Charitable transfers generate an income tax deduction if made during life (inter vivos gifts), and are deductible for estate tax purposes when made at death (testamentary transfers). The advantage of inter vivos gifts over testamentary transfers is that they are tax deductible for income tax purposes, and also remove the gifted asset from the donor's estate. Lifetime gifts can substantially reduce the tax bite of high-income taxpayers with large estates. Apart from the obvious tax benefits associated with charitable giving, charitable transfers allow the donor to fulfill his or her "social contract" by subsidizing programs, scholarships and other charitable endeavors that advance the charitable causes of the donor.

There are a myriad of options and gifting vehicles available to anyone who is charitably inclined. Naturally, gifts can be made in cash. Gifts can also be made with appreciated stock, savings bonds, IRAs and other "hot" assets that would result in income tax to the donor if enjoyed during his or her lifetime. Also, Congress, through the Internal Revenue Code, permits and even promotes a wide variety of gifting vehicles discussed in this Chapter 18 that encourage charitable giving. Far from being controversial, the gifting techniques discussed in this Chapter 18 are in fact subsided by the federal government.

A charitable deduction is available for contributions to what are known as "501(c)(3)" organizations, which include churches, educational institutions, foundations and other organizations promoting charitable works. The philosophy behind the deduction (believe it or not, there is actually a philosophy, although a bit foggy, behind the Internal Revenue Code), is that taxpayers should be encouraged to support organizations, causes or services that the government itself would otherwise be forced to provide.

CHARITABLE SPLIT-INTEREST TRUSTS

To promote gifting, a number of "split interest" trust options are available. All split interest trusts (discussed in greater detail below) involve the division of the gifted assets into two component parts: income and principal. The most common split interest gifts involve the donor retaining the income from the gifted asset for a period of years or the donor's lifetime with the charity owning the entire asset at the death of the donor; charitable remainder trusts, pooled income funds and charitable gift annuities fall into this category. Charitable lead trusts, by contrast, allow the charity to enjoy the income from the gifted asset for the life of the donor, with the family of the donor owning the gifted asset outright at the death of the donor.

Split interest gifts are a compromise: they allow the donor a current income tax charitable deduction without requiring him or her to forfeit the entire enjoyment of the gifted assets. The donor gives the charity future ownership of the gifted asset and retains the income for a period of years (not exceeding 20) or life. The Code promotes current gifting by allowing both a current charitable deduction and continued limited enjoyment of the gifted asset. The charitable deduction is less than the fair market value of the gift on the date of the gift since the charity cannot immediately enjoy the entire gifted asset. A somewhat complicated calculation of the present value of the future interest must be made to determine the current income tax deduction.

CHARITABLE REMAINDER TRUSTS

A charitable remainder trust ("CRT") is a tax-exempt trust created during the donor's lifetime. All, or a portion, of the income generated by the property transferred to the CRT is paid to the non-charitable beneficiaries (typically the grantor and/or grantor's spouse) for a term of years (not to exceed 20 years) or for the lifetime of the non-charitable beneficiary. The balance remaining in the CRT at the end of the income term is paid outright to the charitable beneficiary.

A CRT can solve the problem faced by older taxpayers who hold highly appreciated assets. The assets, if sold, would generate a substantial income tax liability. Consequently, to avoid tax, the non-income producing asset is often held in unproductive use. The standard of living of such individuals can be affected if the highly appreciated assets are not income generating. Despite their high net worth, people in this predicament have no spend able income. The CRT itself is exempt from income tax, and thus, can sell highly appreciated property tax-free. After the sale, the entire proceeds of the sale (undiminished by income tax) are available to pay an annual income to the donor.

Distributions from the CRT are taxable to the non-charitable beneficiary to the extent that the CRT has income. Like partnership income, the character of the income to the non-charitable beneficiary flows through the CRT. Distributions to the non-charitable beneficiary are first considered ordinary income, then capital gains, then tax-exempt income and finally tax-free return of corpus.

There are two basic forms of charitable remainder trusts: the charitable remainder annuity trust ("CRAT") and the charitable remainder unitrust ("CRUT").

