Sharpe Advisor Resources
The following information and references to other resources may be beneficial to you and those who assist you in your estate and financial planning.
Charitable Remainder Trusts
There are two basic types of charitable remainder trusts: the annuity trust and the unitrust. (See IRC section 664 for definitions.) Both must qualify as valid trusts under applicable local law, and both must meet other specific requirements. Income may be paid to the donor annually, quarterly or at other intervals.
Annuity trusts: A charitable remainder annuity trust pays out each year a fixed dollar amount of at least 5% and not more than 50% of the initial fair market value of trust assets. The annuity payments are paid first out of income and then, to the extent necessary, out of principal. Trust income in excess of the required annuity payout must be accumulated and added to the principal or distributed to a qualified charity. See IRC section 664(d)(1).
Annuity trusts, but not unitrusts, are subject to a 5% probability test. Under Rev. Rul. 77-374, no deduction is allowed if the probability exceeds 5% that a noncharitable beneficiary of the trust will survive to the exhaustion of the trust corpus. The probability test limits the availability of annuity trusts during periods of low interest rates or where multiple income beneficiaries are involved. Rev. Proc. 2016-42 addresses this situation by allowing an annuity trust to bypass the probability test. Annuity trusts created after Aug. 8, 2016, can include language directing the trust to terminate early and distribute the corpus to charity prior to the payment of any amount that would cause the value of the corpus to drop below 10% of the initial value of the trust. The early termination is considered a qualified contingency under IRC section 664(f).
Unitrusts: A charitable remainder unitrust makes payments each year, an amount equal to a fixed percentage—at least 5% and not more than 50% as selected by the donor—of the value of trust assets for that particular year. The trust assets are commonly valued as directed by the trust agreement on the first business day of each taxable year.
A unitrust may also be designed to pay out whichever is less—its net income for the year or the specified fixed percentage amount. With this commonly called a net income unitrust, the trust agreement may provide that, for years in which trust net income exceeds the specified unitrust amount, the excess income may be used to make up for past years in which trust net income was less than the specified unitrust amount. This type of unitrust is known as a net income unitrust with a makeup (or catch-up) provision. See IRC section 664(d)(2).
A net income unitrust (with or without a makeup provision) is ordinarily used when the charitable remainder trust is to be funded with unimproved real estate or another type of asset that produces relatively little (or no) income.
Flip unitrusts: So-called flip unitrusts are trusts designed to start out as net income or net income with makeup unitrusts that then flip to become straight-payout unitrusts following some triggering event.
The triggering event generally must be an event outside the control of the trustee or any other person. Permissible triggering events include marriage, divorce, birth or death. The sale of an unmarketable asset is also a permissible triggering event. Impermissible triggering events include the sale of a marketable asset or a request from the donor or any other person or entity that the trust flip. The flip occurs as of the first day of the taxable year following the year in which the triggering event occurs. See Reg. section 1.664-3(a)(1)(i)(f).
Trustee: The donor will select an appropriate trustee to manage their charitable remainder trust. An individual or a corporate fiduciary having experience in the management of charitable remainder trusts may be a good choice. The donor, with certain limitations, may alternately name himself or herself as trustee or co-trustee.
Reformation of defective trusts: Many “defective” charitable remainder trusts, which would not otherwise qualify for favorable tax treatment, may be judicially reformed and transformed into qualified trusts. See IRC section 2055(e)(3).
Specimen provisions: To aid drafters of testamentary and lifetime charitable remainder trust agreements, the Internal Revenue Service has issued specimen provisions to be included in such agreements. Many of these can be found in the August 2003 Internal Revenue Bulletin 2003-31, which contains eight charitable remainder annuity trust specimen documents (Rev. Proc. 2003-53 through Rev. Proc. 2003-60). In 2005, the IRS released eight new charitable remainder unitrust specimen documents (Rev. Proc. 2005-52 through Rev. Proc. 2005-59).
Charitable remainder trusts for a term of years: An annuity trust or unitrust may be set up for a specified number of years (not to exceed 20). See IRC section 664(d). It is possible to establish a trust for one or more lives or for a period of time up to 20 years, whichever is a longer or shorter period of time. It is not possible to provide for a trust to last for the life of one or more individuals plus 20 years.
Tax considerations: When a qualified charitable remainder trust is created, a current tax deduction is allowed for the value of the charitable remainder interest (except in certain situations involving funding the trust with tangible personal property). See IRC section 170(a)(3). The method of computing the deduction is described in Reg. section 1.664-4.
