Charitable Lead and Charitable Remainder Trusts

Charitable split-interest trusts divide a single property between a charitable beneficiary and a non-charitable beneficiary across time. Two forms dominate practice: the charitable lead trust (CLT), which pays a stream to charity first and the remainder to family; and the charitable remainder trust (CRT), which pays a stream to family first and the remainder to charity. Both are codified in §§170, 664, 2055, and 2522. Both succeed or fail based on the §7520 rate at funding and the actual investment performance of the trust.

Charitable lead trusts

A CLT is governed by §2522(c)(2). The trust pays a fixed annuity (CLAT) or unitrust amount (CLUT) to one or more qualified charities for a term of years or life. At term end the remainder passes to non-charitable beneficiaries (typically children or grandchildren).

• Gift value at funding equals the present value of the remainder interest, computed using the §7520 rate. The charitable lead portion is deductible under §2522.
• Zeroed-out CLAT. Setting the annuity to exhaust the funding present value reduces the taxable gift to nominal. Rev. Proc. 2007-45 provides safe-harbor forms.
• How it wins. If trust assets earn more than the §7520 hurdle, the excess passes to remainder beneficiaries without further gift tax. Identical mechanics to a GRAT, but with charity as the lead beneficiary instead of the grantor.
• Grantor vs non-grantor. A grantor CLT generates an upfront income tax deduction (§170(f)(2)(B)) but the grantor is taxed on trust income over the term. A non-grantor CLT generates no upfront deduction but the trust pays its own tax (offset by annual §642(c) deductions).

Charitable remainder trusts

A CRT is governed by §664. The trust pays a stream — at least 5% and at most 50% — to one or more non-charitable beneficiaries for a term up to 20 years or for the life of the beneficiary, with the remainder passing to charity. The remainder must be at least 10% of the initial funding value (the "10% remainder requirement").

• Two flavors. A CRAT pays a fixed annuity; a CRUT pays a fixed percentage of annually revalued trust assets.
• Tax-exempt trust. The CRT itself is exempt under §664(c). It may sell appreciated assets without immediate gain recognition, providing a powerful diversification tool for concentrated low-basis holdings.
• Beneficiary taxation. Distributions are characterized under the four-tier system of §664(b): ordinary income first, capital gains next, other income third, return of corpus last. The trust's accumulated tax character is paid out before its basis.
• Upfront charitable deduction equals the present value of the remainder, computed using the §7520 rate (§170(f)(2)(A)). Higher §7520 rates increase the deduction.

Worked example: CRUT for concentrated stock

A 65-year-old donor holds $5,000,000 of low-basis stock (basis $500,000, gain $4,500,000). She contributes the stock to a 6% CRUT for her life. §7520 rate: 5.2%.

• Charitable deduction: Present value of remainder, approximately $1,420,000. Deductible against 30% of AGI for appreciated property; carryforward up to 5 years.
• Diversification: CRUT sells the stock immediately. Zero current gain. Reinvests in a balanced portfolio.
• Annual distributions: 6% of revalued assets each year. In year one, on a $5,000,000 portfolio, that is $300,000.
• Beneficiary taxation: Distributions characterized first as the trust's $4,500,000 of "trapped" capital gain (taxed at LTCG rates as recognized), then as ordinary investment income.
• Remainder at death passes to charity, replacing what would otherwise have been an estate-included asset.

Net effect: a $1.4M charitable deduction now, full diversification today rather than after a $1M capital gains tax, lifetime income, and the eventual charitable gift the donor planned anyway.

Common mistakes

• Funding a CRT with mortgaged real estate. Triggers unrelated business taxable income (UBTI) under §664(c)(2) (post-2007: 100% excise tax). Always discharge the mortgage first or use a different vehicle.
• Funding a CRAT in a low §7520 environment. The 5% probability-of-exhaustion test (Rev. Rul. 77-374) can fail when rates are below the payout rate. Use a CRUT instead.
• Designating the CRT as the IRA's beneficiary without modeling the payout. A CRT is not a "designated beneficiary" under Treas. Reg. §1.401(a)(9)-4: if the IRA owner died before the required beginning date, the 5-year rule applies; if on or after the RBD, the IRA pays out over the decedent's remaining single-life expectancy. The CRT then distributes per its own terms. Useful when matched to a life-income beneficiary in a low bracket; suboptimal in other cases.
• Funding a CLT when one's children may need access. The lead term locks up the principal for the charitable beneficiary. Family receives only the remainder.
• Failing to comply with private foundation rules. §§4940–4945 self-dealing, excess business holdings, and jeopardy investment rules apply to many CLTs.

Sources

• Internal Revenue Code §664, charitable remainder trusts: law.cornell.edu/uscode/text/26/664
• Internal Revenue Code §2522, charitable gift tax deduction: law.cornell.edu/uscode/text/26/2522
• Internal Revenue Code §170(f), charitable income tax deduction split-interest rules: law.cornell.edu/uscode/text/26/170
• Rev. Proc. 2007-45 (CLAT safe-harbor forms): irs.gov irb07-29
• IRS Publication 526, Charitable Contributions: irs.gov/pub/irs-pdf/p526.pdf

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