by Suan E. Anderson, Ph.D., CPA, CFP®
- Split-interest charitable trusts allow an asset to benefit both charitable and noncharitable beneficiaries, while providing significant tax savings. This article describes charitable lead trusts (CLTs), charitable remainder trusts (CRTs), and pooled income funds (PIFs).
- CLTs make periodic payments to a charity for the trust's term. At termination, the trust assets are transferred to a noncharitable beneficiary. Donors can deduct the present value of payments to be made by qualified CLTs in the year the trust is funded.
- CRTs provide payments, at least annually, to the donor or a noncharitable beneficiary for a term not to exceed 20 years or an individual's life. The charity receives the trust assets at termination. In a CRT, the donor receives an income tax deduction for the present value of the remainder interest in the year the trust is funded. Trust annual distributions are taxed to the recipient using a four-tiered approach.
- PIFs are managed by large charities and permit multiple donors to combine their contributions. The donors, or a named beneficiary, receive income from the fund for the remainder of their lives. After the donor's death, the donated property becomes the property of the charity. In the year a donor contributes to a PIF, the donor can deduct the fair market value of the property for income and gift taxes. All payments received from the fund are taxable as ordinary income.
Do your clients have both philanthropic and family needs to consider in distributing assets? Consider using split-interest charitable trusts, which allow an asset to benefit both charitable and noncharitable recipients while generating significant tax savings. This article describes three popular types of split-interest charitable trusts in which donors contribute assets to an irrevocable trust:
1. Charitable lead trusts
2. Charitable remainder trusts
3.Pooled income funds
Types of Charitable Lead Trusts
Charitable Lead Trusts (CLTs) provide a means of transferring assets to a beneficiary at a reduced gift or estate tax while providing income to a charity. With a CLT, a charity receives an intervening income interest in the property, thus reducing the gift amount to the present value of the remainder interest rather than the property's current fair market value. The donor receives an income-tax charitable contribution deduction for the value of the income interest. The remainderman takes the donor's basis in the property and all post-gift appreciation is removed from the donor's estate.
A CLT's tax consequences are determined by two characteristics: (1) whether it is qualified and (2) whether it is a grantor trust. CLTs must be "qualified" in order to create a deduction for estate, gift, and income taxes at the time the trust is funded.
There are two types of qualified CLTs: charitable lead annuity trusts (CLATs) and charitable lead unitrusts (CLUTs). In a CLAT, the annuity is based on the fair market value of the trust's net assets at the time the trust is formed. Payments from a CLUT are based on the fair market value of the trust's net assets determined annually.1 A qualified CLT's duration may be expressed in either number of years or an individual's remaining lifetime. The measuring life must be that of the donor, donor's spouse, or a lineal descendant of the donor or donor's spouse.2
CLTs are classified as grantor or nongrantor trusts, depending on whether the grantor retains the power to control beneficial enjoyment, the power to revoke the trust, or any of the attributes described in IRC Sections 672–677. A retained reversionary interest triggers grantor trust treatment if the reversion is valued at more than 5 percent of the trust property's fair market value at the time the trust is formed.3
Table 1 summarizes the tax treatment of CLTs. For qualified grantor CLTs, the donor is able to deduct the present value of the unitrust or annuity payments on his or her individual tax return for the year the trust is funded, subject to the 50 percent and 30 percent of adjusted gross income limitations.4 In subsequent years, the grantor will include the trust's income on his or her individual tax return, but cannot deduct the payments to charity.
Nonqualified grantor CLTs require the donor to report the trust income and deduct charitable contributions annually on their personal tax return. In contrast, nonqualified nongrantor CLTs are separate taxable entities that deduct charitable contributions as they are made, resulting in little or no income. Nonqualified nongrantor CLTs are often established to pay all of their income to the charitable life tenant. Although they do not provide the donor income-, estate-, and gift-tax deductions at formation, the grantor is able to deduct the annual payments as charitable contributions for the gift tax. Qualified nongrantor CLTs must take the form of CLATs or CLUTS. If income is insufficient to make the unitrust or annuity payments, the trustee may have to distribute corpus. If a qualified nongrantor CLT makes a charitable contribution greater than the annuity or unitrust payments, it can only deduct payments equal to the annuity or unitrust amounts on its income tax return.5 Trusts do not have a percentage limitation on charitable contributions, but contributions must be authorized by the trust's governing instrument.6
Charitable Remainder Trusts
Charitable remainder trusts (CRTs) must be both qualified and nongrantor to obtain deductions for estate-, gift-, and income-tax purposes at formation. Two types of CRTs meet these requirements: (1) charitable remainder annuity trusts (CRATs) and (2) charitable remainder unitrusts (CRUTs). To qualify as a CRAT, the holder of the income interest receives, at least annually, a fixed-percentage payment ranging from 5 to 50 percent of the initial fair market value of the trust assets. In a CRUT, the payment is calculated using the annual fair market value of the trust assets.
