Charitable Remainder Trusts

What is a charitable remainder trust?

A charitable remainder trust is a special irrevocable trust that you fund with assets or cash. The trust pays income to you or another beneficiary for your lifetime, or for a set period, and then the remainder goes to the charity of your choice. Charitable remainder trusts are subject to special tax rules. People create charitable remainder trusts to reduce income tax, avoid capital gains tax, avoid estate tax, and make a gift to a charity they care about.

How does it work?

A charitable remainder trust works best for an appreciated asset because it avoids the capital gains tax.

You fund the trust with the appreciated asset, like a stock or real estate. 

The trust then sells the asset at market value, but it does not pay capital gains tax. The trust reinvests the money into income-producing assets. You receive income from the trust for the rest of your life, or for a set period of time. When you die, the remainder of the assets go to the charity that you have chosen.

Once you place the asset in the trust, it is no longer part of your estate and so it is not subject to estate tax when you die. (This is in contrast to a revocable living trust, the assets of which will be included in your estate.)

Won't the gift to a charity deprive my beneficiaries of their inheritance?

It's true that the charity receives whatever remains of the asset when you die. But there is a simple way to replace the money for your heirs by taking advantage of the tax savings afforded by the trust.

Take the income tax savings, and add to it part of the income you receive from the trust.  With this money, fund an irrevocable life insurance trust with enough life insurance to replace the full value of the asset for your children or other beneficiaries.

Why use a life insurance trust? Because the insurance proceeds will not be included in your estate, and so they will not be subject to estate taxes. 

What are my income options?

You have two options: (1) every year you can receive a fixed percentage of the trust assets (called a charitable remainder unitrust) or (2) every year you can receive a fixed income (called a charitable remainder annuity trust) .

If you elect the first option—a fixed percentage of the trust assets—your annual income will fluctuate with the value of the trust. For example, if the trust assets are stocks that dip in value in a particular year, then your income will also dip that year. At the beginning of each year, the trust is revalued to determine your income. Charitable remainder trusts often include a provision that allows a higher percentage in a good year to make up for loss of income in a bad year.

Under the special tax rules for charitable remainder trusts, the assets grow tax free, so there is a good potential for your trust to grow in value. If that is the case, your income will grow too.

If you elect the second option—a fixed income—your income stays the same regardless of how the trust assets perform.

This is can be a good choice for older people. It doesn't protect against inflation, but some people place a higher value on receiving a definite sum each year. An annuity trust should be funded with cash or marketable assets.  

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Who can receive trust income?

Most commonly, you elect to receive the income yourself. But you can name any person or entity the income beneficiary. For example, the income can go to your children for their lifetimes.

If you name someone other than yourself, keep in mind that there will be gift tax and estate tax issues to consider.

How long does the income continue?

You can designate income to continue for (1) the beneficiary's lifetime or (2) a set number of years up to 20.

If you are married, the income can continue for as long as either of you are living.

What are the tax advantages of a charitable remainder trust?

There are three primary tax benefits.
 
The first is an income tax deduction. After you have set up the trust, you may take an income tax deduction based on the value of your gift and spread it over five years. The IRS calculates your total deduction as the amount you originally gave minus what you can expect to receive as a return through interest payments. For example, if you funded the trust with $200,000 but you are expecting to get back $100,000 in interest over your lifetime, your total income tax deduction would be $100,000.
 
The second is estate tax savings. The property in the trust belongs to the charity, so it will not be included in your estate for purposes of determining your estate tax. This is in contrast to simply naming a charity as a beneficiary of your living trust, in which case the bequest would be counted as part of your estate.

The third is capital gains tax savings. A charitable trust does not pay capital gains tax upon the sale of an asset. Let's say you own 5000 shares of stock that had appreciated from $10 per share to $100 per share during your ownership, for a total appreciation of $450,000. If you sell the stock, you will pay a 15% capital gains tax on the appreciation, totaling $67,000. But if you donate the stock to a charitable remainder trust, the trust may sell the stock with no captial gains tax at all. That is a sizable savings.

How is the income tax deduction determined?

 The income tax deduction is based on an IRS formula that takes into account the ages of the donors and income beneficiaries, the payout of the trust, and an IRS index rate known as the Applicable Federal Rate (AFR). The older you are, the larger your income tax deduction. Generally, if the trust is for a term of years rather than for life, the income tax deduction will be larger.