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Charitable trusts come in two basic types: remainder trusts and lead trusts.

Remainder Trusts

There are two types of charitable remainder trusts: the annuity trust and the unitrust. Both must qualify as valid trusts under applicable local law, and both must meet other specific requirements. Income may be paid to the donor annually, quarterly, or at other intervals.

Annuity trusts:A charitable remainder annuity trust pays out each year a fixed dollar amount, at least 5% and not more than 50% of the initial fair market value of trust assets. The annuity payments are paid first out of income and then, to the extent necessary, out of principal, subject to the “four-tier” rules (see below). Trust income in excess of the required annuity payout must be accumulated and added to principal or be distributed to a qualified charity. See IRC section 664(d)(1).

Unitrusts: A charitable remainder unitrust pays out each year an amount generally equal to a fixed percentage—at least 5% and not more than 50%, as selected by the donor—of the value of trust assets for that particular year. The trust assets are commonly valued, as directed by the trust agreement, on the first business day of each taxable year. A unitrust may also be designed to pay out whichever is less—its net income for the year or the specified fixed percentage amount. This is commonly called a “net income” unitrust.

With a net income unitrust, the trust agreement may provide that for years in which trust net income exceeds the specified unitrust amount, the excess income may be used to “make up” for past years in which trust net income was less than the specified unitrust amount. This type of unitrust is known as a “net income unitrust with a make-up (or catch-up) provision.” See IRC section 664(d)(2).

A net income unitrust (with or without a make-up provision) is ordinarily used when the charitable remainder trust is to be funded with unimproved real estate or another type of asset that produces relatively little or no income.

Another use for the net income unitrust with make-up provision is in retirement planning. The trust assets are invested voluntarily by the trustee in low-yield, high-growth assets during working years. At retirement, the gains are taken tax-free within the trust, and the trustee then invests the proceeds in higher-yield assets to fund retirement needs. Check for current regulations regarding this type of trust.

Lead Trust

The other type of charitable trust is a lead trust. In many ways, a charitable lead trust is the mirror image of a remainder trust — rather than giving control of a set of properties over to a charity, the donor retains control. Any interest that comes from the trust’s assets either goes to the charity or is split between the charity and the donor’s beneficiaries. Then, when the trust expires, rather than the charity gaining control of the donation at the time of the trust’s termination, it reverts back to a party of the donor’s choosing, usually their heirs or beneficiaries.

Highly appreciated assets like stocks are especially vulnerable to enormous capital gains and estate taxes, but under charitable lead trusts, donors can get an immediate federal income tax deduction based on the trust’s value. Afterward, income tax is only paid on the revenue the property produces. Once the trust expires and passes to the donor’s heirs, estate and gift taxes are substantially reduced.

Special Considerations

Trustee: The donor can select an appropriate trustee. An individual or a corporate fiduciary having experience in the management of charitable remainder trusts may be a good choice. The donor, with certain limitations, may name himself or herself as trustee.

Charitable remainder trust for a term of years: An annuity trust or unitrust may be set up for a specified number of years (not to exceed 20). See IRC section 664(d). It is possible to establish a trust for one or more lives or a period of time up to 20 years, whichever is a longer, or shorter, period of time. It is not possible to provide for a trust to last for the life of one or more individuals plus 20 years.

Tax considerations:When a qualified charitable remainder trust is created, a current tax deduction is allowed for the value of the charitable remainder interest (except in certain situations involving funding the trust with tangible personal property). See IRC section 170(a)(3). The method of computing the deduction is described in Reg. section 1.664-4.

The Taxpayer Relief Act of 1997 added the requirement that the initial present value (as determined under IRS guidelines) of the charitable remainder interest be no less than 10% of the value of the assets contributed to fund the trust. The IRS had previously determined that no deduction would be allowed if it determined that the terms of a trust would lead to a 5% or greater probability that the trust assets would be exhausted prior to the termination of trust. The so-called “5% probability test” is laid out in Rev. Ruling 77-374.

If an individual establishes a charitable remainder trust for his or her life only, the trust assets will be included in his or her gross estate under IRC section 2036. The amount included, however, will “wash out” as an estate tax charitable deduction under IRC section 2055. A surviving spouse’s interest in a qualified charitable remainder trust qualifies for the estate tax marital deduction. See IRC section 2056(b)(8). Note that the marital deduction is lost if there is any non-charitable beneficiary of the trust other than the donor and the donor’s spouse.

Assets sold by a charitable remainder trust are exempt from capital gains tax, as the trust itself is a tax-exempt entity (unless it has any unrelated business taxable income for the year). This can be very advantageous for donors who wish to fund such a trust with highly appreciated, low-yielding assets. The trust will retain the entire net proceeds of the sale of such assets, which can then be reinvested in higher-yielding investments.

There is a four-tier system of attributing ordinary income, capital gain, tax-free income, and corpus to the trust payout. See IRC section 664(b).

This provision may be very favorable in instances where appreciated assets have been used to fund the trust, as distributions deemed to be trust corpus will be reported by the donor as capital gains income until all capital gain realized by the trust has been “paid out.” This is especially attractive to donors who pay tax on capital gains at significantly lower rates than the tax on other income.  When a gift plan is funded with an appreciated asset (securities or real estate, for example) held long-term (more than one year), the donor generally receives a charitable deduction based on the current fair market value of the asset. If the appreciated asset consists of tangible personal property that the organization does not use in a manner related to its exempt purposes, the deduction will be limited to basis. See IRC section 170(e)(1)(B).

Under the four-tier system, it can be possible to report dividend income from a charitable remainder trust at lower tax rates than would be payable on other ordinary income. In addition, income earned by a charitable remainder trust from tax-exempt bonds can be received free of tax by a trust beneficiary.

For example, if an individual funds a 5% annuity trust with tax-exempt bonds having a 5% coupon payment rate, the interest earned by the bonds and paid to the donor will retain its tax-exempt character. The retention of the tax-exempt bonds must be voluntary on the trustee’s part, however, and must be defensible under local law governing fiduciary duties.

Recipients of income from a qualified charitable remainder trust should seek guidance from the trust fiduciary and/or their tax advisor when reporting income from this source.

Mortgaged property: In Letter Ruling 9015049 (January 16, 1990), the IRS ruled privately that a trust cannot be a qualified charitable remainder trust if any trust income (which includes realized capital gain) is used to pay a mortgage debt on which the donor is personally liable. There are, however, ways to use property subject to such a mortgage to establish a charitable remainder trust. The most obvious way is for the donor to pay off the mortgage before transferring the property to the trust.

Testamentary trusts: Some people use trusts in their wills to provide income for a survivor. In the case of a life interest left to a spouse followed by a charitable disposition of the property, a combination of the charitable deduction and the marital deduction will effectively eliminate all tax at the federal level. See IRC sections 2523(a) and 2056(a).