Charitable donations can be made in a variety of forms. Depending upon your estate planning and philanthropic goals, certain planned giving techniques may be very useful. Broadly speaking “planned giving” means that donations are made in some form other than an outright gift. Alternatively, it may be possible to create a new charitable entity controlled by you and members of your family to further a charitable purpose of your choosing.

This discussion will focus on certain common techniques used to make charitable donations. Specifically, these techniques include charitable remainder trusts, charitable lead trusts, life estates, gift annuities, and private foundations. For the most part, the law in this area came into existence in 1969, when Congress created laws designed to minimize perceived abuses in the area of charitable giving.

CHARITABLE REMAINDER TRUSTS

OVERVIEW

A charitable remainder trust (CRT) is a trust which makes payments to a non-charitable beneficiary for a specified period (the “lead interest”), and at the end of that period, the assets remaining in the trust are distributed to the charitable organization designated when the CRT was created (the “remainder interest”). It is permissible for the donor or a member of the donor’s family to be appointed as trustee of a CRT.

If a CRT is funded during the lifetime of the grantor, the grantor will generally be entitled to an income tax deduction. Alternatively, if a CRT is designed to come into existence at the passing of the grantor, the grantor’s estate will generally be entitled to an estate tax deduction. The amount of the tax deduction will primarily depend upon three variables: (1) an IRS index rate known as the Applicable Federal Rate (AFR) ;( 2) the length of time that payments are to be made to the non-charitable beneficiary; and (3) the amount that is to be paid to the non-charitable beneficiary periodically during that time.

THE APPLICABLE FEDERAL RATE

Each month, the IRS publishes an index referred to as the Applicable Federal Rate (AFR). While a detailed discussion of the AFR and its consequences is beyond the scope of this discussion, the purpose of the AFR is to approximate the expected return on the assets held by the CRT.

THE LENGTH OF TIME THAT PAYMENTS WILL BE MADE TO THE NON-CHARITABLE BENEFICIARY

Generally speaking, payments to the non-charitable beneficiary may either be for a set period of time (not to exceed twenty years), or alternatively, for the lifetime of a natural person. In cases where the life of a natural person is the measure of the non-charitable interest in the CRT, tables published by the IRS are used to estimate the natural person’s life expectancy, and thus the period of time that payments will be made to the person. Depending upon the circumstances at the time that the CRT is created, such as the age of the non-charitable beneficiary and the current AFR, it is not always possible to structure the payments so that they are measured by the life of a natural person.

THE AMOUNT THAT IS TO BE PAID TO THE NON- CHARITABLE BENEFICIARY

The amount that is to be made to the non-charitable beneficiary of a CRT may be determined by one of the two methods. First, the same amount may be paid each year. For example, a CRT initially holding assets with a value of $100,000 could provide that it will pay $10,000 each year to the non-charitable beneficiary. Each year, the trustee of the CRT would distribute $10,000, regardless of the income generated by the trust or the value of its underlying assets. Because the income stream generated by this form of payment is a fixed annuity amount, a CRT with this form of payment is a fixed annuity amount; a CRT with this form of payment is referred to as a Charitable Remainder Annuity Trust (CRAT). Alternatively, a CRT can be created which will produce payments that will vary according to the value of the assets held by the trust. For example, if a CRT held $100,000 in assets and had a ten percent payout rate, the non-charitable beneficiary would receive a payout of $10,000 that year. If the value of the assets increased to $200,000 in the following year the non-charitable beneficiary would receive a $20,000 payment (ten percent of $200,000). A payment varying by reference to the value of the assets held by a trust is generally referred to as a “unitrust.” Consequently, a CRT with this form of payout is called a charitable remainder unitrust (CRUT). There are four variations on the CRUT theme:

1. A standard unitrust pays the stated amount from the trust regardless of how much income is earned. The payout is the stated percentage of the trust assets as valued annually.
2. A net income unitrust pays the stated amount from the trust to the extent of income earned in the trust without invading principal. The payout is the stated percentage of the trust assets as valued annually.
3. A net income with makeup unitrust pays the stated amount from the trust to the extent of income earned in the trust without invading principal. It has the ability to makeup income in subsequent years if the income earned is less than the stated payout rate.
4. A flip unitrust is a net income unit trust that “flips” to a standard unitrust when a specified date or event occurs such as a birth, a death, or the sale of a hard-to-market property.

