Differences Between and Benefits of Charitable Remainder Trusts and Charitable Lead Trusts

MOLLY GILROY: Welcome to Cherry Bekaert’s Private Client Services Podcast, where we discuss tax, accounting, and business matters impacting your business and personal growth goals to help guide you forward to achieve your financial objectives. I am Molly Gilroy, a Tax Senior Associate with Cherry Bekaert, and with me today are John Yur and Greg Marks, who are both partners with Cherry Bekaert’s Tax Services team.

Thank you for joining us today as we take a look at charitable remainder trusts (CRTs) and charitable lead trusts (CLTs). As a quick overview, a charitable remainder trust is an irrevocable trust that pays an annuity or unitrust amount to a noncharitable beneficiary for a set term or the life of the beneficiary.

At the end of the term or upon the death of the noncharitable beneficiary, the CRT pays the remainder to a charity. Conversely, a charitable lead trust is an irrevocable trust that pays an annuity or unitrust amount to a charity for a set term, and the remainder interest either reverts to the donor or is paid to a noncharitable beneficiary.

John and Greg, many of our clients use these charitable trusts for income tax benefits. Can you discuss the income tax implications of using a CRT or CLT?

GREG MARKS: I will cover the charitable lead trust side. From an income tax perspective, one thing to note that differs from a charitable remainder trust is that lead trusts are not tax-exempt.

They can be structured as either grantor or nongrantor trusts. Because a lead trust is not tax-exempt, the ability to minimize tax on the sale of low-basis appreciated assets does not exist in the same way it does for remainder trusts.

In either case, the donor is able to remove that asset and any future appreciation from their estate and receive an upfront charitable deduction. For those choosing the grantor trust route, lead trusts provide for an upfront charitable deduction against your income tax.

On the other side of that coin, if it is structured as a grantor trust, the grantor must pick up the income and pay the tax on it during the initial term. With nongrantor charitable lead trusts, the grantor does not receive that upfront charitable income tax deduction, but they are also not taxed on the income of the trust.

In a nongrantor situation, the trust pays the tax on the income and claims its own charitable deduction for the amounts it pays out to charities. In these situations, the income tax deduction is limited to 30% of your AGI even when gifting cash, and certain situations might call for a 20% limitation.

Anything unused in that initial year can be carried forward for the next five years.

JOHN YUR: I will be talking about charitable remainder trusts. Regarding the income tax implications for a charitable remainder trust, it is the opposite of what Greg mentioned.

Charitable remainder trusts are tax-exempt entities, with an exception for Unrelated Business Taxable Income (UBTI). Because they are tax-exempt, the grantor does not have any tax ramifications or impact from stock sales inside the trust.

Since CRTs are similar to a charity or a private foundation, some of the same provisions apply, including prohibiting self-dealing and jeopardizing investments. There are restrictions on CRTs that do not exist on other types of trusts, and there are Draconian penalties if you violate those rules.

The charitable contribution deduction is taken for income tax purposes in the year the trust is funded. This is typically equal to the fair market value of the property less the fair market value of the annuity or unitrust amount.

There are unitrust and annuity split interests associated with both lead trusts and remainder trusts that we could discuss in a separate podcast, but they are treated similarly in this instance.

MOLLY GILROY: What are some additional estate tax implications on lead trusts and remainder trusts?

GREG MARKS: There are inter vivos charitable lead trusts created during a donor's lifetime and testamentary charitable lead trusts. Testamentary charitable lead trusts receive an estate tax deduction, though they generally would not be in a position to receive an income tax deduction.

Because of the taxation of a grantor lead trust, it is most often used for income planning rather than estate planning. However, in a low interest rate environment, if your assets appreciate faster than the Section 7520 rate issued by the IRS, more assets can pass to heirs at the end of the trust term.

This allows assets to pass at a lower cost, eating into less of your lifetime estate and gift tax exemption amount.

JOHN YUR: There are estate tax implications for a CRT as well. If the noncharitable beneficiary receives payments over a term—which can be up to 20 years or for life—the amount gifted to that beneficiary is a taxable gift.

This is typically equal to the fair market value of that annuity or unitrust amount gifted to the recipient, which will require filing a gift tax return. For estate tax purposes, the calculation is the fair market value of the property less the annuity or unitrust amount.

If you use a unitrust type of CRT, you can allow additional contributions if you want to leave the option open to add more over the years. The annuity type of CRT prohibits additional contributions.

MOLLY GILROY: Greg, you mentioned interest rates earlier. We know certain types of trusts can make more sense in a growth market versus a recession. In what environment is each trust most beneficial?

GREG MARKS: Charitable lead trusts are more advantageous in low interest rate environments. The lead or charitable income interest is given a higher value when the Section 7520 rate is lower.

To the extent those assets grow faster than that Section 7520 rate, more assets will pass on to the noncharitable beneficiaries of the lead trust and result in a lower gift tax cost.

A charitable lead trust might also make sense if you are looking to retain long-term benefit of the assets and do not want to relinquish control now, but do want an upfront deduction. It is a balancing act of immediate deductions, cash flow, and control that is individualized to each person’s situation.

JOHN YUR: Often we have clients who ask about using charitable trusts to mitigate or reduce their income tax liability. If a client is not philanthropic and does not want to give much to charity, a charitable trust is not a good option because a significant amount goes to charity either way.

These are for philanthropic-minded owners who seek income or estate tax benefits but also want to give to one or more charities. For lead trusts, we have seen clients with stock in a closely held entity who want to keep that stock inside the family but also want the charitable deduction.

The asset can stay in the trust, pay out over a number of years, and eventually come back to the family. With the remainder trust, the asset eventually ends up with the charity.

Typically, this is used for an asset that has appreciated significantly. If you put it in a CRT and have the trust sell the asset, the trust does not pay income tax on that amount.

You escape that immediate tax and maintain a revenue stream for yourself or your beneficiaries until the trust terminates and goes to the charity of your choice. It is a nice option for clients with highly appreciated stock to consider for their philanthropic and estate planning goals.

If you are not meeting with an advisor who has a sophisticated, holistic approach, you should find someone like that to help you navigate these options.

MOLLY GILROY: Thank you both very much. In conclusion, if you are a charitably inclined individual, both charitable remainder trusts and charitable lead trusts can be great options for your tax planning based on your specific situation.

Thank you for joining us. If you have any questions, please reach out to us at cbh.com. Please join us again for our next podcast.