Charitable Trusts

People create charitable trusts for different reasons. Some people are motivated simply to make a gift to a charitable cause. Others, unmotivated by altruism, create charitable trusts as powerful income producing, tax avoidance devices.  Many people fall somewhere in between these extremes and use charitable trusts to accomplish both goals.

You (donor) create an irrevocable (noncancelable) trust and fund it with assets, typically during your lifetime. You may serve as the trustee and continue to control and manage the assets. You may change the charity that will receive the gift or add additional charities.  In fact, you do not even have to tell the charity that you have made a gift (attractive to those primarily with investment motives).  During the existence of the trust, you or others chosen by you receive income payments for life or a term of years and the remaining assets go to the charity (known as a charitable remainder trust because the charity receives the remainder interest).  Alternatively, the charity receives the income for a term of years and you or others chosen by you receive the remaining assets (known as a charitable lead trust because the charity gets the lead income interest).

Charitable Remainder Trusts (aka, CRATS and CRUTS)

The amount of payment you receive from the trust and the length of time you receive them are chosen by you.  The payments may be a fixed sum certain between 5 and 50 percent of the initial value of the trust assets (known as a charitable remainder annuity trust, aka CRAT) or a fixed percentage between 5 and 50 percent of the value of the assets determined annually (charitable remainder unitrust, aka CRUT).  For example, a CRAT with assets valued at $500,000 which pays 8 percent would pay you $40,000 per year regardless of whether the value of the trust increases or decreases.  An 8% CRUT with a value of  $500,000 would provide the same payments for the first year.  However, if the assets increase in value to say $550,000, the CRUT would pay you 8 percent of the increased value ($44,000) thereby providing a hedge against inflation. 

If the income generated by the trust is not sufficient to make these payments, they are made from trust principal.  This is an important feature for those motivated in part by investment considerations because the trust is akin to a guaranteed, fixed income investment that provides returns commensurate with risk laden investments.  When this feature is combined with the tax benefits (discussed below), you can turn highly appreciated, non-income producing assets into a powerful source of income for you and your family.

The payments may be made to you or others chosen by you for life or a term of years not to exceed 20.  At the end of the period you choose, the remaining assets go to the charity or charities.  The remaining assets may go to the charity earlier in the event that their value declines to 10 percent of their original value.  Those with a strong investment motive will design the trust with the intent to have it make the payments during the entire chosen term and then transfer assets totaling approximately 10 percent of their original value to the charity.  Others will design the trust with lower payments and/or a shorter term in order to transfer more value to the charity. 

Charitable Lead Trusts (aka, CLATS and CLUTS)

These are very similar to the charitable remainder trusts, except that instead of the income going to you and the remaining assets going to a charity, income goes to the charity for a term of years and remaining assets go back to you or others chosen by you when the trust is created.  Like the charitable remainder trusts, charitable lead trusts can provide a sum certain payment (known as a charitable lead annuity trust, aka CLAT) or a percentage of the value of the assets (charitable lead unitrust, aka CLUT). 

Some people use CLATS and CLUTS as a tool to give assets to their children or others at a reduced value for gift tax purposes.  Just as with Qualified Personal Residence Trusts and Grantor Retained Income Trusts, family members do not receive the asset until after a period of time.  Further, during that period, somebody besides the family member receives income generated by the trust assets.  As a result, the gift is worth less to the family member than it would be had the gift been made outright and immediately.  Therefore, the IRS will allow a valuation discount for purposes of gift taxes.      

Tax Benefits of Charitable Trusts

INCOME TAXES.  If highly appreciated assets are transferred to a charitable remainder trust and the trustee (you) sells the assets and reinvests the proceeds, no income tax is owed to the IRS or the state.  For example, if you transfer stock which you paid $100,000 for that is now worth $1,000,000, no income tax will be owed either when the transfer is made to the trust or the trust sells the assets.  This allows the trust to invest 100 percent of the appreciated value of the assets in order to fund your income payments.  If you simply sold the assets and paid federal and state income taxes in the amount of, say, 25 percent, you would only have 75 percent of the assets left to invest.  In addition, the income earned each year by the trust is not subject to immediate income taxes (portions of the payments you receive from the trust may be subject to income tax).

INCOME TAX DEDUCTION.  You will receive an income tax deduction equal to the present value of the remainder interest that will eventually pass to the charity. Or, in the case of a charitable lead trust where the remaining assets will be returned to you after charitable payments cease, the deduction will be in the amount of the present value of the income payments to the charity for the term of years.  The amount of the deduction is determined by referring to mortality and valuation tables created by the IRS and depend on such things as your age, the amount of payments you receive, the length of time payments are made and the applicable IRS interest rate.  The larger the payments you receive or length of time you receive them, the smaller the deduction since the present value of the remaining interest will be worth less to the charity.  In contrast, lower payments, shorter terms or life payments for younger people will result in larger deductions.  Subject to certain limitations, the deduction can be used to offset taxes on income paid to you by the trust or income from other sources.

ESTATE TAXES.  Charitable trusts can be set up so that their assets will not be included in your estate when you pass and will thus avoid estate taxation.  This allows you to enjoy some of the benefits of ownership of the assets (i.e., income payments) while shielding future asset appreciation from estate taxes; A feature referred to as an asset freezing device.

Disadvantage of Charitable Trusts

The most obvious drawback to charitable remainder trusts is that your heirs will not receive the assets you used to fund the trust (the charity will).  Many people create irrevocable life insurance trusts to replace the assets that would have otherwise gone to their children or others.  Instead of the assets, your heirs will receive life insurance benefits equal to the value of the assets.  The premiums required to fund the life insurance trust come from the “increased” income you receive as a result of the creation of the trust.  The increased income results from the fact that: (1) The trust can invest and earn income on 100 percent of the untaxed assets you used to fund it; (2) The trust can sell non-incoming producing assets and invest the proceeds in income producing assets without incurring taxes; (3) You can receive payments from the trust in amounts you choose which could be larger than you would from say, US Treasury bonds, and (4) You will receive an income tax deduction to shield income from the trust or other sources from income tax.