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1 Table of Contents Disclaimer Notice... 1 Disclosure Notice... 2 Charitable Gift Annuity (CGA)... 3 Charitable Giving Techniques... 4 Charitable Lead Annuity Trust (CLAT)... 5 Charitable Lead Unitrust (CLUT)... 7 Charitable Remainder Annuity Trust (CRAT)...9 Charitable Remainder Unitrust (CRUT) Considering a Charitable Gift How a Charitable Gift Annuity Works (CGA) How a Charitable Lead Annuity Trust Works (CLAT) How a Charitable Lead Unitrust Works (CLUT) How a Charitable Remainder Annuity Trust Works (CRAT) How a Charitable Remainder Unitrust Works (CRUT) How a Pooled Income Fund Works (PIF) Pooled Income Fund (PIF) Charitable Gifts and Estate Taxation Charitable Income Tax Deduction...22 Charitable Remainder Trust Numerical Tests Taxation of a Charitable Gift Annuity Unrelated Business Taxable Income Asset Replacement Trust...27 Life Insurance Charitable Plan Private Foundations Supporting Organizations Charitable Remainder Annuity Trust - Graph...34 Wealth Replacement Trust (CRAT) Charitable Remainder Unitrust - Graph Wealth Replacement Trust (CRUT) Charitable Remainder Trust Data and Assumptions...38 Charitable Remainder Trust Data - Fact Finder... 39

2 ImportantNotice Thisreportisintendedtoserveasabasisforfurtherdiscussionwithyourotherprofessionaladvisors. Althoughgreateforthasbeentakentoprovideaccuratenumbersandexplanations,theinformationin thisreportshouldnotberelieduponforpreparingtaxreturnsormakinginvestmentdecisions. Assumedratesofreturnarenotinanywaytobetakenasguaranteedprojectionsofactualreturnsfrom anyrecommendedinvestmentopportunity.theactualapplicationofsomeoftheseconceptsmaybethe practiceoflawandistheproperresponsibilityofyouratorney. Page 1 of 39

3 DisclosureNotice Theinformationthatfolowsisintendedtoserveasabasisforfurtherdiscussionwithyourfinancial,legal, taxand/oraccountingadvisors.itisnotasubstituteforcompetentadvicefrom theseadvisors.theactual applicationofsomeoftheseconceptsmaybethepracticeoflawandistheproperresponsibilityofyour atorney.theapplicationofotherconceptsmayrequiretheguidanceofataxoraccountingadvisor.the companyorcompanieslistedbelowarenotauthorizedtopracticelawortoprovidelegal,tax,or accountingadvice. Althoughgreateforthasbeentakentoprovideaccuratedataandexplanations,andwhilethesources aredeemedreliable,theinformationthatfolowsshouldnotberelieduponforpreparingtaxreturnsor makinginvestmentdecisions.thisinformationhasneitherbeenauditedbynorverifiedbythecompany, orcompanies,listedbelowandisthereforenotguaranteedbythem astoitsaccuracy. Ifanumericalanalysisisshown,theresultsareneitherguaranteesnorprojections,andactual resultsmaydifersignificantly.anyassumptionsastointerestrates,ratesofreturn,inflation,or othervaluesarehypotheticalandforilustrativepurposesonly.ratesofreturnshownarenot indicativeofanyparticularinvestment,andwilvaryovertime.anyreferencetopastperformance isnotindicativeoffutureresultsandshouldnotbetakenasaguaranteedprojectionofactual returnsfrom anyrecommendedinvestment. Page 2 of 39

4 Charitable Gift Annuity CGA When a donor transfers an asset to a charity 1 in exchange for an income for one or two lives, it is called a charitable gift annuity. The income tax deduction from this arrangement will vary depending on the age of the donor, the payout rate and the applicable (mid-term) federal rate (AFR) (which is determined monthly). The following charts illustrate the income tax deduction at various ages and AFRs. assumes a cash gift of $100,000. The payouts vary with the age of the donor. 2 Each example Age 55 / 4.4% / $4,400 Recommended Payout 4.8%/ $4,800 / Age 60 AFR Table Rate Total Charitable Deduction Income Excluded from Taxation 3 Total Charitable Deduction Income Excluded from Taxation 3 2% $14,964 $2,983 $19,079 $3,360 3% 24,955 2,631 27,525 3,010 4% 33,163 2,345 34,612 2,712 Age 65 / 5.3% / $5,300 Recommended Payout 5.8% / $5,800 / Age 70 AFR Table Rate Total Charitable Deduction Income Excluded from Taxation 3 Total Charitable Deduction Income Excluded from Taxation 3 2% $23,672 $3,837 $30,637 $4,361 3% 30,631 3,487 36,054 4,019 4% 36,594 3,185 40,789 3,723 Age 75 / 6.5% / $6,500 Recommended Payout 7.5% / $7,500 / Age 80 AFR Table Rate Total Charitable Deduction Income Excluded from Taxation 3 Total Charitable Deduction Income Excluded from Taxation 3 2% $37,535 $5,037 $43,839 $5,977 3% 41,623 4,706 46,851 5,655 4% 45,267 4,413 49,585 5,362 Note: Table calculated using ACGA recommended Single Life Gift Annuity rates effective July 1, In most states, a charity must be licensed to grant a gift annuity. 2 Many charities follow the suggested payout rates developed by the American Council on Gift Annuities, 1260 Winchester Parkway, Suite 205, Smyrna, GA, Tel: (770) The amount shown represents that portion of the annual payment due to recovery of the donor s basis in the annuity. Once the basis has been completely recovered, all additional payments are fully taxable. A185S Page 3 of 39

