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How can clients take advantage of charitable planning to minimize the amount of estate taxes due? Here are some of the popular charitable planning techniques, their uses, and some general advice regarding their formation.

It is possible according to the Urban-Books Tax Policy Center that 7,130 people in the U.S. will leave estates large enough to require an estate tax return. Some taxes can be saved, however, if proper planning is utilized. As of January 1, 2024 (but subject to increase on January 1, 2025), the estate and gift tax exemption amount (commonly referred to as the “Unified Credit”) is $13,610,000. This is beyond what can be passed to a spouse, because the current estate tax laws allow for spouses to pass an unlimited amount between themselves without incurring any liability for gift or estate taxes.

The most important issue with regards to estate taxes is that on January 1, 2026, the exemption amounts will automatically be cut in half. Thus, for example, a person passing away on December 31, 2025, would be able (based on the current exemption amount) to pass the first $13,610,000 of his or her assets estate tax free whereas a person passing away on the next day would only have an exemption of approximately $6,460,000.

Charitable Trusts

There are two common types of charitable trusts: Charitable Lead Trusts (“CLT”) and Charitable Remainder Trusts (“CRT”). Under both trusts, a charity is, at some time during the term of the trust, a beneficiary.

Charitable Lead Trusts

In a CLT, income payments are made to one or more designated charities rather than the donor. With a CLT, the donor transfers assets to an irrevocable trust, and the trust makes payments to one or more qualifying charities for a fixed number of years or for the life or lives of designated individual(s), or a combination of the two (the charitable term). 

The income of a CLT may be paid using an annuity or unitrust. A CLT with an annuity payment (a “CLAT”) is where the charity receives an annuity that is either a fixed percentage of the initial fair market value of the property gifted into the CLT based on the Internal Revenue Code Section 7520 rate in the month the CLT is created or a fixed sum. A CLT with a “unitrust” payment (a “CLUT”) is where the charity receives a fixed percentage of the net fair market value of the CLT’s assets, revalued each year.

At the end of the charitable term, the assets remaining in the CLT must be distributed to one or more non-charitable beneficiaries, typically, the donor’s descendants (or to trusts for their benefit). 

The creation of a CLT constitutes a taxable gift by the donor to the remainder beneficiaries that is equal to the initial value of the contributed assets, reduced by the present value of the annuity or unitrust payments to be made to charity, discounted at the 7520 rate.  A CLT can be structured to “zero out” at the end of the charitable term, resulting in little or no gift tax.  At the termination of the charitable term of the CLT, any appreciation of the property held in the CLT more than the 7520 rate is passed on to the remainder beneficiaries of the CLT free of federal gift and estate taxes.  Property contributed to a CLT is assumed to grow at a rate equal to the 7520 rate in effect at the time of the transfer.  A CLT works best in low-interest rate environments, as any investment performance more than the 7520 rate (called the “hurdle rate”) passes free of estate and gift tax to the designated family members (or trusts for their benefit) at the end of the charitable term of the CLT. 

Using a CLT to make annuity or unitrust distributions to charities allows the charities to receive benefits over an extended duration of time, as opposed to a lump sum contribution.

Further, a CLT may be structured to qualify as a grantor trust.  As such, the assets of the CLT may continue to grow free of income and capital gains tax.  The donor would also receive a charitable income tax deduction (subject to applicable deduction limitations) based on the present value of the CLT’s required annuity or unitrust distributions to charity in the year the CLT is created and funded.  Alternatively, the CLT may be structured as a “non-grantor trust”.  Structured this way, the donor will not be entitled to a charitable income tax deduction on creation of the CLT, and the CLT will have pay its own income and capital gains taxes; provided, however, the CLT may claim an unlimited charitable income tax deduction for its annual distributions to charity.

CLT’s are subject to annual filing requirements, including filing Form 5227.

Charitable Remainder Trusts

Unlike CLTs, which can provide some income tax benefits, but are primarily designed to be used as a wealth transfer taxation savings device, CRTs are used for potential income tax savings to the donor during the donor’s life.

A CRT provides for a specific distribution at least annually to one or more non-charitable beneficiaries (e.g., the donor’s, the donor’s spouse, or the donor’s children) for life or a term of years with an irrevocable remainder interest for the benefit of one or more qualified charities. The specified annual distribution must either be a sum certain of not less than 5% and not more than 50% of the initial value of the trust (a charitable remainder annuity trust (“CRAT”)) or a fixed percentage that is not less than 5% and not more than 50% of the trust’s fair market value as determined each year (a charitable remainder unitrust (“CRUT”)).

The actuarial value of the charitable remainder interest, as determined by the 7520 rate in effect at the time of transfer, must be at least 10% of the fair market value of the trust on the date of transfer.

Unlike a CLT, a CRT meeting tests outlined in the Code and Regulations is a tax-exempt entity. Thus, the donor can receive an immediate income tax charitable deduction for the actuarial value of the charitable remainder interest. Further, the donor can transfer property with built-in gain to the CRT without incurring capital gains tax. The CRT could later sell the appreciated property without paying capital gains tax due to its tax-exempt status. This immediate income tax deduction coupled with the avoidance of capital gains tax on the transfer of an appreciated asset makes CRTs good choices for income tax savings. Like a traditional IRA, the income generated by the CRT grows tax free until it is distributed to the beneficiary.  Accordingly, CRTs may produce a greater up-front income tax deduction when interest rates are higher than CLTs.

