There are an abundance of trust options out there. Each one can help families with their current financial planning or, more commonly, in estate planning. My clients ask me all the time about the differences between these products, because they can have dramatically different impacts on a family’s long-term financial picture and their ability to support charity. Here are some common questions:
How Do Charitable Trusts Differ from Other Trusts?
The largest differentiator is—you guessed it—a charitable component. Every charitable trust benefits charity in some way. While they’re irrevocable (locked in after they’re funded), there is flexibility in that you can name either one charity or multiple charities to benefit.
How, then, does a charitable entity benefit from the assets put into the trust? Unlike a gift in kind, cash bequest, or other way of giving, the charity/charities will get distributions from the trust itself. This could be a lump sum at the end of the trust’s existence, or it could be a series of payments to charity from the trust over time (determined by the format of the charitable trust, which we’ll discuss in a bit). The charitable entity can be a nonprofit organization, a foundation, or even a fund at a foundation, such as a specific donor advised fund.
Who Benefits From a Charitable Trust?
Obviously, you’ll be benefiting charity through this type of trust. We sometimes call these trusts “give it twice” trusts, because the amount of money that can be given often surpasses families’ wildest dreams for charitable giving. Even a run-of-the-mill charitable trust set up by an average family has the ability to transform the financial future of an organization.
But, there are also major tax benefits to giving this way, so it’s a win-win! With the exception of a Charitable Lead Trust (which we’ll discuss in a bit), you or your estate will receive a charitable tax deduction in the year you fund your charitable trust. Your deduction will be calculated based on a number of factors, including how much money will ultimately go to charity, the type of trust, what assets are used to fund the trust, the duration of the trust, the payout percentage, the Applicable Federal Rate (AFR) which is the value that is used when setting up the trust, etc. With a charitable trust, there is potential to reduce or completely eliminate capital gains tax, as well, which can create HUGE opportunities for passing on wealth, when a trust is funded with appreciated assets.
What Are Charitable Lead Trusts vs. Charitable Remainder Trusts?
There are two overarching types of charitable trusts: lead trusts and remainder trusts. Both have a similar format, where there are a series of payouts over time, and when a designated period of time ends, the whole amount (the “remainder” that is left) in the trust then gets distributed.
The names tell you how they are set up. With a Charitable Lead Trust, the charity gets the annual payments. Essentially the trust “leads” with payments to the charity, and the final balance goes to beneficiaries, typically the initial donor and/or family members.
With a Charitable Remainder Trust, the payments go to the beneficiaries, and the “remainder” of the trust goes to the charity.
In both cases, the trusts are irrevocable (meaning they can’t be changed after funding) because of the potential tax benefits. (The IRS doesn’t allow someone to receive a benefit and then change or reduce the actual benefit to charity.)
What is a Charitable Lead Trust?
These are a little less common than remainder trusts, but there are still some situations where they can be a useful solution.
Charitable Lead Trusts (CLT)
A charitable lead trust is an irrevocable trust designed to provide financial support to one or more charities for a period of time, with the remaining assets eventually going to family members or other beneficiaries.
These are set up for a predetermined set of time, typically 10 to 20 years. The charity or foundation receives payments from the trust over this period of time. When this time period expires, the remainder of the trust is returned to the “non-charitable beneficiaries,” typically the person who funded it or their family. Often, the time frame can be calculated to “zero out” the gift tax with a specific duration based on interest rates (AFR) at the time of funding.
This trust format is often recommended for people with substantial wealth to store assets whose value will undoubtedly appreciate in the future, which can help reduce the taxes on the increased value. These might be ideal for someone who has at least $1 million they can afford to put in the trust and enough income to benefit from the full tax deduction potential. If a donor habitually contributes to charity, this solution is even more suitable, because the trust payments can be substituted for the donor’s regular contributions. So, their income or total assets are not reduced any more than they would be if a charitable trust were not involved.
While there is no income tax deduction for a CLT, the trust itself is a tax-paying entity and for each year it makes a payout, the trust gets a deduction for the gift it makes to charity. While they can be helpful in reducing potential gift or estate taxes, there aren’t as many tax savings as with other types of trusts, because the owner never fully gives up control of the money.
What Are the Types of Charitable Lead Trusts?
Under the Charitable Lead Trust umbrella, there are both Charitable Lead Annuity Trusts (CLAT) and Charitable Lead Unitrusts (CLUT). The annual distribution from an annuity trust is a percentage of the initial contribution to the trust, and will not change over the duration of the trust. The annual distribution from a unitrust is based on the annual valuation of the trust assets and, therefore, the annual payment can fluctuate based on the market. This can also pose a problem if the AFR goes up significantly.
The most common structure is a CLAT because of the opportunity for the growth of the asset value to be passed on to family or back to the donor. Essentially, the charitable interest receives an “annuity” or payment from the trust during the term limit for the exact same amount of money each year, which wont eat into the growth of the assets. This is especially favorable during seasons of low AFR, like right now!