5 Charitable Giving Techniques Gifts to charity during lifetime or at death will reduce the size of the gross estate. An additional benefit of lifetime gifts is that an income tax deduction is available within certain percentage limitations. Split-Interest Gifts If the estate owner is not willing or able to contribute the entire asset during lifetime, he or she may consider a split-interest, deferred gift. The ownership interests in an asset can be split or divided into two parts, a stream of income payable for one or more lifetimes or a term of years (the income interest) and the principal remaining after the income term (the remainder interest). 1 In a split-interest gift, one portion is given in trust for the charity and the other portion is retained. Charitable Remainder Plans When the estate owner retains the right to the income but transfers his or her rights in the remainder to a trust, it is called a charitable remainder trust. To qualify for an income tax deduction the trust must be a unitrust, an annuity trust, a pooled income fund, or a charitable gift annuity. Charitable remainder unitrust: In this type of trust the donor retains a right to a fixed percentage of the fair market value of the trust assets, with the trust assets being re-valued annually. If the value of the assets increases, so does the annual payout and vice versa. Charitable remainder annuity trust: This trust is similar to the unitrust but instead pays a fixed dollar amount each year. Pooled income fund: Assets are transferred to a common investment fund maintained by the charity. Each donor receives annually a share of the income from the fund, in proportion to the contribution made. These annual payments continue for the lifetimes of the donor and spouse. At death, the corpus of the donor s gift, together with any capital gains, passes to the charity. Payments will increase or decrease with the investment performance of the fund. Charitable gift annuity: The donor transfers the asset directly to the charity, in exchange for the charity s agreement to pay a fixed lifetime annuity. The amount of the income tax deduction is dependent upon the percentage of the income interest and the period over which it will be paid (usually the life of the donor and his or her spouse). This is determined from the mortality tables published by the government. Charitable Income Trusts The charitable income or lead trust is the reverse of the charitable remainder trust. The income interest is assigned to the charity, usually for a period of years, and then the remainder generally passes to the donor s heirs. The amount of the estate tax deduction and the amount left for the heirs will depend upon the number of years income is to be paid to the charity, the size of the annual payments, and the investment results achieved by the trustee 1 Technically, the present value of the income share and the present value of the remainder interest. A177S Page 4 of 39

6 A donor may transfer assets to an irrevocable Charitable Lead Annuity Trust (CLAT). The trust then pays a fixed dollar amount to a qualified charity for either a set number of years or the lifetimes of individuals. When the trust term has ended, the remaining assets are distributed to the donor, his or her spouse, heirs or others. The trust must pay out the same dollar amount each year, without regard to its earnings. If the trust earns more than it pays out to the charitable beneficiary, those extra earnings (or asset appreciation) will pass to the non-charitable beneficiaries (children, grandchildren, others) without additional estate or gift taxes. Valuation of assets is required only at the time the assets are transferred to the CLAT. A new trust will be required if additional contributions are made in later years. Ideally, assets in the CLAT should have both income potential (to make the required payments to the charitable beneficiary) and growth potential (to pass long-term appreciation to the ultimate beneficiaries with a minimum of estate or gift taxes). After the lead (or income) period has expired, if the beneficiary of the trust is other than the donor or his or her spouse, there may be a taxable gift. The gift tax would be based on the present value of the beneficiaries right to receive the trust remainder at some future time. This calculation is dependent upon the term of the trust, the amount payable each year to the charity and the applicable federal rate (AFR) at the time of the transfer. A donor establishing a CLAT needs to consider several key issues: Income tax deduction: If certain requirements are met, an income tax deduction is allowed for the value of the income passing to charity. With a grantor trust the donor is considered the owner of the trust (taxable on the income under the grantor trust rules) and is allowed the tax deduction, subject to certain percentage of AGI limitations. If the trust is a non-grantor trust, the trust itself is permitted an unlimited tax deduction for distributions to qualified charities. If these requirements are not met, no charitable income tax deduction is allowed to either the donor or the trust. Remainder interest: At the end of the trust term, should the assets remaining in the trust revert to the donor or pass to other individuals such as the donor s heirs? Generation-Skipping Transfer Tax (GSTT): A taxable event for GSTT purposes will occur if the individuals who ultimately receive the assets when the trust terminates are considered to be skip persons, such as the donor s grandchildren or a later generation. Page 5 of A189S 39

7 Frequently, CLATs are set up as non-grantor trusts, with the ultimate beneficiary of the trust assets being someone other than the donor or his or her spouse. Such CLATs typically provide no income deduction to the donor, but do provide a means of transferring assets to children or grandchildren, with substantial valuation discounts. For example, at a 4.2% AFR, a 10-year CLAT, paying 5% annually 1 to a charity, offers a 40.7% discount from market value. The same trust, over a 15-year term, offers a 55.7% discount from market value; over 20 years a 67.8% discount from market value is achieved. The CLAT is an excellent way for affluent individuals to meet charitable obligations, as well as make discounted, deferred transfers to heirs. 1 5% of the value of the assets, as measured at the time of the transfer into the CLAT. For example, given assets worth $1,000,000 at the time of transfer, a 5% payment would yield a fixed payment to charity of $50,000 per year, for the term of the trust. Page 6 of A189S 39

