Charitable Remainder Trusts can be used as a substitute for, or a supplement to a retirement plan. In the simplest case a client transfers highly appreciated property to a charitable remainder trust, reserving substantial payments for life and the life of a spouse. Upon the death of the last survivor the balance becomes the property of the charity. This arrangement can be attractive for 3 reasons:

1. The gain on the appreciated property is not taxed,
2. The value of the charitable remainder will generate some income tax savings, and
3. The donor's interest in the trust is not subject to the tax on excess distributions.

Under another approach to this arrangement, the client makes gifts to a charitable remainder trust over time, and the income then generated accumulates free of any tax. The growth in value of this trust is sheltered from taxation until distributions are made to the grantor.

With Charitable Remainder Trusts, the marital deduction can still be made available to the client.

The IRS has strict interpretations over how these trusts are to be worded and how they must function. The IRS has published some sample declarations of trust forms for both the Revocable Trust and the Charitable Remainder Trust. An attorney and accountant should be consulted in crafting such an instrument.

Charitable Remainder Trust

This letter is in response to our previous discussion concerning your desire to establish a charitable remainder trust under your will. You indicated that your spouse will be the life beneficiary and that Alma Mater College will be the recipient of the remainder interest. I indicated to you that, to qualify for the estate tax charitable deduction, a remainder trust must satisfy specific statutory criteria. I noted that you have two choices: a charitable remainder annuity trust and a charitable remainder unitrust. You asked me to identify the differences between these trusts. Although there is another alternative, the pooled income fund, you rejected this alternative, since you want your designated trustee, rather than Alma Mater, to have control over the funds during your spouse's life.

Both trusts require that a specified percentage of the trust assets must be paid to the income beneficiary at least annually. That percentage cannot be less than 5% or more than 50%. The annuity trust requires this percentage to be applied to the net fair market value of the trust assets at the time the trust is established. This amount will not change regardless of any subsequent appreciation or depreciation in the value of the trust assets.

The unitrust, however, requires the fixed percentage to be applied annually against the fair market value of the trust assets. Accordingly, if the trust assets have depreciated in value, the net cash amount to be distributed would be reduced. However, if the assets have appreciated in value, the net cash amount to be distributed will be increased. The anticipation is, of course, that assets will appreciate in value and, accordingly, the annual payments will increase. The objective of the unitrust is to enable the life tenant's payments to reflect increases for inflation, thereby enabling the life tenant to retain purchasing power.

The value of the assets in a unitrust may increase merely because the annual percentage distribution is less than the amount of income being received. For example, if the annual payment is on a 5% basis, but the trust assets are in an investment which yields 10%, the 5% differential will accumulate each year and, therefore, constitute a larger base against which to apply the 5% distribution factor in subsequent years. On the other hand, if the annual payment is based on 10% and the trust is invested in growth stocks which are only yielding 3%, the additional 7% of the distribution must come from principal and will reduce the base against which the 10% is applied in subsequent years. However, this reduction of the principal by the amount of the distribution might be offset by appreciation in the value of the underlying assets.

The value of the estate tax charitable deduction for either type of trust depends upon the amount of the annual percentage distribution. The distribution of a higher percentage to the life tenant will reduce the value of the remainder interest to be received by charity. Therefore, ordinarily this means that a higher amount must be included in the taxable estate. However, if the life interest goes to the surviving spouse, a marital deduction will be available for that gift. The trust property could become subject to estate tax if, at the death of the surviving spouse, that spouse has a large amount of unexpended trust funds included in his or her gross estate. If that spouse will also give his or her estate to charity, this matter will not be important, since a charitable contribution deduction will also be available for that transfer.

Charitable Lead Trust

This letter is in response to your request for a general explanation of the structuring of, and benefits to be derived from, a charitable lead trust. As I indicated to you, a charitable lead trust is a trust which provides for benefits to be paid to a charity for the duration of one or more lives, or for a specified term, with the remainder interest passing to noncharitable beneficiaries. If a qualified charitable lead trust is established under a will, a charitable contribution deduction is available for federal estate tax purposes.

The lead interest transferred to the charity must be either a guaranteed annuity or a fixed percentage, distributed yearly, of the fair market value of the property, to be determined yearly. The larger the guaranteed annuity or fixed percentage, the greater will be the amount of the charitable contribution deduction.
This determination is made without regard to the actual income received by the trust. For example, if an 8% annuity is specified, but the trust invests in bonds producing income of 10% per annum, the excess income amount will be accumulated as part of the remainder interest ultimately to be distributed to the remainderman. However, the specification of a fixed annuity amount precludes the trustee from implementing an investment policy which would favor the noncharitable beneficiary, to the detriment of the charity.

Please contact me if you have any further questions. We can develop computations to project the approximate tax costs if you will provide information concerning your specific plans.