This month’s article delves into the basics of Charitable Trust strategies. In future months, we’ll add in some of the bells and whistles that can add flexibility to these strategies. Let’s start with the difference between Charitable Lead Trusts and Charitable Remainder Trusts. In general, Remainder Trusts are more frequently used than Lead Trusts. You see that we still have a lot of “maybes” in our little chart because those answers depend on exactly how your particular trust is structured. The basic difference between the Lead Trust and the Remainder Trust is when the charity will receive the gift. Generally, the tax treatment – whether you are seeking Income Tax advantages or Transfer Tax advantages – differs for Lead Trusts and Remainder Trusts. As we saw last month, these are known as “split gifts” in that there are payouts to the charity as well as to one or more non-charitable recipients. There are strict IRS regulations as to how Charitable Trusts must be designed in order to be recognized as a valid instrument by the IRS – and provide to the donor those tax advantages (s)he is seeking.
With a Charitable Lead Trust, the charity receives income from the trust initially during the term of the trust and then, at the end of the trust term, whatever is left in the trust pays out to non-charitable recipients – often to the donor’s family. Typically, although not always, the Lead Trust strategy is used to pass along assets to future generations with a savings on transfer (estate) taxes. There is a complex IRS formula (imagine that – a complex IRS formula) that determines if the trust is recognized as a valid Charitable Trust and how much tax savings a donor may receive. Some variables that go into this calculation are the regular income being paid out to the charity during the trust term and the length of time the charity will be receiving that income before the trust ultimately pays out. It is possible, with a properly structured Lead Trust, to “zero-out” the transfer tax liability for the donor’s family. Be sure to consult competent, licensed tax and legal counsel when designing a strategy that best meets your needs.
With a Charitable Remainder Trust, the income recipient and ultimate beneficiary are opposite than with the Lead Trust. For a basic Remainder Trust, during the term of the trust, an income stream pays out to a non-charitable income recipient (frequently the donor) and at the end of the trust term, the remainder of the trust assets pay out to the charitable beneficiary. There are nuances that can be built into a trust document, but here we are discussing the most basic sort of trust strategies. There is a complex IRS formula (there’s that complex IRS formula again) that must be calculated at the beginning of the trust to determine whether what you are designing will be recognized as a valid Charitable Remainder Trust by the IRS and to determine how much income tax charitable deduction could be available to the donor at the time that the gift is made into the trust. Oddly enough, the IRS is looking out for the charity here; some key variables that go into that calculation are “How much is going to be coming out of this trust annually before the charity ever sees theirs?” and “For how long is this trust going to be paying out before the charity ever sees theirs?” While it’s possible to design a valid trust with a higher payout annually back to the donor or other income recipient, that could negatively impact the available income tax charitable deduction. With the Remainder Trust, it may also be possible to recognize an Estate Tax Charitable Deduction upon the death of the donor that may reduce the amount of transfer tax owed at that time.
Either the Charitable Lead Trust or the Charitable Remainder Trust could be designed as an “Annuity” trust or as a “Unitrust.” That’s where that alphabet soup of CLUTs and CLATs and CRUTs and CRATs comes in. These terms refer to how the income payout is calculated. With an Annuity trust, the specific dollar amount that will be paid out annually is determined right up front when the trust is established. Based on the value of the trust and the percentage amount payable annually that is defined in the trust document, the trustee calculates the set dollar payment that will be paid each year. Because this calculation is done right up front, an Annuity Trust cannot receive additional gifts in the future.
With a Unitrust, the document defines the percentage payout that will be paid as income each year, however rather than doing that calculation right up front when the trust is established, the trustee does a new calculation at the beginning of each year, based on the then-current value of the trust. This adds in the flexibility to make future gifts to the trust. With a well-designed trust that incorporates a reasonable payout amount and a prudently managed trust portfolio (and cooperative investment market) it is possible that the value of the trust could increase from year to year. Under this circumstance, when that income calculation is done at the beginning of each year, there could be an increase in the payment that will be made. Obviously, if the trust is designed with a high payout percentage or due to market conditions – or less prudent investment management – it is also possible that the value of the trust could decrease in some years. Therefore, when the income calculation is done at the beginning of the year, the income recipient could be getting a smaller amount. A Unitrust does allow for additional gifts in the future which could offer availability of additional income tax charitable deductions.
Charitable Trusts are complex split-interest gifts that could be designed to meet a number of different charitable giving and estate planning needs. Because of the complexity of these strategies, it is essential that donors work closely with competent, licensed legal and tax counsel who are well-versed in working in this specific area of Planned Giving. As these trusts have features requiring in-depth understanding of trust law as well as the tax implications of specific investment strategies for the trust portfolio, entrusting their administration to professional trust services is highly recommended. In next month’s article, we will look more closely at Charitable Remainder Trusts and discuss considerations for and impact of some of the variables that can be added into them.
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Bonnie Lane, Verde Volunteer
Member, Board of Directors
NAZCCA is not licensed to give legal or tax advice and any planned giving strategies you choose to pursue should be discussed with licensed tax and legal counsel