How Does a Charitable Remainder Trust Work?

A charitable remainder trust is often used as an estate planning device. Property is placed in a trust for a charitable organization. The person who sets up the trust, the grantor or settlor in legal terminology, receives income payments throughout their life from the charitable organization. After the grantor’s death, the charity becomes the owner outright of the property in the trust.

The goal of a charitable remainder trust is to reduce the taxable income of the grantor. The grantor also generates income for themselves or they can give the income to named beneficiaries. The grantor then makes a donation to a named charity or charities of the asset that remains in the trust at the end of the grantor’s life. A charitable remainder trust can be set up in a person’s will to provide income for heirs, with the remainder going to charities that the grantor selects.

There are two types of charitable remainder trusts, the unitrust and the annuity trust. They function as follows:

• Charitable Remainder Unitrusts: Income payments are based on a percentage of the value of the trust’s assets; the assets are revalued each year so the amount of the payments can fluctuate; additional contributions are not permitted;
• Charitable Remainder Annuity Trusts: The rate of income paid to the beneficiary is fixed when the trust is first created, so payments do not fluctuate; it is possible to make additional contributions after the trust is first created.

A charitable remainder trust cannot be revoked. This means that it cannot be changed or ended without the permission of the beneficiary, i.e. the person who receives the income payments from the trust. In giving property to the trust, the grantor gives up all rights of ownership in the donated asset. The donation to the trust is irrevocable. Also the grantor has no right of ownership or control in the trust. It is possible to set up a revocable charitable remainder trust, which would allow the grantor to make changes to the trust.

When a charitable remainder trust terminates, the assets remaining in the trust are distributed to a charitable beneficiary. This can be a public charity or a private foundation. Depending on how the charitable remainder trust is established, the trustee may have the power to change the trust’s charitable beneficiary during the lifetime of the trust before it terminates.

What are Some Advantages of Charitable Remainder Trusts?

There are certain tax advantages to using a charitable remainder trust. Highly appreciated property, such as real estate or a stock portfolio, can be donated to a charity for the life of the grantor. The income from the stock portfolio continues to go to the grantor, which is reported to the IRS as taxable income. The donation, however, is tax-deductible in the year in which it is made.

If the grantor does not need the income from the trust when the trust is established, it can stay in the trust tax-free. Or, distribution of the income can be deferred until a later time. Once payment of the income stream begins, it lasts for a term of years but cannot continue for more than 20 years or for the life of one or more named, non-charitable beneficiaries. A named, non-charitable beneficiary might be the ex-spouse or child of the grantor, for example.

Donating assets that have greatly appreciated in value to a charitable remainder trust is a way to avoid paying capital gains taxes when the asset is sold. It can also reduce the estate tax that heirs would have to pay after the death of the grantor if they inherited the asset. Estate taxes on the asset can be reduced by as much as 50%.

However, net distributions to the grantor must amount to at least 5% per year. Depending on how the trust is set up, the grantor or the grantor’s named beneficiaries can receive income annually, semi-annually, quarterly or even monthly. According to IRS rules, however, the annual annuity payment must be at least 5% but no more than 50% of the trust’s assets.

Thus it is often used as a retirement planning tool as the income paid by the trust can be deferred until the retirement of the beneficiary.

A grantor can donate such varied assets as cash, stocks, real estate, private business interests and private company stock, but a charitable remainder trust cannot hold S-corp stock. The grantor then becomes eligible for a partial tax deduction. The amount of the partial income tax deduction is based on the type of trust, the term for which the trust is established, the projected income payments from the trust, and interest rates set by the IRS, which assumes a certain rate of growth for trust assets. Determining the value of the tax deduction can be complicated and might require the assistance of a tax or estate attorney.

What are Some Similar Types of Trusts?

There are other types of trusts that can be used for purposes similar to those of a charitable remainder trust. For example, in a bare trust, the beneficiary has the right to the capital and assets within the trust, as well as the income generated from these assets. While a trustee often oversees the investments within the trust, the beneficiary makes the final decision as to how the trust’s capital or income is distributed. In bare trusts, beneficiaries must pay taxes on the income that trust assets generate, whether that is in the form of interest, dividends, or rent.

Another type of trust is an alimony substitution trust. In an alimony substitution trust a divorced person agrees to pay spousal support, or alimony, by way of income generated by a trust. As for taxation, the ex-spouse responsible for making support payments is not required to pay income taxes on the trust’s income, nor do they receive any tax deduction.

A donor-advised fund is not a trust but is a more flexible way to donate assets to charity. A donor-advised fund cannot be used to generate an income stream. Its sole purpose is to support charitable organizations. A donor can contribute cash, securities or other assets to a donor-advised fund at a public charity. The donor then can take an immediate tax deduction. The donated funds can be invested for tax-free growth. The donor has the continuing power to recommend grants from the fund to almost any IRS-qualified public charity.

Do I Need an Attorney for my Charitable Giving Matter?

You should always confer with a trust lawyer to plan the distribution of your estate. Lawyers understand the tax implications of estate planning, and will guide you through the challenges associated with drafting wills and trust documents. A lawyer near you will also help explain charitable giving, and how best to draft charitable trusts.

A charitable remainder trust might be a good choice if you want an immediate charitable deduction, and you also want to use an asset to generate an income stream for yourself or another person, such as a dependent adult child. There are many different types of trusts that can be used to achieve charitable giving and income streams. An experienced trusts lawyer can help you find the one that would best suit you.

These are complex and technical topics and an experienced trusts lawyer can ensure that the necessary documents are drafted correctly and the best estate plan set up for your individual situation.