The Taxpayer Relief Act of 1997 added the requirement that the initial present value (as determined under IRS guidelines) of the charitable remainder interest be no less than 10% of the value of the assets contributed to fund the trust. The IRS had previously determined that no deduction would be allowed if it determined that the terms of a charitable remainder annuity trust would lead to a 5% or greater probability that the trust assets would be exhausted prior to the termination of the trust. The so-called 5% probability test is laid out in Rev. Rul. 77-374.
If an individual establishes a charitable remainder trust for his or her life only, the trust assets will be included in his or her gross estate under IRC section 2036. The amount included, however, will “wash out” as an estate tax charitable deduction under IRC section 2055. A surviving spouse’s interest in a qualified charitable remainder trust qualifies for the estate tax marital deduction. See IRC section 2056(b)(8). Note that the marital deduction is lost if there is any non-charitable beneficiary of the trust other than the donor and the donor’s spouse.
Assets sold by a charitable remainder trust are exempt from capital gains tax, as the trust itself is a tax-exempt entity (unless it has any unrelated business taxable income for the year). This can be very advantageous for donors who wish to fund such a trust with highly appreciated, low-yielding assets. The trust will retain the entire net proceeds of the sale of such assets, which can then be reinvested in higher-yielding investments.
There is a four-tier system of attributing ordinary income, capital gain, tax-free income and corpus to the trust payout. See IRC section 664(b). This provision may be very favorable in situations where appreciated assets have been used to fund the trust, as distributions deemed to be trust corpus will be reported by the donor as capital gains income until all capital gain realized by the trust has been paid out. This is especially attractive to donors who pay tax on capital gains at significantly lower rates than the tax on other income.
Under the four-tier system, it can be possible to report dividend income from a charitable remainder trust at lower tax rates than would be payable on other ordinary income. In addition, income earned by a charitable remainder trust from tax-exempt bonds can be received free of tax by a trust beneficiary.
Mortgaged property: In Letter Ruling 9015049, the IRS ruled privately that a trust cannot be a qualified charitable remainder trust if any trust income (which includes realized capital gain) is used to pay a mortgage debt on which the donor is personally liable. There are, however, ways to use property subject to such a mortgage to establish a charitable remainder trust. The most common way is for the donor to pay off the mortgage before transferring the property to the trust.
Testamentary trusts: Some people use charitable remainder trusts in their wills to provide income for a survivor. In the case of a life interest left to a spouse followed by a charitable disposition of the property, a combination of the charitable deduction and the marital deduction can effectively eliminate all tax at the federal level. See IRC section 2056(a).
Wealth replacement trust: A common technique that can be used in connection with charitable remainder trusts is for the donor to replace the asset he or she gives away by buying life insurance on his or her life. Insurance can be purchased using the income received from the gift plan, the immediate tax savings generated by the gift plan or some combination of both. In many cases, the life insurance is owned by, and payable to, an irrevocable insurance trust—a so-called “wealth replacement trust.” This can help ensure that the insurance proceeds will be free from estate taxation.
The tax code and regulations governing charitable remainder trusts change frequently. Check for new developments before completing such arrangements. Qualified charitable distribution remainder trusts: Individuals age 70½ and older can make distributions directly from IRAs to charity of up to $100,000 annually. Although no income tax charitable deduction is allowed, donors save tax to the extent their qualified charitable distributions (QCDs) satisfy the required minimum distributions for the year. Starting in 2023, the SECURE 2.0 Act allows donors to make a one-time election to fund a charitable remainder trust with up to $50,000 from an IRA. The donor and/or spouse are the only permissible income beneficiaries, and no other contributions may be made to the trust. Distributions from the trust are taxed as ordinary income IRC section 408(d)(8)(F)(iv).
Charitable Lead Trusts
Historically, the charitable lead trust has been used not only to make very substantial charitable gifts but also to pass wealth to family members, partially or entirely free of estate and gift taxes.
Basic tax law rules
Payout: In order for the charitable interest in a lead trust to qualify for income, gift or estate tax charitable deductions, the payout must take the form of a guaranteed annuity interest or a unitrust interest. See Internal Revenue Code (IRC) section 170(f)(2)(B).
