Charitable Trusts Allow You to Be a Benefactor and Take Care of Your Family
Achieve your own financial and tax planning objectives through generosity.
According to a recent survey conducted by the Brookings Institution, donor confidence in the administration and disbursement of funds contributed to charitable organizations has declined as a result of a few high profile scandals. This reaction is regrettable given that individual donors provide more than 80 percent of the funds raised by charitable organizations in the United States and the need for such funds to benefit the victims of natural disasters, to treat and seek cures for virulent diseases and provide basic necessities for less fortunate members of society has never been greater. Fortunately, with proper planning, it is possible to help meet these growing needs and achieve a number of your own financial objectives through the use of charitable trusts.
Charitable Remainder Trusts
A charitable remainder trust (a CRT) is an irrevocable trust that provides for a specified distribution, at least annually, to one or more noncharitable beneficiaries, for a term of not more than 20 years, or for the life or lives of the beneficiaries.
Upon the termination of the interest or interests of the noncharitable beneficiaries, the remainder interest must be held for or paid out to a charitable organization. The distribution to the noncharitable beneficiary or beneficiaries can be paid out in the form of an annuity, in which case the CRT is known as a charitable remainder annuity trust (a CRAT), or in the form of a unitrust, in which case the CRT is known as a charitable remainder unitrust (a CRUT).
Generally, the creation of a CRT allows a grantor to carry out his charitable intentions, while retaining an income interest in the property or providing a stream of income for a chosen beneficiary. An individual who has low basis or substantially appreciated assets can use a CRT to avoid the recognition of gain on such assets. Further, an individual who has undiversified investments can use a CRT to diversify those investments while avoiding the recognition of gain.
Upon the creation and funding of a CRT, the donor is entitled to an income, gift or estate tax charitable deduction equal to the present value of the charitable remainder interest.
The grantor transfers low basis or substantially appreciated assets that lack diversification to a CRT. The grantor typically recognizes no gain or loss on the transfer of those assets to the CRT. Assuming there is no prearranged plan between the grantor and the trustee of the CRT, the trustee can subsequently sell the assets he receives and reinvest the proceeds in alternative investments. Neither the grantor nor the trustee recognize a gain on the subsequent sale of the assets.
For example, assume that in month three the grantor transfers 50,000 shares of ABC Corp. stock with a basis of $500,000 and a fair market value of $5 million to the trustee of a CRT and retains an annuity interest of six percent per year for his life. The grantor had been receiving an average annual dividend of $150,000 per year on the ABC Corp. stock prior to the transfer. In month six, the trustee of the CRT sells the shares of ABC Corp. stock and reinvests in a diversified portfolio of stocks and bonds. Upon the sale of the ABC Corp. stock by the trustee of the CRT, neither the grantor nor the CRT recognize gain. If the grantor had chosen to sell the ABC Corp. stock rather than transfer it to the CRT, he would have had a gain of $4.5 million and would have had only “after-tax” dollars to reinvest. Moreover, where the grantor had an income stream of only $150,000 prior to the transfer of the stock to the CRT, he now has an income stream of $300,000. Finally, the grantor no longer holds the ABC Corp. stock as his primary asset. He now has an interest in a diversified portfolio of stocks and bonds. Thus, he has disposed of the inherent risk involved in owning only one primary investment.
In addition, the grantor would be entitled to a gift tax charitable deduction and an income tax charitable deduction upon creation of the CRT.
Upon the creation and funding of an inter vivos CRT, the grantor is entitled to an income and gift tax charitable deduction equal to the present value of the remainder interest given to the charitable organization. If the income beneficiary is someone other than the grantor, the grantor may be subject to gift tax upon the creation of the income interest.
Upon the creation and funding of a testamentary CRT, the testator’s estate is entitled to an estate tax charitable deduction equal to the present value of the remainder interest given to the charitable organization. Notably, in the case of a testamentary CRT neither the testator nor his estate is entitled to an income tax deduction.
A CRT is generally exempt from income taxation. Thus, a grantor can fund a CRT with appreciated property and the CRT will not recognize gain on the subsequent sale of the appreciated property by the trustee. This allows the grantor to dispose of the property without recognizing any capital gain.
Upon payment by the CRT of the specified distribution, the recipient of the distribution characterizes the distribution for tax purposes under a special regime applicable only to CRTs. In general, distributions are characterized based upon a tier system that provides that the items of income subject to the highest rate of tax are deemed to be distributed first.
The amount paid by a CRUT fluctuates based upon increases and decreases in the fair market value of the trust assets, while the amount paid by a CRAT does not. Thus, as the value of the corpus of a CRT grows, the noncharitable beneficiary will receive a greater amount if the CRT is structured as a CRUT, while the charitable beneficiary will receive a larger remainder interest if the CRT is structured as a CRAT. In contrast, as the value of the corpus of a CRT decreases, the noncharitable beneficiary will receive a lesser amount if the CRT is structured as a CRUT and a stable amount if the CRT is structured as a CRAT.
A CRT is generally a good planning tool only for a client who is charitably inclined. The client should recognize that he (and his family) will lose all rights to the residual interest in the property and will have only an income interest in the property. It is possible, however, for the grantor to invest some or all of the tax savings and/or increased income yield achieved through the creation of a CRT in a life insurance policy on the grantor’s life and effectively replace a significant portion of the funds that his or her family would have received had the trust not been created. Thus, through the use of this planning strategy, the grantor can diversify a concentrated stock position in a tax-efficient manner, provide for his or her family and give something back to society.
