The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated or impacted many aspects of individual income tax deductions, including the much-cherished charitable contribution deduction. Fortunately for the philanthropic and their chosen charities, Congress did not eliminate the charitable contribution deduction and even expanded the limitation to 60% of adjusted gross income. As the second article in our two-part series examining strategic options for claiming a charitable contribution post-tax reform, this article will focus on the use of trusts.
A non-grantor trust is considered a separate taxpayer from an individual and files its own income tax return, Form 1041. A trust does not have a standard deduction, so all deductions are itemized, which can create income tax planning opportunities for deductions lost on an individual income tax return.
To illustrate, let’s suppose a taxpayer donates $10,000 to charity during the year and pays $20,000 in property tax for their principal residence and a vacation home. Before the TJCA, this taxpayer would have had itemized deductions of $30,000, far in excess of the standard deduction ($6,350 single or $12,700 MFJ). However, under the TCJA, the taxpayer’s property tax deduction is capped at $10,000, leaving them with only $20,000 of itemized deductions. If single, the taxpayer will still itemize their $20,000 instead of choosing the standard deduction at $12,000. If the taxpayer is married, however, they will choose the higher standard deduction of $24,000 (MFJ) instead of itemizing their $20,000 deductions, effectively losing any charitable contribution tax benefit.
By utilizing a non-grantor trust, the taxpayer can salvage their charitable contribution and potentially remove some income from their individual income tax return. After consulting with competent tax professionals, the taxpayer would set up a non-grantor trust and contribute income-producing assets, which they currently do not rely on for support. The taxpayer then designates beneficiaries for the trust, in accordance with their estate plan, and includes a provision allowing the trust to potentially be toggled to a grantor trust in the future, should they desire. Now, instead of making charitable contributions personally, the taxpayer directs the non-grantor trust to make the contribution every year. The trust, without a standard deduction, is able to take a charitable contribution deduction, which offsets the income generated by the trust’s assets. If done carefully, the trust could break about even every year, with little or no tax liability due. To go a step further, the taxpayer could also contribute the vacation home to the trust, thus, also rescuing the excess property tax deduction by transferring it to the trust.
Although this method or related approaches require sophisticated, granular tax planning by experienced professionals, a carefully-crafted plan can remove income from the individual’s income tax return, while salvaging the charitable deduction that would otherwise be lost.
Charitable Lead Trust (CLT)
A charitable lead trust (CLT) is an irrevocable trust that allows a donor to transfer property to a trust in exchange for a charitable deduction equal to the value of an income interest paid to the charity. The CLT provides an income interest to a charitable beneficiary for a specified period of time, after which the property reverts back to the donor or designated beneficiary. Thus, the donor receives a charitable contribution deduction and is still able to control all remaining trust assets after the specified time period.
A CLT is useful to a donor who can afford to lose the income stream generated by the trust assets. The CLT itself is not tax exempt; therefore, any undistributed income is taxed at trust tax rates. Unlike a charitable remainder trust (explained below), a CLT can be structured to distribute higher-taxed income to the charitable beneficiary first, leaving lower-taxed income to be reported by the CLT. Typically, the charitable income beneficiary is tax exempt and will not be affected by the receipt of ordinary income or capital gain. A word of caution: if the income characterization provision is deemed to not have economic effect, the provision will not be recognized for income tax purposes.
Charitable Remainder Trust (CRT)
A charitable remainder trust (CRT) is in many ways the reverse of a CLT. Income from trust assets is paid to at least one non-charitable beneficiary – usually the donor or his/her family – for a specified time period or for life. When that time period ends, the trust assets pass irrevocably to the designated charity.
A CRT can be created as an annuity trust (CRAT), which pays a fixed amount each year to the non-charitable beneficiary, or a unitrust (CRUT), which pays a percentage of the annually determined value of trust assets. The donor’s income tax deduction for a CRAT is determined by calculating the present value of the annuity payments and subtracting the result from the amount contributed. For a CRUT, the deduction is calculated by determining the present value of the remainder interest after the term of years or life of the income beneficiary.
Unlike a CLT, a CRT is tax exempt. This makes a CRT an attractive option for a taxpayer owning low-basis assets seeking to retain lifetime income. The taxpayer can contribute the assets to a CRT, and receive the annual distributions without recognizing any gain either individually or in trust. In addition, the taxpayer can utilize the income tax deduction now for assets that will eventually pass to charity.
Although tax reform threw a wrench in machine of charitable giving, opportunities still exist in many situations to harvest a tax benefit from taxpayers’ charitable contributions. Solutions involving trusts must be custom-designed for each taxpayer’s unique situation and created in concert with the estate plan. Trust documents must include specific provisions and be drafted with flexibility in order to adapt with the next change in tax law or taxpayer circumstances. With the assistance of a few experienced tax professionals, an astute taxpayer is able to support her chosen charities and enjoy perennial income tax savings year after year, all while simultaneously customizing her estate plan.
For more information regarding charitable giving or estate planning, please contact John Ure or one of our experienced tax advisors at 301.231.6200. To read Part 1 of this blog series, click here.