8 A donor may transfer assets to an irrevocable Charitable Lead Unitrust (CLUT) sometimes referred to as a charitable income unitrust. The trust then pays a fixed percentage of its assets to a qualified charity for either a set number of years or the lifetimes of individuals. When the term of the trust has ended, the remaining assets are distributed to the donor, his or her spouse, heirs or other individuals. Valuation of assets is required every year to determine the amount of the payment for the year. Payments to charity will vary from year to year, depending upon the investment performance and expenses of the trust. After the lead (or income) period has expired, if the beneficiary of the trust is other than the donor or his or her spouse, there may be a taxable gift. The gift tax would be based on the present value of the beneficiaries right to receive the trust remainder at some future time. This calculation is dependent upon the term of the trust, the amount payable each year to the charity and the applicable federal rate (AFR) at the time of the transfer. A donor establishing a CLUT needs to consider several key issues: Income tax deduction: If certain requirements are met, an income tax deduction is allowed for the value of the income passing to charity. With a grantor trust the donor is considered the owner of the trust (taxable on the income under the grantor trust rules) and is allowed the tax deduction, subject to certain percentage of AGI limitations. If the trust is a non-grantor trust, the trust itself is permitted an unlimited tax deduction for distributions to qualified charities. If these requirements are not met, no charitable income tax deduction is allowed to either the donor or the trust. Remainder interest: At the end of the trust term, should the assets remaining in the trust revert to the donor or pass to other individuals such as the donor s heirs? Generation-Skipping Transfer Tax (GSTT): A taxable event for GSTT purposes will occur if the individuals who ultimately receive the assets when the trust terminates are considered to be skip persons, such as the donor s grandchildren or a later generation. Page 7 of A191S 39

9 Frequently, CLUTs are set up as non-grantor trusts, with the ultimate beneficiary of the trust assets being someone other than the donor or his or her spouse. Such CLUTs typically provide no income deduction to the donor, but do provide a means of transferring assets to children or grandchildren, with substantial valuation discounts. For example, at a 4.2% AFR, a 10-year CLUT, paying 5% annually 1 to a charity, offers a 39.3% discount from market value. The same trust, over a 15-year term, offers a 52.7% discount from market value; over 20 years a 63.2% discount from market value is achieved. The CLUT is an excellent way for affluent individuals to meet charitable obligations, as well as make discounted, deferred transfers to heirs. 1 This amount is 5% of the value of the assets, as revalued each year. Page 8 of A191S 39

10 Charitable Remainder Annuity Trust CRAT A Charitable Remainder Annuity Trust (CRAT) is an irrevocable trust which pays a fixed dollar amount each year to a beneficiary, such as the donor of the trust assets, his or her spouse, child, etc. This fixed dollar amount is determined by applying the trust s stated percentage payout, e.g., 5%, 6%, etc., to the value 1 of the assets initially transferred by the donor. After the death of the income beneficiaries or at the end of a set number of years, 2 whatever assets remain in the trust are distributed to the charities named in the trust. If additional contributions are desired in later years, new trusts must be established. Income Tax Considerations The charitable income tax deduction is based on the current value of the charity s right to receive the trust assets at some time in the future (a remainder interest). There are several factors in determining this value. The first factor is the estimated length of time which the charity must wait; for example, a term of years (like 10, 15, 20, etc.) or for the donor s or other person s lifetime. Another factor is the percentage rate payable to the income beneficiaries each year and how frequently it is paid, e.g., annually, monthly, etc. Obviously, the higher the rate of payout, the less there will be for the charity; and, therefore, the smaller the charitable deduction will be. The current rate of return on investments as determined by the applicable federal (midterm) rates (AFR) is also an important factor. 3 All of these factors are applied to government tables to determine the current value of the charitable deduction. If the charitable deduction exceeds a certain percentage of the donor s adjusted gross income for the year of the gift, that portion must be carried over into future years. Gift Tax Considerations If the income from the CRAT is payable to someone other than the donor, it may be subject to federal gift taxation. If certain requirements are met, the income gift can be made to qualify for the annual gift tax exclusion of $13,000 4 per beneficiary. Also, the marital deduction will usually eliminate any gift tax on payments to the donor s spouse. 1 In cases of hard to value assets like real estate, a qualified appraisal is required to support the values. 2 If a set number of years is chosen to determine the term of the trust (instead of the lifetime(s) of one or two beneficiaries), the maximum term is 20 years. 3 This rate changes monthly. 4 The annual gift tax exclusion ($13,000 in 2012) is indexed for inflation in increments of $1,000. Page 9 of A181S 39

11 Charitable Remainder Annuity Trust CRAT Estate Tax Considerations The value of the interest passing to the charity is deductible from the gross estate. If there are income beneficiaries other than the donor and his or her spouse, there may be an estate tax on the value of this income interest. Some states allow a surviving spouse to elect to receive a portion of the deceased spouse s estate. Such laws are designed to prevent the surviving spouse from being completely disinherited. If state law allows assets in a CRAT to be used to satisfy the surviving spouse s election, the CRAT could cease to qualify as a charitable trust under federal law. As a result, previous income tax deductions can be lost and the assets in the trust could be added back to the deceased spouse s estate. The IRS originally provided a safe harbor for this situation in Revenue Procedure , with a grandfather date of June 28, In Notice , however, the federal government extended the June 28, 2005 date until further guidance is issued by the Internal Revenue Service. Almost Everyone Benefits A taxpayer can contribute an asset (usually highly appreciated and low income producing) to a CRAT and receive a current income tax deduction. The trustee can sell the appreciated asset without paying any capital gain tax and can then reinvest the entire proceeds at a higher rate of return. The trust will often pay out a higher return than the donor previously received. This, coupled with the income tax deduction, can create a substantial increase in cash flow. Thus far, the only ones to lose are the donor s heirs. To solve this problem, many taxpayers use a portion of the increased cash flow to purchase a life insurance policy (outside of the estate) to replace all or part of the value of the asset placed in the trust. This arrangement lets almost everyone benefit. Party Donor (and spouse) Children/heirs Favorite charity Internal Revenue Service Benefit Increased cash flow during retirement years Same size or larger inheritance (with insurance) Receives remaining assets after donor s death Receives less income and estate tax A181S Page 10 of 39

