Fun Asia Show Recording-December 19, 2013

Transfers to Charity at Death

Tax Issue

A gift to charity at death is deductible for estate tax but generally not for income tax. Lifetime gifts to charity, on the other hand, reduce the taxable estate and also provide an income tax deduction. The problem with a sizable lifetime charitable gift, however, is that it may leave the donor uncertain about their future financial security. The safest course is to wait until death to be sure that the money will not be needed.


Applicable Tax Law

  • Most gifts to charity, regardless of the amount, are fully deductible for both gift and estate tax.
  • Income in respect of the decedent (IRD) remains taxable after death. Tax is paid by the recipient at his or her tax rate. IRD includes IRAs, qualified plans, and the earnings portion of a nonqualified annuity.
  • A charitable remainder trust is an irrevocable trust that makes annual payments to one or more beneficiaries for life or for a fixed term of up to 20 years. At the death of the last beneficiary or at the end of the term, the trust’s remaining assets pass to charity.
  • The remainder interest passing to charity must be at least 10% of the initial value of all property placed in the trust.
  • The probability that the trust will actually make a charitable gift at the end of its term must be at least 95%.
  • A charitable remainder trust must have at least one income beneficiary who is not a charitable organization.
  • Annual payments from a charitable remainder annuity trust (CRAT) must be at least 5% and not more than 50% of the initial value of all property placed in the trust. Income beneficiaries receive a fixed amount annually. If trust earnings are insufficient, payment is made from principal.
  • Annual payments from a charitable remainder unitrust (CRUT) must be at least 5% and not more than 50% of the value of trust assets, revalued annually. Income beneficiaries receive variable amounts. CRUTS can include make-up provisions that allow an annual payment to be reduced if the trust’s current earnings are less than the required payment. The difference is made up when earnings are available.
  • The transfer of property into a charitable remainder trust qualifies for an income tax charitable deduction equal to the present value of the remainder interest. The calculation is based on the adjusted payout rate, and other factors. The deduction for a CRAT is generally lower than for a similar CRUT because the CRAT bears the investment risk.
  • A charitable remainder trust that meets the requirements of IRC section 664 is tax exempt. The trust does not pay tax on its income, including capital gains from the sale of assets transferred to the trust.
  • Trust income, however, is distributable to the beneficiaries each year up to the amount of their income payments. Capital gains, including undistributed gains from prior years, are distributable income. Trust income is distributed on a worst first basis – ordinary income, capital gains (including undistributed gains from prior years), tax-exempt income, and then nontaxable principal. If the trust sells an appreciated asset, distributions to beneficiaries will remain taxable until the entire capital gain is distributed.
  • Charitable remainder trusts file Form 5227 and pass income to beneficiaries on Schedule K-1 (Form 1041).
  • Basis of appreciated property received as a gift in generally the donor’s adjusted basis at the time of the gift. The recipient’s holding period also includes the donor’s holding period.


Tax Planning Strategy #1 – Make a Charity the Beneficiary of an IRA

An IRA or other retirement asset is included in the taxpayer’s gross estate for estate tax. The IRA is also taxable income to the recipient. If an IRA is paid to charity, the IRA is not subject to either estate or income tax.

Example: Anita has an $8 million estate. She included a $500,000 gift to charity in her will and left all her other assets to her children. Anita’s estate pay federal estate tax of $875,000. Anita’s estate includes an IRA of $350,000 that passes to her children by beneficiary designation. The IRA is taxable income as they take distributions. The children are allowed an income tax deduction of $40,833 for the portion of the estate allocated to the IRA. The children pay $102,000 in income tax on the IRA

Anita could have saved her children the full amount of the income taxed by naming the charity as beneficiary of the IRA and reducing the charitable gift made by will to $150,000. Anita’s children receive other assets from the estate that are not taxable income. The charity receives the taxable asset but is exempt from income tax.

Possible Risks

  • A gift to charity made by will can be a fixed amount or percentage of the assets remaining at death. Naming a charity as the direct beneficiary of an asset passes that asset to charity regardless of the amount. The charity’s share of the estate can be much larger or smaller than the taxpayer intended.


Tax Planning Strategy #2 – Transfer Property to a Charitable Remainder Trust

A charitable remainder trust allows a taxpayer to give an appreciated asset to charity while keeping an income stream. The taxpayer receives a current income tax deduction for the remainder interest passing to charity. The capital gains tax on the sale of the asset is deferred, and in some cases reduced, allowing the trust to invest the entire proceeds of the sale. A charitable remainder trust can increase the amount of the gift passing to charity.


Possible Risks

  • The taxpayers cannot access the principal of the trust if they unexpectedly need additional income.
  • Charitable remainder trusts are complicated and must meet IRS tests. Set-up and administrative costs are high. Less expensive alternatives include pooled income funds established and maintained by charities that hold contributions from multiple donors and charitable gift annuities that provide fixed annuity payments for life in exchange for a transfer of cash or property to a charity.
  • If the taxpayer dies soon after establishing a charitable remainder trust, family members or other estate beneficiaries may receive less than the taxpayer expected. To reduce this risk, a life insurance trust is often used in combination with a charitable remainder trust.
  • Trust assets have investment risk. If the investments in a CRUT perform poorly, annuity income shrinks. If the market drops after a CRAT is established, the trust assets could be exhausted before the end of the trust term.
  • Although IRS rules allow a payout rate of up to 50% the actual rate must be set considerably lower when the federal interest rate is low. If the payout rate is too high, a 10% gift to charity with a 95% probability is not possible.
  • The charitable deduction is calculated when the trust is established. If the federal rate is low at that time, the deduction is likely to be lower than the actual amounts received by charity.
  • If the taxpayer’s charitable deduction is limited by income and carried forward, it can be lost if the taxpayer dies early in the trust term.
  • Calculations used to choose trust options are based on life expectancy and estimates of future earnings. The information needed to calculate the relative benefits of the trust to the taxpayers and to the charity is not available until the trust ends.