How Does a Charitable Trust Work?

A charitable trust can be an effective tool for those looking to provide ongoing support to a cause or organization while also providing for their families. As an added benefit, placing assets in a charitable trust may help minimize income, gift and estate taxes.

There are two main types of charitable trusts—charitable lead trusts, or CLTs, and charitable remainder trusts, or CRTs. Each type works differently and has its own unique benefits, so it's important to understand the pros and cons of each option.

Charitable lead trusts versus charitable remainder trusts

CLTs and CRTs are sophisticated estate planning tools that may be used to achieve both philanthropic and personal financial goals. Both types of trusts offer significant potential tax benefits, but each in a different way. They also operate in reverse order, so your personal financial situation and goals can determine the one that's right for you.

A CLT allows individuals to engage in philanthropy during their lifetime, potentially reducing estate taxes while also preserving assets for future generations. With a CLT, the selected charity receives an income stream during the term of the trust. At the end of this period, the trust's assets may revert to its creator—the grantor or donor—or their designated heirs.

A CRT follows the opposite sequence. The trust's grantor or noncharitable beneficiaries receive regular income from the trust during the trust's term. The remainder of the trust's assets goes to a chosen charity or charities.

How does a charitable lead trust work?

As the grantor, you can fund a CLT with various assets—including cash, stock, real estate or a private business interest. However, you'll have no access to the income generated from these assets during the term of the trust. In addition, once the terms of the trust have been set, you can't change these terms or the charitable or noncharitable beneficiaries.

The trust will make regular donations to one or more qualifying US charities during the term of the trust. This may be for either a set number of years or, more typically, your lifetime.

Once the term of the trust expires, the remaining trust assets pass to the noncharitable beneficiary or beneficiaries. This may be either you as the original donor or others, who are typically family members.

Tax impacts for the grantor

There are two types of CLTs, and each has different tax implications for the grantor.

• Grantor trusts: The grantor is treated as the owner of the trust's assets for income tax purposes. The main advantage of this structure is the immediate income tax deduction you'll receive for the present value of future payments to the charity—within certain limits. The main drawback is that you'll continue to pay income taxes on the trust's investment earnings throughout the life of the trust. You also won't receive an additional tax deduction for any distributions the trust makes to the charitable beneficiary.
• Non-grantor trusts: The trust is treated as the owner of the assets for income tax purposes. As a result, the trust pays taxes on any undistributed net income it earns during the trust's term and may claim an income tax deduction for any distributions it makes to the charitable beneficiary. While the grantor isn't eligible for an income tax deduction, gift and estate taxes may be reduced with this kind of trust.

How does a charitable remainder trust work?

A CRT makes regular payments to one or more noncharitable beneficiaries during the life of the trust. The payment amount is set during the creation of the trust. Current IRS rules require a minimum of 5% of the trust's assets—but no more than 50%—to be paid out each year.

Distributions to the donor or family members are taxed as ordinary income or capital gains, depending on the assets used to fund the trust. However, upon the donor's passing, the assets transferred to the CRT will be free from estate taxation and will be left to the charitable beneficiary.

Choosing between an annuity trust and a unitrust

CLTs and CRTs can be structured with either an annuity or a unitrust structure for the payments to charitable or noncharitable beneficiaries during the trust's term. There are several key differences between an annuity trust and a unitrust that may impact which option is right for you.

Annuity payout

With an annuity trust, payments are a fixed dollar amount, calculated as a percentage of the initial value of the trust's principal. This approach creates a steady income stream but doesn't adjust for inflation or how investment performance might affect the trust's value. This may be a problem with a CRT because at least 10% of what you initially contribute to the trust must eventually go to the charitable beneficiary.

Another drawback to annuity payouts is that you may not add assets to either type of trust—a charitable lead annuity trust or a charitable remainder annuity trust—after its initial funding.

Unitrust payout

With a unitrust, payments are variable and are calculated as a percentage of the trust's current value each year. If your unitrust grows, the payouts will grow, which may provide a hedge against inflation. Another advantage is that—unlike with an annuity structure—you may add assets to a unitrust over time.

The choice between an annuity and a unitrust structure may significantly impact the income distributed during the trust's term, as well as the value of any remaining assets. There may be other considerations as well, so it's important to speak with a financial professional before making a decision.

Keep these points in mind

Sorting out the different tax advantages isn't the only critical consideration when it comes to setting up a charitable trust. Some people may prefer to provide for their noncharitable beneficiaries while they're alive. Others want to provide charities with a stream of donations before passing on their assets to heirs. It comes down to your personal and financial charitable giving goals.

Likewise, it's important to know that charitable trusts are irrevocable, which means the terms of the trust can't be changed. For these reasons, it's best to discuss the pros and cons of a charitable trust with a financial professional. They can also help you explore other ways to structure your charitable contributions, including a nonprofit family foundation or donor-advised fund. This may help you to make an informed decision about what would work best for your situation.