Charitable Trust Planning: How And Why To Set One Up

A charitable trust can be a great way to support your favorite charitable organization while taking advantage of the tax benefits that a charitable trust can offer. A lot of people think that in order to set up a charitable trust you have to plan on giving a significant amount to one or more charities. In reality, it is the tax benefits that are often the driving factor in deciding to establish a charitable trust, and the charitable gift can actually be fairly minimal.

To understand charitable trusts, it is helpful to have an understanding of how trusts work in general. A trust is essentially just separating the legal ownership of an asset from the beneficial enjoyment of the asset. There are three main participants in any trust: the grantor, trustee, and beneficiary. The grantor establishes and contributes the assets to the trust. The trustee has legal ownership of the trust assets and a fiduciary duty to act in the best interest of the beneficiary. The beneficiary benefits from the trust assets but does not have the ability to control these assets. In some trusts the same individual may serve in more than one of these roles.

Charitable trusts are what are referred to as split interest trusts because the beneficial interest is split between a charitable beneficiary and one or more individual beneficiaries. There are two basic types of charitable trusts: a charitable remainder trust (CRT) and a charitable lead trust (CLT). A CRT provides a payment stream to an individual beneficiary for a specific term which can be a fixed number of years or can be for the individual beneficiary’s lifetime. CRTs are often set up with the grantor as the income beneficiary. At the end of the payment term, the remaining assets pass to the charitable beneficiary. A CLT is the opposite of a CRT and provides a payment stream to a charitable beneficiary for a specific number of years. At the end of the payment term, the remaining assets pass to one or more individual beneficiaries. CLTs can be set up with the grantor as the remainder beneficiary, but generally the beneficiary is someone else such as the grantor’s children or grandchildren.

The grantor can choose to pay the tax on the income generated by the trust assets (referred to as a grantor trust) or the trust itself can be responsible for these taxes. A trust must be treated as a grantor trust in order for the grantor to take a charitable income tax deduction on a portion of the assets contributed to the trust. The charitable deduction for a CLT is equal to the present value of the payments to the charity determined based on an expected rate of return published by the IRS each month known as the Section 7520 rate. Similarly, the income tax deduction for a CRT is equal to the present value of the charity’s remainder interest determined based on the same Section 7520 rate. Note that a higher Section 7520 rate provides a greater charitable deduction because it assumes the assets in the charitable trust will have a higher return and more will ultimately go to the charity.

CRTs and CLTs can also be structured so that the payment stream to the income beneficiary is a fixed dollar amount (referred to as an annuity trust), or a fixed percentage of the trust assets as of a specific date (referred to as a unitrust). Whether a charitable trust is structured as an annuity trust or unitrust is determined based on the goals of the grantor and whether the actual rate of return on the trust assets is anticipated to exceed the Section 7520 rate.

When Should You Consider A Charitable Remainder Trust (CRT)?

CRTs are often used in connection with the sale of an asset to avoid immediately having to recognize capital gains taxes. CRTs are generally structured as grantor trusts. The benefit of this structure is that the CRT itself is not subject to tax, so the trustee can sell the asset contributed by the grantor and the proceeds can be reinvested in a diversified portfolio within the trust. The capital gains tax is spread out and paid by the individual beneficiaries as they receive payments from the CRT during the payment term. In addition, the grantor receives a charitable deduction equal to the present value of the anticipated remainder interest that will pass to charity.

CRTs are often funded with low basis assets that the grantor would like to sell. This may be in connection with the anticipated sale of a closely held business or the desire to diversify a concentrated position. The CRT can sell these assets without paying tax and invest the proceeds from the sale in a diversified portfolio that aligns with the grantor’s goals without forcing the grantor to recognize tax immediately upon the sale.

As previously mentioned, the amount that must go to one or more charities can be fairly minimal. For a CRT, the remainder going to charity must be at least 10% of the initial net fair market value of the assets contributed to the trust. The IRS also requires that at least 5%, and generally no more than 50%, of the value of the trust be paid out to the income beneficiaries each year during the payment term. This means that most of the amount contributed to a CRT can ultimately come back to the grantor or the grantor’s designated beneficiaries while allowing the grantor to take advantage of the tax deferral benefits the CRT can offer.

When Should You Consider A Charitable Lead Trust (CLT)?

Like CRTs, CLTs can also be used to defer the recognition of capital gains tax but are more commonly used in connection with estate planning. An individual’s estate is subject to what is essentially a 40% federal estate tax on the value that exceeds the lifetime exemption. For 2023, the lifetime exemption is almost $12.92 million per person, or nearly $26 million for a married couple. For wealthy couples, a CLT can allow assets to be transferred without having to use their lifetime exemption. Because this strategy is typically used as an estate planning strategy, the trust is typically set up to pay the tax on any income generated by the trust assets. The grantor does not receive a charitable deduction, but the assets are removed from the grantor taxable estate which is the primary goal.

The charitable gift portion of a CLT is equal to the present value of the payments to the charitable beneficiary based on the Section 7520 rate. A charitable lead annuity trust (CLAT) can be structured so that the charity is expected to receive all the assets of the trust as part of the payment stream with nothing remaining for the individual beneficiaries. This is called a “zeroed out” CLAT and the present value of the payment stream going to the charity is deemed to be equal to the entire initial fair market value of the property contributed. If the trust can generate a rate of return on the assets in excess of the Section 7520 rate, then there will be assets remaining in the trust at the end of the charitable term which would pass to the individual beneficiaries free of estate tax. This strategy is typically used when the grantor anticipates that the rate of return on the trust assets will exceed the Section 7520 rate so that there will be assets remaining for the individual beneficiaries.

Conclusion

In the end, charitable trusts can offer significant tax benefits while allowing you the opportunity to support a charitable organization that you care about. If you are considering the sale of an asset, then a charitable trust could potentially be a good way to defer the income tax liability. A charitable trust may also be a great way to reduce both income tax and estate tax as part of your estate planning. As always, it is important to discuss these strategies with your advisors, estate planning attorney, as well as your CPA.