Tax Incentives for a Charitable Remainder Trust

In addition to providing a benefit to your favorite charity, it can also provide tax benefits to you (the grantor) as a charitable deduction, and income to you and/or your heirs. Structured properly, this income can avoid the gift tax. It is a multi-purpose estate planning tool.

When planning for a charitable trust, your estate planning attorney will take into consideration your life expectancy, market forces, income streams, current income, and the expected longevity of a particular charity over a term of years.

Charitable trusts can be funded with several different types of assets. Real estate and life insurance are both popular options. Keep in mind that charitable trusts are irrevocable trusts. That means that once you start the trust and it comes into operation, you cannot take back what you have given as trust assets.

How a Charitable Remainder Trust Works

A charitable remainder trust is the most common type of charitable trust. To set up a charitable remainder trust, you must first set up a trust and transfer into it all the property that you want to donate to charity. The charity that you choose must be approved by the Internal Revenue Service under the Internal Revenue code. The charity must be exempt from taxes.

The charity will serve as the trustee of the charitable remainder trust and will be charged with the duty of investing, protecting, and managing the trust funds.

The charity will pay you, or someone you have named, a portion of the income that the trust fund earns. These payments will last for a set number of years, or for the remainder of your life, depending on the terms of the trust. The trust will end at the time of your death and the appreciated assets held in the trust will go to the charity.

Another option is a split-interest trust. The charitable trust provides a payout to a non-charitable beneficiary, like a family member of the donor, and the remainder beneficiary is the charity.

Three Tax Advantages for a Charitable Trust

In addition to assisting the charity of choice, a charitable remainder trust (CRT) provides three primary tax benefits.

1. Taxpayers are allowed to take a charitable income tax deduction spread over five years. This is not a dollar-for-dollar tax deduction. The IRS calculates the allowable deduction as the fair market value of the assets placed in the trust, minus the income beneficiaries expect to receive as a payout over their lifetime. For example, if you gave $200,000 but expect to get back $100,000 in interest over the course of your life, your total tax deduction would be $100,000.
2. Because the property that you gave to the trust will go to the charity outright upon your death, the property is excluded from your estate for the purposes of determining your estate tax.
3. A charitable trust allows you to turn assets that aren't producing income into cash without paying capital gains tax on any profits.

For example, Lee held 5,000 shares of stock that had appreciated in value from $10/share to $100/share. That is an increase of $450,000. If Lee sold his shares, he would pay capital gains tax on $450,000. If Lee donates the stock to a charitable trust, the trust can sell the stock and not pay a tax.

The charity can then take the cash they received from the sale to invest in a mutual fund. The interest income they make from that investment allows them to pay Lee a distribution each year for the rest of his life.

Two Types of Income from a Charitable Trust

When you first set up a charitable trust, you will have a choice between two different ways of receiving an income from the trust fund.

Charitable Remainder Annuity Trust (CRAT)

Under this option, you receive a fixed dollar amount from the trust each year. No matter how interest rates rose or fell, or how much the trust made or lost in a year, you still receive the same amount. Once you set up how much you want the trust to pay you yearly, it cannot be changed.

How do you determine how much the fixed annuity payments should be? You will need a trust attorney to help set up a trust and they can advise you.

• If you set it too low, you will never receive the full benefit of setting up a charitable trust, although your income tax deduction will be greater.
• If you set the annuity too high, you may end up depleting the principal of the trust, thus leaving the charity with nothing at your death. Also, when annuity distributions are too high, your income tax deduction is lessened.
• Also, a charity is less likely to agree to be the trustee of a trust where annuity payments are too high because it may end up with nothing at the termination of the trust. All of the principal and income interest has been paid out in annuity payments.

Charitable Remainder Unitrust (CRUT)

A more common option is to set your payout rate as a percentage of the current value of the trust fund. This is called a "charitable remainder unitrust." You will receive the same percentage of the value of the trust each year. (The IRS has ruled that a trust beneficiary must receive at least 5% of the value of the trust each year.) At the end of every year, the trust will be re-appraised to find its current value and will pay 5% of that value to Tony.

This payment option is better suited to handle changing market conditions such as inflation. If the value of the dollar increases, your annual payments will reflect this change by also increasing.

Example of a Charitable Remainder Unitrust

Suppose Rex is trying to figure out what to do with a bunch of stock he bought 10 years ago for $200,000. The stock is currently worth $4 million, but the dividends are small. One option for Rex would be to sell the stock and invest in something that would pay more interest. However, if Rex sold, he would owe $570,000 in capital gains tax.

Another option Rex has is to set up a charitable trust with his favorite museum. He would donate the stock to the trust which would be able to sell the stock for a $3.8 million profit because of its tax-exempt status. The charity would be in charge of investing and managing the $3.8 million.

Rex would be able to claim an income tax deduction, spread over a period of five years, for his charitable donation.

In addition, the trust document that Rex drew up requires the trust to pay Rex 7% of the value of the trust annually for the remainder of Rex's life. During the first year, the trust is in operation, Rex would receive $266,000. This amount will most likely change depending upon how well the trust succeeds in investing and managing the money. If the trust does well, Rex will receive more each year.

Learn More About Charitable Remainder Trusts. Contact an Attorney.

If you're interested in starting a charitable remainder trust, talk to someone familiar with the tax code. It's in your best interest to contact a qualified tax attorney who can help ensure that your trust is tailored to your particular needs.