Charitable Trusts

There are two basic types of charitable trusts: charitable lead trusts and charitable remainder trusts.

Charitable Lead Trust

When you establish a charitable lead trust, you would transfer cash or other assets to a trust, and a charity receives payments from the trust for a period of time. After that period, assets in the trust transfer to a non-charitable remainderman (usually a child or grandchild).

You may receive an immediate income tax deduction if you elect to recognize income from the trust in later years (otherwise, the initial gift is not deductible). You also would receive a lower gift tax for transferring the trust assets to the children or grandchildren or trusts for their benefit. A lead trust may also be established at death as a form of bequest. Both corporations and individuals may establish lead trusts.

A lead annuity trust pays a specified percentage of the initial trust value to one or more charities.

Income, gift, and estate tax deductions are only permitted for transfers to lead trusts if one of the following requirements is met:

  • The income interest is paid out in the form of a guaranteed annuity.
  • The income interest is a fixed percentage of the fair market value of the trust’s assets (calculated annually) and is paid at least annually.

Income tax rules also require the donor to be the owner of the income earned by the trust to claim the charitable income tax deduction. In other words, you receive an immediate, large income tax deduction, but in later years, must report the income of the trust as it is received by the trust. Consequently, the typical lead trust produces little if any net income tax deductions since future income taxes are likely to counterbalance the initial deduction.

Despite future tax obligations, however, the charitable lead trust can be beneficial. For example, if you are in a high-income year, but in future years you are expecting a drop in income, your tax bracket will most likely also drop. Consequently, deductions are received in a high bracket year, and taxes are paid in low bracket years. This premise also applies if a drop in income tax rates is expected.

Another advantage of the charitable lead trust is that it allows a discounted gift to family members. Under present law, the value of a gift is set at the time the gift is complete. The family member remainderman must wait for the charity’s term to expire; therefore, the value of that remainderman interest is discounted for the cost of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the income interest donated to charity.

When the assets in the trust transfer to the children or grandchildren (or their trusts), any appreciation on the value of the assets is free of estate taxation in the client’s estate.

Charitable Remainder Trusts

You may want to create a charitable remainder trust (“CRT” or “trust”) to provide various tax benefits to you and a means of leaving money to charity.

· Income Tax Consequences – A CRT generally is funded with appreciated property, e.g., stocks, income producing real estate or raw land. If appreciated property is used to fund the trust, you will be entitled to claim an income tax deduction for the gift of such property to the CRT in an amount equal to the value of the charity’s remainder interest. The charitable income tax deduction is limited to 20% of your adjusted gross income for the year of the contribution for gifts made to a CRT the beneficiary of which is a private foundation (a/k/a charitable family foundation, discussed below) or 30% for gifts to public charities. Any amount not deductible due to the limitation can be carried forward and used in the next five tax years. In addition, the value of the charitable remainder interest will need to be more than 10% of the total value of the trust.

Importantly, you should not be subject to income tax on the transfer of the appreciated property to the trust or on the sale by the trust of the property. Moreover, the CRT will not be taxed on the sale of the appreciated property or on any income it generates (provided that the trust invests only in investment assets, such as stocks, bonds and other income-producing or capital-appreciating assets). Note that you should avoid reinvesting the proceeds from the sale of the property initially contributed to the trust in tax-exempt securities. If you do so, the IRS is likely to tax the sale directly to you, ignoring the existence of the trust.

The trust generally will be required to pay you annual income based on the value of the trust assets (i.e., at least 5% per year). The type of trust (unitrust or annuity trust) will determine how much income must be distributed annually. The amount distributed generally will be taxable to you to the extent it is paid out of the trust’s current and prior years’ ordinary and capital gains income. Any amounts paid to you out of principal (other than capital gains that are considered part of principal) generally will not be taxable to you.

· Estate and Gift Tax Consequences — The formation of the trust will not be subject to gift tax. In addition, neither your income interest nor the charitable remainder interest will be subject to estate tax at your death, provided the remainder interest is distributed to a qualifying charity (i.e., the property is included in your estate but a charitable deduction is permitted which offsets the value of the included property). The trust agreement could require the trustee to distribute the trust property to your charitable family foundation (see below) if it is in existence and a qualifying charity at the time of your death. If a family foundation does not exist or qualify, the trustee could be required to distribute the trust property to qualifying Section 501(c)(3) charities.

· Charitable Remainder Unitrust (CRUT) — When you establish a charitable remainder unitrust, you transfer cash and/or property to an irrevocable trust but retain (either for yourself or for one or more non-charitable beneficiaries) a variable annuity (payments that can vary in amount, but are a fixed percentage) from that trust. At the end of a specified term, or upon the death of the beneficiary (or beneficiaries, and both you and your spouse can be the beneficiaries), the remainder interest in the property passes to the charity the donor has specified.

The principal difference between a charitable remainder unitrust and a charitable remainder annuity trust is that a unitrust pays a varying annuity. In other words, the amount paid is likely to change each year. The payable amount is based on annual fluctuations in the value of the trust’s property. As it goes up, so does the annuity paid each year. If it drops in value, so will the annuity.

A gift to a charitable remainder unitrust will qualify for income and gift tax charitable deductions (or an estate tax charitable deduction) only if the following conditions are met:

· A fixed percentage (not less than 5% nor more than 50%) of the net fair market value of the assets is paid to one or more non-charitable beneficiaries who are living when the unitrust is established.

· The charity’s actuarial interest must be at least 10% of any assets transferred to the trust.

· The unitrust assets must be revalued each year, and the fixed percentage amount must be paid at least once a year for the term of the trust, which must be a fixed period of 20 years or less, or must be until the death of the noncharitable beneficiaries (i.e., individuals), all of whom must be living at the beginning of the trust.

· No sum can be paid except the fixed percentage during the term of the trust and at the end of the term of the trust, the entire balance of the trust’s assets must be paid to one or more qualified charities.

The donor receives an immediate income tax deduction for the present value of the remainder interest that will pass to the charity at the end of the term.

Because a charitable remainder unitrust is exempt from federal income tax (the income and gains of the trust are only taxed when they are distributed to the noncharitable beneficiaries as part of the fixed percentage of trust assets distributed each year), they are frequently used to defer income tax on gains about to be realized. For example, if either of you have an appreciated asset that is about to be sold (but for which a letter of intent or binding contract has not yet been received), you can give the asset to a charitable remainder unitrust, reserving the right to received a fixed percentage of the value of the trust for life, and for the life of your spouse as well, and the asset can then be sold by the trust and the proceeds of sale reinvested without payment of any federal income tax on capital gains. The capital gains will be taxable to the donor (or the donor’s spouse) only as they are distributed to the donor as part of the annual distributions from the trust.

A variation of the CRUT (which pays a fixed percentage of the value of the trust assets, regardless of income) is the net-income-with-makeup CRUT, or “NIMCRUT,” which pays either the fixed percentage or the income actually received by the trust, whichever is less. However, if the income is less than the fixed percentage, the deficiency can be paid in a future year, as soon as the trust has income, which exceeds the fixed percentage. An additional variation is a “flip” unitrust, which is a trust that changes from a NIMCRUT to a regular CRUT upon the occurrence of a specific event, such as the sale of a specific asset that was contributed to the trust and was not expected to produce much income. However, both NIMCRUTs and “flip” CRUTs are valued in the same way as a regular CRUT for the purpose of determining the income, estate, and gift tax charitable deduction.

In sum, the CRT is an excellent estate planning tool to minimize taxes and provide for charitable beneficiaries.