The benefits of charitable remainder trusts (CRTs) are well known. In brief, you designate an income beneficiary, while the charity receives the remainder interest. Best of all, you can claim a big upfront deduction for the value of the charitable interest transferred to the trust.
Strategy: Flip this tax technique on its head. Set up a charitable lead trust (CLT) instead of a CRT. In other words, establish a trust where the charity receives income for a stated term and the beneficiary keeps the remainder.
You can choose between two main types of CLTs: nongrantor (or nonreversionary) trusts and grantor trusts. Which one should you use? It depends on your objectives.
1. Nongrantor trusts: Usually, you set up a nongrantor trust through your will (i.e., a testamentary trust). In this case, you can’t claim any income tax benefit for your generosity. But this move entitles your estate to a charitable deduction for the present value of the charitable gift. You want to “zero out” the value of the remainder interest passing to your heirs.
Assuming the trust generates investment returns that keep up with the annual payouts to the charity, your heirs will end up with an amount close to what you transferred to the trust, completely free of estate tax. If the returns outpace the payouts, it could turn into a veritable bonanza.
2. Grantor trusts: A grantor trust is generally set up through a lifetime gift (i.e., an inter vivos trust). Instead of leaving the remainder to other beneficiaries, the assets revert to you. So, you can claim a current income-tax deduction for the value of your charitable gifts, but you receive no estate-tax benefit. The IRS limits the income-tax deduction to 30 percent of your adjusted gross income.
This technique may be preferred if you desire a current write-off for property that you will retain.
Tip: Trusts are generally not a do-it-yourself proposition. Have your tax pro handle the details.
Example: Set up your heirs for a jackpot
Say you contribute $1 million to a CLT to benefit your alma mater. The trust agreement states that the school will receive $70,000 annually for 20 years. At the end of the trust term, the principal goes to your daughter. Only the remainder interest that goes to your daughter is subject to gift tax.
Under the IRS tables, the value of the gift is $222,540. Assuming a 3 percent annual net return, the trust principal will actually grow to $2,597,230. Thus, your daughter will receive the difference between that amount and the value of the remainder interest—a whopping $2,374,690—entirely free of gift or estate tax.
The amount currently subject to gift tax ($222,540) can be eliminated or reduced by your lifetime $1 million gift-tax credit.