A charitable remainder annuity trust pays the non-charitable beneficiary a fixed annuity, which is computed either as a fixed dollar amount or as a fixed percentage of the initial value of the trust assets. Whether initially expressed as a dollar figure or as a percentage of the assets, the annual distribution becomes a fixed dollar figure that can never change. The annual distribution must be at least 5% of the initial value of the trust assets and must be paid from principal if income is insufficient. No additional gifts can be made to a charitable remainder annuity trust after its initial funding.

In contrast, a charitable remainder unitrust pays the non-charitable beneficiary an annual payment equal to a percentage (at least 5%) of the value of the trust assets as valued on the first day of the year. An advantage of a CRUT over a CRAT is that it offers greater flexibility. Additional deductible gifts may be made to a CRUT after its initial funding. Also, in a CRUT, the annual payment to the non-charitable beneficiary can increase from year to year as the value of trust assets grow in value.

Recent legislation requires that the charitable remainder interest be at least 10% of the net fair market value of the property as of the date the property is contributed to the CRT. The 10% percent rule when combined with the 5% minimum income rule means that it is impossible to establish a qualified CRT that will last for the lifetime of extremely young beneficiaries.

Individuals with taxable estates typically employ CRTs and the other gifting programs discussed in this Chapter. The first step is for each spouse (if married) to create a revocable trust. This allows the couple to shelter two times the Applicable Exclusion Amount. Couples with estates in excess of two times the Applicable Exclusion Amount (2 times $1,000,000 in 2002-2003) have to explore other planning mechanisms to reduce their estate tax liability. They might consider a Family Limited Partnership or LLC, or an irrevocable life insurance trust. Often, however, because of the size of their estate or the nature of their assets, they are best served by utilizing the split interest gift techniques discussed in this Chapter 18.

Example: Assume that Harry (70 years old) and Wendy (60 years old) have a substantial estate. They own highly appreciated non-income producing stock worth $100,000 for which they only paid $5,000.

If Harry and Wendy were to sell the stock they would have a $95,000 capital gain. Hearing of the benefits of CRTs, Harry contributes the stock to a CRUT. Harry elects to retain an 8% annual income interest for the balance of his lifetime. Based on tables provide by the IRS, Harry is entitled to a whopping $39,845 charitable income tax deduction (see chart below) in the year the stock is contributed to the CRUT.

The CRT will sell portions of the stock as needed to pay Harry his annual 8% unitrust amount. The sale of the appreciated stock by the CRT is not taxable to the CRT since the CRT is tax exempt. The actual amount received by Harry will be taxable to him as a capital gain since the trust had only capital gains. Note that if the CRT had ordinary income (for example, from stock dividends), the distribution to Harry would first be treated as ordinary income to the extent of the CRT's ordinary income, with the excess treated as capital gains.
The actual dollar figure distributed to Harry will change from year to year depending on the fair market value of the CRT on January 1 of each year.

If Harry and Wendy had decided that they wanted an 8% unitrust income interest for their joint lives, their charitable deduction would have been only $19,335. Since CRTs are irrevocable (except that the charitable beneficiary may be changed) decisions as to the type of trust, the percentage income interest retained, and the duration of the income interest (e.g. single life, joint lives or term of years) cannot be changed once established. The following chart can be used as a guide when deciding the income interest to be retained and the effect on the charitable deduction.

POOLED INCOME FUNDS

Pooled income funds are probably the most common type of split-interest gift. Pooled income funds are created and operated by the charity and closely resemble a mutual fund. Gifts to a pooled income fund are merged with the gifts of other donors. As with CRTs, the donor is entitled to a deduction in the year of contribution that is based on the donor's age and the fund's highest rate of earnings in the previous three years. The donor gives money or property to the fund in exchange for fund units, which entitle the named beneficiary to a ratable share of the fund's actual income each year for life (or, in the case of more than one beneficiary, for a series of joint lives). At the death of the income beneficiary, his or her share of the fund's assets passes outright to the charity.

CHARITABLE GIFT ANNUITIES

With a charitable gift annuity, the donor makes a gift to the charity in exchange for a guaranteed income for life. A charitable gift annuity is very much like buying an annuity in the commercial marketplace, except that the donor gets an immediate charitable deduction equal to the excess of the contribution over what the retained annuity is worth, based on IRS tables.

