For those whose estate planning involves tax management and who also are charitably inclined, charitable trusts are top of mind.
But be aware: Not all charitable trusts are created equal.
Put simply, a charitable trust allows an individual to leave a piece of his or her estate to a charitable organization. There are three major benefits from doing so.
First, there's the tax savings angle. The chunk of wealth that goes to the charity is removed from the estate of the donor, meaning it's not subject to estate taxes. Individuals also can reap the benefits of charitable deductions on their income taxes, meaning they can lower their income tax burden over time, based on the magnitude of the charitable gift. Finally, there's also savings on capital gains taxes, should that gift include a piece of appreciated property.
“People want to maximize their deductions, and the charitable deduction is a significant one — one that they can control,” said Adrienne Penta, regional trust head at Brown Brothers Harriman & Co.
Though charitable trusts may make sense for people who want to meet the these objectives, they should bear in mind that there are different ways to set up the trust, depending on their objectives. Enter the two primary types of charitable trusts: the charitable lead trust and the charitable remainder trust.
In a charitable lead trust, the donor makes a contribution to the trust in a specific dollar amount. Over a stated period of years, the charity receives an annual distribution from the trust. Following the term of the agreement, the remainder of the trust goes to the client's noncharitable beneficiaries.
Ms. Penta suggests looking at two factors before even having the conversation about a charitable lead trust: Clearly, the client has to be fairly wealthy, but he or she also has to be charitably inclined “to a substantial degree.”
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A big upside to establishing a charitable lead trust is that the giving goes on during the donor's lifetime because the charity gets the money first.
“The donor sees the distribution go out to the charity, and that gives them a warm feeling,” said Robert E.W. Lineberger, principal at Diversified Trust Co. “But there's also the potential to use whatever remains in the trust at the end of the term to pass on to your beneficiaries free of gift tax and estate tax inclusion. That's a good thing.”
In a charitable remainder trust, the lead interest goes to the donor: He or she can receive income either for life or for a fixed period of no greater than 20 years. After the donor gets the income, the charity receives the remainder at the end of the term. There are charitable remainder annuity trusts, where the noncharitable beneficiaries get a stream of income over a period of time. The charitable remainder unit trust allows the donor to make multiple transfers to the trust and requires a specific income payment annually.
“[The remainder trust] is for clients who have very concentrated positions, other assets that create a lot of income or tax-inefficient assets,” Ms. Penta said. A client who received zero-basis stock in PepsiCo or The Coca-Cola Co. from his grandfather might be facing steep capital gains taxes if he sells the stock outright, but the charitable remainder trust can take the stock, sell it and reinvest the money. The tax burden for the donor receiving the income is spread out over time, and the trustee can delay distribution to the donor to defer taxes.
Interest rates are a factor to consider when deciding which type of trust might be best for a given client. Charities use the applicable federal rate, which is set every month, to determine the value of partial interests in property received as a charitable gift. Low interest rates tend to lead to low AFR rates.
“If you have low rates like we do now, you'll see the charitable lead annuity trust become popular,” Mr. Lineberger said. “A low discount rate means the value of the charitable income tax deduction for the donor increases.”
“Say you give $5 million to a charitable lead trust. You'll want the full value of the initial contribution to be distributed to the charity during the term of the trust,” Ms. Penta said. Ideally, the remainder at the end of the term is valued at zero for estate tax purposes when the non-charitable beneficiaries receive what's left, which makes the charitable lead trust a strong wealth transfer strategy.
With charitable remainder trusts, rates work in reverse, meaning that high interest rates are beneficial. The donor is able to take a charitable deduction on their income taxes for the present value of the remainder interest that will go to charity. If interest rates are low, then the charitable deduction will be lower. Nevertheless, “with the right assets and the right fact pattern, charitable remainder trusts are a good planning tool,” Ms. Penta said.