Charitable Remainder Trusts

Contents

1. What the parts make
2. How the payments run
3. Why appreciated property goes in
4. The deduction and the remainder
5. The trust and the retirement account
6. Where it sits among the alternatives

Brent O’Mara supports the American Cancer Society, the American Heart Association, Susan G. Komen, Angels Among Us and PlaySmart, all of them Omaha causes, and a remainder trust is among the slowest instruments by which a gift reaches an organization like those. Its materials come first. There is a trust document that cannot be changed once signed. There is property, usually property that has grown in value. There is a person, often the donor, who will receive payments from the trust for a set term or for life. There is a charity, or several, named to take whatever remains when the payments stop. And there is the tax code, which exempts the trust from income tax while it runs and sets the rules for how much the person may take and how long the arrangement may last.

What the parts make

Kiplinger’s guide to charitable giving in an estate plan defines the structure as a split interest trust: an individual chosen by the donor receives annual payments for a period of time, and when that interest ends the remaining amount is distributed to charities of the donor’s choosing.¹ There are specific rules on how much the individual may receive and for how long, and the charities must, on an actuarial calculation, be projected to receive a certain percentage of the trust’s value when it is funded, which is why the guide calls a lawyer essential to creating one properly.¹ CNBC’s description adds the two words that matter most: the trust is irrevocable, and because of the charitable remainder the IRS grants it tax exempt status.² South Dakota State University Extension places charitable trusts among the main families of trust, designed to benefit a charitable organization while providing a deduction to the person who sets them up.⁴

Figure

Assembling a remainder trust

1. 01
   An irrevocable documentA split interest trust, drafted by a lawyer, since the rules on payments and duration are specific.
2. 02
   An income beneficiaryA person chosen by the donor who receives annual payments for a term of years or for life.
3. 03
   A remainderWhatever is left when the income interest ends goes to the charities the donor named.
4. 04
   An actuarial floorThe charity must be projected to receive a minimum share of the trust's value when it is funded.
5. 05
   Tax exemptionThe trust itself pays no income tax while it exists, so it can sell what it holds and reinvest the whole proceeds.

How the payments run

The sequence is the reverse of an ordinary gift. CNBC’s 2009 survey of trust planning described it from the donor’s chair: a deduction in the year the trust is set up, income from the trust during life, and the assets passing to the charity at death without tax.³ One estate planner quoted there noted that the required annual payments drive down the value of the gift for deduction purposes, while any appreciation stays in the trust, outside the estate.³ The same article recorded a second use of the income: some donors spend the payments on life insurance held in a separate irrevocable trust, so that heirs receive an amount replacing what went to charity, with the premiums counting against the gift exclusion.³

Figure

The sequence from the donor's chair

1. 01
   Fund itProperty expected to grow in value goes into the trust, out of the estate.
2. 02
   DeductThe donor takes a deduction in the year the trust is created, reduced by the value of the payments to come.
3. 03
   Draw incomeThe required annual payments come to the donor for the term of the trust.
4. 04
   Replace if wantedSome donors use the income to buy life insurance in a separate irrevocable trust so heirs receive a comparable sum.
5. 05
   RemainderAt death the assets, and the appreciation that stayed inside, pass to the charity without tax.

Why appreciated property goes in

The exemption from income tax is the reason the structure exists. An owner of land, art or shares carrying a large unrealized gain who sells during life pays tax on that gain before any gift is made; the same owner who places the property in a remainder trust lets the trust do the selling, and the trust owes nothing. CNBC’s philanthropic adviser wrote that someone holding highly appreciated assets, with a charitable bequest already written into a will, will likely find that this trust delivers income tax advantages the will never could.² The 2009 survey named the holdings that typically go in: securities with built in gains, collections of art, and real property.³ The simpler version of the same arithmetic, giving the shares outright rather than through a trust, is described in gifts of appreciated assets.

The deduction and the remainder

Two deductions attach to the trust. The donor who funds it during life takes an income tax deduction, as Kiplinger’s guide and CNBC both describe, measured by what the charity is expected to receive rather than by the whole amount placed in trust.¹ At the donor’s death a partial estate tax deduction is allowed on the same basis.¹ The trust’s own tax position follows a separate section of the code. In an American College of Trust and Estate Counsel podcast, a fellow explains that a trust or estate claiming an income tax charitable deduction must satisfy Section 642(c): the amount must be paid from gross income, and it must be paid under authority in the governing document, which is where most drafting mistakes occur.⁵ Unlike an individual’s deduction, that deduction is unlimited in amount and may reach foreign charities, and an estate may deduct amounts merely set aside for charity, a privilege otherwise reserved to trusts executed before 1969, the year of the reform that gave these trusts their modern shape.⁵ The rules an individual donor faces are set out in the charitable deduction.

Figure

Why the estate tax stopped driving charitable bequests

amount that could pass to family free of federal transfer tax about twenty years earlier

$625,000

the same figure in 2018

$11.18 million

federal estate tax on a $1 million estate leaving $600,000 to family and $400,000 to charity under the old limit

$0

The trust and the retirement account

The structure has found a new use in the age of inherited retirement accounts. Kiplinger’s guide explains that a remainder trust can be named as the beneficiary of an IRA: because the trust is tax exempt, it receives the account at the owner’s death without paying income tax at that moment, and the individual beneficiary pays tax only as annual payments arrive.¹ The guide ties the idea to the 2019 law under which most heirs other than a spouse must withdraw everything from an inherited account over a decade, compressing the income tax into a short span; a trust that pays out over a lifetime restores the stretch for the person while sending the remainder to charity.¹ CNBC’s adviser made the broader point that IRA withdrawals are ordinary income whether taken by the owner or by an heir, while most other inherited assets arrive with a stepped up basis, so the retirement account is the natural asset to leave to charity, by trust or by designation.² The lifetime version of that gift, straight from the IRA, is the qualified charitable distribution.

Where it sits among the alternatives

The remainder trust is the most elaborate of the ways to leave money to a cause. AARP lists the simpler ones: a bequest in a will or trust naming each charity by its full legal name and taxpayer number, a beneficiary designation for a retirement account, a transfer on death designation on a bank account, and a donor advised fund named as beneficiary so the list of recipients can be changed without a lawyer.⁶ Its advice on designations applies to the trust’s remainder as well: specify percentages rather than dollar amounts, since account values move, and leave the heavily taxed retirement account to the charity and the tax free life insurance to the family.⁶ A financial planner told AARP that there is no single best way to give at death; it depends on the donor’s goals and preferences.⁶ Whether such a trust fits depends on the family’s circumstances, and drafting one is work that qualified professionals in law, tax and planning do together.

CNBC’s adviser gave the reason the question has changed. About twenty years before 2018, a person could pass $625,000 to family free of federal transfer tax, so a $1 million estate that left $400,000 to charity owed nothing; by 2018 the figure was $11.18 million, and most people no longer needed a charitable estate tax deduction at all, which moved the planning from estate tax to income tax.² The comparison below sums up what that shift means for the choice between an outright bequest and a trust that pays someone first.

Figure

A bequest beside a remainder trust

	Bequest or beneficiary designation	Charitable remainder trust
When the charity receives	At the donor's death	When the income interest ends
Who is paid first	No one; the charity takes the gift outright	A person chosen by the donor, for a term or for life
Income tax during life	No deduction until death	A deduction in the year the trust is funded
Estate tax	Charitable deduction for the gift	A partial deduction based on what the charity will receive
Appreciated property	Passes with a stepped up basis	Sold inside the trust with no tax on the gain
Drafting	A sentence in a will or a form at the custodian	A lawyer and specific operating rules