Combining Charitable Giving With Smart Tax Planning

Are you hanging on to some low-basis, highly appreciated assets that you would gladly sell if you could somehow avoid losing much of the value to taxes? One solution might be an estate planning arrangement known as a charitable remainder trust. This type of trust may provide you with income tax deductions and other tax breaks, while enabling you to convert an appreciated asset -- such as stocks or bonds, real estate or a work of art -- into an income stream for life.

With a charitable remainder trust (CRT), you transfer assets into the trust and may take a charitable income tax deduction, subject to certain limitations. Since the asset will not pass to your favorite charity for several years, the deduction will be less than the assets' current value. The trust, in turn, may sell the assets and invests the proceeds into income-producing investments. The trustee pays the donor a certain amount each year for a stated period -- usually for the donor's lifetime -- and then turns over the principal (also known as the "remainder" interest) to the charity named by the donor in the trust agreement. The charity could be your alma mater, a museum, church, or any other qualified charitable institution.

When the CRT sells the asset, it pays no immediate tax on the gain, so all the proceeds can be reinvested to produce income. If you had sold the asset outright instead of giving it to the CRT, you would have paid the IRS capital gains taxes on your profit, in addition to any capital gains tax imposed by your state. In setting up a CRT, you may name yourself as trustee, which enables you to manage the investment of the funds in the trust. You might want to review this with a financial advisor, as there could be reasons why this is not prudent, given your particular financial situation. Alternatively, by using a professional trustee such as a bank or the charity itself, you could help ensure that the arrangement complies with the complex legal rules, which must be followed to retain the tax benefits.

Suppose a 65-year old doctor owns $100,000 worth of ABC Company stock that he bought some years before for $20,000. He wants to sell the low-yielding shares and invest the proceeds in U. S. Treasury bonds. But by simply selling the stock, he would pay capital gains tax of $12,000 on the $80,000 profit. So he transfers the stock into a CRT instead, and elects to receive $7,000 annual income for the rest of his life, at which time the principal will go his favorite cause. The trust sells the shares and buys 4% Treasuries, paying no current, capital gains tax on the $80,000 gain. The yearly income stream the trust pays out will generally be considered distributions of ordinary income, on which the doctor will pay tax.

He also has available an income tax deduction in the year the transfer is made. Since the stock won't pass to the charity for several years, however, the deduction will be less than the stock's current market value. The available deduction will be equal to the present value of the remainder interest given to the charity of his choice.

Calculation of the deduction is based on four main factors: the fair market value of the asset, the life expectancy of the income beneficiary (the person receiving the yearly payout), the discount rate, and the payout rate chosen by the income beneficiary. In this example, using a 4.2 % discount rate, the doctor's available deduction would be approximately $35,000, subject to certain limitations.

Whether you choose to make a gift of an asset directly to a charity or through a CRT, the value of the asset, together with any future appreciation, will effectively be removed from your taxable estate -- which can help reduce your estate tax liability at your death. With a CRT, you can shrink your taxable estate by the amount ultimately retained by the charitable organization of your choice. Of course, since the charity will be the ultimate beneficiary of the trust assets, you will want to make sure that you have otherwise adequately provided for your family.

One way to replace assets donated to charities is by purchasing life insurance for the benefit of your heirs. Funds to purchase the insurance policy may be available through the increased income resulting from the tax deduction for the donated asset and the cash flow produced by the investment of the trust proceeds. By holding the life insurance policy in an irrevocable trust and making it the owner of the policy, the death benefit may be kept out of your estate, thereby reducing your ultimate estate tax bill. Of course, insurance applications are subject to underwriting approval.

There are two kinds of charitable remainder trusts to choose from; both are irrevocable meaning they can't be cancelled once the trust document is executed. The "annuity trust" throws off a steady income flow at a fixed amount each year -- $5,000 or some higher amount annually, for instance. These types of CRTs tend to be more popular with people in their seventies or older who want the security of a guaranteed pay out in their old age and who don't want to take the risk that a market dip could erode the trust principle a few years down the road.

Unlike the annuity trust, the charitable remainder "unitrust" pays out a fixed percentage of the net fair market value of the trust assets as it may vary from year to year. Unitrusts pay a variable return -- annual distributions fluctuate with the fortunes of the invested fund. While annuity trusts are appraised just once, unitrusts must be revalued each year, which can drive up administrative expenses, especially with hard-to-value assets such as closely held business interests, real estate or art work. But unitrusts also permit additional contributions of property under certain conditions, which can increase your income. Younger investors tend to prefer a unitrust to an annuity trust because its flexibility can help provide a hedge against inflation over the long-term.

The Internal Revenue Code limits the yearly annuity and unitrust payments from a CRT and mandates a minimum percentage value for the charity's remainder interest. Regardless of which type of CRT is used, the annual amounts received by the donor are generally subject to income tax, either as ordinary income or as capital gain.

Donating art, antiques, collectibles or other tangible personal property is subject to a special rule, which affects the size of your up-front income tax charitable deduction. Donating such property which you have owned for over one year usually generates a charitable deduction equal to the object's fair market value at the time of the gift, so long as the charitable institution uses the object in a manner related to its charitable purpose.

Thus, donating a Picasso to an art museum which plans to display it in its gallery would clearly meet the "related use" rule. But giving the painting to your charity of choice, which in turn, sells it and uses the proceeds to support various causes would not be a related use. If the charity does not intend to use the art work to further its charitable mission, your income tax deduction is limited to your basis (generally, what you originally paid for the object) -- not its current, appreciated value.

Your deduction may be similarly limited if collecting art is your business, because the artwork would be considered part of your inventory. The amount of deductions you are allowed in any one year are further limited by your adjusted gross income and the type of charitable organization to which you are contributing. Generally, gifts to public charities generate larger tax deductions than gifts to private charities.

It may be easier to meet the "related use" rule by giving an art work directly to a charity, instead of through a trust, thereby increasing the amount of your deduction. Using a CRT as a receptacle for a sculpture, for instance, will probably limit the deduction to your basis in the sculpture. If the CRT converts the sculpture into an income-producing asset, the "related use" test will not likely be met. Nevertheless, the CRT may still be a viable method of transferring appreciated works of art with a low cost basis from a collection in order to avoid immediate capital gains, create a revenue flow, and reduce the size of the donor's taxable estate.

Properly drafted, a charitable remainder trust may be successfully used to achieve numerous tax and financial planning objectives. Consult with a professional adviser to determine whether charitable giving should be a part of your financial planning strategy.