An irrevocable charitable remainder trust distributes income during the lifetime of its beneficiaries, and then donates the rest to charity upon their death. The large deductions from the trust can then be used by an irrevocable trust to purchase life insurance as a replacement to your heirs. Your estate passes to your descendents without tax, but even more benefits can be realized in the interim.

In a typical example, the settlor (the person who establishes the trust) donates property or appreciated securities to the trust. In the case of property, the settlor may continue to use the property after donation. The transfer of securities is considered a charitable donation, so the settlor is not taxed on the capital gains from the transfer. In fact, the donation to the trust is a deductible charitable contribution – at least 30% yearly for long term capital gains property - for a period of 5 years after contribution or until the deduction is depleted. After transfer, the securities are typically sold by the trust and new high income yielding assets are bought with the proceeds. The trust is tax exempt and will not be taxed on the sale.

The settlor typically picks a yearly distribution from the trust of between 5% and 10% - although other options are available. This gives the beneficiaries either income for their lifetime or income for a fixed period not longer than 20 years. As opposed to other irrevocable trusts, the beneficiaries of the trust may be changed. The distributions from the trust may be taxed as income, but certain mechanisms may be set in place so that larger distributions are realized later when taxable income is lower. There are four types of charitable remainder trusts that may be tailored to suit your needs.

CHARITABLE REMAINDER UNITRUSTS

Straight Charitable Remainder Unitrust (CRUT)

In a charitable remainder unitrust, the settlor can receive not less than 5% or greater than 50% of the trust’s fair market value each year. At the end of its term, the trust must contribute to the charity 10% of the net fair market value of the trust measured at the time the property is given to the trust. The value of the trust is reappraised annually, and the distributions from the trust may fluctuate accordingly. This trust may receive contributions in subsequent years, while a charitable annuity trust may not. Another advantage over the charitable annuity trust is that the unitrust contributions will be adjusted for inflation.

Net Income Charitable Remainder Unitrust

Using this trust, the beneficiary opts to receive the lesser of the stated unitrust amount or the trust’s current income based upon its fair market value. This is advantageous in transferring an asset that may not be sold immediately after establishing the trust, resulting in little liquidity in the trust. The beneficiary will receive nothing until the asset is sold.

Net Income With Makeup Charitable Remainder Unitrust (NIMCRUT)

Similar to the net income charitable remainder trust, the beneficiary receives the lesser of the stated unitrust contribution amount or the fair market value of the trust’s income for that year. However, it also provides that if the trust’s accounting income in a certain year or years is below the stated unitrust amount, the difference shall remain in the trust and will be added to its principal. It is then paid out in future years where the accounting income exceeds the stated unitrust amount. The trustee can grow the trust tax free using assets that do not pay dividends or interest, then switch to high income yielding assets at a designated point in time. This is an invaluable retirement tool that allows for deferment of payment from the years where it is not needed to the retirement years where it will be needed most.

FLIP Unitrust

This trust is started just like a net income charitable remainder unitrust, except it is usually funded with hard to value assets, non-liquid assets, or real estate. Upon the occurrence of some objective event, such as the sale of property placed into the trust, or some date or event outside of the settlor’s control, the net income trust flips to a straight income charitable remainder unitrust. Before the trust flips, just like in the income only charitable trust, the beneficiaries only receive the lesser of either the unitrust amount or the fair market value of the trust’s income. Before that point, the beneficiary receives little or no income. After the trust flips, the beneficiaries receive the designated amount of the straight charitable trust. This assures the asset is not forced into a sale prematurely by the trustee in order to make minimum distributions.

CHARITABLE REMAINDER ANNUITY TRUSTS (CRAT)

An irrevocable charitable remainder annuity trust is similar to a unitrust except that the payments are established at the creation of the trust and remain fixed over the distribution period. Unlike a unitrust, no further contributions may be made to the trust once it is established. The fixed payments are a disadvantage in that they do not account for inflation, and if the trust underperforms in a given year, the distribution may erode the principal. This can cause the trust to underperform in later years, and erode the value of the assets to the point that the charity receives nothing. When taking the bare 5% yearly distribution, the annuity trust gives a higher initial tax deduction of about $6,000. At 6%, the unitrust gives a slightly better deduction of about $1,000. At 7%, the unitrust will outperform the deduction of an annuity trust by over $10,000. The annuity trust is subject to the 5% exhaustion test. If there is more than a 5% chance that the trust will be exhausted so that the charity will receive nothing, the creator is not entitled to a charitable deduction.

CHARITABLE LEAD TRUSTS

Under a charitable lead trust, the charity receives the yearly distributions for a fixed period and the principal reverts back to the settlor’s heirs. If a grantor trust is established, the settlor receives an initial tax deduction which may later be wiped out because the later income produced yearly by the trust is considered taxable to the grantor. If a nongrantor charitable lead trust is established no initial tax deduction is available to the settlor, but the settlor is not taxed on the income to the trust. At the end of the trust, the amount received by the heirs for tax purposes is reduced by the income received by the charity.