# Tax Advantages of Charitable Trusts

Charitable trusts are a form of **deferred giving**, or what is sometimes known as **planned giving**. There are 2 types of interest in property: an income interest and a remainder interest. An **income interest** is the income generated by the property for a set duration, while the **remainder interest** is an interest in the property that remains after the income interest ends. The value of these interests depend on the property value, the donor's age, the duration, and on interest rates and actuarial tables promulgated by the IRS. For charitable trusts, donating an income interest to property to the charity usually does not result in a tax deduction for the donor. However, a charitable tax deduction can be taken for donating a irrevocable remainder interest to charity.

The tax advantages of donating to a charity through a trust are realized through a **split-interest trust**, where the interest in the property donated to the trust is split between the income and remainder interest. A charitable split-interest trust benefits both charities and individuals or other noncharitable beneficiaries. If the charity receives trust income before any of the noncharitable beneficiaries, then it is a **charitable lead trust**, because it receives the lead interest in the trust. On the other hand, if the charity receives the remainder interest, then it is called a **charitable remainder trust** (**CRT**), because the charity receives the remainder of the trust after the noncharitable beneficiaries receive their income. Because the charitable deduction is proportional to the present value of the charitable gift, charitable lead trusts will generally have a higher deduction than charitable remainder trusts, because the charity receives the money sooner.

The donor can claim a tax deduction for the remainder interest in the property for the tax year of the contribution while receiving income from the property before the property passes fully to the charity. Furthermore, the donor avoids any capital gains tax on any appreciated property. Some examples of split-interest trusts include charitable remainder trusts, charitable lead trusts, and pooled income funds.

There are some other means of claiming a tax deduction for a planned gift other than by using a split-interest trust, such as a charitable gift annuity, which is based on a contract rather than a trust, or a remainder interest can be given to a personal residence or a farm to a charity without using a trust.

## Charitable Remainder Trusts

A charitable remainder trust holds property that one or more charities have the remainder interest and the donor retains the income interest. The **charitable remainder trust agreement** must specify a distribution of income, paid at least annually, paid to one or more beneficiaries, at least one of which is not a charity. The term could be for life, but only for an individual beneficiary, or for a specified duration not exceeding 20 years, if the beneficiary is a individual, partnership, trust, or corporation. The remainder interest to the charity must be irrevocable.

Both public charities and private foundations can be remainder beneficiaries, but the donor's tax deduction may be limited by the AGI percentage. When the income interest expires, then all the assets should pass to the charitable remainder beneficiaries. If some of the assets are retained by the trust, then it may be classified as a private foundation, which has more limited tax advantages than the government-sanctioned charities.

The income can be paid either as a fixed annuity, in which case, the trust is called a charitable remainder annuity trust, or as a fixed percentage of the trust assets, in which case, the trust is a charitable remainder unitrust.

A bank or other financial institution will often serve as the trustee, since banks can more easily satisfy the distribution and reporting requirements. Sometimes the charitable organization will serve as trustee. However, if the donor or a related person serves as trustee, then any sale of appreciated property by the trust may be taxed to the donor.

To qualify as a charitable remainder trust under tax law, there are number of requirements that must be followed. The trust document must specify a specific charitable organization as the remainder beneficiary and an alternative charitable organization. The trust document can allow a substitute remainder beneficiary to be designated by the trustee, donor, or other noncharitable beneficiary. If all the rules are not satisfied, then the trust will be taxable, disallowing any deductions for any contributions, but it can be reformed to qualify under the tax requirements. Additionally, all income beneficiaries must be alive when the trust is created.

There are strict rules to deducting contributions to a charitable remainder trust, because of the potential for abuses. Because the deduction is calculated when the trust is created, the present value of the charitable benefit would not be calculable unless it was guaranteed to receive the principal amount on which the present value was calculated. Frist, if the noncharitable beneficiaries receive the income, the trustee could invest the principal into income-producing assets or even invade the principal to provide income to the noncharitable beneficiaries, which may result in nothing for the trust.