What are Charitable Remainder Trusts (CRT)? AKA: Our Bread & Butter
These types of trusts are our sweet spot, but we find that there is a real education barrier for the general public. Many of our clients are either unaware that CRTs exist or unsure how to use them. CRTs provide a lot of flexibility and can make sense in many situations.
Charitable Remainder Trust (CRT)
This type of trust provides income for the donor, spouse, or other beneficiaries before making a substantial charitable donation.
Essentially, these work in the inverse way of the Charitable Lead Trust. The payments or distributions first go to the beneficiaries, and then the remainder goes to charity, hence the name. Term length can be for a lifetime, lifetimes, or a specific number of years up to a maximum of 20 years. Or, to make things really confusing, if the donor is receiving payments, a trust can be set up for their lifetime, another person’s lifetime (such as the spouse) after the donor passes away, plus a term of years for payments to go to their kids.
For example, let’s say George owns a significant piece of farmland he is no longer using. A trust could be set up to be funded with the land and give his family income. Once set up, the trust could sell the land and reinvest the proceeds to produce income, and George would receive payments from the trust for the rest of his life. After he passes away, the payment goes to his wife for the rest of her life, and when she passes away the payments could go to children for up to 20 years. At the termination of the trust, 20 years after George and his wife pass away, a substantial gift would go to charity.
What Are the Types of Charitable Remainder Trusts?
Just as with lead trusts, there is both an annuity option and a unitrust option. The Charitable Remainder Annuity Trust (CRAT) always pays a percentage of the initial value, so the payment stays the same, whereas the Charitable Remainder Unitrust (CRUT) pays a percentage of the current trust value. So, the payment can go up or down depending on the changes in the market. We often will recommend the CRUT because of the potential to both grow the trust itself as well as the yearly payments to the beneficiaries. If a trust increases in value, which is often the case, there is potential for the payments to increase in size, meaning you can pass more to your heirs without negatively impacting the remainder value for charity.
In addition, the CRAT remainder can go down if the trust value goes down, reducing or even eliminating the benefit to charity. While this is rare, it is worth considering.
Charitable remainder trusts can be set up during life to benefit the donor, or through a will in testamentary format to benefit heirs. Since both formats retain an income stream to beneficiaries, depending on the assets you have, there can be different opportunities inherent in each type.
CRUTs that are funded during life are typically funded with appreciated assets such as a home, business, or long-term stocks. There can be several benefits to this format. First off, there is the potential to greatly reduce or completely bypass capital gains tax on the growth of those assets. (The trust is a charitable entity and can sell those assets without having to recognize the gain.)
Additionally, there is an opportunity for a charitable deduction. You would receive the deduction in the year you set up the trust, but even if you can’t use up all of the deduction that year, you have up to 5 years to use it. It is not as much of a deduction as if it were a direct gift (since you are retaining a chance for income) but it still can have an impact on your annual tax liability.
How does the income stream work? You can turn your appreciated assets into ordinary income for you and your spouse, for example, and receive payments from the trust monthly, quarterly, or annually. After you pass away, you could continue the payments to your heirs or have the trust terminate. Termination of the trust makes the remainder value go to charity immediately, and this would either be at the end of the specified term of years or, more commonly, at the donor’s death.
A testamentary trust is set up during a donor’s lifetime and sits as an empty shell until it is funded at death. A common strategy is funding a Charitable Remainder Unitrust with pre-tax retirement assets such as 401(k)s, 403(b)s, IRAs, and Annuity Benefits, which give your beneficiaries the benefit of spreading out distributions instead of having to use, and pay tax on, those funds within 10 years.
Again, there are several benefits of a testamentary CRUT. As I just mentioned, one is to bypass immediate taxation for your heirs instead of paying a lump sum at your death. And then there’s the stream of income to heirs after a donor passes. Not only does it minimize their income tax, but they are receiving a gift from Mom and Dad annually for years after they have passed on. How cool is that? Additionally, the estate will receive a charitable deduction, and of course the thing we get most excited about is the significant bonus gift to charity at termination. Although these gifts are not immediate, they ensure gifts to a nonprofit for years to come.
Trusts are not one-size-fits-all. Depending on your stage of life and your current concerns, each trust will look different for your situation. Your needs may come and go, and there may be a trust structure that makes a lot of sense for your family right now, but won’t in 10 or 20 or 50 years.
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About the Author: Ryan comes to Apex Legacy Consultants from the marketing and advertising world, where he learned that effective communication leads to action. Ryan’s interest in personal finance–paired with a passion for stewardship–made gift planning an ideal transition. In his free time, you’ll find him cheering on the Jayhawks, sneaking in another round on the golf course, or taking walks with his wife, Calli, in Minneapolis.