At creation, remainder interests for CRATs and CRUTs must have a value equal to or greater than 10 percent of the initial fair market value of trust assets. Unlike CLTs, CRTs are limited to a 20-year period or the duration of the life or lives of income beneficiaries.7 At the time a CRAT is formed, the donor may deduct the fair market value of the property placed in trust less the present value of the annuity as a charitable contribution on his or her individual tax return and for estate and gift taxes.8 For a CRUT, the deduction is the present value of the remainder interest.9
CRATs do not allow additional contributions after formation.10 Additional contributions can be made to a CRUT only if specified in the trust's governing instrument.11 CRTs cannot allow distributions to benefit anyone other than the designated beneficiaries. No one can have the power to invade, alter, amend, or revoke the trust for the benefit of anyone other than the charity.12
CRTs offer a significant advantage over CLTs in that qualified CRTs are not typically subject to income tax.13 If a CRT has unrelated business taxable income, all of the CRT's income for that year is subject to income tax.14
The CRT instrument must contain prohibitions against self-dealing, excess business holdings, taxable expenditures, and restrictions on investments that jeopardize charitable purposes.15 To help taxpayers establish CRTs that comply with these multiple requirements, the IRS has published draft trust instruments.16
A net-income makeup trust (NIMCRUT) is a special type of charitable remainder trust. In a NIMCRUT, the payment is based on a fixed percentage of the value of the trust assets at the beginning of the year, but is limited to the trust's annual income. If the trust income is less than the payment based on the fair market value of trust assets, the trust may increase payments to the beneficiary in subsequent years to compensate for a prior deficiency.17
Distributions from a CRT are taxable to the recipient. Reg. 1.664-4 delineates three major categories of income:
1. Ordinary income
2. Capital gain
3. Tax-exempt income
Within each category, the highest-taxed items are deemed to be distributed first. Distributions first come from ordinary income to the extent of the trust's gross income for the year plus any undistributed ordinary income from prior years. After all ordinary income is exhausted, distributions are made from current-year capital gains and undistributed prior-year capital gains, starting with the highest-taxed capital gains (short-term capital gains). The third tier of distributions is from current and undistributed tax-exempt income. If the tiers of ordinary income, capital gain, and tax-exempt income are depleted, the remaining distribution is deemed to be from corpus and is nontaxable.
Pooled Income Fund
A pooled income fund (PIF) allows smaller donors the benefits of a CRT. Multiple donors combine their contributions in a trust that is maintained by the donee charity.18 In return, the donor receives a share of the PIF earnings for the remainder of his or her life, or the life of a designated individual.19 The donor will be subject to gift tax if the income interest is given to another individual. Donors receive deductions for estate, gift, and income taxes of the present value of the remainder interest at the time of contribution.20 The remainder interest is valued based on the fund's highest annual rate of return for the three prior years and the number and age of the income beneficiaries.21 PIFs are not allowed to accept or invest in tax-exempt securities.22 If the donor retains the power to terminate the designated beneficiary's income interest, the value of the income interest will be included in the donor's estate. Table 2 summarizes the tax consequences of a PIF and CRT.
Unlike a CRT, a pooled income fund is taxable. Taxable income is reduced by deductions for distributions and charitable contributions. PIF distributions are taxable as ordinary income to the recipient. Income must be distributed within the current taxable year or the first 65 days of the following year.23 Examples of PIF instruments can be found in Rev. Proc. 88-53. Since the Internal Revenue Service provides examples of acceptable PIF instruments, it will not issue a private letter ruling on whether a fund qualifies as a PIF.24
Financial planners must consider several factors when recommending split-interest charitable arrangements. The deduction for individual charitable contributions in a single year cannot exceed 50 percent of the individual's adjusted gross income (AGI). Contributions of property that would generate a long-term capital gain upon its sale are restricted to 30 percent of AGI. When the charitable contribution for a split-interest plan is combined with the donor's other contributions, these limitations may be exceeded. Taxpayers may carry over amounts exceeding these limitations for up to five years. Due to these restrictions, split-interest charitable trusts with large up-front deductions should be funded in years when a taxpayer has high income.
