Charitable Trusts

Giving a big gift to charity can also provide benefits to you especially when you consider a charitable trust. Especially, if you want to make a substantial gift to a charity, it may make sense to use a special kind of trust called a charitable trust. A charitable trust lets you donate generously to charity, and it gives you and your heirs a big tax break.

On the other hand, if you just want to make a few small charitable gifts, then a charitable trust probably isn't worth the bother.

You need to do some serious thinking before setting up a charitable trust. Charitable trusts are irrevocable. Once you create one and it becomes operational, you cannot change your mind and regain legal control of the trust property.

The most common type of charitable trust is called a charitable remainder trust. Here's how it usually works.

First, you set up a trust and transfer to it the property you want to donate to a charity. The charity must have been approved by the IRS, which usually means it has tax-exempt status under the Internal Revenue Code.

The charity serves as trustee of the trust, and manages or invests the property so it will produce income for you. The charity pays you (or someone you name) a portion of the income generated by the trust property for a certain number of years, or for your whole life -- you specify the payment period in the trust document. Then, at your death or the end of the period you set, the property goes to the charity.

In addition to helping out your favorite charity, you get several big tax advantages from this arrangement.

You can take an income tax deduction, spread over five years, for the value of your gift to the charity. Where things get tricky is determining the amount of your deduction. The value of your gift is not simply the value of the property; the IRS deducts from that value the amount of income you're likely to receive from the property. For example, if you donate $100,000 but can expect to get $25,000 in income back (based on your life expectancy, interest rates and how the trust document is set up), the value of your gift is $75,000.

When the trust property eventually goes to the charity outright (at your death or the end of the payment period you specified), it's no longer in your estate -- so it isn't subject to federal estate tax.

A charitable trust lets you turn appreciated property (property that has gone up significantly in value since you acquired it) into cash without paying tax on the profit. If you simply sold the property, you would have to pay capital gains tax on your profit.

A charity usually sells any non-income-producing asset in a charitable trust and uses the proceeds to buy property that will produce income for you. But charities, unlike individuals, don't have to pay capital gains tax. So if you give the property to the trust and the charity sells it, the proceeds stay in the trust and aren't taxed.

Example

Jane owns stock worth $300,000. She paid $10,000 for it 25 years ago. She creates a charitable trust, naming the Red Cross as the charitable beneficiary, and funds her trust with her stock. The Red Cross sells the stock for $300,000 and invests the money in a mutual fund. Jane will receive income from this $300,000 for her life.

Had Jane sold the stock herself, she would have had to pay capital gains tax on her $290,000 profit (for an affluent elder New Jersey taxpayer approximately $50,000 of federal and state income taxes have been avoided - the amount of tax is dependent on the prevailing interest rate and your age). Because no capital gains tax is assessed against the charity, the entire value of the gift, $300,000, is available to produce income. Additionally, the stock is not subject to estate tax upon Jane's death which can lead to additional savings.

When you set up a charitable remainder trust, there are two basic ways to structure the payments you will receive.

You can receive a fixed dollar amount (an annuity) each year. That way, if the trust has lower-than-expected income, you still receive the same annual income. Once you set the amount and the trust is operational, you can't change it. For instance, if you direct that the charity to pay you $10,000 a year for the rest of your life, you can't later say, "Sorry, but, I forgot about inflation. How about $20,000/year?"

Theoretically, you can make the payments as high as you want. Practically, however, there are limits. First, the higher the payments, the lower your income tax deduction. Second, high payments might eat into principal, possibly even using it all up before the payment term is over and leaving nothing for the charity. Third, a charity has absolute discretion as to what gifts to accept or not accept, thus it is unlikely that a charity will accept a gift if it is likely, or even possible, that all the trust property will be paid back to you.

It's common to set your annual payment as a percentage of the value of the current worth of the trust property. For example, your trust document could specify that you will receive 7% of the value of the trust assets yearly. Each year the trust assets will be reappraised, and you will receive 7% of that amount.

Because you receive a percentage, not a flat dollar amount, if inflation (or wise investment) pushes up the dollar value of the assets, your payments go up accordingly. Under IRS rules, you must receive at least 5% of the value of the trust each year.

Making the Most of a Charitable Trust

Bob, age 65, earns a very comfortable salary and has assets worth $3 million, including stock that he bought years ago for $400,000. The stock has appreciated enormously -- it's now worth $1.6 million -- but pays very low dividends.

If Bob sold the stock and bought income-producing assets, he would owe federal and New Jersey capital gains tax of approximately $250,000. Instead, he sets up a charitable remainder trust with his alma mater as the charitable beneficiary. Bob funds the trust with the stock.

For income tax purposes, his donation to the charity is the full market value of the stock, $1.6 million, less the amount Bob is likely to receive, based on his age and current interest rates. He takes this amount as a tax deduction over five years.

The charity, as trustee, sells the stock and receives a profit of $1.2 million, which is not taxed. The trustee reinvests this entire amount. The trust document requires Bob to be paid 6% of the trust value annually for life. He'll get $72,600 the first year; the amount will change each year as the value of the trust assets changes.

So far, Bob has avoided paying capital gain tax and turned an asset that paid little income into one that pays much more. But there is even more good news. Bob has also reduced his estate, and consequently the estate tax that will be due at his death. Bob has also given money to his school instead of to Uncle Sam. And he has a guaranteed income for life.

If Bob lives 20 more years, the trust will pay him at least $72,600 x 20, or $1,452,000. If the trustee invests the original $1.6 million wisely, it -- and the payments to Bob -- should increase significantly.

Estate Tax

Capital Gains Tax