Using Trusts for Year-End Charitable Planning
With the holidays quickly approaching, gifts are on the top of people’s minds. With the end of the year rapidly following, holiday gifts are not the only gifts people are concerned with. With the possible reduction of future income tax rates, the acceleration of income tax benefits for charitable deductions before year-end is on people’s minds as well. Philanthropy not only gives you great personal satisfaction, but it can also give you a current income tax deduction, let you avoid capital gains tax and reduce the amount of future taxes your estate may owe when you pass away.
There are many ways to give to charity. You can make gifts during your lifetime or at your death. You can make gifts outright or use a trust. You can name a charity as a beneficiary in your will, or designate a charity as a beneficiary of your retirement plan or life insurance policy. Or, if your gift is substantial, you can establish a private foundation or donor-advised fund.
One option for your charitable planning is to create a charitable trust. You can name the charity as the sole beneficiary, or you can name a non-charitable beneficiary as well, splitting the beneficial interest (this is referred to as making a partial charitable gift). The most common types of trusts used to make partial gifts to charity are the charitable lead trust and the charitable remainder trust. The recipient of the income interest of a charitable lead trust or the remainder interest of a charitable remainder trust can be a private foundation or donor-advised fund.
Charitable Lead Trust
A charitable lead trust (CLT) pays income to a charity for a certain period of years, and then the trust principal passes back to you, your family members, or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest. A charitable lead trust can be an excellent gift and estate planning vehicle if you own assets that you expect will substantially appreciate in value. If created properly, a charitable lead trust allows you to keep an asset in the family and still enjoy some tax benefits. A charitable lead trust can be funded during lifetime or at one’s death.
Generally, there are two types of charitable lead trust’s for income tax purposes, either grantor or non-grantor trusts:
Grantor Lead Trust
With this type of charitable lead trust, the donor is considered the owner of the trust assets. All trust income and expenses pass through to the donor on the donor’s personal income tax return, and the donor can take an immediate income tax deduction for the value of the income stream that passes to the charity (subject to income limitations). Although the grantor receives an up-front income tax deduction, the grantor recognizes the income earned by the trust during the trust’s term. When established during an individual’s lifetime, minimizing income taxes is the primary motive for creating a grantor lead trust.
Non-Grantor Lead Trust
This type of charitable lead trust is treated as a separate tax-paying entity subject to the income tax rules associated with trusts. All income and expenses are reported on a separate, fiduciary income tax return–they do not flow through the donor, and no income tax deduction is allowed to the donor, although the trust itself can deduct its annual payments to the charity. A non-grantor lead trust can be either established during lifetime or at death.
If a charitable lead trust’s remainder interest does not go back to the donor or the donor’s spouse but passes to other non-charitable beneficiaries, there will be gift or estate tax consequences:
If the remainder interest passes to other non-charitable beneficiaries during the donor’s life, the transfer will be subject to gift tax, but the net present value of the gift can be reduced (discounted) by the value of the income stream granted to the charity. Because the transfer is a gift, the non-charitable beneficiaries will receive a carryover basis in the trust assets.
If the remainder interest passes to the other non-charitable beneficiaries after the donor’s death, the transfer may be subject to estate tax, but at the date of the transfer value. Any appreciation in the trust assets value will be entirely estate tax-free. And, if there are payments still owed to the charity at the donor’s death, the donor’s estate can deduct the net present value of those payments. If the transfer is subject to estate tax, the non-charitable beneficiaries will receive trust assets with a step-up in basis as of the donor’s date of death.
Charitable Remainder Trust
A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to you, your family members, or other heirs for a period of years, then the principal goes to your favorite charity. Tax savings are generated because taxpayers receive income, gift, and estate tax deductions for the value of their donations, and can defer or avoid capital gains tax when appreciated assets are donated.
A charitable remainder trust can be beneficial because it provides you with a stream of current income — a desirable feature if there won’t be enough income from other sources.
A charitable remainder trust is an irrevocable trust used to enable donors to give money or property to charities, while continuing to receive income (fixed or variable) from the property for life or for a period of time up to 20 years. The donor, and/or other beneficiaries (the income beneficiaries) receive distributions from the trust annually, and the charities (the remainder beneficiaries) receive the assets remaining in the trust when the trust ends. The donor gets an immediate income tax deduction for the remainder interest (subject to the usual limitations), defers or avoids capital gains tax on the donated assets, and gets gift or estate tax deductions for the remainder interest.
Generally, distributions from a charitable remainder trust are taxable to the recipient under a tiered system. If the trust payout is from earned income (e.g., interest dividends, rents), the payout is classified as ordinary income. If the trust payout is from the principal, the income is classified as a distribution of long-term capital gain first, then tax-exempt income (e.g., municipal bond interest), then return of principal (tax-free, of course).
Generally, contributions to qualified charities are tax-deductible for taxpayers who itemize. The amount of the tax deduction for a transfer to a charitable remainder trust is usually the present fair market value of the remainder interest to charity, subject to certain IRS limitations (50% of adjusted gross income for gifts of cash, 30% of adjusted gross income for gifts of appreciated stock or real estate) per year. Deductions are available for the tax years in which contributions are made, and any unused portions can be carried over to the next five tax years.
Gift and estate taxes will apply on payouts from charitable remainder trusts to income beneficiaries who are not grantors or their spouses.
Private Family Foundation
A private family foundation is a separate legal entity that can endure for many generations after your death. You create the foundation, then transfer assets to the foundation, which in turn makes grants to public charities. You and your descendants have complete control over which charities receive grants. But, unless you can contribute enough capital to generate funds for grants, the costs and complexities of a private foundation may not be economical.
Similar in some respects to a private foundation, a donor-advised fund offers an easier way for you to make a significant gift to charity over a long period of time. A donor-advised fund actually refers to an account that is held within a charitable organization. The charitable organization is a separate legal entity, but your account is not — it is merely a component of the charitable organization that holds the account. Once you transfer assets to the account, the charitable organization becomes the legal owner of the assets and has ultimate control over them. You can only advise — not direct — the charitable organization on how your contributions will be distributed to other charities.
As addressed, there are many benefits to year end charitable planning.For more information on which trust is best for you, please feel free to contact your Withum Tax Advisors by filling out the form below.
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