Therefore, gifts to a charitable remainder trust are only deductible if the noncharitable income beneficiaries receive a fixed annuity or a fixed percentage of a unitrust, or the beneficiaries receive the income earned by a pooled income fund where the amount is contingent on the annual rate of return.

Charitable remainder trusts are generally used when the donor has highly appreciated assets that can be transferred to the trust and sold by the trust without incurring any capital gains tax liability for the donor. The assets can be exchange for income-producing assets, thereby providing the noncharitable beneficiaries with income.

Naturally, the amount of income that the family will receive will be less because of the remainder interest to the charity, but this is often replaced by a **wealth replacement trust** (**WRT**), which is an irrevocable life insurance trust holding life insurance purchased with some of the income received from the CRT that will replace the wealth lost because of the charitable remainder interest.

### Charitable Remainder Annuity Trust

A **charitable remainder annuity trust** (**CRAT**) pays an annuity to the donor or grantor of the trust or other beneficiary designated by the donor with the remainder interest going to the charity. The **annual annuity payment** is a fixed percentage of the trust assets valued when the trust was created, so the payments do not change year to year. For the remainder interest to be tax-deductible, the following rules must be satisfied:

- the annuity must be for a fixed amount, referred to in the tax code as a
**sum certain**, that can be specified either as a specific dollar amount or as a percentage of the initial fair market value of the property, and paid to at least one noncharitable beneficiary - the annuity cannot be less than 5% of the initial fair market value, but the remainder interest must be at least 10% of the value for the property placed in the trust
- the possibility of depleting the trust assets by the annuity does not exceed 5%
- the annual payment cannot exceed 50% of the initial fair market value of the trust assets.

As an irrevocable trust, the grantor cannot change the trust to divert any payments or other property to anyone other than the charity with remainder interest. Furthermore, once the trust is funded, then no more contributions can be made. However, any number of charitable remainder trusts can be created.

The charitable deduction is proportional to the present value of the remainder interest. As such, the tax deduction depends on the annuity percentage, the dates during the year when payment is made, and the term of the trust; if the term of the trust depends on the life of one or more beneficiaries, then the deduction will depend on monthly interest rates and annuity tables published by the IRS. The deduction will equal a factor, determined by the tables, multiplied by the initial fair market value of the trust assets. In using the tables, the age of the beneficiary is rounded up if the next birthday is less than ½ year away.

### Charitable Remainder Unitrusts

The **charitable remainder unitrust** (**CRUT**) pays income to the noncharitable beneficiaries, equal to a fixed percentage of the fair market value (FMV) — the **unitrust amount** — of the trust assets determined annually; hence, unlike the charitable remainder annuity trust, the annual payments will change as the FMV of the trust changes. The tax requirements are the same as for the charitable remainder annuity trust.

Ordinarily, a unitrust pays a fixed percentage of assets regardless of whether the income is generated by interest and dividends or from capital gains. However, the charitable remainder unitrust can be structured as an income only type, in which only the income that is actually earned by the trust is distributed to the noncharitable beneficiaries, up to a specified percentage, usually the minimum 5%. A makeup option can also be added so that additional payments can be made to make up for deficient payments in the earlier years. This type of trust is sometimes known as a **Net Income with Makeup Unitrust** (**NIMCRUT**). This may be an advantageous option if the property is expected to earn more income in future years. However, if the income is still insufficient, then the property can be exchanged for higher income-producing assets.

The tax deduction is calculated as it is for the annuity trust, except that the unitrust percentage is used, and since the income depends on the valuation of trust assets, the deduction will depend on the annual date when the trust assets are valued and when the income beneficiaries receive payment.

### Taxation of Distributions

The taxation of distributions from charitable remainder trusts to the income beneficiaries is less beneficial than distributions from other types of trusts. The income payments can be divided into 4 classes:

- ordinary income, to the extent that the trust earns an income for the current year and retained undistributed ordinary income from prior years
- capital gains earned or retained from prior years by the trust
- other income, which is composed mostly of tax-exempt income, such as interest on municipal bonds
- nontaxable distribution of the trust corpus, which is nontaxable under the return of capital doctrine.

The part of the distribution characterized as capital gains can be offset with short-term or long-term capital losses from other investments of the beneficiary, but any remaining capital gain will be taxed as ordinary income.

