Tax Incentives for a Charitable Remainder Trust

A charitable trust may be a good thing if you are considering giving a gift to charity. It is a special kind of trust specifically designed for this purpose. Through this, you will benefit from the tax breaks it can give you and your heirs, in addition to helping others. But you have to be ready before creating the trust because charitable trusts are irrevocable. Once it starts and is in operation, you can no longer take back what you have already given.

How a Charitable Trust Works?

One common type of charitable trust is the charitable remainder trust. Here, you set up a trust and transfer all the property you wish to donate into that trust. Your chosen charity must be approved by the Internal Revenue Service to be a charitable and therefore tax-exempt institution.

The charity will be the trustee of the trust you have created, therefore the charity will manage and protect the funds in the trust. The charity will then pay a portion of the income from the trust to you or a person you have chosen. The terms may specify whether the payments will be made within a specific number of years or the remainder of your life. Upon your death, the trust ends and the property in it go directly to the charity.

Three Tax Advantages for a Charitable Trust

There are also three primary tax benefits which you can get through a charitable remainder trust.

1.      Income tax

You can get income tax deduction spread over five years based on the value of your donation. But you have to keep in mind that only a partial amount could be deducted. The IRS calculates the deduction based on the amount of the original donation minus what you expect to receive from the interest payments.

2.      Estate tax

Since it is in a trust, the property is transferred to the charity directly after your death; therefore it will no longer be included in the calculation of the value of your estate.

3.      Capital Gains tax

You can put in a charitable trust the properties that are no longer making income and turn them into cash without having to pay capital gains tax. For example, if Cherry has 5000 shares of stock that increased in value from $10/share to $100/share in the years that she had it, she cannot sell the stocks without paying capital gains tax on it. But if Cherry donates the stocks to a charitable trust, the trust can sell the stocks without paying taxes for the sale. The charity can sell the $500,000 worth of stock, invest in a mutual fund and pay Cherry the interest from the fund for the rest of her life. These are all without paying capital gains tax.

Two Types of Income from a Charitable Trust

There are two ways of receiving an income from the fund:

Annuity Payments

If you choose fixed annuity, you will receive a fixed amount from the trust each year. Even if the trust has not done well during the year, you will still receive the same amount as the years before. But keep in mind that once the amount has been set, you cannot change it.

To determine how to set the amount for annuity payments, you have to take into consideration certain things: One is you may not receive the full benefit of the charitable trust if you sent the annuity amount too low. Another is that you may end up depleting the principal of the trust if you set it too high, and end up with you not being able to leave anything to the charity upon your death. And the higher you set the annuity, the lesser tax deduction you can get from the trust. Another thing is that a charity may not be willing to be the trustee of a trust with high annuity payments because they don’t want to end up with nothing upon the termination of the trust.

Percentage Payments

A more common method of receiving income from the charitable fund is through percentage payments. In this case, the amount paid to you is equal to a certain percentage of the current value of the trust fund. So the amount you receive is based on how much the trust made or lost within the year.

This is most often chosen because of the flexibility of the amount of payment, taking into consideration changing market trends and inflation. The IRS has set that a trust beneficiary must receive at least 5% of the value of the trust annually.

Suppose Ronald is thinking of what he could do with the stock he bought 10 years ago for $200,000 that is now worth $4,000,000. Because the dividends are small, Ronald sees little income from the stock. Ronald could sell the stock and invest the money in another way that would enable him to get more income from it. But if he sells the stock, he will owe $570,000 in capital gains tax. So Ronald can put his stock in a charitable trust for his favorite hospital. He will be able to sell the stock with $3,800,000 profit without having to pay capital gains tax. He could also claim an income tax deduction spread over a period of five years because of this charitable donation.

The charity will now manage and invest the $3,800,000. Plus, the trust document that Ronald created requires the trust to pay him 7% annuity for the rest of his life. In the first year of the trust’s operation, Ronald would receive $266,000 and could change depending on how the trust performs. If it performs well, then Ronald will be paid more each year.

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