What Is a Charitable Lead Trust: How It Works and What the Tax Benefits Are
Theresa de León
A charitable lead trust can facilitate charitable giving and tax-efficient wealth transfer to your loved ones. Learn more about this dual-purpose trust type below, including how it works, the tax benefits, how payouts are structured, and which alternative strategy you might consider.Charitable Lead Trust Defined
A charitable lead trust is an irrevocable legal arrangement that allocates funds in two ways. First, the trust makes income payments to one or more charities for a designated time frame. Then, the trust distributes any remaining funds to non-charitable beneficiaries or the person who created the trust.The trust creator is sometimes called the donor or grantor. Non-charitable beneficiaries are family members or loved ones. Because charitable lead trusts are irrevocable, the grantor normally cannot change or dissolve it. Changes may be allowed with a court order or permission from all beneficiaries, however.
A reversionary trust is a charitable lead trust that returns funds remaining after the donation period to you as the grantor. When the leftover funds are earmarked for other beneficiaries, such as family members, the trust is non-reversionary.
Charitable Lead Trust Lifecycle
Charitable lead trusts pass through three phases:-
Establishment and funding: You can establishthe trust while you are living or at your passing under the order of your revocable trust or will. Once created, you or your estate funds it with cash, exchange-traded equities, real estate, private equity, or other assets. The funding can be distributed in a lump sum or with smaller transfers over time.
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Donation period: During this phase, the trust sends periodic payments to one or more charitable organizations for a set time frame. The donation period can be defined in years, in terms of someone's lifespan, or both. The charitable payments are made at least annually.
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Distribution of remaining assets:Once the donation period ends, the remaining funds are distributed to you if the fund is reversionary. A non-reversionary trust will distribute the remaining funds to your designated non-charitable beneficiaries.
Tax and Estate Planning Benefits
Charitable lead trusts may offer income tax deductions and reduced estate and gift taxes. However, the tax treatment for these entities is complex and dependent on the rules of the trust.One distinction that affects the timing of tax benefits is whether the trust is a grantor or non-grantor trust.
Grantor Trust
As a grantor, you retain legal ownership of the funds within a grantor charitable lead trust. In this structure, the IRS allows you to take an immediate tax deduction for the present value of the payments made to charity.The limit on the available deduction will be either 50% or 30% of your adjusted gross income, not including net operating loss carrybacks. The 50% limit applies when you donate to public charities, private operating foundations, and qualified private foundations. Otherwise, the 30% limit applies.
Because you own the funds within your grantor trust, you are responsible for paying taxes on the trust's investment income.
Non-Grantor Trust
The trust legally owns the funds within a non-grantor charitable lead trust. This has two primary implications:-
When you fund the trust, the value of that transfer gets subtracted from your estate. This can reduce transfer taxes later.
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You cannot take the immediate tax deduction for future donations in a non-grantor trust. Instead, the trust claims tax deductions for its charitable payments going forward. These deductions offset the trust's net income each year.
Payout Structures: Annuity vs. Unitrust
During the donation period, charitable lead trusts can make fixed-dollar payments or payments based on a fixed percentage of the trust's current value. The first format is called a charitable lead annuity trust, while the second is a charitable lead unitrust:
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Charitable lead annuity trustspay designated charities the same amount annually.
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Charitable lead unitrusts pay charities an annual amount equal to a percentage of the fund's total current value. The fund is revalued annually to account for investment income and asset appreciation. The dollar amount of annual payments under a unitrust arrangement can vary from year to year.
Disadvantages of Charitable Lead Trusts
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Irrevocability: Once you transfer your assets into the trust, you cannot get them back, nor can you change the charitable beneficiaries.
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Taxable investment earnings: Earnings from the trust are taxable. In a grantor trust, the grantor pays the taxes. The trust is responsible for the taxes in a non-grantor trust.
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Investment risk: Charitable annuity payments are required, even if the trust assets underperform. Careful planning is needed to ensure an annuity trust remains solvent through the donation period. Otherwise, there may be no wealth remaining for the non-charitable beneficiaries.
Charitable Remainder Trust as Alternative
For estate planning strategies that include giving and wealth transfer, a charitable remainder trust is an alternative to the charitable lead trust. The lead and remainder trusts allow for charitable donations, wealth transfer, and potential tax benefits. These trust types differ primarily in the order of funds distribution and the tax implications.Order of Funds Distribution
A charitable remainder trust first pays income to you as the grantor or to your non-charitable beneficiaries for a designated time frame. After that, the trust distributes leftover funds to charity. This is the opposite of the charitable lead trust, which makes charitable donations first and then follows with the non-charitable wealth transfer.Tax Implications
The initial funding of a charitable remainder trust is partially tax-deductible. The funding also reduces the value of your estate, which can save on transfer taxes later. Unlike charitable lead trusts, charitable remainder trusts do not pay taxes on their investment income. Trust and estate planning have nuances and complexities. You can best navigate those issues under the guidance of your financial advisor, tax advisor, and an experienced trust planning expert.Thoughtful Trust and Estate Planning
Trust and estate planning have nuances and complexities. You can best navigate those issues under the guidance of your financial advisor, tax advisor, and an experienced trust planning expert.The philanthropic team at Arden Trust administers more than $500 million in foundations and charitable trusts. We can partner with your advisors to implement sophisticated estate planning strategies that create lasting legacies. Meet our team and contact us today to learn how we can help you fulfill your charitable giving goals.