Let’s take a strategy we developed last month, build on it, and turn it into something very powerful.
In the “defective” grantor trust we discussed last month the grantor of the trust is taxed on all its income, but the trust is excluded from the grantor’s estate. The combination lets you leave more tax-free dollars to your loved ones.
Now let’s suppose you want to benefit a charity as well. You can combine the little-known charitable lead trust with the grantor trust rules to come up with a very attractive way to give generously to both the charity and your heirs while cutting estate and gift taxes.
You probably have heard of the popular Charitable Remainder Trust. You donate appreciated property to a trust that pays income to you or someone you designate for a period of years or for life. After that, the charity gets what’s left in the trust. You take a charitable contribution deduction up front for the present value of the amount the charity eventually will receive.
The charitable lead trust is basically the opposite. The charity gets income from the trust for a period of years. After that, the property is either returned to you or given to loved ones you designated in the trust agreement. You can get a charitable deduction for the present value of the income payments the charity will receive. A major difference is that the charitable remainder trust is tax exempt, while the charitable lead trust is taxable.
Now let’s look at an example of the charitable lead trust combined with the defective grantor trust rules to see the benefit you can get.
Suppose your IRA has more assets than you need. You are looking at the prospect of taking distributions in the future that will be taxed. You’ll lose the tax deferral plus get thrown into a higher tax bracket.
Instead, you create a charitable lead trust that qualifies as a grantor trust for income tax purposes but not for estate tax purposes, as described last month. That means you are taxed on the income from the trust, but the trust is excluded from your estate. The trust will pay income to a charity for 15 years, then the remaining property will go to your children.
You take a distribution from the IRA and immediately transfer that money to the trust. The distribution will be included in your income for the year, but you’ll get a charitable deduction for a portion of the gift to the trust. Currently, if the charity is to receive income equal to 7% of the trust’s initial value for 15 years, the deduction will equal about 65% of the contribution. You won’t be able to deduct more than 30% of your adjusted gross income in any one year for this gift, but any unused amount can be deducted over the next five years. The rest of the transfer to the trust will be a taxable gift to the children.
The trust principal then is invested. All income of the trust is taxed to you. So you probably want the trust to invest for growth and capital gains. The required annual distributions to the charity can be made by selling shares each year, which most of the time should result in long-term capital gains to you, not ordinary income.
The trust grows faster for your heirs if you pay the annual taxes, and this is not considered a gift to them. Also, if the investments earn more than the amount paid to the charity each year, the trust will grow. If the total return of the trust is 12% and the annual payout is 7% of the initial value, then after 15 years the trust should be worth close to three times its initial value.
Compare this result with what would happen if you left the money in the IRA. You’ll be taxed on required annual distributions. Then, the rest of the IRA would be included in your estate, subject to estate taxes. Your children would have to pay income taxes when they take money out of the inherited IRA. They would be lucky to end up with 40% of the value the IRA had at your death. And unlike with a charitable remainder trust, your children end up with the property instead of having it go to charity.
That is just one way to use a charitable lead trust. It is very flexible and has many variations. If benefiting a charity now and your children later while cutting income, estate, and gift taxes sounds attractive to you, then sit down with your estate planner. Review the different ways to use a charitable lead trust and develop the option that works best for you.