A guaranteed annuity interest is basically the right to receive a fixed dollar payment at least annually (for example, $50,000 a year, regardless of trust income). A unitrust interest is the right to receive a fixed percentage each year of the annually determined value of trust assets (for example, 5% of the annual value of trust assets).
The regulations do not allow for a “net income” lead unitrust, i.e., a lead unitrust that pays out the lesser of its net income for the year or the specified unitrust percentage amount.
Unlike charitable remainder trusts, charitable lead trusts are not subject to minimum or maximum payout rates or to a time limit of 20 years if they are for a term of years rather than for the lifetime of one or more persons.
Tax status of the trust: Ordinary income or realized capital gains not distributed to charity but accumulated by a lead trust are taxed to the trust at normal trust rates except in the case of a grantor lead trust where income is taxed to the grantor.
Non-grantor lead trusts: A non-grantor trust is treated for federal income tax purposes as a separate taxpayer, as discussed in the preceding paragraph.
An individual who establishes a non-grantor trust is not considered the owner of trust assets or income. Therefore, income distributed by the trust to a charity is effectively shifted from the individual to the charity (a tax-exempt entity, which pays no tax on the income it receives). This can be especially advantageous if a donor does not normally itemize their tax deductions or has exceeded charitable gift adjusted gross income limits.
Under IRC section 170(f)(2)(B), an individual receives no federal income tax charitable deduction for the gift of an “income” interest in a charitable lead trust unless he or she is considered the owner of the interest under the grantor trust rules.
In the case of a non-grantor trust, the donor is not considered the owner of the charitable “income” interest and is thus not entitled to an income tax charitable deduction with respect to the charitable interest.
Grantor lead trusts: It is possible to set up a lead trust as a grantor trust—for example, by the donor retaining a reversionary interest in the trust. In this case, the income tax consequences to the donor are essentially the opposite of those resulting from the creation of a non-grantor lead trust.
1. The donor receives an up-front federal income tax charitable deduction for the initial present value of the payments to be made by the trust to charity. The computation of this present value is discussed below.
2. The donor, not the trust, reports and pays tax on all trust income, including the income distributed to charity, with no offsetting yearly charitable deduction for this income. It should be noted that if the trustee voluntarily holds just tax-exempt bonds, there will be no taxable income for the donor to report with respect to the trust.
Determining the Present Value of the Charitable Payout
The initial present value of the payout to charity from a lead trust is the amount of the donor’s gift to charity for income, gift and estate tax purposes.
AFMR: This present value is determined using IRS tables based on the adjusted federal midterm rate (AFMR) in effect for the month the trust is created or, at the donor’s election, for either of the two preceding months. See IRC section 7520(a).
Effect of the AFMR on annuity and unitrust payouts: In a relatively low interest rate climate, the charitable lead annuity trust becomes more attractive. The charitable lead unitrust also gains popularity during times of low interest rates, but only slightly because the present value of a unitrust type of payout is basically independent of any assumed discount rate.
Example: A donor establishes a $500,000 charitable lead annuity trust that is to pay 6%, or $30,000 per year, to a charitable organization for 20 years. The present value of the annuity payout is equal to $463,000 assuming a 2.6% AFMR.
If the AFMR is assumed to be 4%, the present value of the annuity payout is approximately $407,000.
It should be noted that if the lead trust in question is a grantor lead trust, the donor can claim the $463,000 or $407,000 present value, as the case may be, as a charitable contribution for federal income tax purposes, subject to the percentage limitations on the income tax charitable deduction. The donor will, however, be subject to income tax on the amount of the payments to charity as they are received unless they are tax-exempt or paid from principal. See IRC section 170(b).
The same amount also qualifies for the federal gift tax charitable deduction.
Estate and Gift Tax Considerations
A closer look at the federal gift tax charitable deduction: The gift to charity of a guaranteed annuity interest or a unitrust interest in a lead trust qualifies for the gift tax charitable deduction.
To put the gift tax charitable deduction in perspective, consider a lead annuity trust, funded with $500,000 that is to pay $25,000 per year to charity for 20 years. The gift tax charitable deduction for such a trust is approximately $386,000, assuming a 2.6% AFMR.
If the lead trust provides an irrevocably vested remainder interest to the donor’s daughter, upon creating the trust, the donor is deemed to make a gift to her equal to $114,000 ($500,000 minus $386,000).
This gift does not qualify for the annual gift exclusion ($17,000 as of 2023) under IRC section 2503(b), because the gift is of a future interest.
