Charitable trusts have been popular for individuals who wish to receive the benefit of current income for a certain period of time or until a certain event occurs. Charitable trusts also allow individuals to reduce or eliminate estate taxes, eliminate capital gains tax, and receive a current income tax deduction, while supporting charitable causes.
A charitable trust lets you donate generously to charity, and it gives you and your heirs a meaningful tax benefit.
There are two types of charitable trusts. They are:
1.) A Charitable Remainder Trust (CRT) and
2.) A charitable Lead Trust (CLT)
If you are considering making several smaller charitable gifts, then a charitable trust probably is probably not appropriate. There are number implications to a charitable trust which require serious consideration before proceeding. The single greatest factor to consider is the understanding that Charitable trusts require you to give up legal control of your property. Charitable trusts are irrevocable once the trust becomes operational. You cannot change your mind and regain legal control of the trust property.
How it works:
The most common type of charitable trust is called a charitable remainder trust. Here's how it usually works. First, you set up a trust and transfer to it the property you want to donate to a charity, ideally highly appreciated assets. The charity must be approved by the IRS, which usually means it has tax-exempt status under the Internal Revenue Code. The charity serves as trustee of the trust, and manages or invests the property so it will produce income for you. The charity pays you (or someone you name) a portion of the income generated by the trust property for a certain number of years, or for your life. You specify the payment period in the trust document. At your death or the end of the period you set, the property goes to the charity
In addition to helping out your favorite charity, you receive several meaningful tax advantages from this arrangement. First you can take a current income tax deduction, spread over five years, for the value of your gift to the charity. Where things get tricky is determining the amount of your deduction. The value of your gift is not simply the value of the property; the IRS deducts from that value the amount of income you're likely to receive from the property. For example, if you donate $100,000 but can expect to get $25,000 in income back (based on your life expectancy, interest rates and how the trust document is set up), the value of your gift is $75,000.
When the trust property eventually goes to the charity outright (at your death or the end of the payment period you specified), it's no longer in your estate, and thus is not subject to federal estate tax.
Capital Gains Tax:
With a charitable trust you can turn appreciated property (property that has appreciated significantly in value since you acquired it) into cash without paying capital gains tax on the profit. A charity usually sells any non-income-producing asset in a charitable trust and uses the proceeds to buy property that will produce income for you. Charities, unlike individuals, don't pay capital gains tax. If the charity sells your property, the proceeds stay in the trust and aren't taxed.
Toni owns stock worth $300,000. She paid $20,000 for it 20 years ago. She creates a charitable trust, naming her favorite charity as the beneficiary, and funds her trust with her stock. Greenpeace sells the stock for $300,000 and invests the money in a mutual fund. Toni will receive income from this $300,000 for her life. Had Toni sold the stock herself, she would have had to pay capital gains tax on her $280,000 profit. But no capital gains tax is assessed against the charity.
Receiving Income from the Trust:
When you set up a charitable remainder trust, there are two ways to structure the payments you will receive. At a minimum, the trust must distribute at least 5% of the net fair market value of its assets annually. If you don't need the income one year, you may elect to defer income through a "makeup provision" however, the net distributions must eventually equal 5% to be considered valid by the IRS.
You can receive a fixed dollar amount (an annuity) each year. That way, if the trust has lower-than-expected income, you still receive the same annual income. Once you set the amount and the trust is operational, you can't change it. For instance, if you direct that the charity pay you $10,000 a year for life, you can't later say, "Oops, I forgot about inflation. I guess I should have elected to receive $15,000 annually.
Theoretically, you can make the payments as high as you want. Practically, however, there are limits. First, the higher the payments, the lower your income tax deduction. Second, high payments might erode principal, possibly even using all of it before the payment term is over and leaving nothing for the charity. Third, a charity is unlikely to accept a gift if it is likely, or even possible, that all the trust property will be paid back to you.
Percentage of Trust Assets:
It's common to set your annual payment as a percentage of the value of the current worth of the trust property. For example, your trust document could specify that you will receive 7% of the value of the trust assets yearly. Each year the trust assets will be reappraised, and you will receive 7% of that amount. Because you receive a percentage, not a flat dollar amount, if inflation (or wise investment) pushes up the dollar value of the assets, your payments go up accordingly. Under IRS rules, you must receive at least 5% of the value of the trust each year.
Charitable Lead Trust (CLT):
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 charities become the income beneficiaries, receiving a steady stream of income during the owner's lifetime. Upon the owner's death, named beneficiaries, other than the charity then receive the bulk of the CLT's assets. Just like the CRT, Charitable Lead Trusts also receive the same preferential tax treatment.