Unlike the pooled income fund, CRUT or CRAT, income from the charitable gift annuity is an obligation of the charity that does not depend on investment results. The rate of return on the gift annuity is not variable, as in a pooled income fund, or negotiable, as in a CRUT or CRAT. As with any annuity, a portion of each year's annuity payment is tax-free, allowing the donor to recover his or her "investment in the contract" over the donor's life expectancy. The simplicity of charitable gift annuities allows for much lower contribution limits; typically in increments of Five Thousand ($5,000) Dollars (depending on the charity). The donor may recognize capital gain if appreciated assets are transferred to the charity to purchase the annuity.

CHARITABLE LEAD TRUST

A charitable lead trust is a CRT in reverse: The charitable beneficiary is entitled to the current income with the non-charitable beneficiary entitled to the remainder. The general rules of CRT's apply to charitable lead trusts with the exception that there is no requirement that the payout rate be a minimum of 5%. Charitable lead trusts are primarily used to save estate and gift taxes, and do not provide the same income tax saving opportunities as CRTs. To accomplish this result, the grantor must postpone the receipt of the trust assets by his family until the charitable lead interest of the charity has expired.

NIMCRUT

A NIMCRUT is a "net income" CRUT with "make up" provisions. Such trusts annually distribute the lesser of trust net income and the unitrust percentage. For example, if the donor elected an 8% unitrust amount, but the NIMCRUT earned only 4% for the year, the donor would receive only a 4% distribution.

Distributions in years where the net income is less than the unitrust percentage can be made up in later years to the extent that income in the future year exceeds the unitrust amount. NIMCRUTS are a useful tool for high net worth individuals who are still working. They receive a charitable deduction in the year of creation when their income is high, and defer income to retirement years when they are in a lower tax bracket.

Income can be manipulated during the donor's working years by investing in non-income producing assets such as growth stocks and deferred variable annuities. At retirement, the trustee would switch trust investments to high-yield investments producing substantial returns. Because of their resemblance to traditional retirement plans these arrangements are sometimes called "retirement unitrusts" or "charitable IRAs."

WEALTH REPLACEMENT TRUSTS

A potential obstacle to charitable giving is the fact that gifted assets do not pass to the next generation. It is the author's observation that despite the bravado reflected on bumper stickers: "I'm spending my children's inheritance," parents really do want their children to receive their inheritance. Fortunately, the needs of the family can be accomplished by creating a "wealth replacement trust" concurrently with the split interest trust. A portion of the income distributed to the donor from the CRT can be used to purchase a life insurance policy inside an irrevocable trust (called a "wealth replacement trust"). This approach allows for a substantially larger tax-free inheritance to the next generation. While assets would have been fully taxable if not contributed to the charitable entity, they pass tax free from the wealth replacement trust. The donor gets a substantial current income tax deduction and annual unitrust income while leaving an estate tax free inheritance.

Use of a CRT in combination with a wealth replacement trust is illustrated below:

INCOME TAX DEDUCTION LIMITS

The extent to which charitable contributions can be deducted for income tax purposes depends on a number of factors including the type of charity, and the type of property being contributed. Charitable bequests (i.e., transfers at death), by contrast, are 100% deductible.

The status of the charitable beneficiary affects the deductibility of the charitable contribution. Basically, a charity can be either a 50% charity or a 30% charity. Fifty (50%) percent charities are called "public" charities and include churches, educational institutions, hospitals and governmental units. Thirty (30%) percent charities include "private" foundations which are often identified by the name of the benefactor.

The Ford Foundation and Kresge Foundation are examples of private foundations. Charitable contributions to public charities are deductible up to a maximum of 50% of the donor's adjusted gross income ("AGI"), while contributions to private foundations are deductible up to a maximum of 30% of the donor's AGI. Contributions in excess of the 50%/30% ceilings may be carried over and deducted up to five years after the year of contribution.

The nature of contributed property also affects the charitable contribution deduction. Gifts of cash and property that is not long-term capital gain property (ordinary income or short-term gain) are deductible up to 50% of AGI. Gifts of long-term capital gain property are deductible up to 30% of AGI, subject to the overall 50% ceiling. Contributions in excess of the 50%/30% ceilings may be carried over and deducted for up to five future years.

Gifts to private foundations (30% charities) are deductible up to 30% of a donor's AGI, with a five-year carryover, except for long-term capital gain property, which is subject to a 20% ceiling. The deduction is reduced to basis if property is not marketable securities contributed after June 30, 1998.