Charitable Trusts
Charities help those who are not as fortunate, and fill a wide variety of niches. Domestic violence... youths... disease... homes for the poor. Endangered species even have their own charities. And believe it or not, charities serve another purpose: they help wealthy Americans reduce their tax bill.
In 1969, the U.S.Congress created a new type of trust that helped charities and not-for-profit organizations generate more revenue for their causes.
In the past decade, this trust has been steadily gaining in popularity. This vehicle allows taxpayers to reduce estate taxes, eliminate capital gains, claim an income tax deduction, and benefit charities instead of the IRS.
This type of trust is technically a Charitable Uni-Trust, but is more commonly known as a Charitable Remainder Trust (CRT).
The Basics of CRTs
CRT's are irrevocable trusts that actually provide for and maintain two sets of beneficiaries. The first set are the income beneficiaries (you and, if married, a spouse).
Income beneficiaries receive a set percentage of income for your lifetime from the trust. The second set of beneficiaries are the charities you name. They receive the principal of the trust after the income beneficiaries pass away.
Maintaining Control
While a CRT is an irrevocable trust, you and your spouse may change the charitable beneficiaries at any time. Under certain conditions, you may even serve as trustees of the CRT. As trustees, you can maintain full investment control of the assets inside the CRT.
Capital Gains
Because their assets are destined for a charity, Charitable Remainder Trusts do not pay any capital gains taxes. These taxes can range from 10% to 20% of an asset's growth in value. For this reason, CRTs are ideal for assets like stocks or property with a low cost basis but high appreciated value.
For instance, suppose you sell one of your rental properties for $1 million. Let's assume you originally paid $100,000 for the property. Upon completion of the sale, you would owe capital gains taxes on the $900,000 difference. That tax could easily top $150,000, depending on how long you owned the property and your overall tax situation.
Funding a CRT with highly-appreciated assets (like real estate) allows you to sell those assets without paying any capital gains taxes. Since CRTs have a charitable intent and do not have to pay capital gains, the full value of any assets transfers to the trust (and thus, to your family and favorite charity).
Draw Income
The amount of income to come out of the CRT depends upon the payout percentage that you choose, and the amount of income your assets generate while inside the CRT.
The IRS states that, at a very minimum, the CRT must distribute at least 5% of the net fair market value of its assets. If you don't need the income one year, you may elect to defer income through a "makeup provision." However, the CRT's net distributions must eventually equal 5% to be considered valid by the IRS.
When setting the payout percentage, be forewarned: the higher it is, the lower your charitable income tax deduction. Considering market conditions and the possibility that taking out too much may reduce the principal inside the trust, you should probably not receive income of more than 10% each year.
Retirement Planning
Many clients use Charitable Remainder Trusts to augment their current retirement plan. By setting one up in your peak earning years, you can make contributions to the CRT in the form of zero coupon bonds, non-dividend paying growth stocks, or professionally-managed variable annuities.
By letting the CRT grow without taking income from it during the early years, the CRT can begin making payouts to you when you retire. These payouts can include make-ups for any shortfalls in income you did not receive earlier. Unlike IRAs or 401(k) plans, there are no limits on how much you can contribute.
Income and Estate Taxes
A CRT is considered "outside of your estate" by the IRS. Because of this, you may end up saving as much as 48 cents of every dollar you move to the CRT. Plus, you are usually not limited in how much you can contribute by the annual gifting limit or the Estate and Gift Tax Credits.
CRTs, because they benefit a charity, also qualify you for an income tax deduction. The amount of your deduction is the present value of the remainder interest to the charity.
Your current deduction also depends on the type of property you contribute, as well as the type of charity you name as a beneficiary.
Average deductions normally fall in the range of 20-50% against your adjusted gross income. Any deductions not used in the year of contribution may be carried forward for the next five years.
Combining With Other Strategies
CRTs are designed to give the principal to charities when you and your spouse pass away. This bypasses any children, which could lead your heirs feeling slighted.
These feelings of ill-will can be overcome by combining the CRT with another strategy to "make up the difference" that goes to the charity.
For instance, some large estates combine the CRT with The Legacy Trust to provide a cash distribution upon the death of the owner. The Legacy Trust then subdivides into individual trusts for each of each named heir.
In this scenario, everyone wins. The estate owner receives income streams and tax deductions, the charity gets the principal of the CRT, and the children receive a cash distribution.
For more information on combining strategies, contact us and request a personal visit from Mr. Fisher.
A Reverse CRT
If you wish to reverse who receives income and who receives the asset, you can create a Charitable Lead Trust.
Here's how a Charitable Lead Trust works:
Like a CRT, CLTs offer current income tax deductions and a reduction of capital gains taxes. The only difference is the CLT flip-flops the parties involved. Charities become the income beneficiaries, receiving a steady stream of income during the owner's lifetime.
At the owner's death, named beneficiaries then receive the bulk of the CLT's assets. And just like the CRT, Charitable Lead Trusts also receive the same preferential tax treatment.
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