Life is all about the legacy you leave for others. When you’re long gone, what trail will you leave behind to showcase your time on earth? If you've been fortunate to accumulate wealth and want to share it beyond your inner circle, a charitable trust is an opportunity to reach that goal.
A charitable trust is when a donor gives ownership to a charity or creates a charitable foundation to manage and distribute assets such as cash, securities, and valuables, among others. Not only does the donor do a good deed, but the IRS also offers attractive tax benefits for creating a trust.
Types of Charitable Trusts
There are two types of charitable trusts: charitable remainder trusts and lead trusts. Based on your specific needs, you'll need to decide between which of the two is a better fit.
Charitable Remainder Trusts
For a period of time determined by the donor, the charitable organization has ownership of the donor's assets. The time frame is decided by the donor and has some flexibility, so it could be 5, 10 or 20 years—or whatever works best for you. When that designated time expires, the assets solely belong to the charity, along with any interest or profits that accrued. A charitable remainder trust is a tax-exempt, irrevocable trust, which means it can’t be changed once the ink dries. As a donor, that's a huge plus.
There are two types of charitable remainder trusts. A charitable remainder annuity trust (CRAT) pays a non-charitable beneficiary an income for a pre-determined time, either for a dedicated number of years or until the donor's death. When the period is up, the designated charity begins receiving the trust’s remaining interest. The charity has the option to withdraw it or keep it where it is and continue growing.
A charitable remainder unit trust (CRUT) is much like a CRAT, but they differ in a couple of ways. With a CRUT, the donor can transfer more funds into it at any time. The trust must also pay out at least 5% of the original investment each year as income for a specified time period or until the beneficiary dies.
A lead trust works inversely to a charitable remainder trust. Instead of the charity having control of the properties in the trust, the donor maintains control. When it comes to earned interest or gains, the proceeds either go to the charity or they are split between the charity and the donor’s beneficiaries. Unlike a charitable remainder trust, when the lead trust expires, the charity does not gain control of the donation; rather, its ownership goes wherever the donor has stipulated, be it heirs or other beneficiaries.
Advantages of Charitable Trusts
With a charitable remainder trust, you’re paid an income for a fixed time period or until you die, and ownership goes to the charity you’ve chosen. Furthermore, you get to choose how you are paid, whether it's annually, for set time periods or as a percentage of the current property value.
The goods news is the charity also shoulders the responsibility for managing or investing the property while you reap the rewards. When the trust expires, there is no federal estate tax on the property donated to the charity.
You can also spread the income tax deduction for the value of your gift over a five year period. This gives you more favorable tax treatment. If you own property that has appreciated, the charitable trust allows you to convert that growth into cash, yet you will not have to pay capital gains on your good fortune.
Typically, a charity will sell any non-income-producing asset in a charitable trust and use the proceeds to buy property that will generate income for you. Charities don't have to pay capital gains tax, so if the charity sells your property, the proceeds stay in the trust and aren't taxed.
A charitable lead trust is particularly attractive in that it helps you avoid potential gift taxes and estate taxes. The bottom line: charitable trusts are a smart tax strategy.
How Do I Set Up a Charitable Trust?
In setting up a charitable trust, you have key decisions to make. First, you'll have to determine what assets you'd like to put in the trust. Appreciated assets with low returns held for more than a year can be ideal assets to donate, as the income tax deduction is based on the higher fair market value, rather than on the initial cost. You'll also need to select your beneficiaries, as well as what charity you'd like to benefit or if you prefer to create a charitable foundation in your name.
This is not a DIY project. You'll need to work with an estate planning attorney to draw up a trust document. Any time you make an investment of this significance, it's also a smart idea to consult a financial advisor.
What You Need to Know and Understand
Charitable trusts can be complex. Unlike a charitable remainder trust, a charitable trust is not tax exempt. In most cases, it's treated as a private foundation by the IRS (not as a public charity, unless it meets certain requirements), so it is subject to private foundation excise taxes and other provisions. Also, an estate is usually not yet considered a charitable trust during the period of the estate administration or settlement.
Be sure you understand that unlike your relationship with your stockbroker, where you give input on investment decisions, the charity is in control, and they can invest as they see fit without any input from you.
This is not a minor investment. Generally, tens of thousands of dollars are put into play. You may not realize any value from estate tax benefits unless your assets exceed $11.58 million.
While you’ll welcome big income payments from your trust, you'll also reduce your allowable income tax deduction. Furthermore, higher payments chip away at the principal, lessening what the charity will receive.
Who are Charitable Trusts Ideal For?
Charitable trusts are of most value to wealthy investors with big hearts who want to do good, make some extra income and also take advantage of an opportunity to minimize taxes.
Mistakes to Avoid
Choose your payout method wisely. If you go the percentage route, each year the trust assets will be re-appraised, and you will receive that set percentage. Understand that if inflation or a good investment boosts the value of your assets, your payments will go up, too. You do have a safety net. IRS rules state that you must receive at least 5% of the value of the trust each year.
It's common to set your annual payment as a percentage of the trust property's current worth. 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.
A charitable trust can be an effective tool for accomplishing financial and philanthropic goals. Talk to a financial advisor to determine if it’s the best option for you.