1 The Charitable Remainder Trust & Charitable Lead Trust Presented by: Jeffery T. Peetz Woods & Aitken LLP
2 The Charitable Remainder Trust The charitable remainder trust is a popular and time-tested method of making a generous deferred gift to a charitable institution that the donor wants to support. The donor irrevocably transfers money or property to a trust that has been created. The trust agreement (drafted by an attorney) directs that a specified income be paid each year to the donor and/or other individuals named in the agreement. The trustee may be directed to make the income payments for as long as the donor or other designated beneficiaries may live, or for a specific term of years up to 20. After the income benefits terminate, the principal of the trust is paid to the designated charitable beneficiary.
3 A Gift and an Income Every charitable gift can bring you personal satisfaction the joy of knowing that you have helped ensure the financial future of charitable causes you feel are important. Certain charitable gifts can provide tangible returns as well as intangible ones. With careful planning, a tool known as the charitable remainder trust can provide both a good, solid lifetime income and immediate tax benefits for the donor and their family. You may find that a charitable remainder trust can increase retirement income, help you escape from a locked-in investment position, and provide more security for you and your family all this, while still helping to achieve your charitable goals.
4 Steps in a Charitable Remainder Trust First, the donor transfers property to the trust and gains several immediate tax benefits. Second, the trustee invests the trust assets and pays an annual income to the donor for his or her life. Third, the trust can pay an income to a designated beneficiary after the donor s death or concurrently with the payments to the donor. Fourth, when all income rights have been satisfied, the principal of the trust will be distributed to our institution or held in trust for the benefit of our institution.
5 An Illustration Mary transfers assets worth $400,000 to a charitable remainder annuity trust and directs that $24,000 be paid to her each year for as long as she lives. The assets will be invested by the trustee during Mary s life, and both income and principal may be used to make the annual payments. After Mary s death, the trust will end and the property remaining in the trust at that time will be paid to our institution. Mary is assured an income of $24,000 annually from the trust for as long as she lives. Mary gains an immediate and substantial tax saving because she can deduct, as a charitable contribution, the present value of our institution s right to receive the trust property at some later time. Mary will not incur a current capital gains tax when she transfers appreciated property to the trust, even if the property is immediately sold by the trustee. In short, she can convert appreciated property to a stream of income without an immediate capital gains tax liability.
6 Benefit #1 A Lifetime Income Every charitable remainder trust provides an annual income to the donor or other beneficiaries designated in the agreement. The income can be a specific sum of money (a so-called annuity trust), or it can be a percentage of the value of the trust as redetermined each year (a so-called unitrust). In most cases, the income payments will be made for the life of the beneficiary, but they can also be made for a fixed period of years, up to 20. Typically, the donor will retain an income that is 5 percent to 7 percent of the value of the trust. The amount of income is always a decision made by the donor to accomplish personal objectives, subject to the general constraints of federal tax law. Some donors want an income that will vary with the value of the trust assets. Under the unitrust arrangement, the trust assets will be valued each year and a specified percentage of the annual value will be paid to the donor or other beneficiaries. A unitrust can be a hedge against future inflation, but with the risk that trust assets may decline in value. Other donors who prefer the stability of a fixed-dollar amount of income for as long as they live may choose the annuity trust.
7 Converting an Asset to Produce a High Income Peter, age 70, owns appreciated stock that is now worth $150,000. The property provides little income, but it has appreciated tremendously in value since Peter bought it some years ago for $25,000. Peter could sell the stock, but he would incur combined costs (selling costs, capital gains taxes) of about $34,500. If he invested the after-tax sales proceeds of about $115,500 in C.D.s earning 2.5 percent, he would realize an income of $2,888 a year. On the other hand, Peter can transfer the appreciated stock to a charitable remainder annuity trust that will pay him $9,000 (6 percent) a year and also give rise to an income tax charitable deduction of about $65,000*. Peter s charitable deduction will result in a tax savings of nearly $22,775 in his 35% tax bracket. If this sum is invested at 2.5 percent, it will earn about $570 each year. Peter s total annual income will be $9,570 ($9,000 trust income plus $570) $6,682 a year more than if he sold the property and invested the after-tax sales proceeds. The charitable organization designated by Peter in the trust agreement would receive the principal of the trust at his death. *AFR = 4.8%
8 Benefit #2 An Immediate Income Tax Charitable Deduction The most obvious tax benefit produced by the charitable remainder trust is a federal income tax charitable deduction. Even though the charitable institution will receive no benefits until the termination of all the income interests, the donor can deduct on his or her federal income tax return the present value of the deferred charitable interest, subject to the general limitations of tax law. Computing the charitable deduction depends in part upon the particular applicable federal rate, or AFR, in the month of the gift and the two preceding months. Generally speaking, the higher the AFR, the larger the charitable deduction for a charitable remainder trust. We can provide you, the donor, with the exact figures for a proposed gift.
