount must be included in the taxable estate. However, if the life interest goes to the surviving spouse, a marital deduction will be available for that gift. The trust property could become subject to estate tax if, at the death of the surviving spouse, that spouse has a large amount of unexpended trust funds included in his or her gross estate. If that spouse will also give his or her estate to charity, this matter will not be important, since a charitable contribution deduction will also be available for that transfer.