12 Charitable Remainder Unitrust CRUT A Charitable Remainder Unitrust (CRUT) is an irrevocable trust which pays a fixed percentage of the value of its holdings each year to a beneficiary such as the donor of the trust assets, his or her spouse, child, etc. Unlike the fixed dollar payment of a charitable remainder annuity trust, the unitrust payments will fluctuate with the changing asset balance in the trust, reflecting year-to-year investment performance. 1 After the death of the income beneficiaries or at the end of a set number of years (no more than 20), whatever assets remain in the trust are distributed to the charities named in the trust. Additional contributions can be made to the trust in later years if desired. CRUT Variations The standard form of CRUT requires payment of the full stated percentage throughout the life of the trust, even if assets must be liquidated. Other CRUT variations include: Net-Income CRUT: A CRUT may be drafted to pay out less than the established percentage if the trust income during the year is less than the required payout percentage. This shortage can be made up in later years when the trust earns more than the required payout percentage. Flip CRUT: Under IRS regulations, a CRUT may begin life as a net-income trust, and, at some predetermined future date or triggering event, permanently convert ( flip ) to a standard unitrust. A flip CRUT is an option for an individual seeking a current income tax deduction, tax-deferred buildup and increased income at a later date. Income Tax Considerations The charitable income tax deduction is based on the current value of the charity s right to receive the trust assets at some time in the future. Three factors are involved: The estimated length of time, which the charity must wait; for example, a term of years (like 10, 15, 20, etc.) or for the donor s or other person s lifetime. The percentage rate payable to the income beneficiaries each year and how frequently it is paid, e.g., annually, monthly, etc. The higher the rate of payout, the less there will be for the charity; and, therefore, the smaller the charitable deduction. The current investment return, as determined by the IRS. These are called the IRC 7520 mid-term rates. 2 These factors are applied to government tables to determine the current value of the charitable deduction. If the charitable deduction exceeds a certain percentage of the donor s adjusted gross income in the year of the gift, the excess must be carried over to future years. 1 Assets must be revalued each year to determine the payout amount. 2 This rate changes monthly. Page 11 of A183S 39

13 Charitable Remainder Unitrust CRUT Gift Tax Considerations If the income from the CRUT is payable to someone other than the donor, it may be subject to federal gift taxation. If certain requirements are met, the income gift can be made to qualify for the annual gift tax exclusion of $13,000 1 per beneficiary. Also, the marital deduction will usually eliminate any tax on payments to the donor s spouse. Estate Tax Considerations The value of the interest passing to the charity is deductible from the gross estate. If there are income beneficiaries other than the donor and his or her spouse, there may be an estate tax on the value of this income interest. Some states allow a surviving spouse to elect to receive a portion of the deceased spouse s estate. Such laws are designed to prevent the surviving spouse from being completely disinherited. If state law allows assets in a CRUT to be used to satisfy the surviving spouse s election, the CRUT could cease to qualify as a charitable trust under federal law. As a result, previous income tax deductions can be lost and the assets in the trust could be added back to the deceased spouse s estate. 2 Almost Everyone Benefits A taxpayer can contribute an asset (usually highly appreciated and low income producing) to a CRUT and receive a current income tax deduction. The trustee can sell the appreciated asset without paying any capital gain tax and can then reinvest the entire proceeds at a higher rate of return. The trust will often pay out a higher return than the donor previously received. This, coupled with the federal income tax deduction, can create a substantial increase in cash flow. Thus far, the only ones to lose are the donor s heirs. To solve this problem, many taxpayers use a portion of the increased cash flow to purchase a life insurance policy (outside of the estate) to replace the value of the asset placed in the trust. This arrangement lets almost everyone benefit. Party Donor (and spouse) Children/heirs Favorite charity Internal Revenue Service Benefit Increased cash flow during retirement years Same size or larger inheritance (with insurance) Receives remaining assets after donor s death Receives less income and estate tax 1 The annual gift tax exclusion ($13,000 in 2012) is indexed for inflation in increments of $1, The IRS originally provided a safe harbor for this situation in Revenue Procedure , with a grandfather date of June 28, In Notice , however, the federal government extended the June 28, 2005 date until further guidance is issued by the Internal Revenue Service. A183S Page 12 of 39

14 Considering a Charitable Gift Charitable giving provides help to those less fortunate than ourselves. Reasons for Making a Charitable Gift Many persons make gifts or bequests to charitable organizations for a number of reasons. Some of the more common motivations would include the following: Compassion for those in need Religious and spiritual commitment Perpetuation of one s beliefs, values and ideals Support for the arts, sciences and education A desire to share one s good fortune with others Whatever the reasons, U.S. tax law is designed to encourage these gifts. Different Types of Charitable Gifts Some donors prefer to make outright gifts of cash or other valuable assets to their favorite charities. Other individuals, although they would like to make an outright gift, depend on the income from their assets for their daily needs. Often, such donors decide to wait until they die to transfer assets to a charity, through a will or trust. However, there are methods which allow a donor to make a gift now, while still retaining an income for life. The most popular of these methods include: Charitable Remainder Annuity Trust Charitable Remainder Unitrust Pooled Income Fund Charitable Gift Annuity Another gifting technique assigns an income interest to the charity for a period of years (or the lifetime of a person), after which the remainder passes to the donor s heirs. Gifts made in this manner involve what are known as charitable lead trusts. Potential Financial Benefits of Charitable Gifts Income taxes: May provide an income tax deduction. 1 In many cases, can avoid or delay payment of capital gains tax. Cash flow: May increase personal after-tax cash flow. Estate planning: May increase the amount passing to one s heirs. 1 Federal Income Tax Law. State or local income tax law may differ. A346S Page 13 of 39

