Op-ed: Here’s how to create a charitable trust as part of an estate plan

As we near the end of 2020, it’s time to review and evaluate your overall financial outlook for the coming year, including any charitable, estate or general tax planning for 2021 and beyond.

While direct giving has an immediate impact, some individuals may be considering charitable planning strategies that will have a larger and longer-lasting impact not only on charities, but their own lives or that of their families.

Other individuals may be considering year-end tax planning, given potential Democratic tax proposals that could be implemented during President-elect Biden’s term.

Meanwhile, some may be considering their tax planning over the next few years, whether or not any new tax proposals are enacted. Many of the individual income tax provisions of the 2017 Tax Cuts and Jobs Act are scheduled to expire after 2025.

Whatever your reasons, creating a charitable trust can provide a way to meet your wishes for loved ones and charities.

A charitable trust is a set of assets, usually liquid, that a donor signs over or uses to create a charitable foundation. The assets are held and managed by the charity for a specified period of time, with some or all interest that the assets produce going to the charity.

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There are pros and cons to both so-called charitable remainder trusts and charitable lead trusts. Consult with an estate-planning attorney to determine if either one is appropriate for you.

For example, a charitable trust allows you to donate generously to non-profits of your choice, while providing a tax break for yourself and your heirs. However, to achieve the desired tax treatment, a charitable trust must typically be irrevocable, so you won’t be able to change your mind about the amount or the recipient once it’s finalized. Charitable trusts provide a way to ensure current or future distributions to yourself or loved ones.

Charitable remainder trusts, or CRTs, provide an income stream either to you or to individuals you select, for a set of years or throughout your, your spouse’s or your beneficiary’s lifetimes, ultimately distributing the remaining assets to one or more charities. In contrast, charitable lead trusts (CLTs) pay income to one or more charities for a set term, and the remaining assets pass to individuals, such as your children.

For both CRTs and CLTs, there are two ways to determine the annual distributions during the initial term (whether to the charitable or non-charitable beneficiary, depending on the type of trust): a unitrust (CRUT or CLUT) and an annuity Trust (CRAT or CLAT). In a unitrust, the income distribution for the coming year is calculated at the end of each calendar year and changes as the value of the trust increases or decreases. In an annuity trust, the distribution is a fixed annual distribution determined as a percentage of the initial funding value and does not change in future years.

Whether a CLT or CRT will be more beneficial will depend on interest rates when the trust is established. For example, the current historically low-interest rates yield minimal income to donors from a CRT.

The key benefits to funding a CRT include the income tax deduction, deferral of capital gains taxation, annual income and a desire to ultimately support your favorite organizations.

Possible advantages to funding a CRT include being over age 60, having no children, a desire to defer capital gains taxation and a need to diversify assets. Likewise, this trust could work for a high-income individual who has maxed out his or her qualified plans such as 401(k)s yet wants to put more away for future income on a tax-deferred basis.

Perhaps the best candidate for a CRT is a business owner with a C-Corp. looking to retire soon or possibly getting bought out. Another great candidate for a CRT is an owner of real estate who is thinking of selling but does not want to pay capital gains taxes and wants to cash out in a tax-efficient manner.

Transferring appreciated property or securities to a CRT instead of selling the assets can be a win-win for those with charitable intentions. This tax-advantaged technique allows an individual to defer, and potentially eliminate, all or a portion of any capital gain that may be recognized upon the sale of the appreciated assets transferred to the CRT.

Further, the donors enjoy a charitable deduction and retain an income stream.

Let’s say, for example, that John and Mary — ages 70 and 68, respectively — gift an appreciated parcel of land worth $1 million to a CRUT to benefit their university in December 2020, and they want a 6.5% return for life. Upon creating and funding a CRUT, John and Mary will first bypass a capital gain of $225,000 on the sale of the appreciated land, saving $53,500 (20% capital gains tax + 3.8% net investment income tax).

They receive a charitable income tax deduction of $299,810, saving them another $112,729 (37.6% bracket). State income tax would increase this tax savings benefit. Their annual income from the CRT would initially be $65,000; the distribution would be recalculated annually. John and Mary can expect to receive more than $1.4 million over 19 years.

Suppose the income and capital appreciation of the trust exceed the income distribution to John and Mary, as well as any related fees. In that case, it is possible that the amount allocated to the charity upon both John and Mary’s passing would exceed the initial funding value of $1 million. Overall, John and Mary saved more than $166,000 in taxes and received $1.4 million in distributions, and the charity received $1 million to further its purpose.

There are two types of CLTs, and the selection will determine the charitable tax deductions, if any. In a grantor CLT, you can take a charitable deduction for the year of funding equal to the present value of the charitable payments over the set term. (Note: The phase-out rules may apply, though you may carry-forward the excess deduction over five years.)

However, to obtain the tax benefit, the CLT’s investment income is taxable to the donors during the entire trust term. In contrast, a non-grantor CLT funding does not provide any charitable deduction for funding the trust. Still, the trust itself pays tax on its undistributed net income, which is offset by an unlimited income tax charitable deduction for the distributions to the charities.

With either CLT structure, at the end of the set term, the remaining assets are distributed to the individuals you select. Based on various factors at the time of funding, you may be required to report the remaining distribution as a gift to the individuals. However, the gift will not result in tax if you have not exceeded your lifetime gift and estate tax exemption ($11.58 million in 2020).

With a CLAT, you can structure the annuity payments to “zero out” the remainder, which is calculated at the time of funding based on the historically low interest rates (the Internal Revenue Code 7520 rate for November 2020 is 0.40%). This tactic results in no reportable gift to the remainder beneficiaries, though as long as the income and appreciation exceed the 0.40% “hurdle,” the excess amount will distribute to your beneficiaries without utilizing any of your lifetime gift and estate tax exclusion.

Let’s get back to John and Mary.

If they, instead, contribute the land worth $1 million to a CLUT for a 20-year term, assuming the Internal Revenue Code 7520 rate of 0.40% and an actual growth rate of 6%, the charity receives $52,048 per year. John’s and Mary’s loved ones receive $1.25 million at the end of the 20-year term without utilizing any gift or estate tax exclusions.

However, John and Mary will need to determine if they should utilize the charitable deduction of $1 million, meaning they would report the CLT’s income on their individual income tax returns for the next 20 years. Or, John and Mary can forego the charitable deduction, but the CLT’s income does not flow-through to their joint income tax return.

Note that for John and Mary to receive the charitable deduction of $1 million, they will forego the capital gain attributable to the land’s sale.