White Paper: Charitable Lead Trust

Transcription

1 White Paper: Toll Free Tel Fax Securities offered through Securities Equity Group Member FINRA, SIPC, MSRB

2 Page 2 Table of Contents... 3 What is it?... 3 When can it be used?... 4 Strengths... 4 Tradeoffs... 6 How to do it... 7 Tax considerations... 9 Questions & Answers Disclosures... 15

3 Page 3 What is it? A charitable lead trust is a trust with both charitable and noncharitable beneficiaries. It is called a lead trust because the charity is entitled to the lead (or first) interest in the trust property, and the noncharitable beneficiary receives the remainder (or second in line) interest. The operation of a charitable lead trust is thus the exact opposite of a charitable remainder trust. Every year for the trust term, the charity receives a payment from the trust property. At the end of the trust term, the remaining assets pass to the noncharitable beneficiary. A charitable lead trust works like this: You transfer property to a trust. It can be almost anything: cash, securities, real property, a rare collectible item (though this would need to be sold to produce income). You choose a noncharitable beneficiary. This person can be anyone: you, your spouse, your hockey coach. You choose a charity. You determine how much money the charity will be paid each year from the trust assets. This payment can be either an annuity amount, which is a fixed amount of the initial fair market value of the trust assets, or a unitrust amount, which is a specified percentage of the value of the trust assets based on an annual revaluation of the assets. You determine how long the trust will last. It can be for a term of years or for the life of an individual who is then living. At the end of the stated period of time, all the remaining trust assets pass to the noncharitable beneficiary. Example(s): Mike decides to donate some money to his favorite charity. He transfers $200,000 to a 10 year charitable lead trust and names his wife, Carol, as the noncharitable beneficiary. Mike specifies that the payout rate to the charity will be a fixed 7 percent annuity amount. The result is that, every year for 10 years, the charity will receive a payment of $14,000, which is 7 percent of $200,000 (the initial fair market value of the trust assets). After 10 years, all the remaining property in the trust will pass to Carol. A charitable lead trust can be established to take effect either during your life (a living or inter vivos trust) or at your death (a testamentary trust). A charitable lead trust operates in an identical manner in either situation. The reasons you might choose one over the other include tax consequences and the ability to see your trust in operation. For example, in the case of a testamentary trust, your personal representative is entitled to subtract the present value of the charity's interest from your gross estate.

4 Page 4 When can it be used? You want to donate an asset to charity for a period of time but want a noncharitable beneficiary to receive the property at a later date With a charitable lead trust, you can provide an income stream to your favorite charity for a period of years, potentially receive an income tax deduction, and, at the same time, provide for the eventual return of the trust property to a noncharitable beneficiary. The income stream to charity is in the form of an annuity payment or a unitrust payment and is paid to the charity at least once per year. When the trust term ends, the remaining trust assets pass to the noncharitable beneficiary. Strengths Provides a gift and estate tax haven for assets expected to appreciate in value When you establish a charitable lead trust, the IRS assigns an immediate value to the interest of the noncharitable beneficiary, even though this person will not receive the trust assets until the trust term is over. Yet, during these years, the trust assets might appreciate substantially in value. When the assets eventually pass to the noncharitable beneficiary, any appreciation in the property's value is not included in your gross estate for purposes of determining estate tax liability, nor is the appreciation considered in determining the value of your gift to the noncharitable beneficiary. Tip: The value of the noncharitable beneficiary's interest is determined by first calculating the value of the charity's interest. This is done using special IRS tax tables. The charity's interest is then subtracted from the total trust assets to arrive at the noncharitable beneficiary's interest. Example(s): Tom transfers $500,000 worth of Acme stock to a 15 year charitable lead trust and names his son, Jamie, as the noncharitable beneficiary. The trust is to pay the charity a guaranteed annuity amount of 8 percent. Using special IRS tax tables, the charity's interest is determined to be $322,428. Thus, Jamie's interest is $177,572. The result is that Tom has made a taxable gift, and may owe federal gift tax. However, any gift tax due may be offset by Tom's $1 million gift tax applicable exclusion amount (formerly known as the unified credit), if it is available. Yet, the value of the gift to Jamie has been reduced substantially by the value of the charity's interest. The advantage is that, if the stock appreciates to $1 million in Tom's lifetime, Tom will not owe any federal gift tax on the appreciation amount. Similarly, the value included in determining Tom's gross estate is fixed at $177,572. In addition, the gift tax Tom paid can be credited against any estate tax that may be owed. (Note: State gift tax may also be imposed.) Caution: Keep in mind that the applicable exclusion amount for gift tax purposes is fixed at $1 million even though the applicable exclusion amount for estate tax purposes increases through

