Primer on Charitable Trusts

Charitable trusts, also referred to as life income plans, allow donors to benefit themselves, their beneficiaries and charities simultaneously. They can be structured in a variety of ways to meet the donor’s specific needs and goals. Benefits of charitable trusts may include tax deductions, reduced estate taxes and income provided for beneficiaries, all while supporting causes that matter most to the donor.

As with all structured gifts that offer tax benefits, it is important for donors to consult with an experienced estate planning attorney or financial advisor.

There are two primary types of charitable trusts: charitable remainder trusts and charitable lead trusts. These trust types mirror each other but serve different needs. For both types of trusts, in order to receive charitable deductions, the supported charity must qualify under IRS rules.

Within these two types of trusts are additional categories.

Types of Trusts

Charitable remainder trust (CRT)

  • Charitable remainder annuity trust (CRAT)
  • Charitable remainder unitrust (CRUT)

Charitable lead trust (CLT)

  • Charitable lead annuity trust (CLAT)
  • Charitable lead unitrust (CLUT)

What is a charitable remainder trust?

A charitable remainder trust is an irrevocable legal arrangement between a donor and a charity to provide income to the donor or another beneficiary for a predetermined period of time (not to exceed 20 years), while the remaining assets are distributed to a charity or charities designated by the donor at the end of the term. Because of its irrevocability, charities often see CRTs as “accelerated bequests.”

CRTs are popular because they contain appreciated assets, and when the trust sells, it is tax-exempt. Donors also have the potential to take a partial income tax deduction when the trust is funded and avoid capital gain taxes.

CRTs can be funded with cash, publicly traded securities, some types of closely held stock, real estate and certain other complex assets.

The income portion can be a solution to personal and family challenges in ways such as:

  • Supplementing retirement savings.
  • Paying alimony.
  • Liquidating art collections.
  • Selling businesses.
  • Supporting disabled family members.

How a charitable remainder trust works:

  • A trust is drafted by an appropriate professional advisor based upon the donor’s circumstances and IRS rules and regulations.
  • Assets are transferred to the trust to be managed by the donor or another person or an entity that the donor chooses as trustee.
  • Payments are made from the trust to the donor and/or others named for life or a certain period of years.
  • Donors are entitled to a federal (and perhaps state) income tax charitable deduction and may enjoy capital gains tax savings in the year the trust is created. Amounts used to fund the trust may not be part of the donor’s probate or taxable estate.
  • When the trust ends, its remaining assets become a gift to the charity or charities of the donor’s choosing. The gift portion is known as the charitable remainder.

There are two primary types of charitable remainder trusts: the charitable remainder annuity trust, which provides donors with a consistent, predictable fixed income, and the charitable remainder unitrust, which provides donors with a variable income.

A charitable remainder annuity trust is a way to make a gift while ensuring a fixed, regular income. Income from such a trust can be a reliable income supplement in retirement years. The payments received each year must be at least 5% of the amount originally placed in the trust. The donor determines the exact amount when the trust is created.

Annuity trusts are less common than unitrusts, in part because they are at risk in times of inflation, but primarily because they lack the flexibility and planning options of unitrusts. Falling interest rates (AFRs) also heighten the chances that annuity trusts will fail the 5% probability test or the 10% minimum charitable deduction requirement.

Like the annuity trust, the charitable remainder unitrust provides for a gift that allows a donor to retain income for life or other period of time. Unlike the annuity trust, the income from a unitrust can fluctuate over time with the value of the assets placed in the trust.

The donor determines the annual payment percentage when the gift is made. Each year, this percentage (at least 5%) of the value of the trust assets is paid to the donor or others they name. When the value of the investments increases, more income is received. The income will be less if the value of the assets declines. If provided for in the trust agreement, additions can be made to a unitrust, and an additional tax deduction is allowed for part of any additional amounts contributed.

For those who would like an income that can grow over time, the charitable remainder unitrust can be an attractive option. Another benefit is the fact that no tax is payable by the trust at the time investment gains are realized, making it possible to enjoy increased income over the years based on tax-free growth within the trust. This can be a good choice for those who anticipate increases in growth in investments over time.

Charitable remainder unitrusts can be broken down into further categories:

  • STANCRUT “standard unitrust”
    • Pays a percentage (minimum 5%-maximum 50%) of the value, revalued at least once a year.
    • Payments rise or decline according to investment results.
    • Additional contributions may be made if the trust instrument provides.
  • NICRUT “net-income unitrust”
    • If the portfolio produces $0 net income, then $0 will be distributed to the income beneficiaries that year.
  • NIMCRUT “net-income with makeup unitrust”
    • Provision to “make up” or “catch up” deficiencies from years where payouts are less than the payout percentage stated in the agreement.
    • The trustee can make up to the extent that current income exceeds the specified trust amount.
    • Note: The IRS has approved several trusts where realized capital gains are “income” for purposes of making payments and “makeups” from net income unitrusts.
  • FLIPCRUT “flip unitrust”
    • Unitrusts can “flip” from a net-income trust to a standard unitrust upon the occurrence of a specific date or triggering event. The conversion must occur at the start of the taxable year immediately following the year in which the triggering event occurs.
    • The event must be outside the control of trustees or any other person, such as age change, divorce, death, birth of a child or sale of unmarketable assets (such as real estate). They cannot be triggered by such actions as the sale of marketable assets or a request from a beneficiary to convert to a fixed percentage payout

What is a charitable lead trust?

Conceptually, the charitable lead trust operates in the reverse of a charitable remainder trust. Instead of individuals receiving income for life or a term of years with a nonprofit organization receiving the remainder, the charity receives its gift first, and the donors or others receive the trust assets at the end of the trust term.

Many donors and planners became intrigued with charitable lead trusts after learning about a provision in Jacqueline Kennedy Onassis’ will that would effectively eliminate gift and estate transfer tax on a significant fortune by providing income interests to charity for a number of years.

How a charitable lead trust works

  • The donor arranges for a regular source of charitable gifts that will begin immediately and continue for as long as they decide.
  • The amount of the gifts can be fixed or vary over time.
  • The donor or their advisors can continue to manage the funds in the trust, if desired.
  • Such a gift can serve to reduce or eliminate income, estate and gift taxes now—and in future years as well.
  • The donor may be able to provide younger heirs with a larger inheritance than would otherwise be possible at a time when it is more appropriate that it be received.

With a charitable lead trust, the charity immediately begins to receive gifts in the form of payments from the trust, and the gifts continue for the period of time determined by the donor. At the end of that time, assets remaining in the trust are returned to the donor or other named loved ones.

Gift and estate taxes can be due on amounts over a certain amount given to others during their lifetime or through their estate. Because of the front-end gifts to charity over time from a charitable lead trust, however, donors are allowed to reduce the amounts that would otherwise be taxable by the value of those charitable gifts.

Depending on the amount of the payments, how long they last and other factors, it can be possible to greatly reduce, or even entirely eliminate, gift and estate tax on unlimited amounts ultimately passing to heirs. In addition, at the termination of the trust, the heirs can benefit from any growth in trust assets, free of additional gift and estate taxes, during the time the trust is in existence.

The Nonprofit’s Role

There are organizations, such as some community and denominational foundations, that will administer charitable trusts if you don’t wish to establish your own program.

If your organization does offer charitable trusts, they should be outlined in your gift acceptance policy and communicated along with other giving options.

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