As the new administration and other constituents are discussing income tax increases for wealthy Americans and lowering the estate tax exemption (currently $11.7 million), many Americans are wondering what planning opportunities are still safe for them to consider. Utilizing trusts as part of a charitable planning strategy could be an answer to some of the income and estate tax concerns that exist. This article will focus on several common charitable giving strategies available using trusts.
Charitable Remainder Trusts (CRTs)
Charitable Remainder Trusts (CRTs) pay amounts to one or more noncharitable beneficiaries (often the grantor) for their lifetime or over a fixed period of up to 20 years. The remainder is then paid to charitable beneficiaries at the end of the trust term. There are two types of distribution options that can be used when choosing the payment options to the income beneficiary(ies):
- Charitable Remainder Annuity Trusts (CRATs) which pay a fixed amount each year to the noncharitable beneficiaries (donor, donor’s spouse, or children); and
- Charitable Remainder Unitrusts (CRUTs) which pay a fixed percentage of the fair market value of the trust assets, generally valued at the beginning of each year.
The annual income distribution must be a minimum of 5% but no more than 50% of the trust’s assets. State law may impact the required distribution and should be considered when the trust is drafted.
CRTs are typically not subject to income tax at the trust level. Instead, tax attributes are passed out to the income beneficiaries based on a calculation that takes into consideration the different tiers of income. Since CRTs are generally tax-exempt, they are a great option if a taxpayer wishes to sell appreciated property on a low basis. The property may be transferred to the trust, then sold while in the trust. If done correctly there should be no income tax on the sale at the trust level, and only a portion of the gain will pass out when distributions are made to the noncharitable beneficiaries. This allows the taxpayer to stretch out the recognition of and resulting tax on, the gain over time.
In addition to deferring tax on gains, CRTs allow the donor to take income tax and gift tax charitable deductions in the year the property is contributed to the CRT. The amount of the income tax deduction is limited to 60% of adjusted gross income (AGI) for gifts of cash, 30% of AGI for gifts of long-term capital gain property, and 20% of AGI for gifts of long-term capital gain property if the charity is a private foundation. The deduction amount is based on the actuarial value of the amount that will be paid to the charitable beneficiaries and can be calculated by your HBK Tax Advisor or attorney at the time of contribution. For this reason, CRTs are also a good option for wealthy taxpayers and/or those recognizing unusually high income in one year due to a large capital gain from a sale or significant ordinary income recognition from a Roth IRA conversion.
As an estate planning tool, CRTs can also be funded at death by writing them into a will or revocable trust document. If CRTs are funded at death, an income tax deduction would not be available, however, the estate may be eligible for a charitable estate tax deduction.
Charitable Lead Trusts (CLTs)
CLTs are the opposite of CRTs: amounts are paid to the charitable beneficiaries first and the remainder goes to the noncharitable beneficiaries. CLTs may also be structured as an annuity trust that pays a fixed amount each year to charitable beneficiaries, or a unitrust that pays a fixed percentage of the FMV of the trust’s assets to charitable beneficiaries on an annual basis. CLTs are not tax-exempt, meaning income from trust assets is subject to income tax. CLTs can be structured as non-grantor or grantor trusts. The differences in the income tax treatment and deductibility of the charitable contribution are described below.
- Non-grantor-type CLTs: The income interest is paid to charity and the remainder is paid to a noncharitable beneficiary other than the donor or donor’s spouse. Since the donor and donor’s spouse are not beneficiaries of the trust, income generated from the assets is taxed to the trust, and the trust deducts the payments made to the charity. The donor does not have to pick up any income from the trust assets and is not entitled to an income tax deduction on amounts passing to the charitable beneficiary. Only the remainder interest passing to the noncharitable beneficiary is subject to gift or estate tax when the trust is funded. Gift or estate tax may be due if the value of the remainder interest exceeds the donor’s applicable exclusion amount ($11.7 million for 2021, plus any deceased spouse’s unused exclusion amount if the portability election was made).
- Grantor-type CLTs: The income interest is paid to charity and the donor is the remainder beneficiary in the trust. The donor (grantor) recognizes the trust’s income as it is earned even though the grantor does not legally have access to the income of the trust. The grantor also receives a deduction for the payments made to the charity. Since the charitable contribution is considered “for the use of” the charity, it is subject to the 30% AGI limitation even if the original contribution is cash. If the original contribution was other than cash, it may be subject to a lower AGI limitation. Any charitable deduction is not used in the year it is generated, it can be carried forward for up to five years.
Grantor-type CLTs are often used in income tax planning. Although the grantor is taxed on the income, they receive a charitable deduction on an amount passing to charity at funding. For many, the deduction is driving the decision-making process when transferring assets to a grantor CLT as the grantor would be taxed on any income generated on the trust assets had they not transferred the assets to the trust. Non-grantor type CLTs are more often used in estate planning as they remove appreciation out of the taxpayer’s estate. If an asset is expected to appreciate significantly, a non-grantor CLT may be used as a vehicle to pass the expected appreciation to the noncharitable beneficiaries at the end of the trust term, removing the appreciation from the grantor’s gross estate.
Non-grantor CLTs can also be funded at death by including them in the terms of a will or revocable trust document. CLTs funded at death do not receive an income tax deduction but may be eligible for a charitable estate tax deduction.
Both CRTs and CLTs are effective planning tools and may provide significant income and estate tax benefits. Please contact your HBK Tax Advisor if you would like to learn more about these charitable trusts and whether or not they fit with your situation.