5 Page Any portion of the gift tax applicable exclusion amount you use during life will effectively reduce your estate tax applicable exclusion amount that will be available at your death. Allows you to donate to charity and at the same time keep trust assets within the family If you want to donate an interest as sacred as your family compound to charity, a charitable lead trust can help you keep this asset in the family over the long haul. Even if the trust is funded with other types of property, a charitable lead trust permits the development of investment strategies that will serve family interests. Allows you to postpone the noncharitable beneficiary's receipt of the trust assets Suppose you have a teenager who is too financially immature to successfully manage a chunk of money. Using a charitable lead trust, you can set the duration of the trust to coincide with the age at which you believe your child will best be able to manage the money. At the end of the trust term, the trust property passes to your not so little money manager. Provides for an orderly program of annual charitable giving A charitable lead trust is an orderly way to donate to charity on an annual basis for a predetermined period of time. The money used to fund the trust is money that might otherwise go largely for taxes. Allows you to choose the payment method to charity In a charitable lead trust, the IRS allows you to pay the charity under the annuity method or the unitrust method. The annuity method is a payment of a fixed sum or a fixed percentage of the initial fair market value of the trust assets (the trust assets are valued only once). An annuity payment remains the same from year to year. By contrast, the unitrust method is a payment of a specified percentage of the trust assets, which are revalued every year. So the amount fluctuates every year depending on the value of the trust assets. Additional contributions to the trust are allowed only under the unitrust method. Does not require any minimum percentage payout to charity Unlike charitable remainder trusts, there is no rule that says the charity must receive annual payments equal to at least 5 percent of the original or annual value of the trust assets. So, if you want to give the charity 4 percent of the trust assets, you can. Provides you with positive social, religious, and/or psychological benefits for donating to your favorite charity Yes, the tax benefits can be nice. In addition, donating to charity can be a real morale booster.

6 Page 6 Reduces potential federal estate tax liability When you create a testamentary charitable lead trust, the IRS allows the executor of your estate to deduct the entire present value of the lead interest to charity. This amount is calculated using special IRS tax tables, which take into account the duration of the trust and the payout amount to charity. Example(s): Pat establishes a 10 year charitable lead trust in his will, with the remainder to his pal, Mark. Assume that the present value of the charity's lead interest is $1 million. The result is that Pat's executor will be entitled to subtract $1 million from the gross estate. Tradeoffs No income tax deduction unless you are also the owner of the charitable lead trust In a typical charitable lead trust, the individual who creates the trust (the donor) is not the noncharitable beneficiary. In this case, the donor is not entitled to deduct the present value of the charity's interest on his or her income tax form. However, if you are both the donor and the owner of the trust (as defined by the IRS), you are entitled to a one time income tax deduction in the year of the trust's creation for the present value of the interest to charity. Caution: If you are the owner of the trust, the IRS taxes you on the income earned by the trust each year. Requires an irrevocable commitment If you have any doubts about donating to charity, you should think twice before establishing a charitable lead trust. Once you transfer property to the trust, it's the charity's to keep for the duration of the trust. Requires the charitable payment to be made each year, regardless of whether there is sufficient trust income available IRS rules require that if the income earned by the trust (such as dividends and/or interest) is insufficient in any given year to meet the required payment to the charity (whether an annuity or unitrust amount), then the difference must be paid from capital gains or principal. A drastic result would be the noncharitable beneficiary ending up with nothing. Example(s): Suppose the trust asset is an apartment house and the rents are the income from which the annual payment to charity is made. If the rents collected fall below the required payment amount, the trustee would have to borrow against the property or, even worse, sell the property to make the required payment to charity.