15 The donor transfers an asset to a charity and receives a fixed dollar amount, set at the time the gift is made, each year thereafter. A current income tax deduction is also available. When the donor or other named beneficiary dies, the charity has no further financial obligations to pay. Donor Transfers asset to charity. Receives annual payout. 1 Receives income tax deduction. 2 CGA Charity sells asset and reinvests for greater return Charity pays no capital gain tax on the appreciation at the time of sale 3 Charity pays a fixed dollar amount, established at time of gift each year for lifetime of beneficiary After the beneficiary is deceased the charity has no further obligations to pay. 1 Annuity payments are part return of principal (nontaxable), part ordinary income and (if any) part capital gain. Once a donor has recovered his or her basis, the annuity payments are fully taxable. 2 This deduction may have to be spread over more than one year if it exceeds certain percentage of income limitations. 3 If certain requirements are met, the donor may recognize any capital gain ratably over the time period the annuity is expected to be received. Otherwise, the donor must recognize all capital gain in the year the annuity transaction is entered into. Page 14 A186S of 39

16 The donor transfers an asset to the trustee of the Charitable Lead Annuity Trust (CLAT), which pays the same fixed dollar amount for each year thereafter to a selected charity. A current income tax deduction is generally allowed for the present value of the income interest paid to the charity. At the end of the term of the trust, the remaining assets pass to the donor s heirs, spouse, or sometimes back to the donor, if living. Donor Transfers asset to CLAT. Receives income tax deduction. 1 Asset Income Tax Deduction 1 CLAT Trustee pays fixed dollar amount each year to the selected charity for the term of the trust. Annual Payout Charity of Choice Receives fixed dollar amount each year. After the trust is terminated the remaining trust assets pass to the person or persons selected by the donor. Final Beneficiaries These beneficiaries could be the donor, if the trust was set to last only a term of years, or it could be the donor s spouse, children, grandchildren 2, etc., which may also produce an estate tax reduction. 1 The income tax deduction, allowable only to grantor trusts, is based on a government determined applicable federal rate and may have to be spread over more than one year, if it exceeds certain percentage of income limitations. 2 Choosing grandchildren (or later descendants) to receive the assets when the trust terminates may trigger the Generation-Skipping Transfer Tax (GSTT). Page 15 A190S of 39

17 The donor transfers an asset to the trustee of the Charitable Lead Unitrust (CLUT), which pays a fixed percentage of the trust assets as valued each year thereafter to a selected charity. A current income tax deduction is generally allowed for the present value of the income interest paid to the charity. At the end of the term of the trust, the remaining assets pass to the donor s heirs, spouse or sometimes back to the donor, if living. Donor Transfers asset to CLUT. Receives income tax deduction. 1 Asset Income Tax Deduction 1 CLUT Trustee pays a fixed percentage of the trust value each year to the selected charity for the term of the trust. Annual Payout Charity of Choice Receives fixed percentage of the trust assets each year. After the trust is terminated the remaining trust assets pass to the person or persons selected by the donor. Final Beneficiaries These beneficiaries could be the donor, if the trust was set to last only a term of years, or it could be the donor s spouse, children, grandchildren 2, etc., which may also produce an estate tax reduction. 1 The income tax deduction, allowable only to grantor trusts, may have to be spread over more than one year if it exceeds certain percentage of income limitations. 2 Choosing grandchildren (or later descendants) to receive the assets when the trust terminates may trigger the Generation-Skipping Transfer Tax (GSTT). Page 16 A192S of 39

18 The donor transfers an asset to the trustee of the charitable remainder annuity trust (CRAT) and receives a fixed dollar amount for each year thereafter. A current income tax deduction is also available. When the donor or other named beneficiary dies, the remaining trust assets pass to the designated charity. Donor Transfers asset to CRAT. Receives fixed dollar amount each year. 1 Receives income tax deduction. 2 CRAT Trustee sells asset and reinvests for greater return. Pays no capital gain tax on the appreciation at the time of sale. Trustee pays fixed dollar amount yearly. After the beneficiary is deceased, remaining trust assets pass to the charity. 3 Charitable Organization Receives any assets remaining in the trust when the beneficiary is deceased. 1 The annual annuity payout is taxed under a four-tier system. Generally speaking, ordinary income is paid first, followed by capitalgain, other income, and trust principal. 2 The income tax deduction is based on a government determined applicable federal rate and may have to be spread over more than one year, if it exceeds certain percentage of income limitations. 3 If a surviving spouse elects to claim a part of a deceased spouse s estate, the income and estate tax benefits of a CRAT may be lost. Page 17 A182S of 39

