How do you want to be remembered? This question is not easily answered and there are many factors to consider. The impetus of the question, many times, is in trying to decide how and where to leave a legacy through a charitable donation.
When I meet with clients who are attempting to map out how and where to leave money behind, it is important to first understand what your current and future income needs are as well as what your personal tax situation looks like before recommending a particular wealth management strategy. In an ideal scenario, we will address all of your income needs first and then help you decide how to best leave assets behind, taking into account the most tax-efficient way to accomplish both goals.
Many times, in working with top-level executives, the conversation of charitable gifting will lead us into the realm of charitable trusts and whether or not they are a good fit for your estate plan. One question many executives have is: Are charitable trusts tax exempt? Here’s a closer look at that question.
Tax Exemption for Charitable Trusts
There are multiple forms of charitable trusts, and with multiple forms and limitless scenarios, the answer to the question of tax exemption is typically answered with: “It depends.” The short answer is that there are many tax advantages to using a charitable trust.
To better understand the advantages of using charitable trusts, let’s look at the two most popular forms of charitable trusts. Both types of trusts are considered split-interest trusts, meaning they offer a benefit to a charitable organization as well as a non-charitable beneficiary (typically you or a family member).
Charitable Remainder Trust
This type of charitable trust offers the owner the option to fill it with appreciated assets, whether it be real estate, stock, or other types of assets. The benefit of doing so is that, by allowing the charitable remainder trust to hold the asset, you avoid paying the full capital gains tax on that asset.
The asset can be sold within the trust or held within the trust to generate income to be paid to the non-charitable recipient (typically you) for a set period of time, which can even include the rest of your life. The remainder of the assets left after the period of time has expired or after you have passed away is then automatically donated to the charity of your choice. You are also eligible to receive a charitable tax deduction for the year in which you set up and fill the charitable remainder trust with assets.
This charitable trust option makes the most sense for executives who know that they want to leave a legacy behind but also have a need for income for a set period of time or throughout their retirement. It is very beneficial for anyone looking to offset capital gains with a charitable contribution.
Charitable Lead Trust
This is the counterpart to the charitable remainder trust, in that it is almost completely the opposite. A charitable lead trust “leads” with the charitable organization in mind. You designate the charity you want to benefit, and the charity receives a stream of income on an annual basis for as many years as you see fit. You can choose which assets to sell or utilize for income generation within the trust to fulfill the income need for the charity. Once the period of time has expired, the remainder of the assets are then directed to a non-charitable recipient, such as a family member or a family trust that you have established.
A charitable lead trust is a nice option for any executive looking to benefit a charitable organization sooner rather than later. This could also be earmarked to fund a building project for a charitable organization such as a college or church. Many times, if the trust is set up irrevocably, meaning the organization is guaranteed to receive the income, the organization is able to take a loan against it and then make the principal and interest payments using the cash flow generated from the charitable lead trust.
While there are tax exemptions built into both types of charitable trusts, the driving force is how much income you generate from the trust and how you generate it.
How Is Income from a Charitable Trust Taxed?
When it comes to generating income from the charitable trust, there are four main ways in which you could be taxed. Different scenarios of income generation can lead to one of the four ways of taxation highlighted below:
- Tax exempt: Income typically generated from a tax-exempt asset, such as interest on a tax-free municipal bond.
- Nontaxable distribution: The return of your own capital that was invested, know as “the trust corpus” or body of the trust.
- Ordinary income: Income generated from the trust that is subject to ordinary income tax.
- Capital gains: Income earned or retained from prior years paid to a non-charitable recipient.
One caveat to note regarding the capital gains taxation is that it can be offset through short-term or long-term capital losses from other investments of the non-charitable beneficiary.
A charitable remainder trust is exempt from federal income taxation. However, it could be subject to excise tax on any unrelated business income. As a general rule, consider that you would need to pay tax on any income generated to be paid to you or another non-charitable beneficiary. On the flip side, you can look forward to tax avoidance when it comes to the portion of the “split trust” that is designated to be paid to a charitable organization.
In general, it is always a good idea to consider all of the potential charitable giving strategies that could benefit you, your family, and your legacy. It is best to consider these strategies under the care and supervision of a trusted estate planning attorney alongside a seasoned financial advisor that specializes in helping top-level executives like yourself. There are many charitable giving strategies that are tax advantageous, so don’t get set on one perfect strategy. Rather, consider the vision you have for your legacy and let the giving strategy compliment it.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for estate planning and charitable gifts planning for executives. For more information on how Wade and the Carpenter Team can advise you on setting up a charitable trust, reach out today for a complimentary consultation.
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