7 Page 7 How to do it Consult a competent legal advisor to draft the trust document A legal advisor well versed in the area of charitable lead trusts is your best bet. A charitable lead trust is subject to many technical requirements and must be drafted with the utmost care in order to gain favorable tax benefits. Often, additional advisors, such as tax specialists, accountants, life insurance experts, and/or certified financial planners, will be necessary to devise the best strategies and crunch the numbers. Pick a noncharitable beneficiary The noncharitable beneficiary can be anyone: you, a spouse, another family member, or friend. Caution: If you are both the donor and the noncharitable beneficiary and you die before regaining full control of the trust property (e.g., during the trust term), the value of your remainder interest is included in your gross estate. Pick a charity you wish to donate to and verify that it is a qualified charity The IRS allows you to deduct contributions only to qualified charities. Generally, qualified charities are those operated exclusively for religious purposes, educational purposes, medical or hospital care, government units, and certain types of private foundations. Every year, the IRS publishes a list of all qualified organizations in IRS Publication 78, commonly known as the Blue Book. Check to make sure your charity is listed in this publication. Tip: Once you have picked a charity, it is a good idea to contact the charity to make sure it is willing to accept such a gift. Identify the asset(s) you want to use to fund the trust You can use any type of property to fund the trust, including cash, securities, or rental property. It's a good idea, though, to use at least some type of income producing property. You don't want to dump a piece of bare real estate into the trust and assume the land can be sold in time to make the required payment to charity. Tip: When hard to value assets are placed into the trust (like a closely held business), the annuity method is a wise choice because the assets need to be valued only once at the inception of the trust.

8 Page 8 Determine the duration of the trust The trust term can be for the life of the noncharitable beneficiary or for any period of years. The term can even be a combination of a life and a period of years (for example, the life of Mary, plus 10 years). The only prerequisite is that if the trust is measured by the life of an individual, that person must be living at the time the trust is created. Determine the payment method In a charitable lead trust, the annual payment to charity can be either an annuity amount or a unitrust amount. An annuity amount is a fixed sum or a fixed percentage of the initial value of the trust assets. A unitrust amount is a fixed percentage of the annual value of the trust assets. Once you select the method, you must then select a payout rate (for example, 8 percent). Select a trustee Once you transfer property to a charitable lead trust, it is the trustee's responsibility to manage, invest, and conserve this property. The trustee has a dual fiduciary responsibility: to generate income for the charity and to preserve the trust assets for the noncharitable beneficiary. Caution: You can appoint yourself trustee. However, you are then responsible for investing the trust assets to produce sufficient income to pay the charity. If the trust income is insufficient, you must invade the principal to make up the difference. Frequent dips into principal may mean an early demise of your trust. Another pitfall is that, as trustee, you will need to keep abreast of any new IRS regulations on charitable lead trusts and comply with them in order to gain favorable tax treatment. Further, if you are the noncharitable beneficiary as well as the trustee, some states require that a cotrustee be appointed who is not also a beneficiary. Tip: Members of your family may serve as trustees. If a closely held business interest is used to fund the trust, the use of a family member as trustee can assure control of the family business. Coordinate the charitable lead trust with your existing will and/or living trust It is a good idea to make sure your charitable lead trust is coordinated with any other estate planning documents you have in order to achieve an integrated plan. A competent professional should undertake this review. File Form 5227 Split Interest Trust Information Return You must file Form 5227 (Split Interest Trust Information Return) every year your charitable lead trust is in existence. Further, if it is your first year filing Form 5227, you must also include a copy of the trust document and a written declaration that the document is a true and complete copy.

