When you’re dealing with a loved one’s estate, you’ll likely encounter a wide variety of accounts, trusts, and investment vehicles. One increasingly common investing tool that you might encounter during the estate settlement is a charitable trust.
What is a Charitable Trust?
A charitable trust is an irrevocable trust that allows you to donate assets to a tax-exempt charitable organization while still retaining income or benefits from the assets.
Yes, we know that is a lot to take in. Let’s break down some of those confusing terms.
Irrevocable Trust:
A trust is a financial tool that can assist grantors (the individual who creates a trust) in transferring assets, lowering tax liabilities, and shielding assets from the probate process.
When an individual creates a trust account, they can create the trust as revocable or irrevocable.
Revocable trusts can be changed, amended, or revoked after they have been created. If an individual creates a trust but then decides that they want to change the trust, a revocable trust will allow the individual to make any alterations.
Once the grantor passes away, a revocable trust automatically becomes irrevocable.
An irrevocable trust is exactly the opposite of one that is revocable—an irrevocable trust cannot be changed or altered once it has been created. Only an order from a court can change or modify an irrevocable trust.
Now, why would an individual choose to create an irrevocable trust if it cannot ever be changed? Well, irrevocable trusts are preferred for their tax benefits.
When an individual creates an irrevocable trust, they are essentially ceding control of those assets. The assets that fund the irrevocable trust are no longer considered as part of the individual’s estate, thereby lowering the possibility of future federal estate or inheritance taxes.
Because of the nature of the donation involved in charitable trusts, all charitable trusts are irrevocable.
Tax-Exempt Charitable Organization:
Charitable trusts are formed with the intent of donating assets to a tax-exempt charitable organization.
A charitable trust cannot be formed to donate money to just any organization, as the receiving institution must be recognized as a charitable organization by the IRS.
Retaining Income:
A charitable trust isn’t just a gift to a charitable organization, of course. If that were the case, then individuals would just give the funds directly to the charity in their will as a general bequest, rather than go through the trouble of creating a charitable trust.
The purpose of a charitable trust is to donate gifts to the charity but still benefit from a portion of the assets, either through the interest that the funds accrue or from the funds that remain after the organization has received an income stream from the assets.
If that’s confusing, don’t worry—you’ll see how both the charitable organization and grantor can benefit from the assets by looking at the two main categories of charitable trusts.
Charitable trusts are divided into the following two categories:
- Charitable Remainder Trusts (CRTs)
- Charitable Lead Trusts (CLTs)
Among these two types of charitable trusts, charitable remainder trusts are the most common.
Let’s take a look at charitable remainder trusts to learn more about this unique financial tool.
What is a Charitable Remainder Trust?
A charitable remainder trust (CRT) is a tax-exempt investing vehicle that allows donors to pursue philanthropic goals while still receiving an annual income.
Although they might seem complicated on the surface, CRTs are relatively straightforward.
There are three main parties involved in a CRT:
- Grantor - The individual who creates the trust and benefits from a percentage of the trust value.
- Trustee - The individual that administers the trust (this can be the same individual as the grantor, although that is not required).
- Charitable Beneficiary - The charity that receives the principal amount of the trust after a certain period of time or after the grantor’s passing.
There’s a lot to unpack there, so let’s take a look at the creation of the CRT.
How does a CRT work?
Like all trusts, a CRT really only involves three main aspects: trust creation, income accrual, and remainder distribution.
Take a look at the image from Fidelity Charitable below, which outlines the process involved in a CRT.
As outlined in the image, a CRT boils down to three important steps:
- Creation: The grantor creates an irrevocable trust and funds the trust with a significant donation.
- Income Accrual: The grantor or a named beneficiary receives a percentage of the trust’s market value each year.
- Remainder Distribution: After a set period of time or upon the grantor’s death, the remaining funds go to the remainder charitable beneficiary. This charity can either be a public charity or a private foundation.
If that still has you a little bewildered, don’t worry–this example might help:
John is a wealthy widower with a net worth of roughly $20 million. On his eightieth birthday, John creates a charitable remainder trust. He funds the trust with $10 million. The trust agreement states that John can receive 10% of the trust’s market value each year.
In the trust agreement, John names his local church as the charitable beneficiary.
John will receive a tax deduction off of the initial funding amount, as the IRS deems that as a donation to charity.
Each year, John receives 10% of the trust’s market value as income.
After fifteen years, John passes away. The remaining funds in the trust go to the church and are not included in John’s taxable estate.
Now, I imagine that you likely have a few questions about this example. Let me try to address some of those questions that might be creeping into your mind:
Can you receive 100% of the CRT’s market value as income?
No, you can’t. The IRS states that a grantor must receive anywhere between a minimum of 5% and maximum of 50% of the trust’s market value. In this example, John’s 10% is perfectly reasonable.
So a CRT lets you avoid all taxes?
John won’t pay taxes on the funds in the trust—in fact, he’ll get a nice tax deduction from funding the trust in the first place. But he will still be taxed on whatever income he receives each year from the trust.
