By Cymbre Van Fossen, Senior Vice President, Trust Advisor and Director of Fiduciary Services
Charitable trusts can be an excellent vehicle for doing several things that may be important to you — setting aside present and future funds for a charity while retaining both a current income stream and other economic benefits for you and your family. When you make a transfer into one of these trust types, you may qualify for income, estate, and gift tax charitable deductions.
In this article, I’ll go through the two main types of charitable trusts, the reasons it might make sense to use one or the other depending on your needs and goals, and a few hypothetical scenarios that can help you get a better picture of the nuances of this type of gifting.
The Two Types: Charitable Remainder Trust & Charitable Lead Trust
There are two types of charitable trusts — the charitable remainder trust and the charitable lead trust. Charitable remainder trusts are the most common. Once you have set up a charitable remainder trust, you can fund it by transferring in property that you’d like to ultimately donate to a tax-exempt charity at your death.
When you transfer your closely held stock into a charitable remainder trust, you’re retaining the right to receive payments from the trust for a certain number of years — usually your life span. At the end of the payment period — usually at your death — your assets will pass to the charity you’ve named.
The benefit to you is an immediate tax deduction equal to the charity’s remainder interest in the gift (subject to standard adjusted gross income limits). This also means that the assets in the trust, and the growth on those assets, typically will not be included in your estate. Sometimes a public charity will have to sell the closely held stock and buy marketable securities to provide you with lifetime income. If the charitable trust were to sell the closely held stock, it pays no capital gains tax as it is deemed to be a tax-exempt entity. Therefore, this type of trust is an excellent vehicle for gifts of highly appreciated, closely held securities or real estate. There are two primary types of charitable remainder trusts:
A charitable remainder annuity trust (CRAT), where you’d pay an income stream to a designated beneficiary in the form of an annuity, which is calculated as a fixed percentage of the initial value of the trust’s assets;
A charitable remainder unitrust (CRUT), which ties your annuity to a percentage of the fair market value of the donated assets.
Charitable lead trusts are just the opposite of a charitable remainder trust — well, almost. You still transfer your closely held stock to the trust and the trust will sell those low-basis assets thus avoiding capital gains tax on appreciated assets. However, the charity itself receives regular payments for a certain period, and at the end of the payment period, the trust’s assets either pass back to you, or to your designated beneficiaries. Unlike the charitable remainder trust, there’s typically no income tax deduction, but there might be substantial estate tax savings when you pass away. Similar to the charitable remainder trust, a charitable lead trust can be set up as a charitable lead annuity trust (CLAT) or a charitable lead unitrust (CLUT).
CHARITABLE TRUSTS & CLOSELY HELD BUSINESSES
If you have a closely held business, where shares are only held by a small number of stockholders and shares of stock are generally not traded on the public market, using a charitable trust isn’t very common for a few reasons. One is if the business doesn’t pay a dividend on that closely held stock, then the charity will have to foot the bill when it comes to annuity or unitrust interest. And, the charitable organization may not be able to even sell your stock on the open market — there might not be a buyer, and frankly, you probably don’t want a stranger owning your company anyway. Some estate planners use a specific technique, where the charitable trust sells the stock back to the company and invests the money they’ve made in income-producing assets.
Why Use a Charitable Remainder Trust?
The type of charitable trust you choose to set up will largely depend on your income situation. A charitable remainder trust — either type — will give you a substantial, steady income for the rest of your life, will allow you to take an income tax deduction the year you transfer your assets, and will remove those assets from your taxable estate.
Here are an example with some numbers to put it into context:
Let’s say you transfer stock (worth $1 million) from your closely held business to a charitable remainder annuity trust (CRAT). The charity sells the low-basis stock and reinvests it into income-producing assets. You receive a set income payment of $50,000 a year until you pass away, and, based on these numbers, your accountant determines you can take a $425,000 income tax deduction the year you transfer the assets. When you die, the assets in the CRAT won’t be included in your taxable estate. So, in doing this, you’ll receive a good income for the rest of your life, receive a large income tax reduction, and effectively remove all assets from your taxable estate. Of course, keep in mind you then won’t have these assets to leave to your family members or other individual beneficiaries!
In addition, using a charitable remainder unitrust (CRUT) comes with the potential to provide you with an increase in income over your income interest period. With a CRUT, the income interest is based on a percentage of the assets, and the assets have to be revalued each year. If the assets increase over time, your income will increase over that same period — although, it’s important to note that if the assets decrease in value, so will your income. This is different from the CRAT scenario above, in which you get a set income from the trust every year which won’t increase or decrease. A CRUT is a good option for someone who wants to maintain a standard of living through a time of inflation, but is confident the assets in your trust will increase in value.
So, let’s put this into context with some numbers as well: Let’s say you transfer your stock (worth $500,000) to a CRUT and retain a 7% unitrust interest. In the first year, the trust pays you $35,000, and that’s taxed as ordinary income. By year three, your assets in the trust have increased to $700,000, and the trust now is paying you $49,000. Same as the CRAT, there will be a substantial income tax reduction for the first year of the trust, and the assets will effectively be removed from your taxable estate.
Why Use a Charitable Lead Trust?
One of the key reasons to use a charitable lead trust is for the dual benefit of making current gifts to a charitable organization while still leaving a large portion of your assets to your heirs and simultaneously reducing your estate and gift taxes. You transfer your stock into the trust, the charity of your choice either retains an annuity or unitrust interest in the trust for a set period of years, and at the end of the term, your assets revert back to you or can be passed to your heir(s). There’s a gift or estate deduction available based on the value of the charity’s interest, which makes it an effective way to pass assets on to the next generation at a reduced tax cost. The key here, however, is that you have to agree with giving up the income from those assets in the meantime.
One more example:
Let’s say you transfer $1 million in stock into a charitable lead trust. The charity of your choice receives a $50,000 annuity payment from the trust over a period of 20 years. At the end of those 20 years, it’s designated that the assets then get passed on to your three children. With the help of your accountant, you determine the present value of the gift is $900,000, with the taxable gift of the remainder interest $100,000. Assuming the trust assets increase in value, you can pass almost the entire amount of those assets to your children and pay very little in gift taxes.
Note that if a sizeable income tax deduction is of more interest than an estate tax deduction, charitable lead trusts can be structured as grantor trusts. A qualified charity gets a regular payment over a period of years, with the remaining assets passing back to the original donor. However, the trust is not deemed to be tax exempt, and the original donor pays the annual income tax. The result is a current income tax charitable deduction equal to the present value of the charitable gift. If the growth in the trust exceeds the payout rate to the charity, the donor may even get back more than was originally donated!
First Business Bank’s Private Wealth team can help you think through these complex scenarios. In partnership with your tax and legal advisors, we will walk through the options with you to design and administer a customized plan that makes the most sense for you, your family, and the charities you care about the most.
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