9 Page 9 Tax considerations Income Tax Possible income tax deduction for donor of living charitable lead trust In order to receive an income tax deduction for the present value of the charity's lead interest, you must first be considered the owner of the trust under IRS rules. As owner, the IRS allows you to take a onetime income tax deduction (in the year of the trust's creation) for the present value of the payments the charity will receive over the life of the trust. One of the easiest ways to be considered the owner is to name yourself the noncharitable beneficiary. Caution: However, if you are the owner of the trust, the IRS taxes you on the income earned by the trust each year. If you qualify for a deduction, your deduction is limited to either 30 percent or 50 percent of your adjusted gross income, depending on the type of property donated to charity (via the trust) and the classification of the charity as a public charity or a private foundation. If you cannot take the full deduction in a given year, you can carry over and deduct the remaining amount the following year, for up to five years (assuming you still itemize deductions). Tip: Generally, a public charity is a publicly supported domestic organization, whereas a private foundation does not have the same base of broad public support. IRS Publication 78, published every year, notes whether your charity is public or private. Example(s): Using the tax tables, the income tax deduction for a $100,000, five year charitable lead trust with a 9 percent annuity payout rate is $35,007. The deduction for a 9 percent unitrust payout rate is $37,597. Income tax consequences for charitable lead trust The income tax treatment of a charitable lead trust is very different from the income tax treatment of charitable remainder trusts like CRATs and CRUTs. Unlike these trusts, a charitable lead trust is not exempt from income tax. Instead, it is treated for income tax purposes as a complex trust and taxed under the normal rules of Subchapter J of the Internal Revenue Code. Under these rules, the charitable lead trust is taxable on all of its income but is entitled to all available deductions, including a deduction for any amount paid to charity. The trust document should identify the sources of payment and the order in which these sources are to be used. Ordinarily, the trust instrument will provide that payments are to be made in the following order: ordinary income (including short term capital gain), capital gain, unrelated business income, taxexempt income, and principal. Unless specific provisions for the order are made, state law may determine the source of payments and the order of use. If the payment to charity is not made out of gross income, the trust's deduction for the payment will be disallowed.

10 Page 10 Gift Tax Tip: If the trust is a grantor trust under IRS rules (which means you are the owner of the trust), then the trust does not owe taxes on the trust income, but you do. No gift tax if you and/or your spouse are sole noncharitable beneficiaries If you and/or your spouse are the only noncharitable beneficiaries of a charitable lead trust, you do not owe gift tax. The payment to your spouse falls under the unlimited marital deduction. Caution: In community property states, a husband and wife are treated as equal owners. If community property is used to fund a trust that benefits only one spouse or if separate property of one of the spouses is used to fund a trust that provides lifetime benefits to both parties, there is a recognized gift to the other spouse. This may have implications under the particular state's gift tax law. Possible gift tax consequences if someone other than spouse is noncharitable beneficiary If the noncharitable beneficiary of a charitable lead trust is someone other than or in addition to your spouse, federal gift tax rules will come into play. The remainder interest to the noncharitable beneficiary is valued at the time the charitable lead trust is created. However, the $12,000 annual gift tax exclusion cannot be used to offset any of the taxable portion of the gift because the gift is of a future interest. Technical Note: The gift to the noncharitable beneficiary is included in your estate for purposes of determining your tentative estate tax. However, any gift tax paid is credited against any estate tax owed. Also, the gift tax paid is excluded from your estate unless you die within three years after the trust is created. State gift tax may also be imposed. Estate Tax Reduces size of gross estate When you create a testamentary charitable lead trust, the IRS allows the executor of your estate to deduct the present value of the lead interest to charity from your gross estate. Example(s): In his will, Frank transfers $1 million to a 20 year charitable lead trust that names the local humane society as charitable beneficiary and his best friend, Ken, as the noncharitable beneficiary. He chooses the annuity payment method and sets the rate at 6 percent. Assuming a 10 percent interest rate under the IRS tax tables, the allowable estate tax deduction is $510,816, which wipes out over one half of the estate tax liability on the trust property. If the annuity rate is increased to 9 percent, the resulting estate tax deduction would be $766,224.