Can a CRT last forever?
No, a CRT cannot last forever. A CRT can last for the length of the grantor’s life or for a term as large as 20 years. In many cases, the trust agreement will stipulate how long the CRT will last for.
Is the grantor always the main beneficiary of the CRT?
The grantor does not need to be the one receiving an annual income from the trust. In fact, grantors often name their spouse, children, or grandchildren as the income beneficiaries of the CRT.
Can you change your mind after you create a CRT?
No, a CRT is irrevocable. This means that the trust cannot be changed once it has been created.
If you choose to create a CRT and then later decide that you don’t want one, you’ll have a hard time nullifying the original trust agreement. Because of this, grantors should weigh the pros and cons of CRTs carefully before deciding to create the trust.
We’ve presented a broad overview of CRTs, but these trusts can get a bit more confusing as you dig a little deeper.
If you’re dealing with a loved one’s charitable remainder trust, you’ll need to know whether it’s a CRUT or a CRAT.
Types of CRTs
There are two common types of CRTs that you might encounter:
Charitable Remainder Unitrust (CRUT)
A CRUT is the most common type of CRT. This trust pays out a percentage calculated from the market value of the trust each year.
Let’s suppose that there’s a trust with a market value of $100,000 and a 5% payout. The first year, the income beneficiary will receive $5,000.
The second year, the trust’s market value has risen up to $120,000. The payout proportion of 5% is the same, but this year the income beneficiary will receive $6,000.
It’s important to recognize that the annual payout will be different each year with CRUTs. Although the payout percentage remains the same, the actual payout changes because the market value will fluctuate.
Charitable Remainder Annuity Trust (CRAT)
As its name suggests, a CRAT pays out a fixed percentage based on the initial market value of the trust at the time of funding.
Unlike a CRUT’s payments, which fluctuate from year to year, a CRAT’s payments are fixed for the lifetime of the trust.
Why could this be beneficial? If the trust’s market value plummets, the CRAT payout remains the same. If the market value rises, however, then the income beneficiary would be missing out on potential payout increases.
Now that we’ve looked at CRTs, it’s time to look at the second form of charitable trusts: charitable lead trusts (CLTs).
What is a Charitable Lead Trust?
The definition of a charitable lead trust (CLT) is very similar to that of a CRT:
A charitable lead trust (CLT) is a tax-exempt investing vehicle that allows donors to pursue philanthropic goals while still receiving an annual income. Unlike a CRT, which gives the remainder of the assets to a charity, the remainder of the assets in a CLT goes to a non-charitable beneficiary.
Like in CRTs, the main components of CLTs revolve around the three primary characteristics: creation, income accrual, and remainder distribution.
Unlike CRTs, however, the order of who gets which assets is reversed in CLTs.
The following image explains CLTs well:
Let’s take a look at those three components mentioned above in more detail:
- Creation: The grantor creates an irrevocable trust and funds the trust with a significant donation.
- Income Accrual: A charitable beneficiary receives a percentage of the trust’s market value each year.
- Remainder Distribution: After a set period of time, the remaining funds go to a non-charitable beneficiary.
You can see what the difference is between CRTs and CLTs.
In CRTs, the income first goes to the grantor or beneficiary and then goes to the charitable beneficiary after a certain amount of time.
In CLTs, the income first goes to the charitable beneficiary and then goes to the charitable beneficiary or grantor after a certain amount of time.
As with CRTs, there are two main types of these trusts.
Types of CLTs
There are four types of CLTs that we should focus on. Let’s focus on the first two types: CLUTs and CLATs:
Charitable Lead Unitrust (CLUT)
A CLUT is calculated just like a CRUT: This trust pays out a percentage calculated from the market value of the trust each year.
With a CLUT, the charitable organization is the beneficiary that receives a percentage of the trust’s market value each year.
Since the market value changes each year, the amount that the charitable organization receives will also change each year.
Charitable Lead Annuity Trust (CLAT)
As with a CRAT, a CLAT pays out a fixed percentage based on the initial market value of the trust at the time of funding.
Unlike a CLUT’s payments, which fluctuate from year to year, a CLAT’s payments are fixed for the lifetime of the trust.
Once again, however, it is important to remember the obvious distinction between a CLAT and a CRAT: with a CLAT, the charitable organization receives the fixed percentage payout. With a CRAT, it is the non-charitable beneficiary or the grantor receiving the fixed percentage payout.
Now, we said that there are four types of CLTs. We now know about CLUTs and CLATs, but what about the other two types?
Before we can get into the last two common types of CLTs, we need to ask an important question. What other differences separate CRTs and CLTs?
CRT vs. CLT: What’s the Big Difference?
We know that CRTs and CLTs are different when it comes to distribution patterns. CRTs give the remainder of the assets to a charitable beneficiary, while CLTs give the remainder of the assets to a non-charitable beneficiary after first giving an annual payout to a charitable beneficiary.
