Split Interest Trusts

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If you’re looking for a way to benefit your loved ones, take a good look at charitable remainder trusts (CRTs) and charitable lead trusts (CLTs). Often referred to as “split interest” trusts because of their dual beneficial interests, they have the ability to benefit a qualified charity as well as noncharitable beneficiaries.

How CRTs work

A CRT provides noncharitable beneficiaries with exclusive rights to all distributions until their interests have terminated. At that time, charitable beneficiaries receive the remainder — the assets left over in the trust.

A CRT can be a particularly useful tool if you’d like to divest yourself of a highly appreciated asset to diversify your portfolio but are concerned about the capital gains tax. You create a CRT, name yourself the noncharitable beneficiary and transfer the appreciated asset to the trust. Then, the CRT can sell the asset (tax-free to the trust because the CRT is tax-exempt) and use the proceeds to purchase diverse, income-producing assets.

You can receive annual payments from the trust for a specified period of up to 20 years or for your lifetime, increasing your cash flow. A portion of each payment may be taxable to you based on the income earned or capital gains recognized by the trust. You might, for instance, have capital gains income attributable to the sale of the highly appreciated shares you transferred to the trust. But the gain you report will be spread out and taxed to you only as you receive payments.

In addition, you’ll enjoy an immediate income tax charitable deduction on creation of the trust, calculated as the present value of the charity’s remainder interest. You also can enjoy recognition within the charitable organization(s) and community as a result of the contribution, unless you prefer to donate anonymously.

If you’re concerned that, should you die early in the CRT’s existence (before you’ve received many payments from it), there won’t be enough assets in your estate for your heirs to receive the inheritances you intended, there are at least two potential solutions.

One is to set the CRT term for a specific number of years (rather than your lifetime) and name your heirs as contingent beneficiaries. The other is to purchase a life insurance policy to make up for the shortfall your heirs might experience.

Finally, keep in mind that you can name someone other than yourself as a noncharitable beneficiary and even fund the trust at your death, but the tax consequences will be different.

Where CLTs differ

A CLT differs from a CRT in that it reverses the timing of when charitable and noncharitable beneficiaries receive distributions. That is, charitable beneficiaries receive the initial distributions and noncharitable beneficiaries receive the remainder.

A CLT can be useful when an asset generates substantial income every year, you don’t need the income and you wish to eventually pass the asset to your heirs. The CLT generates an income stream for the charity during the trust term, and at your death (or the end of the CLT term, if you’ve set it for a specific number of years) the asset passes to your family.

If structured as a grantor trust, the trust is essentially disregarded for income tax purposes, and a CLT then works similarly to a CRT in that you receive an immediate income tax deduction on the transfer of assets into the trust. But, in subsequent years, the income generated by the CLT will be taxable to you. If you don’t structure it as a grantor trust, the CLT income won’t be taxable to you, but you also won’t get an income tax deduction when you fund the trust.

Unlike a CRT with you as the noncharitable beneficiary, a CLT has a gift tax component, which is calculated as the present value of the noncharitable beneficiary’s remainder interest. As with CRTs, CLTs can also be funded at your death, but the tax consequences will be different.

Who can help?

In the world of estate planning, harnessing the power of either a CRT or CLT can help the charities you support while also benefiting your beneficiaries. So, consult with your tax advisor to see whether a CRT or CLT suits your estate plan. 

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