Charitable trusts are an effective way to balance personal financial goals with philanthropic endeavors. Two types of these trusts, charitable remainder trusts (CRTs) and charitable lead trusts (CLTs), are particularly useful for their tax benefits. Let’s delve into the inner workings of these trusts and how they can serve as tax-efficient strategies in your financial plan.
Charitable Remainder Trusts
A CRT is an irrevocable trust that pays you or your designated beneficiaries an income, with the remainder of the assets ultimately going to a charitable organization. The income could be either a fixed amount (charitable remainder annuity trust – CRAT) or a percentage recalculated annually (charitable remainder unitrust – CRUT).
The tax advantages of a CRT are three-fold. First, you receive an income tax deduction for the value of the assets that will eventually go to the charity, distributed over a five-year period.
Second, if you donate appreciated assets to a CRT and the trust sells them, the sale does not trigger immediate capital gains tax. This allows for full reinvestment and potentially higher income. Lastly, the assets in the CRT are outside of your estate, providing potential estate tax savings.
Charitable Lead Trusts
A CLT, conversely, operates in the opposite manner. A CLT pays income to a charity for a set term, and the remaining assets then pass to non-charitable beneficiaries.
CLTs also offer substantial tax benefits but function differently from CRTs. If you set up the CLT as a grantor trust, you receive an immediate charitable income tax deduction for the present value of the income interest going to the charity.
However, you must report the trust’s income on your tax return. For a non-grantor CLT, there’s no immediate income tax deduction, but the trust can deduct the income paid to the charity, which can offset the tax on trust income.
A major benefit of a CLT lies in its potential for estate tax savings through zeroing out the trust. To begin with, the act of funding the trust will shave down the value of the estate.
The idea is to arrange for the charitable beneficiary to receive payments equal to the entire taxable value of the trust. Appreciation is accounted for by the IRS through the application of the hurdle rate, which is 120% of the federal midterm rate.
If the assets appreciate at a rate that exceeds the hurdle rate, there will be a remainder after all of the charity receives the entirety of the taxable value of the trust. But for tax purposes, the value is zero. That remainder is transferred to the non-charitable beneficiaries tax-free.
Summary
CRTs and CLTs are effective tools for the charitably inclined, offering the ability to give generously while enjoying considerable tax benefits. CRTs provide an income stream, an immediate charitable deduction, avoidance of capital gains tax, and potential estate tax reduction.
CLTs, alternatively, provide immediate charitable deductions (for grantor CLTs), potential offsetting of trust income (for non-grantor CLTs), and reduced taxable estate or gift value. The choice between a CRT and a CLT will depend on your specific circumstances, and professional guidance is invaluable in making this decision.
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