But there is one crucial difference that we have failed to mention so far: tax exemption status.
A charitable remainder trust is tax-exempt, but a charitable lead trust is not tax-exempt.
That is the main reason that CRTs are more popular than CLTs. With CRTs, the interest in the assets is revoked after a period of time. But with CLTs, the interest in the assets returns to either the grantor or the trust once a set period of time elapses.
This brings us to the two other types of CLTs:
Grantor Charitable Lead Trust
With a grantor charitable lead trust, the grantor is considered as the “owner” of the assets. Because of this, the grantor is the one who makes the donation to the charitable organization.
For his or her donation to charity, the grantor receives an income tax deduction for the present value of the future payments to the charitable beneficiary.
Despite that, however, the grantor is taxed for the CLT’s investment income during the lifetime of the trust.
Non-Grantor Charitable Lead Trust
In a non-grantor charitable lead trust, the trust is considered as the “owner” of the assets. The grantor is not the one who receives an income tax deduction—it is the trust that receives an income tax deduction on the charitable donation.
The trust will end up paying the income tax on investment income, due to the fact that the trust is the “owner” of the assets.
If grantor and non-grantor CLTs are confusing, don’t worry—unless you’re the one trying to set up a CLT, you don’t really need to fully grasp the tax concepts behind these trusts.
What’s important to recognize with all charitable trusts, however, is that these types of trusts have many benefits.
These benefits are a large reason as to why charitable trusts have become so popular as an estate planning tool.
Let’s take a look at those benefits:
Benefits of Charitable Trusts
From an estate planning perspective, there are three main benefits to charitable trusts:
Avoids estate taxes
The opportunity to avoid estate taxes is one of the leading reasons why many people choose to create charitable trusts.
By funding a CRT or CLT, individuals lower their estate assets and ensure that those assets are not included in federal or state inheritance taxes upon the individual’s death.
Avoids income taxes
The main reason individuals tend to choose CRTs over CLTs is because of the income tax benefits that CRTs have to offer. In both cases, however, individuals may be able to take tax deductions on the donations to the charities.
Before you decide which type of charitable trust you plan to set up, be sure you understand the tax consequences involved in the different types of CRTs and CLTs. Because these trusts are irrevocable, there is no changing them after you have set them up!
Avoids probate
One of the benefits of trust accounts is that the assets within the trust are not viewed as part of the estate. Because of this, the assets are not included in probate during the estate settlement process.
This factor serves to increase the efficiency of the probate process, as fewer assets generally results in a quicker estate closing. In addition, another benefit of avoiding probate is that the grantor’s privacy is maintained.
While assets that are included in probated wills can be viewed by the general public, assets held in trusts are not available to the public. Grantors who hope to shield their assets from the public eye may choose to create a trust for the sole purpose of ensuring privacy of the estate after the grantor’s death.
Provides a clear estate planning plan
The probate process can be tedious, costly, and time-consuming. A charitable trust avoids the mess by providing a clear guideline for asset distribution.
With most assets, there’s usually a question of “who gets it now?” after the original owner passes away. With charitable trusts, however, there is never a question of who rightfully owns the assets after the grantor’s death.
The fact that a charitable remainder beneficiary is named in the trust agreement ensures that asset ownership will transfer smoothly after the trust grantor passes away.
Disadvantages of Charitable Trusts
There are three main disadvantages surrounding CRTs that any potential grantor should be aware of:
Charitable trusts are irrevocable
As mentioned earlier, you cannot change your mind after creating a CRT. The funds held within the trust are viewed as donations to the charity—even if you are still receiving income payments from the funds.
You can’t take a gift back after you give it. In the same sense, you cannot remove the funds from a CRT once you have made the initial donation.
The initial contribution must be large
One aspect of CRTs that often deters would-be grantors is that the initial contribution must be substantial if the grantor hopes to receive any income payment.
This is pretty obvious, of course—5% of $1 million is a bit more than 5% of $100. To make the interest payments actually meaningful, the grantor must make a large initial contribution to fund the CRT.
The income you receive will take away from the charity
If your intent in creating a CRT is to benefit a charity after your passing, you will need to carefully consider the income payout percentage that you want to take from the trust.
Remember, the income you receive from the CRT is less that the charity will end up receiving. If you choose to receive a high percentage of income from the trust, you risk leaving the charity with nothing.
CRTs get pretty heady
We could write hundreds of articles on CRTs and still not fully cover the topic in complete detail. CRTS — and any type of charitable giving — is confusing. Trust us, we get it.
If you’re serving as the executor of an estate with a CRUT or CRAT, you should find relief in the fact that the trust agreement will stipulate the distribution of property from the trust. Since the CRT avoids probate, the burden of distribution — or trust administration — will be off your shoulders.
If you’re just getting started as the executor and still learning about probate, check out our resources here.
We have a variety of other resources on trustees and executors, special needs trusts (SNTs), and other aspects of wills.
Please take the time to check it out and learn more about probate. It's worth your time, we promise.
