Charitable Trusts: Doing Good While Avoiding the Tax Man

It's easy to see why charitable remainder trusts, or CRTs, continue to grow in popularity. You get to eat your cake and have it, too. CRTs allow donors to sell appreciated stock without paying capital gains, place them in trust and hang onto an income stream from those assets for life. There is, of course, a catch: These devices are only practical for clients who can afford to give up the principle — when they die, what remains in the trust goes to the charity of his or her choice. That's no small matter, of course, but the tax advantage of avoiding a huge capital gain in life and moving money out of a taxable estate after death can make a charitable trust appealing to clients who had never considered significant charitable giving. Jim Barber, a general partner at Edward Jones in Greensboro, N.C., who works with charitable trusts, says his clients “tend not to be really charitably inclined, but when you explain the terrific tax benefits of a CRT, they become charitable after the fact.”

What makes a CRT a tax planning tool for ordinary clients — as opposed to just the filthy rich — is that it can be used to sell concentrated low-basis stock positions to diversify their portfolios without paying capital gains taxes. “When you hear a client say ‘highly appreciated’ and ‘I want to diversify,’ a CRT should be the conditioned response,” says Larry Elkin, head of Palisades Hudson Asset Management, in Scarsdale, N.Y. To see how it works, take the example of a client who puts $100,000 in appreciated shares of Procter & Gamble into a CRT. The client originally bought the shares for $20,000, giving her a capital gain of $80,000. If she sold the shares outright, she would owe 20 percent on an $80,000 appreciation, or $20,000 in taxes. That would leave her only $80,000 to reinvest. By selling the asset through the CRT, however, the whole $100,000 can be reinvested to feed the income stream for the client.

CRTs offer other tax breaks. First, clients get a current income tax deduction when the trust is funded that is based on the value of the portion that will ultimately go to charity. The charitable portion must be at least 10 percent of the original assets. That is, if a client funds a trust with $100,000, he can receive up to $90,000 back in income over the life of the trust. The smaller the income the client takes back, the greater the gift to charity, and hence the greater the immediate tax deduction. The client can pass the income stream on to a family member as well, but that too will lower the current income tax deduction. The icing on the cake is that the assets are also removed from the client's estate. (While there has been an effort in Congress to permanently repeal the federal estate tax, which is set to disappear for just one year in 2010, estate planners doubt that it will happen, especially if big deficits return.)

CRTs come in many flavors, according to how the income is distributed. A CRAT, or charitable remainder annuity trust, pays the donor a fixed dollar amount each year (or quarter or month). A CRUT, or charitable remainder unitrust, pays the donor a fixed percentage of the value of the trust assets. Payments will fluctuate based on how well the trust assets fare. “It's more popular to pay the same percent of value every year,” says Laura Peebles, a director at Deloitte & Touche in Washington. This is why it's more popular. “If the property is well managed and goes up in value, the payment goes up, too.”

Two exotic CRTs, NIMCRUTs and Flip CRUTs, allow clients to delay their income stream from the trust until some point in the future — say retirement. NIMCRUT, or net income with makeup charitable remainder trusts, are usually funded with appreciated illiquid assets such as real estate or closely held stock. But because NIMCRUTs can only pay out accounting income — income from dividends, interest and rent — they don't have to pay anything if the illiquid asset is producing no income. But the owed income from nonproducing years can build up inside the trust like a big IOU to the client. When the assets are eventually sold and reinvested to produce income, there can be a bigger payout to the client.

A Flip CRUT allows the NIMCRUT to turn into a standard CRUT when a certain predetermined event occurs. There is no makeup provision, but when the trust starts paying, the payout isn't limited to accounting income. These trusts offer more flexibility to invest for income and growth. The trick is that clients must decide in advance on a triggering event that will turn on the payment spigot. The trigger could be a marriage, a child's graduation or retirement if you can define that. Or you can find a trigger that is easier to control, says attorney and real estate planning expert Conrad Teitell: “Why tie your hands? Decide the trust will flip when you sell the three shares of XYZ closely held stock you put in the trust.”

Yet another kind of CRT, made famous when Jackie Onassis used it in her estate plan, is a charitable lead trust. In a CLT, the cash flow is paid to charity and the remainder in the trust goes to your client's heirs. These tend to be most beneficial to those with Jackie O.-sized wealth. They don't save much in current taxes, but can pass sizeable amounts to heirs without paying gift or estate taxes of roughly 50 percent when transferring wealth to heirs. “What you're trying to do is create stream of payments to charity and get a residual gift or bequest to family at reduced transfer tax cost,” says Elkin.

To demonstrate how a CLT works, Elkin cites the example of a CLT that's used for more than estate planning: Dad sets up a four-year CLT for his alma mater when his son enters high school. The trust is designed to “zero out,” or pay out all its assets over four years to the college. But, the assets in the trust do better than expected, and when the CLT ends, $300,000 is left that can go to the son tax-free. And guess where the son got accepted for college? “There was no downside,” says Elkin. “The father got a tax deduction in year one, the school got its annual gift for four years, junior got in, and any appreciation will go to junior tax-free.”

Brokers can hold onto and manage assets in a charitable remainder trust, but proceed with caution. “Don't practice law,” warns Elkin. “You should treat any philanthropic entity as if it had a big skull and crossbones on the label.” A number of mistakes can rob the trust of its tax-preferred status at least for that year. These include putting margined securities, hedge funds, restricted stock or publicly traded partnerships into a standard CRUT or CRAT. With a Flip CRUT, says Teitell, you can't use the sale of listed securities as the trigger to turn on the payout. And you can't borrow money from a CRT for the client. “People will get into trouble by looking at a CRT and saying, ‘It's my money,’” says Elkin. “It's not your money anymore; that's why they gave you the tax deduction.”

And CRTs don't come cheap. They can cost anywhere from $5,000 to $25,000 to set up depending on how fancy they are, says Peebles. NIMCRUTs, for example, can cost $5,000 each year just to maintain.

To cut the costs and attract donors, many charities have created pooled income funds and charitable gift annuities. Pooled income funds are like mutual funds sponsored by the charity. They pool donations from many clients, invest them, and pay each donor a pro rata share based on the size of his or her contribution. A charitable gift annuity, which can be either immediate or deferred, operates much like a CRT, with slightly less of a tax advantage. “The gift annuity is literally taking less money back than you could get commercially,” says Elkin. “So it leans more toward donative intent. The client really wants to do something for charity but is worried what will happen if they don't die on schedule and live to be 100.”

These are just a few of the simple ways you — with the help of a qualified lawyer — can get clients into a charitable remainder trust. There are myriad exotic variations. Many wealthy individuals, for example, use the income stream from the CRT to fund an insurance policy that will go to their heirs tax-free to make up for the amount being removed from their estate by the CRT. Another option: If the client sets up his or her own private foundation, that foundation can be the charity the CRT assets go to when the trust ends. This way they can keep the charitable imperative going among their heirs indefinitely — a gift that truly keeps on giving.

GETTING THE MONEY TO CHARITY

CRTs are a way to set aside money for charity and retain some income from the assets. Here's a comparison.