If you’re trying to reduce your estate tax liability, a charitable trust might be the ideal vehicle. A charitable lead trust and a charitable remainder trust are the two options to consider. As you weigh the pros and cons of each, keep in mind the current low-interest-rate environment is more favorable for lead trusts than remainder trusts because of the way charitable deductions are calculated. Let’s take a closer look.
Charitable Lead Trusts. This type of trust can provide for a favorite charity and for future generations with very little gift or estate tax consequences. The charitable deduction is based on the value of the income that goes to charity, discounted at the monthly Section 7520 rate according to the Internal Revenue Service. The lower that rate is, the greater the gift to charity and the charitable deduction, and the smaller the remainder gift to heirs, at least from a gift tax perspective. For December 2015, the discount rate was 2.0 percent, which results in a fairly large gift to charity in most cases. In contrast, higher discount rates result in smaller gifts to charity and larger remainder gifts to heirs.
Here’s an example: Let’s say you have a $3 million apartment building that will likely appreciate significantly during the next 20 years and produces annual rental income. If that apartment building is in a charitable lead trust, the income it produces each year will go to charity. At the end of that 20-year term, the building goes to heirs.
It’s possible to establish the trust so the value of that income stream going to charity is equal to the current fair market value of the building. In other words, the charitable gift completely offsets the gift going to your heirs, so the gift to heirs is effectively $0 for estate and gift tax purposes.
Grantor Trust. This is another type of charitable lead trust. With a grantor trust, the assets in the trust at the end of the trust term are returned to you. For example, if you want to give $10,000 a year for five years to a charity, you can set up a charitable lead trust using income-producing assets.
You may also receive an income tax deduction for the value of that income stream up front in the year you set up the trust, though you still have to pay taxes on the income earned by the trust each year. However, if the trust is invested in municipal bonds, the income produced isn’t taxable for federal purposes. (It may still be taxable at the state level.) The income goes to charity for the term of the trust, and the bonds themselves or the cash goes to the remainder beneficiary at the end of the trust.
Charitable Remainder Trust. This is essentially the inverse of a charitable lead trust, and may be a good tool if you’re worried about giving up income-producing assets, or want to provide a stream of income to a beneficiary for a period of time. You donate appreciated assets into a charitable remainder trust. The trust then sells the assets without paying taxes on gains at the sale, and reinvests in a well-diversified portfolio invested to grow and generate income.
For example, if you contribute $1 million in stock that has basis of $500,000, there are no taxes owed at sale — the whole $1 million can be invested in a well-diversified portfolio. You aren’t avoiding the taxes but instead deferring them out over the trust term. You can be the recipient of the income stream or you can give the income stream to heirs — say, for a child’s lifetime or for a period to cover college expenses — and then the remainder goes to charity.
These charitable trust strategies are complex, so be sure to work with financial advisers, including a CPA, as well as an estate attorney who’s experienced at drafting them and not a business attorney who’s doing estate planning on the side as a favor to you. You’ll save money in the long run by doing things correctly.
kathryn garrison is a senior financial adviser with Moss Adams Wealth Advisors. Reach her at firstname.lastname@example.org. kelli anderson is a CPA with Private Client Services at Moss Adams. Reach her at email@example.com.