PAYOUT PERCENTAGE

Once the donor has chosen between a CRAT and a CRUT, it is necessary to select a payout percentage. A higher payout percentage results in more going to the non-charitable beneficiary, and consequently less is distributed to the charitable beneficiary. As a result, a higher payout to the non-charitable beneficiary will result in a lower charitable deduction for the remainder interest. Conversely, a lower payout to the non-charitable beneficiary means that the charity receives more, and consequently increases the charitable deduction. The precise percentages that will be permissible in a particular case depend upon a number of factors, and require calculations based upon the facts of each specific case.

TAXATION OF CRTs

Charitable remainder trusts (CRT) are tax-exempt trusts and generally do not have to pay income taxes at the trust level. As a result, a CRT does not have to pay capital gain tax when it sells appreciated property. In addition, CRT’s enjoy tax-free growth on their investments. These two benefits provide donors with excellent opportunities to diversify and invest for the future in a tax efficient manner. Payouts from charitable remainder trusts (CRT) are taxable to most recipients. However, the taxable amount and the tax rate of these payouts may vary greatly from year to year, depending upon the character of the trust assets.

It should be noted that there are significant restrictions with respect to the activities that may be conducted by a CRT. A CRT will lose its tax exempt status in any year that it has unrelated business taxable income (“UBI”) or debt-financed income. This could occur, for example, if the trust borrows funds to purchase investments, operates a business, or holds mortgaged property. In addition, a CRT will lose its exempt status for a year in which it fails to timely make the required payment to the non-charitable beneficiary, or fails to make a timely payment of real property taxes or assessments, resulting in a lien on trust property.

CONCLUSION

A CRT is often an effective tool to provide an income stream to a non-charitable beneficiary while benefiting charitable causes. Additionally, the use of CRT’s can produce significant tax benefits for the donor.

CHARITABLE LEAD TRUSTS

INTRODUCTION

A charitable lead trust (“CLT”) is very similar to a CRT, except that the interests of the charitable and non-charitable beneficiaries are reversed. Recall that with a CRT,
a certain amount is paid to a non-charitable beneficiary for a certain period, and at the end of that period, the assets remaining in the trust are distributed to a charitable organization. With a CLT, the charity receives payments for a certain period, and the assets remaining in the trust at the end of that period are distributed to the non-charitable beneficiary. In other words, where a CLT is used, the charity receives the lead interest and the non-charitable beneficiary receives whatever is left in the trust after the charity has received its payments.

Just as with a CRT, the payment to the lead interest in a CLT must be either a fixed dollar amount (an annuity) or a percentage of the value of the assets held by the trust (a unitrust). A CRT that pays the amount to the charity each year is called a “charitable lead annuity trust” (“CLAT”) and a charitable lead trust that pays a percentage of the value of the assets held by the trust is called a “charitable lead unitrust” (“CLUT”). Generally speaking, the CLAT is the more useful of the two possible forms of CLTs. As is the case with a CRT, the donor or a member of the donor’s family may act as a trustee of a CLT.