Charitable remainder trusts are exempt from federal income taxation, but they may be subject to an excise tax on unrelated business taxable income.

A gift tax may be due on any income received by any noncharitable beneficiaries other than the donor. However, no gift tax is assessed on a beneficiary who is a spouse, because of the unlimited marital deduction. Additionally, the annual gift tax exclusion and the unified tax credit can be used to eliminate or lower gift taxes. If the donor, whether or not he is an income beneficiary, dies before the term of the trust, then the value of the trust will be added to the decedent's estate.

## Pooled Income Funds

A **pooled income fund** is a split-interest trust, but the assets are pooled from many donors. Donors receive a pro rata share of the income from the fund while the charitable organization that maintains the fund receives the remainder interest. Unlike charitable remainder trusts, the trust document cannot be customized according to the donor. Instead, the trust terms apply to all the donors to the fund. Only money or marketable securities, but not tax-exempt securities, can be contributed. Tax-exempt securities cannot be contributed because their donation is not deductible. Income interest beneficiaries receive income at least annually, equal to the rate of return earned by the fund. Income beneficiaries receive **units** equal to the fair market value of the assets that they transfer; the income is proportional to the number of units owned by the beneficiary. The tax deduction depends on the value of the donated property, and on interest rates and actuarial tables published by the IRS.

The main benefit of a pooled income fund over a charitable remainder trust is that smaller amounts can be donated by each individual. By contrast, a charitable remainder trust would not be economical if the contribution was less than $1 million. However, the pooled income fund operates much like a unitrust, in that the income equals a fixed percentage of the trust assets on specified annual dates. With a pooled income fund, the donor does not have to become trustee nor pay the annual maintenance costs, which can run from hundreds to thousands of dollars.

The assets in the pooled income fund are held by the trustee, which may be the remainder interest charity, and cannot be sold or redeemed by the donor or income beneficiary. Realized capital gains are reinvested, so they are not distributed. When the income interest terminates, then the assets are transferred to the charity.

Because the pooled income fund must be maintained by a charity organization, it must exercise control over the fund, either by appointing a trustee or by acting as a trustee itself. A financial institution may be selected as a cotrustee with the charity creating the fund as the other cotrustee. However, no donor or income beneficiary can serve as trustee. Most types of public charities, but not private foundations nor some public foundations, can maintain a pooled income fund.

To deduct the remainder interest to the charity, the pooled income fund must meet the following requirements:

- the donor must transfer the assets irrevocably
- at least 1 of the charitable organizations with a remainder interest must qualify to operate the pooled income fund
- transferred funds must be commingled with those donated by others
- the fund cannot invest in tax-exempt securities
- the donor must create, as a condition of the transfer, an income interest for the life of 1 or more noncharitable beneficiaries.

The income interest of a beneficiary is proportional to the number of units assigned to the beneficiary. The fair market value of the pooled fund is determined periodically, typically on the 1^{st} business day of each quarter. The value of each unit is determined by dividing the fund's value by the number of outstanding units. Additional gifts by donors are added on the next determination day after their receipt. Like an annuity, the number of units held by any one beneficiary does not change — only its value changes. When the life of the beneficiary ends, the units allocated to the beneficiary are transferred to the charity. Any units outstanding for less than the full tax year will receive an income equal to a percentage of the time that the units were outstanding over the full taxable year.

Distributions are usually made on the 15^{th} of the month following the close of each fiscal quarter. All income must be distributed annually. If it is not, then an additional payment equal to the remaining income must be made within the 1^{st} 65 days of the next tax year.

Any gains by the fund that are not recognized as income according to federal tax laws are treated as principal and retained by the fund, including:

- gains from the sale or other disposition of assets
- capital gain dividends of mutual funds
- stock dividends, stock splits, and similar distributions
- liquidating distributions

Like contributions to charitable remainder trusts, the charitable deduction to pooled income funds depends on the present value of the income interest retained or designated by the donor. The remainder interest = the value of the contribution minus the value of the income interest. Because the term of the income interest for each beneficiary depends on their life expectancy, the present value of the income interest will depend on the beneficiary's age and by the highest rate of return experienced by the fund for the 3 years before the year of the contribution. If the fund has not existed for at least 3 years prior to the year of the contribution, then a 9% rate of return must be presumed.