9 Benefit #3 Avoidance of Capital Gains Tax Under today s tax laws, a charitable remainder trust can be especially rewarding if it is funded with appreciated property. The reason: There will be no capital gains tax liability either when the donor transfers the property to the trust or at the time the property is sold by the trustee. When the trust makes the annual income payout to the donor, part of that payout may be taxed as capital gain. Perhaps the donor owns securities that provide little or no income, but have appreciated significantly in value. The donor can transfer the securities to a charitable remainder trust that will pay the donor a high income for their lifetime and will pay no capital gains tax, even though, in most cases, the charitable deduction will be based on the full fair market value of the property. The ability to convert a low-income producing asset into a high-income producing asset without incurring a capital gains tax is a distinct benefit that can be gained through a carefully planned charitable remainder trust.
10 Planning Your Charitable Remainder Trust Although the tax benefits of a charitable remainder trust are extremely generous, it is important to determine whether the trust will fit into your broad estate, tax and financial plans. The charitable remainder trust is extremely flexible.
11 Income Beneficiaries The donor can name his or herself, or anyone they wish, as the income beneficiary of the trust. If desired, the donor can direct that the income benefits be paid to the donor for his or her life and then to their spouse for his or her life. The donor can name one or more of their children as beneficiaries, so long as the present value of the charitable remainder interest doesn t fall below 10 percent. Caution: Naming a third party (other than a spouse) as beneficiary may have gift tax consequences. Donors should consult their tax advisors.
12 Percentage Paid The donor sets the exact percentage that will be paid each year. Typically, a donor will fix the annual income at 5 percent to 7 percent of the value of the property placed in the trust. The minimum is 5 percent and the maximum is 50 percent.
13 Fixed or Variable Income The donor can elect a fixed or variable income. While the fixed-dollar income (annuity trust) has received more emphasis in this booklet, the donor may very well prefer a variable income (a unitrust) that can keep pace with inflation. Some unitrust arrangements allow the donor to defer part of the annual income payments until he or she is in a lower tax bracket.
14 Property The donor selects the property transferred to the trust. There may be real advantages to funding your trust with appreciated property, especially if the property produces little or no income. But there may also be advantages to funding your trust with cash, certificates of deposit, closely held stock or other properties. An advisor can tell you the tax consequences that will result from the choice of properties transferred to the trust.
15 The Trustee The donor can name the trustee a bank, an attorney, a family member, etc. The donor also can fix the commission that will be paid to the trustee or direct that the trustee serve without compensation.
16 A High Income for Retirement Richard transfers undeveloped real estate worth $500,000 to a charitable remainder unitrust that will pay him, for his lifetime, 5 percent of the value of the trust, or trust income, whichever is less. Because Richard, now 55 years of age, does not need immediate income, the trustee will retain the real estate that has great growth potential but produces no income. Ten years from now, the property is expected to be worth $1 million. At that time, the trustee will sell the real estate and invest in high-yielding securities. Richard will begin to receive 5 percent of the value of the trust each year. Richard will receive a very substantial addition to his retirement income when he reaches age 65. He also gains an immediate tax deduction that will significantly reduce his current income tax liability. He is, of course, delighted that his trust arrangement also will provide a major gift to a charitable institution he has long supported.
17 Final Word on Charitable Remainder Trusts The charitable remainder trust can be tailored to meet your individual needs and objectives. It can be a vital and rewarding part of your financial, retirement and estate planning. It can be a means of increasing your own spendable income or providing a reliable income for another person, while carrying out your philanthropic objectives. Please note that any figures used in our examples are based on average interest rates. Figures may be slightly different at the time of a gift in view of rate volatility. Figures also need to be monitored frequently because of the many phase-ins and phase-outs of tax legislation. Always check with your tax and financial advisors before implementing any gift plan.
18 The Charitable Lead Trust The Charitable Lead Trust is in reality a mirror opposite of the more popular Charitable Remainder Trust (CRT) and although used less often is a great tool for charitable giving through one s estate plan. With today s low interest rates, this is an excellent time to think about implementing this type of trust. Low interest rates lead to larger savings in transfer taxes (gift and estate) for the donor and larger immediate gifts for the designated charity.
19 Workings of Lead Trust The charitable donor makes an irrevocable transfer of assets for a term of years or for the life of an individual. At the end of the term, the principal can return to the donor, or more often, be distributed to the donor s heirs (usually children or grandchildren). With careful planning, one can reduce substantially or even eliminate estate and gift taxes.
