Charitable Lead Trust

What Is a Charitable Lead Trust?

Trusts can be used in estate planning to pass on a person’s assets smoothly and to the best financial effect. A charitable lead trust is a type of irrevocable trust designed to reduce a beneficiary’s potential transfer taxes upon inheritance. They can be funded with cash and/or other assets, such as publicly traded stock, real estate, private business interests, and private company stock. 

How Does a Charitable Lead Trust Work?

A charitable lead trust works by donating payments out of the trust to charity for a set amount of time, which could be a certain number of years or the life of one or more persons. After that period expires, the balance of the trust is then paid out to the noncharitable beneficiary, who could be the original donor of the funds (making it a “reversionary” trust) or someone else, frequently a family member (making it a “non-reversionary” trust).

A charitable lead trust sets up a continuous way for the benefactor to make charitable contributions without having to manually issue monthly payments and provides a guaranteed income stream for the charitable beneficiary. It is often set up during the process of estate planning or during the writing of a will, when benefactors wish to reduce the possible burdens noncharitable beneficiaries would normally incur by receiving their inheritance. There are two basic types of charitable lead trusts:

• Grantor Trusts - In this case the grantor, or person who donates to the trust, remains the owner of the funds. This allows the grantor to take an immediate tax deduction for all future payments to the charity, using their fair market value at the time of the donation, although there are deduction limitations based on whether the trust is benefitting a public charity or private foundation. However, the trust’s investment earnings are taxable to the grantor for the life of the trust, so they should make sure that this doesn’t unduly diminish the tax deduction.
  
• Non-Grantor Trusts - In this case the trust owns the funds, not the grantor, making the grantor ineligible for an immediate tax deduction and requiring the trust to pay tax on the investment income. However, the trust may take a tax deduction for the distribution of funds to the charitable beneficiary, with no limits on the deduction. It is this structure that is more suited to minimizing transfer taxes.
  

Payouts can be structured in one of two ways:

• Annuity Payout - A fixed amount must be paid out to charity annually, with that amount determined by a stated percentage of the initial value of the trust’s principal. In this structure investment performance is not taken into account and the payment amount never varies.
• Unitrust Payout - The trust’s principal is revalued annually, and the payments are determined using the same percentage of that value each year. This results in variable annual payment amounts.

What Is a Charitable Remainder Trust?

A charitable remainder trust is thought to be the opposite of a charitable lead trust. Instead of making monthly payments to a charity, the trust makes monthly payments to a noncharitable beneficiary or beneficiaries. This amount must be set at somewhere between 5% and no more than 50% of the balance of the trust.

Unlike some trusts, a beneficiary or benefactor can continue making payments into the trust as time marches on. The benefactor may be eligible to take a deduction for the establishment of the trust. It can be funded with various assets that can include cash, publicly traded securities, qualifying stocks, and real estate.

Like the charitable lead trust, the charitable remainder trust lets beneficiaries take advantage of the donations they are making. The maximum term allowed on this type of trust is 20 years or the life of one or more of the beneficiaries. When the trust ends, it must pay out the balance to the charitable beneficiary, which may be either a public charity or private foundation.

With a charitable remainder trust these charities and foundations can be changed over time, unlike a with a charitable lead trust, which generally must adhere to the groups that were originally written into the language of the trust at its initial signing.

Pros and Cons of a Charitable Lead Trust

Charitable lead trusts are useful for reducing transfer taxes, such as gift and estate taxes, that could encumber noncharitable beneficiaries. They may also provide the benefactor with one large tax deduction for the initial funding of the trust. They allow regular charitable giving with a minimum of effort.

However, charitable lead trusts are not tax exempt. Taxes are levied to the grantor on their investment earnings. They are also irrevocable, meaning that the grantor loses access to the funds in them and any income that they generate. Also, unlike with a charitable remainder trust, it is usually not possible to change the charitable beneficiary of the trust. They are complicated enough to require legal help in setting them up and carry ongoing maintenance costs. They must be carefully planned so that there is enough money in them to make all required payments during their existence.

The Bottom Line

A charitable lead trust is a way to organize a continuous stream of donations to a designated charity, reducing gift and estate taxes. The donation to set up the trust is tax-deductible. However, earnings on trust income are taxable to the donor, so it is wise to make sure that the upfront tax benefits outweigh the ultimate tax cost going forward.