For business owners trying to juggle financial planning, estate planning, and tax planning concerns while also supporting a worthy cause, a charitable remainder trust can be a highly effective solution. Although the benefits of these trusts can be appealing, it is also important to understand their complexities, potential drawbacks, and the critical need for sound guidance from both legal and tax professionals.

How Charitable Remainder Trusts Work

A charitable remainder trust is an irrevocable arrangement that allows individuals to donate their assets to charity, receive an immediate partial tax deduction, and then receive annual income for life or for a specified period of time. Here’s how it works:

• First, the donor establishes the trust as a separate legal entity, naming a qualified US charitable organization as the ultimate beneficiary.
• Next, the donor transfers certain assets (such as cash, real estate, stocks, or an ownership interest in a private company) into the trust and receives an immediate partial tax deduction based on the value of the charitable interest in the trust.
• The donated assets become the property of the trust, and the trust can then either retain ownership or sell the assets and reinvest the proceeds.
• The trust then makes regular payments to one or more non-charity beneficiaries, which may or may not include the original donor, family members, or other individuals. The payments will continue for a specific term up to 20 years or for the life of one or more of the beneficiaries. The beneficiaries pay taxes on the payments.
• At the end of the specified payment term, the remainder of the trust’s assets are passed on to the charity.

The payment amount for beneficiaries can be established as either a specific dollar amount each year (a charitable remainder annuity trust) or as a percentage of the annual fair market value of the assets (a charitable remainder unitrust). In either case, the annual payments must equal at least 5 percent of the value of the assets but no more than 50 percent.

Tax Consequences

The tax benefits of a charitable remainder trust can be significant. For example, rather than selling a business, real estate, securities, or some other highly appreciated asset outright, the owner can instead donate the asset into a charitable remainder trust and receive an immediate tax deduction based on the current value of the charity’s interest.

In addition, because the owner is not selling the asset, there is no immediate capital gains tax involved. If the trust chooses to sell the asset at some point, capital gains tax liability would be deferred until the trust’s recipients actually begin to receive payments. Simply put, this means the trust can reinvest the entire value of the asset rather than only the balance that would remain after a large one-time capital gains tax bill.

There are also important estate planning advantages to consider. Because a charitable remainder trust is irrevocable, its assets are no longer considered part of the donor’s estate, which means they will not be subject to estate taxes or probate requirements.

Bear in mind that tax laws regarding charitable remainder trusts can vary from state to state. Thus, it’s important to seek guidance from legal and tax professionals who have experience in the specific states that might be involved.

Concerns and Complexities

While a charitable remainder trust can potentially offer the benefits discussed here, business owners should also be aware of the complications that can arise from these complex entities. These include:

• Irrevocability: Once established, charitable remainder trusts are irrevocable—they cannot be dissolved. This lack of flexibility can be a major drawback for some.
• Complexity: Setting up a charitable remainder trust is only the first step. Afterwards, there are significant legal, tax, and reporting requirements that must be met throughout the trust’s duration. Donors will need professional guidance from experienced legal and tax professionals before taking any irrevocable steps.
• Costs: In addition to the initial costs of establishing the entity, the trust will also require professional accounting and tax services on an ongoing basis. These expenses could make a charitable remainder trust impractical for smaller interests or estates.
• Trustee Selection: Choosing the right trustee is crucial. In some instances, the original donors and the ultimate charity recipients will also be involved in managing the trust.
• Compliance: To qualify for the tax advantages of a charitable remainder trust, the IRS requires strict compliance with a multitude of detailed rules and procedures. For example, the IRS will disallow the deferral of capital gains taxes if it finds an owner had already taken steps to sell a business or property prior to forming the trust.

To underscore the importance of compliance, business owners should understand that if the IRS believes a charitable remainder trust is being misused to evade taxes or to hide capital gains or income the consequences can be severe. In fact, the agency included charitable remainder trust “schemes” in its most recent “Dirty Dozen” list of tax scams, noting that “these trusts are sometimes misused by promoters, advisors and taxpayers to try to eliminate ordinary income and/or capital gain on the sale of the property.” The IRS also offers more information on charitable remainder trusts on its website at https://www.irs.gov/charities-non-profits/charitable-remainder-trusts.

Despite their complexities, charitable remainder trusts can offer significant advantages depending on your specific situation. With qualified and experienced professional guidance, such a trust can provide both immediate and long-term tax benefits, a stable and reliable income stream, and the opportunity to make a lasting impact by supporting a worthwhile charity in the process.

Reach out to Holbrook & Manter with any questions you may have.