19 The donor transfers an asset to the trustee of the charitable remainder unitrust (CRUT) and receives a set percentage of the trust value for each year thereafter. A current income tax deduction is also available. When the donor or other named beneficiary dies, the remaining trust assets pass to the designated charity. Donor Transfers asset to CRUT. Receives annual payout. 1 Receives income tax deduction. 2 CRUT Trustee sells asset and reinvests for greater return. Pays no capital gain tax due on the appreciation at the time of sale. Trustee pays a percentage of trust assets as valued each year. After the beneficiary is deceased, remaining trust assets pass to the charity. 3 Charitable Organization Receives any assets remaining in the trust when the beneficiary is deceased. 1 The annual annuity payout is taxed under a four-tier system. Generally speaking, ordinary income is paid first, followed by capitalgain, other income, and trust principal. 2 This deduction may have to be spread over more than one year, if it exceeds certain percentage of income limitations. 3 If a surviving spouse elects to claim a part of a deceased spouse s estate, the income and estate tax benefits of a CRUT may be lost. Page 18 A184S of 39

20 The donor transfers an asset to the trustee of the pooled income fund (PIF) and receives a proportionate share of the trust s income for each year thereafter. A current income tax deduction is also available. When the donor or other named beneficiary dies, the remaining trust assets pass to the designated charity. Donor Transfers asset to PIF. Receives annual payout. Receives income tax deduction. 1 PIF Trustee sells asset and reinvests for greater return. Pays no capital gain tax due on the appreciation. Trustee pays a proportionate share of the fund s income each year for lifetime of beneficiary. After the beneficiary is deceased, remaining trust assets pass to the charity. Charitable Organization Receives any assets remaining in the trust when the beneficiary is deceased. 1 This deduction is based on life expectancy and the highest rate paid by the fund over the last three years. The deduction may have to be spread over more than one year, if it exceeds certain percentage of income limitations. Page 19 A188S of 39

21 Pooled Income Fund PIF A pooled income fund (PIF) is similar to a charitable remainder trust to which more than one donor is able to make contributions. A public charity must establish and maintain a common investment fund into which donors transfer assets while retaining a share of the annual income in proportion to his or her contribution. The federal income tax deduction is based on the ages of the beneficiaries and the highest rate of return paid by the fund over the last three years. 1 The frequency of payments, e.g., monthly, quarterly, etc., does not affect the tax deduction. Pooled income funds may not invest in tax-exempt securities nor accept them as contributions. Also, neither donor nor beneficiary may serve as trustee. Estate and Gift Taxation If the donor causes the income to be paid to another person (like a child or a parent) there would be a taxable gift. If certain requirements are met, the income gift can be made to qualify for the annual gift tax exclusion of $13,000 2 per beneficiary. The value of the asset passing to the PIF is removed from the donor s gross estate. Periodic payments, if received by the donor, will, however, tend to increase the estate size unless they are otherwise consumed. After the life income beneficiaries die, the remaining assets pass to the charity. 1 If the fund has been in existence for less than three years, the rate used is based on interest rates provided by the federal government. 2 The annual gift tax exclusion ($13,000 in 2012) is indexed for inflation in increments of $1,000. Page 20 of A187S 39

22 Charitable Gifts and Estate Taxation Gifts to a charity or to a charitable remainder trust can reduce one s taxable estate by not only the value of the gift but also its potential appreciation. If the donor retains the right to the income, as in a charitable remainder trust, the estate tax savings will not be as large. However, the donor (or donors) may choose to make gifts of the income each year to children, grandchildren or to a trust on their behalf. If certain requirements are met, these gifts will qualify for the annual gift tax exclusion of $13,000 1 from each donor to as many qualified beneficiaries as there are under the terms of the trust. The chart below illustrates the potential savings, based on a hypothetical situation. Assumptions: Current estate size: $6,000,000 Estate growth rate: 6.00% Value of charitable gift: $1,000,000 Year of death: 2012 Applicable credit: $1,772,800 Years From Now Taxable Estate Federal Estate Tax 2 Savings in Without the Gift With the Gift Without the Gift With the Gift Federal Estate Taxes With Gift Now $6,000,000 $5,000,000 $308,000 $0 $308, ,029,353 6,691,128 1,018, , , ,745,086 8,954,238 1,968,780 1,341, , ,379,349 11,982,791 3,240,772 2,401, , ,242,813 16,035,677 4,942,984 3,820,487 1,122, ,751,224 21,459,354 7,220,929 5,718,774 1,502, ,460,947 28,717,456 10,269,331 8,259,110 2,010, ,116,521 38,430,434 14,348,782 11,658,652 2,690,130 Note: If both the income from the trust and the income tax savings from the charitable deduction are given to an irrevocable trust (or to adult children) to purchase life insurance on the life of the donor, one is able to transfer a substantial amount of money to one s heirs which is not subject to either income tax or estate tax. 1 The annual gift tax exclusion ($13,000 in 2012) is indexed for inflation in increments of $1, Calculated as if death occurred in 2012, under the provisions of the 2010 Tax Relief Act. A180S Page 21 of 39