11 Page 11 Caution: If you are both the donor and the noncharitable beneficiary and you die before regaining full control of the trust property (i.e., during the trust term), the value of your remainder interest is included in your gross estate. Caution: If you name your grandchildren as the noncharitable beneficiaries of your charitable lead trust, generation skipping transfer tax (GSTT) issues may arise when the trust term ends. Questions & Answers Can you choose more than one noncharitable beneficiary? Yes, you can pick more than one noncharitable beneficiary. Make sure the trust document sets forth how they will split the trust assets. Can the noncharitable beneficiary also be the trustee? Yes, the noncharitable beneficiary of a charitable lead trust may also act as trustee of the trust. In this way, the beneficiary can control the property he or she will someday own. If there is more than one noncharitable beneficiary, they can all be appointed trustees. What are the strengths and tradeoffs of the annuity method and the unitrust method? In a charitable lead trust, the IRS allows you to choose whether the charity is paid by the annuity method or the unitrust method. You must identify the method in the trust document. With the annuity method, the charity is paid a fixed sum or a fixed percentage of the initial fair market value of the trust assets. The main advantage of this method is simplicity, in that the trust assets need to be valued only once at the inception of the trust. The disadvantages are that the payment remains the same every year, and no additional contributions to the trust are permitted once the trust is funded. With the unitrust method, the charity is paid a specified percentage of the trust assets, as revalued every year. The main advantage of this method is that you can make additional contributions to the trust. The disadvantage is that the trust assets need to be revalued every year and the expense comes out of the trust. Another important difference is that once a unitrust amount is set, it cannot be changed. By contrast, an annuity amount can be changed by a specified amount at a specified time, the details of which must be spelled out in the trust document. The caveat is that the new annuity amount cannot be determined by reference to any fluctuating index (such as a cost of living index). Tip: The annuity method is a wise choice when hard to value assets are put into the trust because they have to be valued only once. Do you get an income tax deduction for establishing a charitable lead trust? In order to receive an income tax deduction for the present value of the charity's lead interest, you must be considered the owner of the trust under IRS rules. Once the IRS considers you the owner of the trust,

12 Page 12 you receive an income tax deduction for the present value of the charity's interest. This deduction is a one time event allowed in the year of the trust's creation. One of the easiest ways to meet the owner test is to retain an interest in the trust assets as a noncharitable beneficiary. This interest, called a "reversionary interest" because it reverts to you, must be at least 5 percent of the total trust assets. This calculation is made at the inception of the trust using IRS actuarial tables. You may also be considered the owner of the trust under the 5 percent reversionary interest rule if your spouse has more than a 5 percent interest in the trust assets. However, your income tax deduction comes at a price. The cost of this deduction is that once you are considered the owner of the trust, the IRS then taxes you every year on the income earned by the trust under the grantor trust provisions of the Internal Revenue Code. This is true even though the charity receives the trust income, not you. So the bottom line is that while you receive an income tax deduction, you must also pay income tax on the trust income each year. Unfortunately, the IRS does not allow you to offset any amount of trust income paid to charity. Tip: One way to eliminate paying taxes on trust income is to have the trust hold only assets that produce tax exempt income, such as tax exempt municipal bonds. However, these assets may not produce enough income to make the required payment to charity. In most instances, your deduction is limited to 30 percent of your adjusted gross income. The 30 percent limitation is used because the IRS considers your gift "for the use of" and not "to" the charity. If the trust is funded with long term capital gain property and the charity is not a public charity, then the 20 percent limitation applies. If you are unable to take the full deduction in the given year, you can carry over and deduct the difference for up to five succeeding years (assuming you still itemize deductions in those years). Technical Note: The amount of your deduction is calculated using special interest rate tables established by the IRS. The current rules require the value of a remainder interest to be calculated using an interest rate that is 120 percent of the federal midterm rate then in effect for valuing certain federal government debt instruments for the month the gift was made. In addition, the calculation uses the most recent mortality table available to determine the mortality factor. Example(s): John sets up a five year charitable lead trust with $200,000 for a wilderness charity and names himself the noncharitable beneficiary. He selects the annuity method and sets the charity's payment at 5 percent. Assume: (1) the present value of the charity's interest (under the tax tables) is $65,000, (2) the trust earns $16,000 of income in the first year, and (3) John's adjusted gross income for the year is $80,000. The result is that John is considered the owner of the trust because he has retained a reversionary interest. Thus, in the first year of the trust, John is entitled to a one time income tax deduction for the value of the charity's interest ($65,000), limited to 30 percent of his adjusted gross income ($24,000). So, assuming he itemizes deductions, John can take a $24,000 charitable deduction on his tax return.

