Posted by Michael Boncher and Rachel Bendon
Many taxpayers are generally familiar with the tax benefits of charitable contributions. Each year, individuals donate to charities of their choice and are allowed to deduct the amount contributed as an itemized deduction on their tax return, subject to limitations.
However, there are a couple other charitable planning tools you may not be as familiar with that can help you achieve both charitable and noncharitable goals, while still allowing you to take the related income tax deduction. Charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) are two key options to be aware of, and each is treated quite differently for tax purposes.
A charitable remainder trust (CRT) is an irrevocable trust funded with cash or other assets. A CRT distributes payments annually to one or more noncharitable beneficiaries for a select number of years, limited to 20, or for the duration of the beneficiary’s life. Once the payment term ends, any remaining, as in “charitable remainder,” interest is paid out to the charity of the taxpayer’s choice.
CRTs themselves are generally not subject to income tax. Distributions to the noncharitable beneficiaries are taxed at the beneficiary level, and any income retained in the trust is not taxed because it will eventually be distributed to a charitable organization. Upon creation of a CRT, the taxpayer (donor) will receive a charitable deduction on their income tax return equal to the present value of the remainder that eventually is donated to charity.
Distributions from a CRT to noncharitable beneficiaries are classified for tax purposes in four different categories:
Broadly, the current and accumulated income of each category must be completely distributed before moving to the next category. For example, if the trust cannot cover the required distributions with current and accumulated ordinary income, the next category of income to be distributed would be capital gain income. In other words, a CRT cannot sell a highly appreciated capital asset and distribute the capital gain income without first distributing all of its ordinary income (earned in both the current year and prior years) first.
A CRT could be used as a vehicle to stretch inherited IRA payments beyond the general 10-year rule. The SECURE Act changed the rules related to inherited IRAs, generally requiring an IRA to be fully distributed within 10 years from the date of the original account owner’s death. If a CRT inherits the original account owner’s IRA, the liquidation of that IRA by the CRT would not be a taxable event. The income would only be taxable as it is distributed to the noncharitable beneficiary, which could be set to a maximum 20-year term or set to the life of the noncharitable beneficiary. Even though the payments would still be taxable as ordinary income, the tax could be deferred well beyond the 10-year general rule. The trade-off under this structure is the noncharitable beneficiary will not receive the full account balance of the IRA, as the remainder must be distributed to charity.
A charitable lead trust (CLT) is an irrevocable trust funded with cash or other assets. However, this trust functions in an opposite way compared to a CRT, leading with a charitable organization. A CLT distributes payments annually to a charitable organization for a select number of years, or for the lifetime of named individuals, such as the donor, donor’s spouse or a lineal ancestor of the remainder beneficiaries. Once the payment term ends, the remaining interest is paid out to either the donor or one or more noncharitable beneficiaries.
CLTs can be structured as either a grantor trust, if the donor is alive when the trust is created, or a non-grantor trust. The non-grantor trust is subject to tax, while in the scenario of a grantor trust, the grantor pays the tax on the trust’s income.
If a CLT is structured as a non-grantor trust, the taxpayer will not receive a charitable deduction for the assets contributed to the trust. The trust itself is entitled to a charitable deduction each year income from the trust is used to pay the charitable distribution.
If a CLT is structured as a grantor trust, the taxpayer (donor) will receive a charitable deduction equal to the present value of only the income interest, because the remainder interest will be distributed to a noncharitable beneficiary.
A CLT could be used as a vehicle to reduce or eliminate estate or gift taxes for an individual who has consumed all of their lifetime exemption, while still providing some benefit to next generation. The income (charitable) interest is valued using a specific formula. In other words, for estate/gift tax valuation purposes, the assets of the CLT are assumed to grow at the formula determined rate. As a result, CLT payments can be defined in a manner in which the CLT would “zero-out” at the end of the CLT term, meaning the remainder interest is valued at zero. If the assets of the CLT grow at a rate greater than the formula determined rate, assets will remain at the end of the term and can pass to the next generation gift- or estate-tax free.
When it comes time to consider your charitable contributions for this year, consider adding CRTs and CLTs to your toolbox as they make sense for your scenario and goals.
Contact Michael Boncher, Rachel Bendon or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.