For clients with complex estate and transfer tax planning needs, now might be a good time to think about establishing a charitable trust. The current (and likely future) low interest rate environment is particularly favorable to charitable lead trusts, according to Kathryn Garrison, a senior financial advisor with Moss Adams Wealth Advisors.
“A favorable tax environment is not a reason to do a gift, but if you’re thinking about doing one, it can make a lot of sense,” she told ThinkAdvisor on Tuesday.
Charitable trusts are ideal for high-net-worth clients with large estates who are trying to reduce their estate tax liability, Garrison said.
Charitable lead trusts allow donors to make a gift of property or some other kind of asset into that trust, and the income generated by those assets are distributed to charity, Garrison said. In a grantor reversionary trust, any remaining assets go back to the donor, while non-reversionary trusts pass remaining assets on to any heirs.
“Charitable lead trusts can be a very good way to leave assets that are producing income and likely to appreciate significantly” to heirs, Garrison said. “It’s a great tool for getting those assets handed down to future generations without a whole lot of gift tax attached to it.”
Non-reversionary non-grantor trusts — where the donor completely forfeits the assets in the trust and nothing is passed on to heirs — are the most common type of lead trusts, Garrison said.
For example, she said, say a client has a $2 million apartment building that they expect will appreciate significantly over the next 20 years, as well as produce income. The client can put the apartment building in a charitable lead trust so that the income it produces each year goes to charity, and at the end of that 20-year term, the building goes to the donor’s heirs.
The donor can take a tax deduction for the value of the income that goes to charity discounted at the federal funds rate. “The lower that rate, the greater the gift to charity,” Garrison said. “Right now I think it’s 2.2%, so you get a pretty nice gift to charity. If the discount rate’s really high, like around 8%, which is has been in the past, that gift to charity isn’t worth as much.”
The donor’s heirs inherit the apartment building at its current fair market value, Garrison said. “If you’re getting the maximum charitable deduction because the discount rate is really low, you’re also going to have a lower amount that’s considered gifted to your heirs. It’s actually possible if you get a discount rate and your payout rate and your number of years right, to conceivably set up a trust where you’ve contributed a $2 million building, the value of the income stream to the charity is $2 million and your [taxable] gift to your heirs is zero.”
In a reversionary grantor trust, the assets still in the trust at the end of the trust term are returned to the donor. “A good example of that would be if there’s somebody who wants to give $100,000 a year over a period of time, say five years, to a charity,” Garrison said. “They can set up a charitable lead trust and they’ll get a tax deduction in the year they set up the trust.”
Say that client sells some real estate, she continued. They can take the “big tax deduction up front, then over the next five years the charity will get the income off what’s in the trust. Then at the end of the five years, the assets in the trust go back to the grantor.”
In that situation, the client still has to pay taxes on the income in the trust because they got that charitable deduction up front, Garrison said. She suggested using municipal bonds to mitigate the tax bite. “You put tax-exempt bonds in there to produce income that’s not taxable [and] all that income goes to charity, then the bonds themselves or the cash goes back to the donor,” she said.
Charitable remainder trusts come with more restrictions than lead trusts, though, even though they “tend to be more common than the charitable lead trust,” Garrison said. “On the lead trust, the gift that’s going to charity is that income, so as long as the charity gets the income, there’s not a concern about how much is left in the trust at the end of the trust period. With the remainder trust, it’s the remainder that’s going to charity so there are more restrictions on how much the trust can pay out because the IRS wants to make sure there is some kind of gift going to charity at the end of it.”
Another stroke in favor of a lead trust over a remainder trust is that remainder trusts benefit from higher interest rates, but Garrison stressed that the benefit of a favorable interest rate environment is a nice side effect, not a factor in the decision. “It’s nice that it’s great for a lead trust and it’s unfortunate that it’s not as great for a remainder trust, but I think these income needs and the transfer and legacy needs really should be what drive the decision on what kind of gift to make,” she said.
Still, a charitable remainder trust is a good tool for donors who are worried about giving up income-producing assets, even though they have sufficient retirement funds.
Garrison gave an example from her time at the University of Washington’s office of gift planning: “I had a donor who was pretty well set up for retirement, but they were just a little bit worried and wanted to hold onto the income stream that these stocks were producing.”
The donor put those stocks into a charitable remainder trust that generated an income stream, but they didn’t need it, so they used it to make charitable gifts to their church every year, Garrison said. “In later years, if they need to go into assisted living or they find their assets are depleted, they can just keep that income for themselves, then when they die, the remainder goes to the University of Washington to fund a scholarship.”
Another use for charitable remainder trust is when a client has a highly appreciated asset like stocks with a really low basis. “They need to sell to diversify, but there’s huge capital gains involved, so you could put that stock into a charitable remainder trust,” Garrison said.
When the stock is sold within the trust, there are no taxes due at the time that it’s sold, she explained. “Let’s say you put in $1 million in stock and your basis is only $50,000. If you were to sell it outright, you’d owe taxes on $950,000. If you sell it in the trust, there are no taxes owed right when it’s sold so that whole million can be invested in a well-diversified portfolio.”
The donor doesn’t avoid the taxes entirely, she said, “but you’re deferring them out” over the trust term.
These strategies are complex, according to Garrison, who encouraged advisors to work with an attorney who “is experienced at drafting these [charitable lead trusts], not the client’s business attorney who’s doing estate stuff on the side.”
She recommended including the client’s CPA in discussions as well. “In calculating what that charitable deduction is going to be, you’re going to need a really good valuation on that building. There are a lot of experts that need to be brought in.”
So what about donor-advised funds? Garrison said DAFs have been growing in popularity, especially as Fidelity’s and Schwab’s funds take off. They’re not as expensive or complicated as setting up a private foundation, she said.
“Private foundations are still the most flexible way of giving in terms of if your client wants to be able to make donations directly” to, say, survivors of a hurricane like Sandy, she said. “The flip side of that is that [although] you get more freedom in terms of gifts, generally, you’re not going to get as big a tax deduction for your contribution to a private foundation as you are to a donor-advised fund or a 501c(3).”
For some clients, that may not matter much. “A lot of people like the idea of having a private foundation with their name on it, although at Fidelity I think they can do a donor-advised fund where it has the donor’s name on it and it looks almost like a private foundation, it’s just a lot easier to manage.”
and 3 Estate Planning Strategies for a Low-Rate Environment on ThinkAdvisor.