20 Workings of Lead Trust This trust, the opposite of the CRT, has the income paid to the charity for a period of time with the remainder interest designated back to the donor or his or her family. There are different options and varieties of this type of trust called the non-grantor family lead trust. Your personal attorney should work with you to determine which type of trust best suits your specific situation.
21 Charitable Deductions The size of the donor deduction for gift and estate tax is determined by three factors: The amount designated to charity The designated length of the trust term The federal interest rate when the trust is established It is integral to the creation of the trust to have the donor s accountant and attorney work with the donor to review their specific information and other variables for the donor.
22 Savings Transfer Tax When assets are transferred to a non-grantor lead trust, the IRS calculates the value of the remainder interest to the family members at its discounted percent value at the time the trust is established. When the trust ends some years later the period of time is established by the donor and assets are distributed to the heirs, the assets may have appreciated considerably. But regardless of the amount of appreciation, there will be no additional gift tax or estate tax (transfer taxes) on the paper gain.
23 Savings Transfer Tax Since all appreciation in the value of assets during the term of the trust escapes taxation and transfer taxes can deplete almost half an estate the tax savings result can be huge. Thus, a lead trust can allow the donor to pass untaxed wealth to heirs after the charitable interest expires.
24 No Charitable Income Tax Deduction The donor is not entitled to a charitable deduction with this type of trust. The objective with this type of charitable trust is to reduce or eliminate transfer tax. With the fiscal cliff approaching, should we fall off the cliff and interest rates remain low, this strategy may gain some traction.
25 What assets should be used to fund this trust? Cash or marketable securities are often used to fund a lead trust. Usually the donor will want to select an asset with strong potential for growth for the benefit of the remainder beneficiaries. However, there are other considerations. Since the lead trust is not tax-exempt, it must pay taxes on its income and realized gains. Even though the trust can claim tax deductions annually for the dollar amounts paid to charity, careful management is necessary to offset the trust s tax liabilities and ensure sufficient income and liquidity to make the required annual payments to charity.
26 Charitable Lead Annuity Trust (CLAT) or Charitable Lead Unitrust (CLUT) To qualify for a charitable deduction the lead trust must make income payments to a qualified charity either in the form of a fixed dollar amount (the lead annuity trust); or a fixed percentage of the trusts assets as revalued annually (the lead unitrust). The donor must decide which type of trust suits them and their objectives.
27 Charitable Lead Annuity Trust (CLAT) or Charitable Lead Unitrust (CLUT) If the donor expects assets to grow substantially and wants charity to share in the growth, the donor would select the unitrust version. Both the income payments and remainder interest grow as the trust assets increase in value. On the other hand, if the object is to pass more wealth to the family, then the donor may prefer the lead annuity trust. Since annual payments to charity are fixed, any growth in the trust assets would inure to the donor s family. Also, administrative expenses would be minimized since annual valuations are not required as with the unitrust option.
28 Charitable Lead Annuity Trust (CLAT) or Charitable Lead Unitrust (CLUT) Whichever trust type is selected keep in mind that there are no minimum or maximum annual payout requirements as with a charitable remainder trust. Still, the payout should be in line with the trust s ability to generate the income payments to charity, so that it is not necessary to invade the trust s principal and reduce the remainder interest of family members.
29 When should you establish a lead trust? A lead trust can be established either during your lifetime or in your will. Many lead trusts are created by will. However, when federal interest rates are low (low interest rates generate higher charitable deductions for lead trusts), there is an incentive to create and fund a lead trust during life, rather than risk much higher rates and a lower charitable deduction when the trust comes into existence at some uncertain future time under a will.
30 When should you establish a lead trust? A lead trust created during life also would reduce the size of your taxable estate, and any gift tax payable (on the present value of the remainder interest) would come out of the estate. Equally important, all appreciation in the value of the trust properties occurring after funding the trust would be completely free of gift and estate taxes. An important consideration is the loss of income from the trust assets for the duration of the trust. Also, the heirs would not receive a stepped-up basis (in contrast to a trust created by a will). But if the trust were funded with assets that had a relatively high cost basis, it may be far better to pay a long-term capital gain tax than to lose almost half of an estate to transfer taxes.
31 Team of Advisors Recommended There are many factors to consider before creating this type of charitable trust. The involvement of your accountant and attorney are needed for valuable input. Each donor has unique factors that are taken into consideration for this type of trust. However, the income from this type of trust would allow for immediate use and you as the donor would be able to see the immediate benefit of your gift.
32 Questions? Jeffery T. Peetz Woods & Aitken LLP 301 South 13 th Street, Suite 500 Lincoln, NE