Highly appreciated, low-basis assets are excellent sources of funding for CRTs. A CRT can sell the asset without recognizing a taxable gain. The sale proceeds may be invested in a diversified portfolio, generating cash flow to supplement the donor's income. If family members are concerned that their inheritance will be reduced, the donor may use the tax savings created by the charitable contribution deduction to buy life insurance. This plan reduces the client's taxable estate and provides a liquid inheritance for heirs.
CLTs are attractive for clients with ample income seeking to transfer assets at minimal estate and gift taxes. By prolonging the payment period to the charitable beneficiary, the present value of the remainder interest is decreased and the value of the gift is reduced. In deciding whether to use a CLAT or CLUT, planners should consider the donor's goals. If the donor seeks to maximize the payment that the noncharitable beneficiary will receive at the trust termination, a CLAT is preferable if the trust assets are expected to significantly appreciate in value. A CLAT also favors the remainderman if the amount paid to the charitable beneficiary is less than the trust's annual income, since the excess accumulates for the benefit of the noncharitable beneficiary.
Appreciation in the value of trust assets causes annuity payments in a unitrust to increase, maximizing the payment to the charity in a CLUT or to the noncharitable beneficiary in a CRUT. The annual valuation requirements for unitrusts increase administrative costs over annuities.
Alternatively, if trust assets in a unitrust decline in value, the noncharitable life tenant will receive a reduced annuity payment. The IRS has allowed early termination of CRUTs when the donor is dissatisfied with the annual return or needs access to the corpus. To avoid repayment of the tax benefits from the initial charitable contribution, the charity must receive the present value of its proportionate interest. Distributions made to the noncharitable beneficiary are taxed as long-term capital gains.25
Clients who do not have the wherewithal to establish charitable trusts may want to use pooled income funds to diversify their investments. Many large charities have PIFs requiring as little as a $5,000 investment. Since the payments from a PIF are taxed as ordinary income, it is preferable that they be received after the taxpayer's income has decreased, as in retirement.
The possible elimination of the estate tax does not reduce the need for split-interest charitable trusts and pooled income funds. Eighteen states have no plans to phase out their estate taxes.26 Gift tax rates will remain as high as 35 percent in 2010, even as the estate tax is repealed for that year. Thus, split-interest charitable trusts and pooled income funds will continue to be valuable tools for several years.
Susan E. Anderson, Ph.D., CPA, CFP®, is associate professor of accounting in the Walker College of Business Administration at Appalachian State University in Boone, North Carolina. She can be reached at email@example.com .
- IRC Sec. 2055(e)(2)(B).
- Reg. 20.2055-2(e)(2)(vi)(a).
- IRC Sec. 673(a).
- Reg. 20.2055-2(e)(3)(f)(1), IRC Sec. 170(d)(1)(A)(i), and IRC Sec. 170(b)(1)(C).
- Reg. 20.2055-2(e)(2)(vi)(d) and (vii)(d).
- IRC Sec. 642(c)(1).
- IRC Sec. 664(d)(1) and (2).
- Reg. 1.664-2(c).
- Reg. 1.664-4(a).
- Reg. 1.664-2(a)(6)(iv).
- Reg. 1.664-3(b).
- Reg. 1.664-3(a)(3)(ii).
- IRC Sec. 664(c).
- Reg. 1.664-1(c). IRC Sec. 512 defines unrelated business taxable income.
- Reg. 1.664-1(b).
- See Rev. Proc. 2003-53 through 2003-60 for CRATs and Notice 2000-372005-52 through 2005-59 for CRUTs. The IRS will not issue private letter rulings as to whether a particular trust qualifies as a CRT.
- IRC Sec. 664(d)(3).
- Reg. 1.642(c)-5(b)(5).
- IRC Sec. 642(c)(5).
- Reg. 1.642(c)-6.
- Reg. 1.642(c)-6(a)(2).
- IRC Sec. 642(c).
- Reg. 1.642(c)-7.
- Rev. Proc. 88-54 PLR 200408031 and PLR 200441024.
- "Estates of Pain," Wall Street Journal, August 1, 2005, p. A8. These states are Connecticut, Illinois, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, Washington and Wisconsin.