Meeting Your Philanthropic Goals
By Lynne L. Pantalena
A properly structured charitable trust can help you do well by doing good, supporting any IRS-recognized philanthropic endeavor while potentially giving you valuable income tax, gift tax and estate tax management advantages.
If your client would like to mitigate the tax implications on highly appreciated assets, would like to receive current income and wants to serve a long-term philanthropic purpose, a charitable remainder trust (CRT) can be an effective tool to help them meet those objectives.
Assets placed in a CRT are immediately removed from the donor’s estate. They will be entitled to claim a current income tax deduction for the present value of the eventual remainder that goes to the charity of their choice. These deductions are subject to the general limits but any unused deduction may be eligible for carry-forward treatment for the next five years. The donor, and typically the donor's spouse, can receive cash flow from the trust, often act as trustee or reserve the right to change the trustee, reserve the right to change the charitable beneficiary at any time and even reserve the right to change the non-charitable beneficiaries.
The Many Ways to Fund CRTs
A donor has significant flexibility in funding a CRT in whatever way best meets their financial and philanthropic objectives — using stocks, bonds, real estate or virtually any other assets as well as cash. If the trust sells those assets, the donor does not recognize the capital gains at that time. As a result, the CRT can help them to diversify a concentrated stock position and avoid immediate recognition of capital gains while creating an enhanced cash flow.
A CRT itself has no income tax liability for income earned by assets in it. Any person who receives cash flow from the trust — known as an annuity or unitrust beneficiary — may be taxed, depending on how the source of the cash flow is categorized. For the beneficiary, cash flow funded from ordinary income earned by assets in the trust is taxed at the appropriate ordinary income tax rate.
Cash flow derived from long-term gains or qualifying common stock dividends may be taxed at the more favorable capital gains or dividend rates. Cash flow funded from a tax-exempt source creates no ordinary tax liability, although there may be exposure to the alternative minimum tax.
Finally, cash flow not attributable to any of the preceding sources is accounted for as a return of capital. The beneficiary of the CRT is generally an individual or a married couple. There are no gift tax implications if the beneficiary is the donor or the donor's spouse. If the beneficiary is anyone else, however, there may be gift tax exposure.
The CRT’s term can be defined as the lifetimes of beneficiaries, and it will remain in force for however long is required. It can also be structured to exist for a fixed period of time not to exceed 20 years. In either case, assets remaining in the trust when the term ends pass immediately to the charity or charities designated as charitable beneficiary.
There are two types of CRTs. The charitable remainder annuity trust (CRAT) pays a fixed percentage of the initial donation to the trust. It provides a steady, predictable annuity stream. The charitable beneficiary, alone, will feel the impact of any market volatility.
In contrast, a charitable remainder unitrust (CRUT) is designed to determine its annual unitrust payment based on the value of trust assets on the date of the annual valuation. Thus, the impact of any market volatility is shared between the unitrust beneficiary and the charity. Because of this variance, a CRAT and CRUT of equal donation value and annual percentage may have different values as tax deductions.
The Lead Trust Alternative
Aside from CRTs, another primary category of philanthropic trust is the charitable lead trust (CLT). A CLT is essentially the reverse of a CRT in that the intended charity receives the annuity and the donor (or donor’s family members) receives the remainder.
The CLT can efficiently channel assets to beneficiaries — even restricted stock that the donor might continue to control as trustee. This form of trust removes assets from the donor's estate and can shelter further appreciation from gift and estate taxes (unless the donor receives the remainder), but it generally offers no immediate income tax benefit.
The tax incentive here comes from giving a future interest rather than current ownership — with a CLT, heirs cannot use the assets and they cannot collateralize them or benefit from them until the trust expires, so the value of the gift in tax calculations may be discounted significantly. In light of the recent tax law changes, CLTs have also become more interesting in comparison to other approaches. Lower income tax rates have helped to level the playing field and reduce the potential advantage of strategies that focus on current income tax management. The current low interest rate environment also enhances the viability of CLTs.
The grantor form of the CLT may give the donor an immediate deduction for donations they actually intend to make over a period of years. This front loading might help offset an unusual surge in the donor’s taxable income stream from a special bonus, royalty payment or other one-time source.
The downside of the grantor CLT is that the donor is responsible for taxes due from income earned in the CLT. Because the donor received an up-front income tax deduction, there is no offsetting income tax deduction for charitable distributions from the trust. As a result, the funding and investment management of a CLT should be carefully monitored, weighing the estate tax benefits with the income tax ramifications.
Each charitable vehicle has unique strengths depending on the individual's needs and goals. Each also has unique costs that might weigh against other features of the donor’s overall wealth management strategy. As advisors, bankers can work with their clients and their clients’ legal and tax advisors to help them analyze their charitable goals and suggest appropriate ways to achieve them — laying the foundation for a charitable legacy while reducing estate, capital gains and income taxes.
Lynne L. Pantalena, JD, LLM, is director of wealth strategies for Fleet Bank’s Private Clients Group.