13 Page 13 The remaining $41,000 can be carried over for up to five succeeding years and deducted in a similar manner. In addition, in the same year, John must also report income of $16,000 on his tax form, which is the income earned by the trust. He is not allowed an offset for $10,000, which is the annuity amount paid out to charity in the first year. Technical Note: If you are no longer taxed on the yearly income earned by the trust (due to your death, for example), there will be a partial recapture by the IRS of your previous one time deduction for the value of the charity's lead interest. Example(s): Suppose you establish a charitable lead trust for a five year term and name yourself the noncharitable beneficiary. In the first year of the trust, you are entitled to an income tax deduction for the present value of the charity's interest. If you die in year three, however, the recapture rules will take effect. The result is that your income in year three must include a recaptured portion of the deduction that you took in year one. Can a charitable lead trust pay a noncharitable beneficiary during the same period of time it is paying a charity? Ordinarily, the noncharitable beneficiary of a charitable lead trust holds a remainder interest only, which means it is second in line to the charity's interest. However, in certain situations, the IRS allows a noncharitable beneficiary to receive an income interest that runs concurrently with the charity's interest. The income interest is allowed only if it is paid from trust assets that are segregated from the assets used to pay the charity. Caution: Make sure this provision is drafted correctly in the trust document and implemented according to IRS regulations. Otherwise, the IRS may rule that the entire charitable lead trust is invalid. Can you pay the charity an amount in excess of the required annuity or unitrust payment? Yes, the trust document can provide that any trust income in excess of the amount required to be paid to charity must be set aside for the charity, too. The trust assets need not be segregated for you to take advantage of this rule. However, the amount of your charitable deduction does not increase. It is based only on the amount that must be paid to charity. Example(s): Peter transfers $100,000 to a five year charitable lead trust and sets the unitrust payment at 7 percent. The trust document provides that any excess trust income be paid to charity. Assume that in year one the trust earns $10,000 of income. The result is that the charity will receive all $10,000 of income, even though the required unitrust payment is only $7,000. The charitable deduction is $7,000.

14 Page 14 What are the advantages of using a charitable lead trust over other charitable remainder trusts (CRAT or CRUT) or a pooled income fund? A charitable lead trust allows you to donate to charity for a period of years and then give the remaining trust assets to your family (or other noncharitable beneficiary). The charitable remainder annuity trust (CRAT), charitable remainder unitrust (CRUT), and pooled income fund all operate in the reverse. They provide an income stream to the noncharitable beneficiary for a period of time and then pass the remaining assets to charity. One of the biggest advantages of a charitable lead trust is the potential to pass property to your family with minimal gift and estate tax liability. This is especially true when you fund the trust with an asset that is expected to appreciate substantially in value. The reason for this is that your gift and/or estate tax liability is determined by the fair market value of the property at the time of transfer to the trust, not by its appreciated value when it passes to the noncharitable beneficiary 10, 20, or 30 years in the future. Also, the IRS does not require you to give any minimum amount to charity. However, unlike a CRAT or CRUT, a charitable lead trust is not exempt from income tax. It is taxed as a complex trust. Also, the donor of a charitable lead trust is not entitled to an income tax deduction for the charitable contribution unless he or she is also considered the owner of the trust under IRS rules. However, as owner, the donor is then taxed on the trust income earned each year.

15 Page 15 Disclosures This material does not constitute the rendering of investment, legal, tax or insurance advice or services. It is intended for informational use only and is not a substitute for investment, legal, tax, and insurance advice. State, national and international laws vary, as do individual circumstances; so always consult a qualified investment advisor, attorney, CPA, or insurance agent on all investment, legal, tax, or insurance matters. The effectiveness of any of the strategies described will depend on your individual situation and on a number of other factors. After reviewing your personal situation, we may recommend that you not use any strategy in this document but instead consider various other strategies available through our practice. Securities offered through Securities Equity Group, member FINRA, SIPC, and MSRB. Copyright 2006 Forefield, Inc. All rights reserved.