Charitable remainder trusts

In short

A friend of mine sold his small company last spring and then stared at a tax estimate for a good ten minutes without blinking. If you are holding a big gain on stock or a business, a charitable remainder trust is one way to spread the tax over years while still giving to a cause you love. You give the asset to a trust, and the trust sells it with no tax at the moment of sale. The trust then pays you an income for life or for a set number of years. Whatever is left when that period ends goes to the charity you chose. You also get a partial income tax deduction in the year you fund it. Once made, the gift cannot be undone. Go slowly, and keep a good tax lawyer beside you.

The whole of it

What it is

I once watched a neighbor try to move a heavy stove by himself, and the lesson stuck with me. Some jobs go better when the right tool comes first. A charitable remainder trust is a tool of that kind. It is a legal arrangement, set up under Section 664 of the Internal Revenue Code, that holds an asset you give it. The trust owes no income tax on its own sales. That is the heart of the matter.

You are the donor. You name an income beneficiary, which is usually you, perhaps with a spouse. You name a charity to receive what remains, and that leftover is called the remainder. The trust has a trustee who manages the assets and sends out the payments. In many cases you can serve as trustee yourself, though a lot of founders hire a bank or trust company so the records stay clean.

There are two main kinds. A charitable remainder annuity trust pays a fixed dollar amount each year. A charitable remainder unitrust pays a fixed percent of the trust value, and that value is checked again every year. The payments rise when the trust grows. They fall when it shrinks.

How it works

If you have ever sold a house that gained a lot in value, you know the feeling of watching the bill come due. A founder who sells shares outright pays capital gains tax on the whole gain that year, all at once. With a trust, the founder gives the shares first. The trust sells them and keeps the full price, because the trust itself owes no tax on that sale.

The trust then invests the full proceeds and pays you your set income. Each payment you receive carries some tax, and the tax rules sort the money into tiers. Ordinary income comes out first, then capital gain, then tax free money, and last a return of principal. In practice, much of the old gain gets taxed bit by bit as the payments arrive, instead of landing in a single year.

You also get a charitable deduction in the year you fund the trust. The IRS sets the amount with a present value formula. That formula looks at your age, the payout rate, and a federal interest rate that changes every month. Higher payments to you mean a smaller deduction. The deduction has limits tied to your income, and any extra can be carried forward for up to five more years.

A few rules keep the arrangement honest. The payout rate must fall within the range the law allows. The law also requires that the charity's share be worth at least a set percent of the starting value, and the trust must pass a test on its odds of leaving anything to the charity. A trust that fails these tests does not qualify. No new gifts can go into an annuity trust after it starts. A unitrust may allow them if the document says so.

The numbers, and where to find yours

You have probably noticed that the rules here lean on numbers that move around. The payout rate has a floor of the current figure, which the official source publishes each year and a ceiling of the current figure, which the official source publishes each year. The charity's remainder must be worth at least the current figure, which the official source publishes each year of the starting value. The term of a trust for a set period cannot pass the current figure, which the official source publishes each year years.

The interest rate used in the deduction formula is called the Section 7520 rate, and the IRS publishes it each month. Your current rate is the current figure, which the official source publishes each year. Your deduction limit as a share of income is the current figure, which the official source publishes each year. To find your own figures, read IRS Publication 526, Charitable Contributions, and the instructions for Form 5227, which a trust files each year. Your tax adviser can also run the deduction math with your exact ages and dates.

A worked example

A woman named Dana, age 60, founded a software firm and holds stock worth $1,000,000. Her cost basis, which is what she paid in, is $100,000. Her gain is $900,000.

Say she sells outright. At a federal long term capital gains rate of 20 percent, the tax is 20 percent of $900,000, which is $180,000. Add the 3.8 percent net investment income tax, and that is another $34,200, since 3.8 percent of $900,000 is $34,200. She would keep about $785,800 to invest, since $1,000,000 minus $180,000 minus $34,200 is $785,800. State taxes would cut it further.

Now say Dana gives the stock to a charitable remainder unitrust first. The trust sells it for $1,000,000 and pays no tax on the sale. All $1,000,000 goes to work. Dana chooses a 5 percent payout, so her first year payment is 5 percent of $1,000,000, which is $50,000.

Suppose the trust earns enough that its value is $1,100,000 at the next yearly check. Her second payment is 5 percent of $1,100,000, which is $55,000. If it falls to $900,000, her payment is 5 percent of $900,000, which is $45,000. Her income moves with the trust.

Compare the starting capital. The trust invests $1,000,000, while the outright sale leaves $785,800. That is $214,200 more working for her, though she gets it back as taxable payments over time. She also gets a partial deduction up front. Say her adviser figures it at $250,000 for her age and rate. At a 37 percent federal rate, a $250,000 deduction could save $92,500, since 37 percent of $250,000 is $92,500, if her income limits allow it. Those figures are plain assumptions of mine, and a real quote will differ.

Where it goes wrong

I made a bad trade once, years ago, and I still remember how it felt to learn that no one could take it back. The same hard truth lives here. The gift to the trust is irrevocable. Dana cannot take the stock back if she changes her mind, or if she needs a lump sum for a new business.

Some people fund the trust with an asset that the trust cannot hold well. Private company shares are one example. Real estate with a mortgage is another. Debt on an asset can create taxable income inside the trust. A pending sale can also cause trouble. If a buyer and seller already agreed on a deal before the gift, the IRS can treat the donor as the real seller, and the tax benefit disappears. Timing matters a great deal. The gift must come before any binding sale agreement.

Payments can disappoint. A unitrust pays on value, so a poor investment year means a smaller check. A trust that takes too much risk may leave you short when you counted on the income. Fees add up too, since the trust needs a lawyer to draft it, a trustee to run it, and a return filed each year.

Then there is the charity side. The remainder goes to the charity you named. Your heirs get none of it. Families sometimes buy a life insurance policy to replace what the heirs would have received. That idea has its own cost and its own rules, and it deserves a careful look. Skip it, and a family can be surprised later.

Questions to answer before you leave this page

Have you asked yourself whether you can live with giving this asset away for good, even if your plans change? Do you know the cost basis of what you hold, and have you checked how large your gain really is? Is there a sale agreement already in place, and does a lawyer know about it before you sign anything? Which charity do you want to receive the remainder, and have you talked with them about how they accept such gifts? Would you rather have a fixed payment or one that rises and falls with the markets? How do your children feel about a gift that leaves them less, and have you talked about it honestly? Who will serve as trustee, and what will that person or firm charge each year? What does your adviser project for your deduction, using the current Section 7520 rate of the current figure, which the official source publishes each year, and does your income allow you to use all of it? Finally, who is the tax professional that will draft the trust and check every figure with you?