Charitable Trusts – Save Taxes While Benefiting Charity

Charitable Remainder Trusts

For those of you who have the desire to make a gift to charity but feel that you can’t afford to part with a significant portion of your estate and receive nothing in return, a charitable remainder trust may prove to be the answer. The attraction of CRTs is that in addition to the income tax and estate tax deductions available, the donor of the trust receives income from the trust for a specified period. As discussed below, making a charitable gift by way of a CRT is most advantageous when highly appreciated, low-yield assets are used to fund the trust.

The Internal Revenue Service defines a CRT as a trust which provides for a specified distribution, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or for a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, charity.

There are two types of CRTs, charitable remainder unitrusts (CRUTs), andcharitable remainder annuity trusts (CRATs). Both are irrevocable trusts that pay out a portion of the value of the trust assets each year to a beneficiary chosen by the trust donor (which can be the donor or his or her spouse). The two types of trusts differ in that the CRUT pays a fixed percentage of the value of its holdings, while the CRAT pays a fixed dollar amount.

The income tax deduction for CRTs is based on the present value of the charity’s right to receive the trust principal at a future date. This value is determined by the use of several factors: 1) the estimated period of time the charity must wait to receive the assets; 2) the percentage rate payable to the income beneficiaries; and 3) the current rate of return on investments as determined by the Applicable Federal Rate (AFR), which changes monthly.

The income tax deduction is subject to certain percentage limitations, but excess deductions can be carried over to future years.

For someone owning stocks or other assets that have appreciated greatly since their purchase but do not produce much income, a CRT can be very attractive. If the donor were to sell the stock, the proceeds would be subject to capital gains taxation. However, by placing the stock in a CRT, the donor receives a current income tax deduction, and the charity can sell the appreciated property with no capital gains taxation. The charity can then reinvest the proceeds in such a manner as to produce a higher rate of return, which enables the donor to receive more income from the trust than he or she would have received from the donated assets. In addition, the value of the donated property is removed from the donor’s estate, resulting in an estate tax savings as well. As with any charitable gift, the donor also receives the satisfaction of knowing that he or she has furthered a worthy cause.

A potential disadvantage to a gift to charity by means of a CRT is that the donated asset would be removed from the donor’s estate, decreasing the amount received by the donor’s heirs. A solution is to create an irrevocable life insurance trust, which would own an insurance policy on the donor’s life and provide that the proceeds are payable to the heirs. Using such a trust eliminates any estate taxation of the insurance proceeds and replaces the value of the donated property in the donor’s estate. The income from the CRT can be used to pay the life insurance premiums.

The desire to benefit others through charitable giving is only slightly less strong than the desire to avoid paying the IRS any more than absolutely necessary. By using a charitable remainder trust, both objectives can be met.

Charitable Lead Trusts

A charitable lead trust (CLT) differs from a CRT in that it pays income to a qualified charity for either a set number of years, or the lifetimes of individuals. When the trust ends, the remaining assets are distributed to the donor, his or her spouse, children, or other individuals.

If the trust earns more than it pays to the charitable beneficiary, those extra earnings (or asset appreciation) will pass to the non-charitable beneficiaries (e.g., children or grandchildren) without additional estate or gift taxes.

Assets transferred to a CLT should have income potential (to make the required payments to the charity) and, most importantly, growth potential (to pass the appreciation to the ultimate beneficiaries with a minimum of estate or gift taxes).

If the beneficiary of the trust is other than the donor or his or her spouse there may be a taxable gift when a transfer is made to a CLT. The gift tax is based on the present value of the beneficiaries’ right to receive the trust remainder at some future time (when the trust ends). This calculation is dependent upon the term of the trust, the amount payable each year to the charity, and the AFR at the time of the transfer.

A charitable lead annuity trust (CLAT) pays the same dollar amount each year, without regard to its earnings. Valuation of assets is required only at the time the assets are transferred to the CLAT. A new trust will be required if additional contributions are made in later years.

A charitable lead unitrust (CLUT) pays a fixed percentage of the value of the trust. Valuation of assets is required annually, so additional contributions can be made to a CLUT in the future.

If the CLT is set up as a “Grantor Trust”, the donor is considered the owner of the trust and is allowed a tax deduction for the income passing to the charity. In a grantor trust, the assets revert to the donor or spouse at the end of the trust term.

In a non-grantor trust, the donor is not treated as the owner of the trust. The trust itself is permitted an unlimited tax deduction for the income passing to the charity. In a non-grantor trust, the assets pass to someone other than the donor or spouse at the end of the trust term.