A pooled income fund, unlike a charitable remainder trust, is not tax-exempt, but may eliminate its tax liability by distributing all the income to its beneficiaries and using long-term capital gains for charitable purposes. The income received by the noncharitable beneficiaries is taxable as ordinary income.

A pooled income fund is based on 2 types of agreements: the declaration of trust or trust agreement, and a pooled income fund life agreement. The **trust document**, of course, specifies the operations of the trust, and for contributions to be deductible, the trust must follow IRS rules. The **pooled income fund life agreement** is the agreement between the donor and the fund, specifying the beneficiaries for a particular gift and how the income is to be distributed if there is more than 1 beneficiary.

Financial institutions often serve as trustees, but they require a minimum trust principal to justify the expenses of operating the fund. Since charities oftentimes do not have enough investments to satisfy the minimum from gifts, it is permitted to use some of its own assets to satisfy any minimum value requirements. However, as the fund receives more gifts, then the charity will withdraw its own assets until the fund consists only of gifts. None of the income beneficiaries will benefit from any income earned by the charity's assets.

## Charitable Gift Annuities

A **charitable gift annuity** is much like a CRAT, but the annuity is based on a contract rather than a split-interest trust. In exchange for property from the donor, the charity pays a donor, or some other named beneficiary, a fixed annuity. The law requires that the term be for 1 or 2 lives — it cannot be for a term of years. As an annuity based on life expectancies, the amount of the annuity will depend on interest rates and life expectancies based on IRS tables. The gift to the charity is the amount given by the donor that exceeds the cost of the annuity. The gift portion is what is deductible. The income is taxable as ordinary income, but a portion of the annuity is treated as a tax-free return of capital.

Unlike with split-interest trusts, where the amount paid as income cannot exceed the trust value, the charity assumes some risk, in that the fixed annuity must be paid regardless of the return earned by the property. Because the income may exceed the amount of property given, some states require that the charities establish a reserve fund to pay the annuities. However, the charities may simply purchase insurance to cover any shortfalls.

## Charitable Lead Trusts

The **charitable lead trust**, inter vivos or testamentary, is structured so that the charity receives the income for a specified time, either as a term of years or based on one or more lives. The income period is called the **lead period** — hence, the name of the trust. The remainder interest is then transferred to beneficiaries specified by the donor. The charitable lead trust is generally structured to save on gift or estate taxes when property is transferred to the donor's beneficiaries. As such, it does not give a current charitable deduction, but the donor is not taxed on income going to the charity. Thus, the charitable lead trust is an effective way for a donor to give to a charity when the donor has already exceeded the AGI limits for charitable deductions. Although it is not a gift of a present interest, which would qualify it for the gift tax annual exclusion, the gift tax is reduced because only the present value of the gift is taxable. Additionally, any appreciation of the property is removed from the estate of the donor. Charitable lead trusts are often formed by individuals who will receive a high income for the year. The CRT will allow the deduction of the present value of all payments that the charity will receive in the year that the trust is irrevocably funded, thus reducing taxable income.

The income can be a fixed annuity interest or a unitrust interest, a percentage of the trust value on specified annual dates. Unlike a charity remainder trust, where a term of years cannot exceed 20 years, there is no limit to a term of years for the charitable lead trust, so it can be set up to last for decades.

Contribution amounts to charitable lead trusts are not restricted by law, in contrast to charitable remainder trusts, where tax-deductible contributions may be limited to 50% or 30% of AGI, depending on whether the charity is public or private.

However, charitable lead trusts have several disadvantages. Capital gains tax must be paid on any capital gains, and if the trust earns more income than is paid to the charity, then the excess amount is taxable as ordinary income either to the trust or to the grantor if it is a grantor trust. There are also legal costs in setting up the trust and annual accounting fees. Additionally, a grantor serving as trustee will have additional duties in maintaining and carrying out the provisions of the trust.