Charitable Planning

Charitable Remainder Trusts

A Charitable Remainder Trust (CRT) is a very popular estate planning tool because it allows you to benefit your favorite charity and receive a stream of income while not interfering with your other estate planning objectives. The mechanics of a CRT are as follows: after your attorney drafts the CRT instrument creating the trust, you transfer assets (preferably stocks, real estate, or other property that has gained substantially in value since you acquired it) into the CRT. The trust will pay you income for life (and a percentage of the principal if desired) and the remaining trust property will then pass to the charity at your death.

Because the trust is for the ultimate benefit of a charity, you can take a charitable deduction now on the present value of the assets that will pass at your death, and you do not have to pay any capital gains tax. The trust, as a charitable entity, can then sell the appreciated asset without having to pay capital gains tax. This leaves the entire value of the assets in trust to generate a greater income stream for you.

With this increased income, along with the additional income tax savings from the charitable deduction, you can purchase a life insurance policy for your heirs that will more than replace the value of the assets that you transferred into the CRT. The result is that you have given away an appreciated asset without having to pay capital gains tax, benefitted your favorite charity, increased your current cash flow, and replaced the value of the asset with life insurance to your heirs.

Charitable Lead Trusts

With a married couple of very high net worth, the creation of a non-grantor Charitable Lead Unitrust (CLUT) at the death of the surviving spouse is frequently the most desirable approach from many standpoints. The way the testamentary CLUT works is that upon the death of the surviving spouse, assets are irrevocably transferred to a trustee.

The trustee then pays a fixed percentage (called the Unitrust Percentage) of the trust assets (redetermined annually) to a qualified charity for either a set number of years, or the lifetime of individuals. When the term of the trust has ended, the remaining trust assets are distributed to donor’s children, grandchildren, or other individuals (called the remainder beneficiaries or remaindermen).  A long-term lead trust with a sufficiently high payout rate can eliminate a gift or estate tax on the assets or at least significantly reduce these taxes.

As stated above, each year the value of the trust’s assets must be redetermined. Accordingly, payments to charity will vary from year to year, depending upon the investment performance and expenses of the trust. Although the charity will continue to receive the same percentage of the trust’s assets each year, if the total value of the trust assets increases, the charities will receive more; and of course if the value of the trust’s assets fall, the charity will receive less.

For example, if the trust is worth $5,000,000 when you create it and you’ve given the charity a 9% annuity, it will receive $450,000 in the first year. If the trust doubles in value in the second year, the charity will still receive 9% – but of $10,000,000, i.e., $900,000. Of course, if the value of the trust in the third year falls to only $3,000,000, the charity receives 9% of $3,000,000, $270,000.

The federal estate tax (if any) upon the death of the surviving spouse is based on the present value of the remainder beneficiaries’ right to receive the trust remainder at some future time. This calculation is based upon the term of the trust, the amount payable each year to the charity (the present value of which amount results in a charitable deduction to the estate), and the AFR (applicable federal rate) at the time of the transfer. Stated another way, the present value of the charity’s future stream of income is a charitable deduction for estate tax purposes. Stated yet another way, the donor’s estate is entitled to an estate tax deduction equal to the actuarial value of the income interest payable to the charitable organization.

Because your beneficiaries don’t pay estate taxes on this charitable portion, the money that otherwise would have been paid in estate taxes can instead be invested. During the term of that trust, increased investment income can help pay for the fixed annuity promised to the charity — and if there is any surplus, that extra income (plus any appreciation on the value of the assets) will be compounded for your children and grandchildren (or other remainder beneficiaries) and pass to them — free of gift and estate tax — when the trust ends.

Part of the significant advantage of the testamentary CLUT is that it allows discounted gifts to family members – i.e., gifts with substantial valuation discounts. Under present tax law, the value of a gift is determined at the time the gift is made (i.e., at the death of the surviving spouse).

Because the family members who are the remaindermen must wait for the charity’s income term to expire, the present value of that remainder interest is discounted for the time cost of waiting. In other words, the tax value of the gift is reduced because the value of the gift is decreased by the value of the annual income interest donated to charity. If the term of the trust is long enough, the value of the remainder interest can sometimes be reduced to zero.