23 Federal income tax law allows a deduction for gifts to qualified charitable organizations, such as churches, colleges, hospitals, charitable foundations, etc. The actual amount of the deduction is dependent upon several factors. Type of charity: Does the organization benefit the general public or does it have a more limited or private purpose? Type of asset: Is the donated item cash, a capital asset with untaxed appreciation, tangible personal property, etc.? Portion of asset given: Is it a gift of the entire asset or only an interest in the asset, like a remainder interest, which will pass to the charity at some time in the future? When gift is given: Is the gift being made now or will it occur at some future date, as under the terms of a will or trust? The gift of an asset to a charity generally results in a federal income tax deduction, 1 which should decrease the tax due and increase the amount of net after-tax income for the year. However, charitable contributions are not always 100% deductible against an individual s federal income tax liability. Federal law limits the amount that is deductible for the year in which the gift is made, based upon one s adjusted gross income (AGI). If the limit is exceeded for the year, any excess deduction can generally be carried forward for up to five years. If combined charitable contributions for the year do not exceed 20% of AGI, they may all be deducted. If, however, contributions exceed 20% of AGI, the deduction may be limited to 50%, 30% or 20% of AGI, depending upon the type of property given and the type of charitable organization receiving the gift. In no event can the deduction exceed 50% of the donor s adjusted gross income for the year. 50% limit: This limit applies to contributions to public charities, i.e., most churches, hospitals, colleges, etc., unless the gift is of capital gain 2 property and the deduction is taken for the fair market value, in which case a 30% limit will apply. The 50% limit is available for gifts of capital gain property if the deduction is limited to the cost basis of the asset. 30% limit: This limit applies to gifts for the use of any charitable organization and gifts (other than capital gain property) to non-50% type charities. 20% limit: This limit applies to gifts of capital gain property to non-50% type charities. Patents and Intellectual Property: A donor s deduction for gifts of patents and other intellectual property is limited to the lesser of the taxpayer s basis or the fair market value of the property. An additional deduction may be available for a limited number of future years if the donee organization realizes income from the gifted property and certain requirements are met. 1 The discussion here concerns federal tax law. State or local income tax law can vary. 2 Capital gain property as used here applies to capital assets held long-term (at least 12 months and one day). Page 22 A179S of 39

24 As AGI increases, federal law also acts to reduce certain itemized deductions, including charitable contributions. In addition to individual floors (such as the 2% of AGI limitation on certain miscellaneous itemized deductions), there is also an overall limitation on itemized deductions. Under this overall limitation, the otherwise allowable total of itemized deductions is reduced by 3.0% of the amount by which a taxpayer s AGI exceeds a threshold amount. This reduction may not exceed more than 80% of the otherwise allowable deductions. Under the 2010 Tax Relief Act, the overall limitation on itemized deductions is suspended for 2011 and Unless Congress acts to change the law, the limitation will again apply in Determining the federal income tax deduction for a split-interest gift, i.e., a charitable remainder or charitable lead trust, can be complicated. The key factors involved are: How long the charity must wait before it benefits; and How much income is paid to the beneficiaries each year; and The prevailing interest rates at the time of the gift (as indicated by the applicable federal rate).! The counsel and guidance of a CPA, IRS Enrolled Agent, or other qualified tax professional is strongly recommended. Page 23 A179S of 39

25 Charitable Remainder Trust Numerical Tests Charitable remainder trusts (CRTs), including charitable remainder annuity trusts (CRATs) and charitable remainder unitrusts (CRUTs), are subject to a complex maze of law and regulation. The failure of a CRT to meet all requirements the law imposes can result in it being disqualified as a charitable trust, with negative income, gift, and estate tax consequences, as well as defeating the donor s charitable intent. 1 Numerical Tests A number of these requirements involve specific numerical tests: 5% probability test: This test, which applies only to CRATs, measures the theoretical possibility that a non-charitable beneficiary might live long enough to exhaust the assets in the trust, leaving nothing for the charity. 2 Using a complicated mathematical formula, and government interest and longevity tables, the probability of exhausting the assets is calculated at the time property is transferred to the trust. If the probability of exhaustion is greater than 5%, no income or estate tax deduction is allowed. 5% minimum payment test: This test concerns the minimum annual payment which must be made from a charitable remainder trust. For CRATs, federal law requires the payment to be not less than five percent of the initial fair market value of all property placed in the trust. For CRUTs, the law requires the minimum payment to be a fixed percentage, not less than five percent, of the net fair market value of the CRUT s assets, valued annually. 50% payout limitation test: Federal tax law limits the annual payout from a CRAT to no more than 50% of the initial net fair market value of property in the trust. For CRUTs, annual payments are limited to no more than 50% of the net fair market value of the trust s assets, valued annually. A CRT which fails this test will be treated as a complex trust, with all income taxed to either the trust or its beneficiaries. 10% minimum charitable benefit: There is a minimum benefit that must ultimately pass to the charity. For CRATs, this minimum is 10% of the initial net fair market value of all property placed in the trust. For CRUTs, the remainder interest passing to the charity must be at least 10% of the net fair market value of trust property, valued as of the date the property is contributed to the trust. Seek Professional Guidance Because of the complexity of the law and regulations governing charitable remainder trusts, individuals considering a CRT are strongly advised to consult with an attorney, CPA, IRS enrolled agent, or other competent financial professional. 1 The discussion here concerns federal tax law. State or local law may differ. 2 With a CRUT, exhaustion of the trust assets is considered impossible as payments from the trust are based on a percentage of trust assets, not a fixed dollar payment. A290S Page 24 of 39

26 Taxation of a Charitable Gift Annuity Payments received from charitable gift annuities are taxed in the same manner as commercial annuities, i.e., using the annuity exclusion ratio. This often gives them an advantage over payments from pooled income funds or charitable remainder trusts, from which the income may be fully taxable. A portion of each payment from an annuity is considered to be a return of principal and is, therefore, exempt from income tax. Also, a portion of the payment may be taxed at capital gains rates. Payment Allocation The chart below illustrates the allocation of payments from a charitable gift annuity as various types of income. The examples are based on the following set of assumptions. Assumptions: Amount contributed: $100,000 Age of beneficiary: 75 Payout rate: 6.5% 1 Applicable federal rate (AFR): 3.0% Years Assuming a Cash Contribution with Basis of $100,000 Annual Income Ordinary Income Exempt Income Long-Term Capital Gain $6,500 $1,794 $4,706 $0 Thereafter 6,500 6, Assuming a Stock Contribution with Basis of $50,000 Years Annual Income Ordinary Income Exempt Income Long-Term Capital Gain $6,500 $1,794 $2,352 $2,354 Thereafter 6,500 6, Note: The donor will also receive a current income tax deduction of approximately $41,623. Appreciated Capital Assets Appreciated capital assets held long-term may be exchanged for a charitable gift annuity without taxation of the unrealized capital gain at time of transfer (much like a charitable remainder trust) unless an income beneficiary other than the donor and his or her spouse is named. In such cases, the full, unrealized gain is taxable to the donor/grantor. 1 This would be $6,500 per year, paid quarterly. A348S Page 25 of 39