Charitable Lead Trusts
A charitable lead trust (a CLT) is an irrevocable trust that provides for an income interest to be paid to one or more charitable organizations for a specified period of time and for the remainder interest to revert to the grantor or to be paid to one or more noncharitable beneficiaries. The distribution to the charitable organization can be paid out in the form of an annuity, in which case the CLT is known as a charitable lead annuity trust (a CLAT), or in the form of a unitrust, in which case the CLT is known as a charitable lead unitrust (a CLUT).
Generally, the creation of a CLT allows a grantor to provide a stream of income for one or more charitable organizations while retaining ultimate ownership of the income-producing property for himself or for his family. In addition, the creation of a CLT may allow a grantor to reduce gift tax and estate tax on assets that appreciate following their contribution to the CLT.
Upon the creation and funding of a CLT, the donor may be entitled to an income, gift or estate tax charitable deduction equal to the present value of the charitable lead interest.
The grantor transfers property that is expected to substantially appreciate in subsequent years to the trustee of a CLT. At the time of the transfer, assuming that the grantor does not retain the remainder interest, the grantor is subject to gift tax only on the value of the remainder interest. This is because the grantor is entitled to a gift tax charitable deduction for the value of the income interest passing to the charitable organization. Notably, the value of the remainder interest for gift tax purposes is determined upon the transfer of assets to the CLT. Thus, any appreciation that occurs after the funding of the CLT is not subject to gift tax or estate tax. Moreover, if the CLT is structured as a CLAT, the amount distributed to the charitable income beneficiary will remain constant throughout the term of the charitable income interest; thus, as the property increases in value over the term of the charitable interest, the value of the remainder interest will also increase.
For example, assume that a grantor transfers property with a fair market value of $5 million to the trustee of a CLAT and provides that the charitable income beneficiary will receive an annuity interest of six percent per year for 10 years. The charitable income beneficiary will receive $300,000 per year, or $3,000,000 total. If the property is worth $15,000,000 at the end of the 10-year charitable term, the grantor has transferred property worth $15,000,000 while being subject to gift tax on a transfer of only approximately $2,000,000. None of the property contributed to the CLT will be included in the grantor’s gross estate at his death.
There are three types of CLTs: an inter vivos non-grantor CLT; a testamentary non-grantor CLT; and an inter vivos grantor CLT. A grantor trust is one in which the grantor is treated as the owner of the trust under special rules set forth by the Internal Revenue Service. The tax consequences for each of these three types of CLTs are discussed below.
Inter Vivos Non-Grantor CLT. Upon the creation and funding of an inter vivos non-grantor CLT, the grantor is entitled to a gift tax charitable deduction equal to the present value of the charitable lead interest; however, he is not entitled to an income tax charitable deduction. Generally, an inter vivos non-grantor CLT allows a grantor to remove an appreciating asset from his estate at a minimal gift tax cost. Further, this type of CLT allows a grantor to circumvent the percentage limitations on charitable deductions. A trust, in contrast to an individual, is not subject to percentage limitations on charitable deductions.
Testamentary Non-Grantor CLT. Upon the creation and funding of a testamentary non-grantor CLT, the donor’s estate is entitled to an estate tax charitable deduction equal to the value of the charitable lead interest. Because the asset(s) passing to the CLT are included in the donor’s gross estate, the assets passing to the CLT receive a stepped-up basis. The primary tax advantage of a testamentary non-grantor CLT is the potential elimination of estate tax on the property used to fund the CLT. If the charitable income interest extends for a significant period of time, it is possible for the estate tax charitable deduction to equal the estate tax value of the transferred property, thus, eliminating the payment of estate tax on the property.
Inter Vivos Grantor CLT. Upon the creation and funding of an inter vivos grantor CLT, the grantor is entitled to an income tax charitable deduction. Notably, this deduction is “recovered” over the term of the charitable interest as the donor is treated as the owner of the CLT and is taxable on all of the income earned by the CLT. Thus, the principal reason for creating an inter vivos grantor CLT is to obtain an immediate income tax deduction.
A CLT that is not a grantor trust is taxable in accordance with the rules applicable to complex trusts. Thus, during the term of the charitable income interest, any income that is earned by the CLT that is not required to be distributed to the designated charitable organization, will be taxed to the CLT.
The amount paid by a CLUT fluctuates based upon increases and decreases in the fair market value of the assets of the CLUT, while the amount paid by a CLAT does not. Thus, as a general rule, if the assets contributed to a CLT are expected to increase in value, it is best to structure the CLT as a CLAT. This is because as the value of the assets increases, the income produced by those assets is likely to increase and, thus, there will be more left in the CLT for the ultimate noncharitable beneficiaries. In contrast, if the assets contributed to the CLT are expected to decrease in value, it is best to structure the CLT as a CLUT. The foregoing assumes that the donor or grantor intends to maximize the assets passing to the remainder beneficiaries.
For the charitably inclined, CRTs and CLTs provide a unique opportunity to give something back to the society from which they have benefited and, at the same time, achieve one or more of their estate and financial planning objectives.