Help charities—and yourself

Are you facing the enviable task of trying to make a huge capital gain disappear legally? Well, if charitable giving is also on your to-do list, you should consider a charitable remainder trust.

Here are the basics: you gift an asset to the trust, which, being a charitable entity, can sell it and diversify without realizing any capital gain. The trust then provides you or someone else of your choosing with an annuity for a predetermined time, after which the remainder goes to a charity you’ve designated. You claim the deduction for the allowable amount of the charitable gift, as determined by an IRS formula, and pay any applicable income taxes on the annuity distributions.

It’s a good way to realize the capital gain and invest in something with less risk,” says Martin A. Schwab, chair of the trust and estate department for the law firm Bond Schoeneck and King in Syracuse, New York. 

Schwab tells a story that illustrates the potential benefit. “About 15 years ago, a woman came to me,” he recalls. “Her husband had invested around $15,000 in Intel stock in 1982, and now it was worth $1.7 million. I said, ‘You need a charitable remainder trust.’ She had no children. She would have had a distribution of maybe $130,000 per year. It would have set her and her brother up for the rest of their lives. 

Unfortunately, she didn’t do it. The stock went from $72 to about $10. She lived for probably another 15 years after that. They ended up going through all the money for a nursing home.”

To obtain preferential treatment on capital gains, the trust must be set up so that at least 10 percent of the present value will go to the charity. (Schwab recommends building into the trust document the right to change charities.) The annuity term can be up to 20 years or for the lives of one or more beneficiaries. (Of course, making someone else the beneficiary could bring gift taxes into play.) The annuity payments can be an unchanging dollar amount (a charitable remainder annuity trust) or a percentage of the trust as revalued annually (a charitable remainder unitrust). The latter is far more common. 

People like the idea that if the trust grows, the annuity will grow,” Schwab says. “If the annuity will run for 15 years and you’re worried about inflation, you’d rather participate in the growth.”

Another advantage: the unitrust allows for future contributions, which could come in handy if the original contribution (real estate, for example) turns out to be illiquid and can’t support the annuity payments.

If you’re planning to place a privately held company in the trust, the trustee must independently decide to sell for you to avoid capital-gains tax. In other words, a prearrangement with the trustee will not fly. “You can’t put a company into the trust the day before closing,” Schwab says. 

The type of income that the trust asset kicks out—ordinary income, capital gain, tax-exempt income, return of principal—determines how the annuity is taxed, with the highest tax rates applied first. For example, assume that $800,000 of a $1 million trust is invested in taxable bonds paying 3 percent interest and the remaining $200,000 is invested in stocks that generate 10 percent realized capital gains. Now let’s say that the trust has a 5 percent annuity payout (the minimum allowed, generally speaking). The first $24,000 of that distribution (3 percent return on the $800,000 bond portion) would be taxed as ordinary income. The next $20,000 (10 percent realized gain on the stocks) would be taxed as capital gains. The remaining $6,000 would constitute non-taxable return of principal.

Keep in mind that charitable trusts are complex vehicles and, as such, this column has been able only to skim the surface. If you think a charitable trust might make sense for you, consult with your advisor or attorney and carefully think through your goals and ways to achieve them.

Paul Palazzo, a Certified Financial Planner, is the managing director at New York-based Altfest Personal Wealth Management.