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Leading or Ending with Charity

In my last two columns, I summarized the income tax benefits of the most common charitable gift approaches, like gifts to public charities, private foundations and community foundations. I also discussed reasons and ways to involve family members in those activities to build moral values and investment skills.

But is that "all" you can get from being charitable . . ."just" income tax savings and well-adjusted family members? No, there can be more if you turbo charge your charitable activities. Instead of giving property lock, stock and barrel, consider splitting the income and the remainder between the charity and the family. The two primary ways to do this have very different objectives and tax consequences.

Charitable Remainder Trusts

A charitable remainder trust (CRT) provides an income interest to a non-charitable beneficiary for life or a term of years, with the remainder passing to charity. The income interest can be structured as a guaranteed annual payment or as a fixed percentage of the annual value of the CRT's assets.

The CRT's sex appeal is that it's tax-exempt. You can contribute highly appreciated property to it. The CRT sells the property, but pays no tax on the sales proceeds. By avoiding tax, the CRT can generate greater investment returns than would be possible if the donor simply had sold the property. The CRT distributions are taxable to the income beneficiary to the extent of the CRT's income. If the payout exceeds the CRT's income, the gain on the originally contributed property starts to be distributed and to become taxable.

The donor receives a charitable income tax deduction for the value of the remainder interest upon creation of the CRT. However, it's usually modest and not a primary motivation to use the technique.

In recent years, CRTs have been Congress' and the IRS' whipping boy. The reason is that advisers discovered numerous ways to take advantage of CRTs' income tax avoidance opportunities. To reduce abuse potential, numerous new rules have been created over the past few years, including:

  1. At inception, the present value of the charitable remainder must be at least 10 percent of the value contributed. Previously, CRTs could be designed with the expectation that virtually nothing would be left for charity. This rule effectively requires at least a modest charitable objective to benefit from the CRT's tax-exemption.
  2. The payout to the non-charitable income beneficiary may not exceed 50 percent per year. This rule prevents a sophisticated technique that permitted distribution of the lion's share of the CRT's assets to the income beneficiary with virtually no income tax.
  3. An independent trustee or qualified appraisal is required if the CRT owns hard-to-value property. This rule prevents manipulation of the CRT's annual payout.
  4. Naming someone in addition to the donor and/or the donor's spouse as an income beneficiary results in an unexpectedly large taxable gift. This rule prevents the use of CRTs as a gift tax planning technique.

These crackdowns have emasculated CRTs, although many in the advisory community have yet to recognize the economic consequences. Consider their primary use to be a way to sell highly appreciated marketable securities in order to diversify without immediate capital gain recognition. Subject to complex rules, if your family's business is a C corporation, stock may be contributed to and later redeemed. S corporation stock cannot be contributed to a CRT.

Charitable Lead Trusts

A charitable lead trust (CLT) is the flip-flop of a CRT. Charities receive an annual payment (usually a fixed dollar amount) for a term of years. Family members (usually children) are entitled to what's left when the charitable commitment ends.

The CLT's charm is its ability to leverage wealth to your children. At inception, you've made a taxable gift of the remainder interest. That gift is the value of property contributed to the CLT, reduced by the present value of the charitable commitment. Increasing the amount and/or length of the charitable commitment reduces the taxable gift. Often, the taxable gift is minimal.

If the CLT's investment performance exceeds the discount rate used to determine the value of the charitable interest, there will be a substantial amount remaining for the kids. That growth in value passes to them with no additional gift or estate tax.

Typically, no income tax deduction is allowed when you create a CLT. However, the CLT's income from the contributed property is excluded from your income tax return and the CLT gets a deduction for its contributions. That's roughly equivalent to you receiving an annual deduction for what actually goes to charity. The added benefit is that the CLT's deduction is not limited to a percentage of its adjusted gross income (AGI). That can be a big advantage to donors who are subject to AGI limitations. (See last month's Professional Insights column for the AGI percentage limitations.)

Whether you use a CRT or a CLT, you can involve the family in trust investment decisions and in deciding charitable recipients.

Sorting through these alternatives can be confusing. But, with the help of experienced advisers, you can take maximum advantage. The key is to first consider your objectives, both tax and nontax. Then, select a technique or techniques that most closely accomplish those objectives.

So, now you see how the benefits of giving can be multiplied when you combine family and charity.




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