“FLIP”

An inverse of the CLAT, a flip charitable remainder trust (Flip-CRUT) can be funded with a large one-time transfer but rather than making present distributions to a qualified charity, the donor is the present beneficiary. As a donor with other assets may not need present distributions, the “flip” feature allows the donor to delay distributions for a period of years or until a triggering event, such as retirement. Until the trust flips, the assets can remain invested. Once flipped, distributions continue for the donor’s lifetime. At the donor’s death, the remainder goes to the qualified charity. Although present distributions start and may continue, the donor receives a charitable deduction in the year the Flip-CRUT is funded.

Private Foundations

A private foundation is a charitable organization, often created by a family to carry out its charitable goals.  Contributions to the private foundation are deductible for federal income tax purposes within certain limits.  The foundation itself does not pay federal income tax, although it does pay a federal excise tax on its net investment income.  A U.S. taxpayer can deduct amounts contributed to a private foundation, subject to the following limits:

1. Contributions of cash can be deducted in an amount equal to up to 30% of the donor’s adjusted gross income (AGI) each year.  Cash gifts to public charities can be deducted in an amount equal to up to 50% of the donor’s AGI.
2. Contributions of appreciated property (e.g. stock worth more than its purchase price) can be deducted in an amount equal to up to 20% of the donor’s AGI each year.  Gifts of appreciated property to public charities can be deducted in an amount up to 30% of the donor’s AGI.
3. Contributions of appreciated property, except publicly traded stock, can only be deducted to in an amount equal to their income tax basis.  Publicly traded stock can be deducted at its fair market value less any short-term capital gains which would have been recognized on a sale of the stock.  As an example, a gift of real estate can only be deducted at the lesser of its fair market value or depreciated purchase price.  Conversely, any gifts of appreciated property to public charities can be deducted at their full fair market value reduced by any short-term capital gain which would have recognized had the asset been sold.

In all cases, amounts exceeding the deduction limits can be carried forward for use in the five succeeding years.

A private foundation created as a nonprofit corporation is controlled by its board of directors in a manner like a for-profit corporation.  Unlike in the case of a for-profit corporation, a nonprofit corporation does not have shareholders to elect its board of directors.  The general practice is to allow the existing board to fill any vacancies.  The board also elects officers and authorizes the hiring of employees to carry out the work of the foundation. The sole activity of most private foundations is making grants to other charities. The foundation invests its assets and uses a portion of them each year for charitable purposes.  The board of directors meets periodically to review grant requests and make decisions on distributions.  The foundation may employ staff members to carry out the review of prospective grant recipients and direct the management of the foundation’s investment assets. A private foundation created as a nonprofit corporation will have Corporate Transparency Act (“CTA”) reporting due.

A privation foundation created as a charitable trust is controlled by trustees in a manner like an irrevocable trust. Unlike a traditional irrevocable trust, the beneficiaries are charities. The trust instrument sets out a succession order for how trustees are chosen in the future. The trustees meet periodically to review grant requests and make decisions on distributions. One difference between a private foundation which is created as a nonprofit corporation and a private foundation which is created as trust is that at the State level, a private foundation which is created as a nonprofit corporation registers with the State of creation and files an annual renewal filing, while a trust does not have the requirement. Further, under current law, a private foundation created as a nonprofit corporation has CTA reporting requirements, but a private foundation created as a trust does not.

There are restrictions under federal tax law on the operation of a private foundation:

1. Grants can only be made to recognized charities or for charitable purposes.  Distributions to individuals for charitable purposes are governed by a complex set of rules requiring monitoring by the organization and the filing of reports with the Internal Revenue Service (“IRS”).
2. The donors, their family members, businesses they control, etc. (“disqualified persons”) cannot engage in business transactions with the foundation, even transactions at a fair price, with a few exceptions including the payment of reasonable compensation for services rendered.  Reasonable compensation is subject to greater scrutiny in this area than in other areas of federal income tax law.
3. The foundation must make charitable distributions each year equal to approximately 5% of the value of the foundation’s assets.
4. The foundation cannot make certain kinds of “risky” investments.
5. The combined holdings of a foundation and all disqualified persons cannot exceed 20% of any business entity unless the foundation itself owns less than 2% of the entity.

The penalties for violating the above restrictions consist of excise taxes and the possible loss of tax-exempt status.  It is important that the rules be adroitly followed.

Each year a private foundation is required to file a report with the IRS showing compliance with the above rules and listing assets, income, etc. on Form 990-PF.  Form 990-PF requires answering a number of questions related to the operations of the foundation. 

Other Options

There are other options individuals use to pursue their charitable planning goals.  These options have fewer administrative requirements.  The first is the creation of an advised fund at a community foundation or with a corporate or investment bank (sometimes called a “donor advised fund”).  A donor advised fund permits a donor to contribute to the fund.  This allows an immediate deduction while postponing the decision on the actual recipients.  It allows the donor to get family members involved in the decision-making process as a part of a family advisory committee.  Although the community foundation, corporate or investment bank does not have to follow the advisory committee, in practice they do.

The second option is the creation of a supporting organization of a community foundation.  A supporting organization is a separate entity (nonprofit corporation) for which the donor appoints a minority of board members, and the community foundation appoints a majority of the members (usually in consultation with the donor or the donor’s family).  The foundation has its own name and is not part of the community foundation.  The community foundation provides the back-office record keeping etc. for a modest fee each year.  The supporting organization sets its own investment policy and approves its own grants.  This allows a higher level of participation in the process by the donor and the donor’s family.

If you have any questions regarding estate planning or charitable planning, please contact Michael A. Sneeringer at 216.294.4996, masneeringer@bmdllc.com or Kimberly J. Baranovich at 440.951.1525, kjbaranovich@bmdllc.com.