Charitable Giving

Is charitable giving an important part of your family’s financial life— something that brings you closer through shared values and a common purpose? Do you budget for philanthropy on an annual basis? While there’s nothing wrong with outright gifts (even when large), there may be situations where you’d like to provide for charities but need to retain an income stream from the gifted asset for a period of years to meet other goals. You may also have large, highly appreciated assets for which you’d like to reduce potential capital gains and estate-tax exposure.

One commonly used strategy designed to give structure to your family’s lifetime giving inclinations while delivering valuable tax benefits is through the use of a charitable remainder trust (CRT).

There are two varieties of CRTs—a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). To qualify for beneficial tax treatment, the trustee of a CRAT must pay a fixed-dollar amount at least annually to one or more people for a period no more than 20 years (or for the life or lives of those noncharitable beneficiaries). The amount payable annually to the noncharitable beneficiaries must be at least 5% but not more than 50% of the initial fair market value of the trust property. And to be tax deductible, there must be less than a 5% probability that the income beneficiary of the annuity trust will exhaust the trust principal. At the end of the trust term, the remaining trust assets then pass to the designated charitable beneficiary or beneficiaries. No additional contributions are allowed once the CRAT has been established.

The IRS also permits a net income with makeup charitable remainder unitrust (NIMCRUT). A NIMCRUT allows distributions to be made only up to the amount of net income the trust earns, with any shortfall made up in years where the trust’s net income exceeds the stated percentage. The same structure with no makeup provision is also acceptable. This is called a net income only charitable remainder unitrust (NIOCRUT).

While both CRATs and CRUTs allow for a wide range of annual noncharitable beneficiary distributions (5% to 50%), the value of the income-tax deduction for the remainder interest to charity must equal at least 10% of the initial value of the trust. Often, this prevents high payouts to noncharitable beneficiaries. See FAQ No.3 for how the income-tax deduction is determined.

3. How are charitable deductions determined on CRATs and CRUTs?

The donor of a lifetime CRT is entitled to an income-tax deduction for the remainder interest that will ultimately pass to charity. The deduction is calculated based on several factors, including:

• Type of trust – annuity or unitrust
• Trust term – how long will payments be made to noncharitable beneficiaries (life expectancy or fixed number of years)
• When payments begin to noncharitable beneficiaries
• Discount factor – IRS tables

The interest rate used in the discount factor for a CRT is equal to 120% of the applicable federal midterm rate (AFR), commonly referred to as the §7520 rate. The AFR is equal to the yield on federal midterm securities (defined as more than three years, but not more than nine years in duration) and is published monthly by the U.S. Treasury. A donor to a CRT can elect to use the rate in the current month or from either of the two months preceding the transfer. But the calculated remainder interest-income tax deduction must equal at least 10% of the value initially transferred to the trust.

Your current deduction will also depend on the type of property gifted, as well as the type of charity named. Gifts of appreciated property to public charities are limited to 30% of your adjusted gross income in any one year. Any deductions not used in the year the CRT is established can be carried forward for up to five years.

4. How are CRT beneficiaries taxed?

Income received by the CRT beneficiaries is taxed under a tiered system as follows:

First Tier – Ordinary income by two tax-rate classes:

• Gross income that’s not a qualified dividend or capital gains (interest, nonqualified dividends from pass-through entities such as money market funds, REITS and S-corporations, rents, royalties, and annuity payments)
• Qualified dividend income (domestic or qualified foreign corporations)

Second Tier – Capital gains in the following order: short-term capital gains, gains from collectibles (28% rate), unrecaptured §1250 gains, and other long-term capital gains

Third Tier – Tax-exempt income

Fourth Tier – Trust principal: If you transferred $1 million of stock with a cost basis of $100,000 to a CRT, and the trust sold the stock and invested the proceeds in municipal bonds, the first $900,000 of income received by your income beneficiaries would be considered capital gain income. It’s important to note that, because you’re taxed on the income from the CRT under multiple tiers, the timing of the sale of assets after they are transferred to the trust and how the proceeds are reinvested will determine your after-tax return.

5. What’s the maximum time period that distributions can be payable to noncharitable beneficiaries of a CRT, and how is the payout rate determined?

Payments to the noncharitable beneficiaries can be made for:

• Either a term of years, not to exceed 20 years
• The lifetime of the person or persons designated to receive payments from the trust or
• A combination of the two

The payout rate to the noncharitable beneficiary is set forth in the trust document but must be at least 5% of the initial value of the property transferred to the trust and cannot exceed 50%.

6. What are the estate tax implications of a CRT?

When you die, 100% of the trust will be included in your estate. But the estate is entitled to a deduction for the remainder interest passing to charity. So, if you’re both the donor and the only income beneficiary, 100% of the value of the trust would be deductible as a charitable deduction for estate-tax purposes. Unlike income-tax rules that have limits on the size of charitable deductions as measured by adjusted gross income, there are no such limits on charitable deductions for estate-tax purposes.

Because property transferred to a CRT is irrevocable and passes to charity at the expiration of the trust term, this can result in a “lost inheritance” for your family. Often, this is remedied using life insurance held in an irrevocable life insurance trust (ILIT) for their benefit (wealth replacement trust). If purchased, owned, and payable directly to your children or an ILIT, the insurance proceeds would neither be included in your estate nor subject to transfer taxes at death.