Federal gift tax on the gift, however, may be avoided to the extent the donor has any remaining gift tax exemption amount. Creating a lead trust to fund gifts to charity before assets are transferred to heirs can be an excellent way to use unified gift and estate tax amounts during lifetime. In the example above, only $114,000 worth of exemption must be used, while heirs will receive $500,000 or whatever other sum remains in the trust at its termination. It would require growth of 7.7% per year for the $114,000 exemption amount to be worth $500,000 in 10 years, while the trust must only distribute 6% to preserve that amount for heirs.
When trust assets appreciate: To take this example one step further, assume that over the course of the 20-year trust term, the value of the trust assets increases from $500,000 to $750,000 due to capital appreciation, reinvestment of after-tax income or both.
The $250,000 of growth in the value of trust assets passes to the donor’s daughter without being subject to federal gift or estate taxes. In this way, the lead trust has served to accomplish an “estate freeze.”
The donor’s daughter will take the trust’s basis in the assets she receives from the trust. If the basis is relatively low, the daughter will owe any capital gain tax due if/when she sells the assets. To put this capital gain in perspective, however, one must compare the capital gains tax rate the daughter is likely to pay with the gift or estate tax rate that would have been applicable to the appreciation had the lead trust not been created. The highest federal capital gains tax rates have historically been substantially less than the highest estate tax rates, thereby adding to the attractiveness of the lead trust as a planning tool in certain circumstances.
Expanded Gift Tax Exemptions
Tax legislation enacted in 2011 set the lifetime gift tax exemption amount at $5 million per person, indexed for inflation beginning in 2012. In 2017 Congress acted to double this amount. The exemption adjusts to $12.92 million per person for 2023. Check for current exemption amounts.
As noted earlier, the charitable lead trust can be an excellent way to make charitable gifts while maximizing the benefit of lifetime exemptions currently available.
For example, assuming a 2.6% AFMR, a charitable lead annuity trust funded with $20 million that makes fixed charitable gifts of 5.1% per year for 10 years results in a charitable gift tax deduction of $8.9 million, leaving an $11.1 million taxable gift. If the donor has the full $12.92 million exemption available, it will serve to completely shield the gift amount from gift tax. He will have made charitable gifts totaling over $10 million while effectively transferring $20 million or whatever other amount remains in the trust in 10 years. This plan nearly doubles the amount of a $12.92 million gift tax exemption while making a very substantial charitable gift. A couple could transfer up to $40 million tax-free using the assumptions of this example.
Miscellaneous Planning Considerations and Questions
Generation-Skipping Transfer (GST) tax considerations: If a lead trust, upon termination, distributes its assets to one or more “skip persons,” the distribution is considered a taxable termination for federal (and possibly state) GST tax purposes. The federal GST tax rate applicable to the amount distributed depends on whether the trust is a lead annuity trust or a lead unitrust.
If a lead unitrust, the GST tax rate (under current law) is basically equal to:
TR (1 – E/[FMV – CD])
“FMV” is the value of the assets transferred to the trust, determined as of the date of transfer. “CD” is the gift or estate tax charitable deduction allowed with respect to the trust. “E” is the amount of the donor’s GST tax exemption allocated to the trust. “TR” is the highest applicable federal tax rate.
In the case of a lead annuity trust, the GST tax rate (under current law) is equal to:
TR (1 – [(E x F)/FMV])
“E” is the amount of GST tax exemption allocated to the trust. “F” is the compound interest factor corresponding to the length of the trust term and the IRS discount rate applicable to the trust at the time the trust is created. The quantity “FMV” is the fair market value of the assets passing from the trust at the time of its termination.
The descriptions here of tax and financial considerations inherent in the design of a lead trust are intended as a starting point to identify some of the issues a professional planner may wish to explore in advising a client on the potential benefits and risks of creating a lead trust. Donors and their advisors should always check for the latest legislation and regulations prior to completing a charitable lead trust or similar charitable gift.
This information is solely educational, namely, to provide general gift, estate, financial planning and related information. It is not intended as legal, accounting or other professional advice, and you should not rely on it as such. For assistance in planning charitable gifts with tax and other implications, the services of appropriate and qualified advisors should be obtained. Consult an attorney for advice if your plans require revision of a will or other legal document. Consult a tax and/or accounting specialist for advice regarding tax- and accounting-related matters.