Charitable Trusts
A charitable trust lets you support a cause you care about while providing for your family and reducing income, capital gains, and estate taxes. There are two main forms, and which suits you depends on whether you want the income now or the charity to have it first.
Charitable remainder trusts
What is a charitable remainder trust?
A charitable remainder trust is an irrevocable trust that you fund with assets or cash. It pays income to you, or to another beneficiary, for your lifetime or a set period. Whatever remains then goes to the charity of your choice.
People create them to reduce income tax, avoid capital gains tax, avoid estate tax, and make a gift to a charity they care about.
How does it work?
A charitable remainder trust works best with an appreciated asset, because it avoids capital gains tax.
You fund the trust with the appreciated asset — stock or real estate, for example. The trust sells it at market value without paying capital gains tax, and reinvests the proceeds into income-producing assets. You receive income from the trust for life or for a set term. On your death, the remainder passes to the charity.
Once the asset is in the trust it is no longer part of your estate, so it is not subject to estate tax. This is in contrast to a revocable living trust, whose assets are included in your estate.
Won't the gift deprive my heirs of their inheritance?
The charity does receive whatever remains. But there is a straightforward way to replace that value, using the tax savings the trust generates.
Take the income tax savings, add part of the income you receive from the trust, and use it to fund an irrevocable life insurance trust with enough cover to replace the full value of the asset for your children or other beneficiaries.
Why a life insurance trust rather than a policy held outright? Because proceeds held in the trust are not included in your estate, and so are not subject to estate tax.
What are my income options?
Two.
You can receive a fixed percentage of the trust assets each year — a charitable remainder unitrust. Your income then fluctuates with the value of the trust. If the assets dip in a given year, so does your income. The trust is revalued at the start of each year. These trusts often include a provision allowing a higher percentage in a good year to make up for a poor one.
Because assets in a charitable remainder trust grow tax free, there is real potential for the trust to increase in value — and your income with it.
Or you can receive a fixed income each year — a charitable remainder annuity trust. Your income stays the same regardless of how the assets perform.
A fixed income can suit older donors. It offers no protection against inflation, but some people place a higher value on a predictable sum. An annuity trust should be funded with cash or readily marketable assets.
For both types, the IRS requires the payout rate to fall between 5% and 50% of the initial fair market value of the trust's assets.
Who can receive the income?
Most commonly you receive it yourself, but you may name any person or entity — your children for their lifetimes, for instance.
If you name someone other than yourself, there are gift tax and estate tax consequences to consider first.
How long does the income continue?
For the beneficiary's lifetime, or for a set number of years up to twenty. If you are married, the income can continue for as long as either of you is living.
What are the tax advantages?
Three.
An income tax deduction. Once the trust is established you may take a deduction based on the value of your gift, spread over five years. The IRS calculates it as the amount given minus what you can expect to receive back through income payments. If you funded the trust with $200,000 and expect $100,000 in income over your lifetime, the deduction would be $100,000.
Estate tax savings. The property in the trust belongs to the charity, so it is not included in your estate. This differs from simply naming a charity as a beneficiary of your living trust, where the bequest is still counted as part of your estate.
Capital gains tax savings. A charitable trust pays no capital gains tax on the sale of an asset. Suppose you hold 5,000 shares that have appreciated from $10 to $100 each — a gain of $450,000. Selling them yourself means paying capital gains tax on that appreciation.
Contributed to a charitable remainder trust, the trust may sell them with no capital gains tax at all.
How is the income tax deduction calculated?
By an IRS formula accounting for the ages of the donors and income beneficiaries, the trust's payout rate, and an index rate known as the Applicable Federal Rate. The older you are, the larger the deduction. A trust for a term of years rather than for life generally produces a larger deduction.
Charitable lead trusts
What is a charitable lead trust?
Like a charitable remainder trust, a charitable lead trust is an irrevocable trust funded with assets or cash.
The difference is the order. A charitable lead trust pays income to a charity — not to you — for a set number of years. The remainder then goes to your heirs.
People create them to reduce income tax, shelter the assets' appreciation from estate tax, and support a charity they care about.
Why do interest rates matter?
The IRS sets the rate at which assets are expected to grow inside the trust. This is known as the "hurdle" rate, because any growth beyond it can generally pass to your heirs tax free.
The rate is adjusted monthly but locks in for the life of the trust. So from the heirs' perspective, a period of low interest rates is a good time to establish a charitable lead trust.
Which one is right for me?
It depends on whether you need income from the asset now.
A charitable remainder trust pays you first and the charity last. It suits someone holding a highly appreciated asset who wants income, wants to avoid capital gains tax on a sale, and is content for the charity to receive what remains.
A charitable lead trust pays the charity first and your heirs last. It suits someone who doesn't need the income and wants to pass appreciation to their heirs with reduced estate tax.
Both are irrevocable, both involve significant tax analysis, and neither should be entered into without advice specific to your circumstances.
We offer a free initial consultation.
Call 707.636.4611.