27 Under federal income tax law, a charitable remainder trust which has unrelated business taxable income is subject to a 100% excise tax on such income. 1 For example, if a CRT had $50 of UBTI, the tax would be equal to $50. UBTI is defined in IRC Sec Generally, it is income derived by a charity from any unrelated trade or business carried on by it and not specifically excluded by statute. Typically, investment income or capital gains are not UBTI (unless the asset is debt financed). Revenue from an active trade or business, however, is generally considered to be UBTI. Many limited partnerships generate UBTI and should be avoided in CRT funding and investment. Besides limited partnerships, donors should avoid unincorporated business transfers and property subject to participating leases. Indebtedness on property can be a problem when creating a CRT. In all debt-encumbered property transfers, the donor is considered to have received proceeds from a sale in the amount of the indebtedness. The IRS rationale is that relief from debt is the same as receiving income, and is a taxable event. At best, one has taxable income (in the amount of the debt relief) with a partial, offsetting charitable deduction for the equity in the property. However, for some time now the IRS has indicated that the UBTI problems discussed above would apply to indebted property transfers to a CRT unless the debt was old and cold. An exception was allowed when the debt had been placed on the property, and the donor had held the property, more than five years before transfer. However, even this limited exception has been overruled. The IRS, in a private letter ruling, 2 completely disqualified a CRT funded with old and cold indebted property. The service contended that the grantor trust rules applied, i.e., the grantor is treated as the owner of the trust if income from the trust is used to discharge a legal obligation of the grantor. To be safe, the donor should payoff the debt or move it to other property prior to the transfer to a charitable trust. If the debt is too substantial for this, the donor may have to use a different charitable income instrument, such as a charitable gift annuity, rather than a charitable remainder trust.! Given the complexities involved, the advice and guidance of competent tax and financial professionals is strongly recommended. 1 The discussion here concerns federal income tax law; state or local law may differ. 2 See PLR dated 1/16/90. A IRS Private Letter Ruling is applicable only to the taxpayer who requested it and may not be cited as precedent. Page 26 A347S of 39

28 The combination of a charitable remainder trust (CRT) and an asset replacement insurance trust can greatly benefit you, your heirs and your favorite charity. Step 2: Donate Asset Appreciated asset is contributed to CRT Life insurance of equal value 1 is purchased by the trustee of the asset replacement trust Charitable Remainder Trust (CRT) Step 1: Set Up Two Trusts Step 3: Purchase Insurance Donor Cash flow and income tax savings from deduction (based on a portion of the value of the asset placed in Earnings on assets are paid to donor as cash payments. the CRT) are used to pay insurance premiums Asset Replacement Trust (irrevocable life insur. trust) Principal account Income account Cash Payments Insurance policy on life of donor After Donor and Spouse Die Remaining Balance Passes to your favorite charities Value is not part of the taxable estate Insurance Proceeds Can benefit surviving spouse and children Proceeds can be outside of the taxable estate The charitable remainder trust can sell the appreciated asset without paying any income tax on the capital gain. By reinvesting this larger amount, the trust can pay to the donor (and spouse, if desired) a fixed percentage of the trust assets, e.g., 5%, 6%, 8%, etc., for the remainder of their lives. The charitable deduction is based on the ages of the donor and spouse at the time of transfer, current interest rates and the percentage cash return received each year. The result: An appreciated asset has been given away which will eventually benefit a charity. Additionally, cash flow has increased for life. The value of the asset has been replaced with life insurance payable to the heirs. This combination is a true win-win-win situation. 1 Where the donated asset faces a significant potential estate tax, some practitioners recommend insurance equal to the after-tax (after paying the estate tax) value of the asset rather than 100%. Page 27 A178L of 39

29 For the individual who would like to make a substantial bequest to his or her favorite charity, but does not have sufficient assets to fulfill this desire, a charitable plan consisting of a life policy should be considered. The policy owner (typically, the insured) can transfer an existing life insurance policy to the charity or contribute the funds necessary to purchase a new policy. Additional tax-deductible contributions can be made to help the charity pay the annual premium. This not only spreads out the amount to be given, but allows one to experience the feeling that comes from sharing with others on a more frequent basis. You Receive An income tax deduction, and A feeling of satisfaction Charity Receives 1 A large sum in the future If circumstances change, the insured can discontinue making the gifts and the charity will either continue the payments or surrender the policy for the cash values. Note: Merely naming a charity as a beneficiary of a policy will not produce an income tax deduction, since the owner (insured) still has the power to surrender the policy. The income tax deduction is limited to the lesser of: Donor s cost basis (premiums paid less dividends received in cash and policy loans outstanding); or The policy s value, which varies with type of policy. Ordinary life: The interpolated terminal reserve (roughly cash value) plus any pre-paid premium. Paid-up policy: Present cost of a comparable policy at the donor s current age. New policy: The gross premium just paid. Term insurance: The portion of premium that is still unearned by the insurer. 1 This is generally funds to purchase a new policy and a small annual contribution to pay premiums. Page 28 A194S of 39