There are a number of ways in which clients can incorporate their desire to benefit charities into an estate plan. At the most basic level, the Internal Revenue Code (the “Code”) generally provides for a federal estate tax charitable deduction for amounts passing to charities at death. However, one particularly powerful method of charitable giving is the incorporation of charitable trusts into an estate plan. Charitable trusts, also known as “split interest” trusts because they have both non-charitable and charitable beneficiaries, create a unique opportunity to ensure the financial stability of a client’s surviving spouse or family while also entitling the client’s estate to a charitable deduction. While there are many legitimate and useful reasons to create a charitable trust during life, this article will focus on the funding and use of charitable trusts at death.
In general, there are two main types of charitable trusts: the charitable remainder trust (the “CRT”) and the charitable lead trust (the “CLT”). Both the CRT and the CLT are unique creatures of the Code and applicable Treasury Regulations that are strictly governed by certain prescribed qualifications. Charitable trusts should be distinguished from trusts that simply have a charity as either a current income beneficiary or a remainder beneficiary. Failure to strictly comply with the charitable trust rules can result in the loss of the trust’s income tax exempt status as well as the loss of a charitable deduction.
Charitable Remainder Trusts
A testamentary CRT is a trust that is funded at death and that provides for the distribution of a specified amount, at least annually, to one or more non-charitable beneficiaries (such as a client’s surviving spouse or family). The distributions must be for the life or lives of the non-charitable beneficiaries or for a term of years not to exceed twenty years. Once the non-charitable beneficiary’s interest in the trust ends, the balance of the trust must then be held for the benefit of, or paid over to, one or more charities.
CRTs come primarily in two forms: the charitable remainder annuity trust (the “CRAT”) and the charitable remainder unitrust (the “CRUT”). The distinction between the CRAT and the CRUT is in the annual distribution amount. The CRAT is a CRT that initially pays an annual annuity amount (a fixed dollar amount) to the non-charitable beneficiary, which amount must be a sum certain that is not less than 5% nor more than 50% of the initial net fair market value of the property placed in the trust. A CRUT is a CRT that initially pays an annual unitrust amount (a fixed percentage amount of the trust’s net fair market value) to the non-charitable beneficiary. The unitrust amount must be between 5% and 50% of the net fair market value of the trust assets valued annually. The remainder interest (the amount passing to charity) must be at least 10% of the initial net fair market value of all property placed into the CRAT or CRUT.
Charitable Lead Trusts
A testamentary CLT is, in many ways, the opposite of the testamentary CRT. The testamentary CLT is a trust that is funded at death and that provides for the distribution of a specified amount, payable at least annually, to one or more charitable beneficiaries. The distributions may be made for a term of years or for the life or lives of an individual, each of whom must be living at the creation of the trust. Notably, however, unlike the CRT there is no limitation on the number of years that the annual distributions may be made to the charitable beneficiary or beneficiaries.
Similar to the CRT, the CLT comes primarily in two forms: the charitable lead annuity trust (the “CLAT”) and the charitable lead unitrust (the “CLUT”). The CLAT provides a charitable beneficiary with a guaranteed annuity payment. The CLUT provides a charitable beneficiary with a right to receive a payment, at least annually, of a fixed percentage of the net fair market value of the trust assets valued annually. Unlike the CRT, there is no limit on the maximum amount of the annuity or the unitrust payment that can be made to the charitable beneficiary.
The foregoing rules illustrate the qualifications of a valid charitable trust. Once a testamentary CRAT or CRUT has been validly established, a client’s estate becomes entitled to a charitable estate tax deduction equal to the actuarial value of the remainder interest passing to the charity. Once the testamentary CLAT or CLUT has been validly established, a client’s estate becomes entitled to a charitable estate tax deduction equal to the actuarial value of the guaranteed annuity or unitrust interest. These calculations are designed to determine the present value of the amounts passing to charity. The values are not subsequently adjusted even if the value of the trust assets appreciates or depreciates significantly from the projected values. Thus, the charitable deduction is locked upon the creation of the charitable trust.
Example: Assume that X is charitably inclined and has a taxable estate of $12,000,000. Assume further that X has not utilized any of his $5,340,000 estate tax exemption amount. If X dies leaving all $12,000,000 to his two sons, A and B, X’s estate would owe approximately $2,448,000 in federal estate tax and $540,000 in Pennsylvania inheritance tax. After the payment of death taxes, A and B would each receive approximately $4,506,000. Thus, approximately 25% of the X’s estate will be lost to death taxes, and no portion of X’s estate will be left to charity.
Assume now that rather than leaving all $12,000,000 outright to A and B, X’s estate plan provides for the distribution in equal shares to A and B of an amount equal to X’s remaining federal estate tax exemption amount (preferably these amounts would be held in generation-skipping dynasty trusts for the benefit of A and B and their respective descendants), with the balance to be divided equally into two shares. One share would fund separate CRATs for the benefit of A and B for a twenty year period, with the remainder to be distributed to X’s favorite charity, C, and the other share would fund a single CLT that benefits C for a term of twenty years with the remainder to be distributed equally to A and B.
If we assume these shares are each $3,330,000 ($12,000,000 less $5,340,000 divided by 2), then the CRATs could pay out approximately $85,000 annually to A and B for twenty years. Assuming growth of 8% annually, the remainder of each CRAT would be almost $4,000,000. Thus, approximately $8,000,000 would be distributed to C when the trusts terminate. The CLAT for 20 years would distribute $165,000 annually to C. At the end of its twenty year term, the remainder, which would be almost $8,000,000 assuming 8% growth, would be distributed to A and B. Additionally, the combination of the CRATs and the CLAT would provide a charitable deduction against estate tax in the amount of $3,356,355, which would save almost $1,500,000 of estate tax and inheritance tax.
By incorporating charitable trusts in his estate plan, X is able to provide each of X’s children with an initial distribution of $2,670,000, an income stream of approximately $85,000 for a term of 20 years, and a distribution of almost $4,000,000 after 20 years. Additionally, X is able to provide a significant benefit to his preferred charity, for which his estate is entitled to a charitable estate tax deduction.
Incorporating charitable trusts into an estate plan can be an excellent way for clients to ensure the financial stability of a client’s surviving spouse or family while also entitling the client’s estate to a charitable deduction. Although the requirements to establish a charitable trust can be very technical, and the consequences of failing to comply with the rules quite severe, there are many ways in which charitable trusts can be individually tailored to fit a variety of estate plans and can accomplish a wide range of objectives.