Two Types of Charitable Trusts You Should Know About
- David S. Sietsma
Charitable trusts are often synonymous with estate planning because they provide you — the donor — with a wide range of benefits. Charitable trusts can help you reduce income taxes, reduce your estate tax, and protect your assets. And beyond that, depending on the type of trust, you can create a tax-advantaged reliable revenue stream for yourself or your beneficiaries, all while incorporating your charitable goals into your planning.
There are two types of charitable trusts you should know about: charitable lead trusts and charitable remainder trusts. Both can play roles in your estate plan.
Charitable lead trusts (CLTs) and charitable remainder trusts (CRTs) are both irrevocable trusts created to benefit two parties:
1. Your chosen beneficiaries (which could include yourself)
2. One or more named charitable organizations
The primary difference between CLTs and CRTs is which of these two parties receives annual distribution payments, and which party receives the remainder interest (i.e., the assets remaining in the trust at the end of the payment term).
CLTs distribute periodic payments to the charity during the trust term, after which the remainder interest is disbursed to your beneficiaries. CRTs are the opposite; CRTs provide you or your beneficiaries with cash distributions for a set time, after which the remainder interest is paid out to charity.
It is important to understand how charitable trusts are formed and how they operate.
To create a charitable trust, you must first identify your charitable goals and work with a trust attorney to create a trust document. Then make a transfer of assets into your trust account. This transfer is irrevocable. Most charitable trusts accept both tangible and intangible assets, including cash, securities, business interests, cryptocurrency, art, and real estate. These initial assets are considered the trust principal or corpus.
Over the life of the trust, those principal assets typically appreciate and likely generate income. This income may come from stock dividends, interest, rents from real estate holdings, or business earnings.
When you establish a trust, the trust document outlines how the income and principal will be disbursed. There are two main ways to calculate interest and principal disbursements: Amounts can be predetermined when the trust is established, or they can be calculated each year based on changes to the trust’s value. To understand this concept, we need to explore two different subsets of charitable trusts: annuity trusts and unitrusts.
Annuity trusts pay a fixed percentage of the trust’s initial value each year until the trust terminates. The annual payments promised to the income beneficiaries are fixed and predictable, just like any other annuity. If the trust generates more income than predicted, a larger amount will be disbursed to the beneficiaries of the remainder interest. If the trust generates less income than predicted, the trustee may need to sell off some of the trust’s principal assets to make those promised income payments.
Unitrusts pay a fixed percentage of the trust’s current value each year until the trust terminates. Each year, the trust is revalued. This means that payments to income beneficiaries will vary each year. In years when returns on trust assets are strong, payments will be larger, but when returns are weaker, those payments will fall.
When designing your ideal trust, it’s helpful to make one decision at a time. First, you should determine whether you want a CLT or a CRT, and from there you can decide whether you want an annuity trust or a unitrust.
When making your decision, it’s important to consider the tax consequences, discussed below. Keep in mind that the tax outcomes differ depending on whether the trust is a grantor trust or a non-grantor trust.
CLTs and CRTs can be great tax planning tools and great methods for protecting your wealth. We have created a table that summarizes the factors to consider when selecting a CLT or a CRT. Refer to this chart when talking to your tax advisor or estate planner. If you’d like to talk to our CPAs about CLTs or CRTs, please reach out to us today.
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