LEVERAGING YOUR ASSETS WITH A CLAT

If you have an asset that you anticipate will appreciate in value, a CLAT can be a very attractive estate planning tool. For example, suppose that you own stock with a value of one million dollars, and that you select a CLAT that will pay $100,000.00 to charity each year. (Recall that with a charitable lead annuity trust, the amount that paid to the charity will be the same each year.) Assuming an AFR of 3.8 percent and a payout period of five years, the relevant calculations reveal that the charitable lead interest would have a value of $447,690. Stated somewhat differentially, in dividing up the value of the $1,000,000 in stock held by the trust, the government assumes that the annuity transferred to the charity has a value of $447,690. The donor would therefore be entitled to an immediate charitable deduction of $447,690. The remaining $552,310 is allocated to the non-charitable beneficiaries. (In other words, the $1,000,000 in total assets contributed to the trust, less the $447,690 allocated to the charitable beneficiary.) The donor has therefore potentially made a taxable gift of $552,310 to the non-charitable beneficiaries. If the donor has never made gifts in excess of the annual gift tax exclusion in past years, no gift tax will be due. This is true because there is a $1,000,000 credit for gifts made during lifetime. (In other words, you may make $1,000,000 of gifts during your lifetime before gift taxes will be imposed.)

Recall that the AFR is the rate that the government assumes that the assets will appreciate. If the assets of the trust perform at a rate that is higher than the AFR, the non-charitable remainder beneficiaries will receive greater value that was assumed for transfer tax purposes. In other words, if the government assumes that the value of the assets in the trust transferred for the benefit of the non-charitable beneficiaries had a value of $552,310 that $552,310 value is locked in for transfer tax purposes. If stock contributed to the trust has increased in value to $5,000,000 when the last payment is made to charity, the $5,000,000 in stock will be transferred to the non-charitable beneficiaries with no further transfer taxes. In other words, the donor will have transferred $5,000,000 in value for a transfer tax cost of $552,310. By contrast, if the stock becomes worthless before the charity has received all of its payments, the non-charitable beneficiaries will receive nothing. The donor will then have used up $552,310 in transfer tax credit without actually passing assets to the beneficiaries. Stated somewhat differently, the amount that the donor can gift during their life, or leave upon their passing, before taxes are imposed will be reduced by $552,310.

Depending upon the anticipated growth of the assets, it may even be possible to avoid the consumption of the lifetime gift tax exclusion. In the above scenario, if the annual payments to the charity were increased to $223,360 per year, the government’s formula values the interest transferred to charity at almost $1,000,000. Recall that in this example, the stock has a total value of $1,000,000 when the trust is allocated to the charity; almost nothing is allocated to the non-charitable beneficiaries. The remainder interest therefore has a value of almost nothing for transfer tax purposes. In other words, the government is willing to bet that the trust will have almost nothing left if it starts out with $1,000,000, and pays $223,360 per year to a charity for five years. If the remaining assets have increased in value to $100,000,000 after all required payments have been made to the charity, $100,000,000 will have been transferred to the non-charitable beneficiary, and the donor has not been required to consume a significant portion of their $1,000,000 lifetime gift tax exemption. By contrast, if the government has wagered correctly, and the trust runs out of money before any distributions are made to the non-charitable beneficiaries, nothing has been lost except for the cost of creating the CLAT.

As a general proposition, it is unlikely that stock valued at $1,000,000 will either appreciate to $5,000,000 or become completely worthless in five years as in the above examples. In most cases, the actual performance of the assets held by the CLAT fall somewhere in between these two extremes. However, these examples have been provided to illustrate the point that a CLAT makes sense only when the donor is willing to gamble that the property to be contributed will increase in value.

CLUTs

While it is possible to create a CLUT, the utility of this device is somewhat limited because it has the effect of increasing the amount transferred to the charity, without a corresponding increase in the charitable deduction, if the assets of the trust appreciate at rate that is higher than the government’s assumed rate (the AFR). Conversely, if the donor is concerned that the assets contributed to the trusty may decline in value, a CLUT may ensure that the non-charitable beneficiaries will receive at least some benefit from the trust so long as its assets do not become completely worthless. Moreover, the charitable deduction received by the donor under a CLUT is based upon the value of the assets at the time that the trust is created. Consequently, the donor may receive a higher charitable deduction by using a CLUT, rather than making an outright donation after the assets have declined in value.

