Charitable lead trusts

In short

A friend of mine sold his small company last spring and called me the next week, half thrilled and half worried about the tax bill. If you are holding a large gain, you have probably asked whether giving to charity could also help your family. A charitable lead trust is one way to do both, though it is not for everyone. The trust pays a charity for a set number of years, and then what is left goes to your children or other heirs. The tax benefit comes from how the law values that gift, so the size of the benefit depends on an interest rate the IRS publishes each month. A lawyer must draft the trust, and the numbers need checking before anything is signed. It is a slow, careful tool, not a quick fix.

The whole of it

What it is

I once sat on a porch with an old farmer who leased his north field to a neighbor for ten years. The neighbor got the crops, and the farmer kept the land for his daughter. A charitable lead trust works much the same way. The charity gets the lead, meaning the first stream of payments. The family gets what remains after that.

You give assets to a trust. The trust pays a charity each year for a set term, or for someone's lifetime. When the term ends, the leftover assets go to the people you named, usually children or grandchildren. The name says it plainly. The charity leads, and the family follows.

There are two main kinds. A grantor lead trust gives the person who funds it an income tax deduction up front. A nongrantor lead trust gives no up front deduction, but the trust itself is treated as a separate taxpayer. The trust has to be written down by an attorney. It must meet the rules in the Internal Revenue Code, including section 170(f)(2)(B) for the income tax deduction and section 2522(c)(2) for the gift tax deduction.

How it works

You have likely wondered why anyone would hand money to charity first and family second. The reason is the gift tax. The law treats the gift to your heirs as happening on the day the trust is made, but it values that gift at a discount. The IRS subtracts the worth of the charity's payments from the value of what goes in.

Here is the plain idea. Say the trust holds $1,000,000 and pays the charity $50,000 a year for 10 years. That is $500,000 in payments over the term. If the trust earns more than the IRS assumes, the extra growth passes to the heirs with no added gift tax. If it earns less, the heirs get less, and the charity still gets paid.

The discount depends on the section 7520 rate, which the IRS sets every month. A lower rate makes the heirs' gift look smaller, so the tax cost drops. A higher rate does the opposite. That is why the timing of the setup matters so much.

The numbers, and where to find yours

I have learned that a plan is only as good as its inputs. Three numbers drive this one. The first is the section 7520 rate, which the IRS publishes in a monthly revenue ruling and on the IRS website. The current figure is the current figure, which the official source publishes each year, and the trust uses the rate for the month of funding or for either of the two months before it.

The second is the federal gift tax rate and the lifetime exemption. Today the lifetime gift and estate exemption is the current figure, which the official source publishes each year, and the top rate on taxable gifts above it is the current figure, which the official source publishes each year. The annual exclusion per recipient is the current figure, which the official source publishes each year. These come from the IRS and change by year.

The third is the limit on the income tax deduction for a grantor lead trust. A deduction for gifts of cash to a public charity is capped at a share of your income, set by law at the current figure, which the official source publishes each year. You can find all of these on IRS.gov, in Publication 559 and in the instructions to Form 709 and Form 1041.

A worked example

Let me tell you about a woman named Marcy Doyle. She started a software company, sold it, and held $2,000,000 in cash she did not need. She loved her local food bank and wanted her two sons to inherit something too.

Marcy set up a nongrantor lead trust for 15 years. She funded it with $2,000,000. The trust pays the food bank 5 percent of the starting value each year. That is 5 percent of $2,000,000, which is $100,000 a year. Over 15 years, the food bank receives 15 times $100,000, which is $1,500,000.

Now suppose, for simple math, the IRS valuation treats the charity's stream as worth $1,100,000 today. The taxable gift to her sons is then $2,000,000 minus $1,100,000, which is $900,000. That is the number that counts against her lifetime exemption, not the full $2,000,000.

Suppose the trust grows 6 percent a year, and the IRS assumed less. After paying $100,000 a year for 15 years, the trust could still hold real money for her sons. The gap between actual growth and the IRS rate is where the benefit lives. If the trust grew only 2 percent, the sons might get far less, and Marcy would have used up exemption for little gain. Those figures are my own plain ones, chosen to show the method. Her lawyer would run the real ones.

Where it goes wrong

I have seen good plans stumble on small things. The first trouble is a poor market. If the trust earns less than the IRS rate, the heirs may receive little or nothing, even though a gift was counted against the exemption. That is the main risk.

The second trouble is the trust itself. It is irrevocable, which means the grantor cannot take it back. The charity must be paid, whatever happens. A family that later needs the money has no way to reach it.

A third trouble is cost. The trust needs a lawyer, an accountant, a trustee, and yearly tax filings. A small trust may not earn back those fees. Fourth, a grantor lead trust can bring a big deduction in year one, but the grantor must report the trust's income on the personal return every year after. That surprises people. A grantor lead trust also carries a recapture rule in section 170(f)(2)(C) of the Internal Revenue Code, and the tax adviser can explain how it would apply to a given trust.

Last, the charity must qualify. Pay a group that lacks proper status, and the deduction can vanish. The IRS keeps a search tool for exempt organizations, and the trustee should check it.

Questions to answer before you leave this page

Have you named the charity you want to support, and have you confirmed with the IRS exempt organizations search that it qualifies? Do you know how many years the trust should run, and whether you want a fixed term or one tied to a lifetime? Will your heirs be fine if the trust leaves them little, or does the plan depend on strong growth? Have you looked up the section 7520 rate for this month and the two months before it? Can you live without the assets you plan to give, since the trust cannot be undone? Have you sat down with an estate attorney and a tax adviser to draft the trust and run the numbers with your own figures? And have you asked your family what they hope to receive, so that nobody is surprised years from now?