Unlike a CLAT, the assets of a CLUT can not be entirely consumed by the payments to charitable beneficiaries. For example, if the assets have a value of $1,000,000 and a payout rate of ten percent, the charity would receive a payment of $100,000, or ten percent of the value of the assets. If the assets decline in value to $100,000 the next year, the charity would only be entitled to $10,000 (again, ten percent of the value of the assets). By contrast, if the charity had been entitled to a fixed payment of $100,000 per year under a CLAT, the entire $100,000 held by the trust would be distributed to the charity, and nothing would be left for the non-charitable beneficiaries.

LIFE ESTATE AGREEMENT

Under a life estate agreement, the donor retains the right to use a personal residence or farm for their lifetime. Upon the donor’s passing, the property passes to a qualified charitable organization. A charitable trust is not part of this gift plan. Under Nevada law, the life tenant will generally be obligated to maintain the home during their life. However, a contract that clarifies the roles and responsibilities of both the donor and the charity is commonly incorporated into this type of gift plan in order to avoid any misunderstandings following the transfer. Specifically, this agreement generally requires the donor to maintain the property in its current condition, maintain property insurance, and pay the real estate taxes.

A gift of a remainder interest in a home produces a charitable income tax deduction equal to the actuarial value of the remainder interest. When computing the remainder interest in a personal residence or farm, depreciation must be taken into account if any part of the contributed property is subject to exhaustion, wear and tear, or obsolescence. In order to compute depreciation, a donor must determine the estimated useful life and salvage value of the building. For this reason, it is necessary to obtain a detailed appraisal of the property.

GIFT ANNUITIES

A charitable gift annuity is a contract between you and a charitable organization. You make a gift to a charity that is legally obligated to pay you a fixed amount of income for your lifetime. The transaction is, in reality, a bargain sale--part sale and part gift—because the value of your gift to the charity exceeds the value of the annuity promised by the charity. The annuity is backed by the general assets of the issuing charity.

A portion of the annuity payment received by the donor may be subject to income taxes; however, if the donor had sold assets, rather than donating them, the entire amount of the tax would be due in the year of sale. In other words, by exchanging assets for an annuity, the donor may defer the recognition of taxable gain. Moreover, the donor generally will be entitled to a charitable deduction in the year that the annuity is created. The net result is that the donor’s cash flow is increased and the donor’s favorite charity is benefited.

PRIVATE FOUNDATIONS

A private foundation is a charitable entity that primarily receives its support from a small group of individuals, rather than the general public. Private foundations are generally founded by an individual, a family or a group of individuals, and are organized either as a nonprofit corporation or as a charitable trust. You can appoint yourself, as well as other family members or friends, to sit on the foundation’s governing board. One common form of a private foundation is a family foundation. Families sometimes use a family foundation as a forum in which family members can work toward common goals, or as a way to instill the value of charitable giving in future generations of the family. Generally speaking, a private foundation provides the donor with greater control over the charitable purposes for which the donated property is used; however, there are some trade offs for this control.

Inasmuch as a private foundation does not depend upon the public for its funding, there is a perception that private foundations are particularly susceptible to abuse. The primary concern is that the public can not cut off the funding of the entity if it assets are used for the benefit of private individuals, rather than charitable purposes. Consequently, significant restrictions have been placed upon the activities engaged in by private foundations. It must be emphasized that self-dealing between private foundations and their substantial contributors or other disqualified persons will result in the imposition of significant penalties. As a result, great care must be exercised in the operation of a private foundation. Indeed, even some seemingly innocuous activities, such as the use of facilities owned by the foundation, may result in the imposition of penalties.

Moreover, it is necessary to exercise diligence to avoid the imposition of penalties for failure to meet distribution rules, having excess business holdings, holding speculative investments, and engaging in lobbying efforts or other non-charitable distributions. As a result, there are very detailed administrative requirements for private foundations, which can result in significant operating expenses. Additionally, donations to private foundations are subject to lower adjusted gross income requirements than donations to public charities.

There are generally three types of private foundations:

1. Private Endowed foundations

This is the most common type of private foundation. The foundation’s financial assts create a principal—or endowment—that is invested, and income from the endowment is paid out annually to charity. Generally, the principal can increase with good investment, ensuring the foundation’s continuation and growth to meet future community needs. Private foundations are required by law to pay out annual grants and other qualifying distributions totaling a minimum of 5 percent of the fair market value of their assets.

2. Pass-Through Foundations

A pass-through foundation is a private grant making organization that distributes all of the contributions it receives each year (not just 5 percent of its assets). The pass-through option may be made or revoked on a year-to-year basis.

3. Private Operating Foundations

A private operating foundation uses the bulk of its income to actively run its own charitable programs or services. Examples include the operation of a museum, library, research facility or historic property. Some private operating foundations also choose to make some grants to other charitable organizations

A private foundation permits a donor to donate assets to charity, while still effectively maintaining control over the donated assets. For many donors maintaining control is an attractive aspect of a private foundation; however, this virtue also leads to the greatest vice of a private foundation. There is a perception particularly susceptible to abuse, and elaborate rules have been enacted to ensure that private foundations are not misused. While a private foundation may involve significant restrictions and administrative expenses, it is often a useful vehicle where a donor desires to maintain a high degree of control over the donated assets.

COMMUNITY FOUNDATIONS

While a community foundation does not permit the donor to retain the same degree of control as a private foundation, it does allow the donor to avoid the complicated administrative issues associated with private foundations. Indeed, the community foundation, rather than the donor, is responsible for maintaining records and ensuring that all of the administrative details are handled properly.

When a donor donates assets to a community foundation, an account is created in the donor’s name. Funds are then distributed from this account to other charitable organization, typically (although not necessarily) in the donor’s community. Following a donation, the donor gives up the legal right to make binding directives dictating where the donated assets are to be distributed in a particular manner, and community foundations are generally sensitive to the reasonable recommendations of donors. In other words, the donor can not legally control the dispositions of the assets, but may still be able to exercise control from a practical standpoint.

A particular advantage of a community foundation is that it permits the donor to benefit several charitable causes with a single gift. Rather than addressing a single charitable cause, a community foundation may make distributions to a diverse group of causes. For example, rather than creating a private foundation that is limited to providing food for the needy, a community foundation may distribute a portion of its funds to support educational institutions. A community foundation can also adjust its donations as particular issues emerge or subside. For example, while the donor may generally desire to donate money to support medical research, a distribution may be made to assist victims of a disaster in a particular year.

While donations to a private foundation are only deductible to the extent that they are less than thirty percent of the donor’s adjusted gross income, donations to community foundations are subject to a limit of fifty percent of adjusted gross income. Moreover, donating certain appreciated assets to a community foundations are not subject to certain excise taxes, thus ensuring that more of your money goes to the charitable cause of your choice, rather than the government.

Perhaps most notably, a community foundation provides the donor with a simple and convenient method of benefiting their favorite charitable causes without the administrative expenses and complications involved in creating and running a private foundation. The community foundation presents less opportunity for mischief than a private foundation because the community foundation acts as an intermediary between the donor and the distribution of assets. Unlike a private foundation (which may be wholly controlled by the donor), the government has greater assurance that assets donated to a community foundation will be used for charitable purposes, as opposed to a private person. Consequently, the rules governing community foundations are far less restrictive than those relating to private foundations. While a donation to community foundation will be used for charitable purposes, as opposed to a private person. Consequently, the rules governing community foundations are far less restrictive than those relating to private foundations.

While a donation to a community foundation does not permit the donor to retain the same degree of control that would be permissible with a private foundation, issues of flexibility and convenience make a community foundation the right charitable vehicle for many donors. We will be happy to assist you in determining if a community foundation is right for you.

CONCLUSION

Charitable giving is often an effective method of minimizing taxes while advancing your estate planning and philanthropic goals. In order to maximize the benefits to you, your family, and your favorite charitable cause, it is imperative that the transaction be structured appropriately for your individual needs, and a careful analysis of your circumstances is necessary.