Whether an individual is actively planning their estate or just looking for ways to decrease their tax burden and increase what they can leave behind for loved ones, it makes sense to consider how to make the most of an entire asset portfolio. Sometimes friends or financial advisors will suggest that it is possible to avoid capital gains tax with a charitable remainder trust. While there may be some truth to the assertion, it is important to understand all the ramifications of creating such a trust. Unlike some other trusts, this type of trust cannot be revoked if an individual changes their mind, or if their circumstances change. If you are considering a charitable remainder trust, or any other type of trust, as part of your estate planning process, whether for tax purposes or for other reasons, the San Francisco estate planning attorneys with Von Rock Law at (866) 720-0195 may be able to help you.
Do Charitable Trusts Pay Capital Gains Tax?
The final result of a charitable trust is that it benefits one or more charities. These can be local San Francisco charities, California-specific charities, or national or even global charities. When and how the trust benefits the charity depends on whether it is a charitable lead trust or a charitable remainder trust. Charitable lead trusts (CLT) are set up entirely for the benefit of the charity, with the remaining assets being returned to the donor or distributed to the donor’s beneficiary after the trust ends. Charitable remainder trusts (CRT) are set up to provide an income for the donor or other beneficiaries specified by the donor and provide the remaining assets to the specified charity when the trust ends, either after a set period of time or when the beneficiary or beneficiaries have died.
Unlike individuals, charities do not pay capital gains tax. This means that, if the charity sells an asset in the trust, the proceeds remain in the trust and are not taxed. In a CRT, the trustee sells assets to produce an income for the donor. This allows the donor to put high value assets in the trust so they can be sold without the donor having to pay capital gains tax. However, it is important to know that it may not be possible to completely avoid capital gains tax.
Can I Avoid Capital Gains with a Trust?
Trusts are often taxable, but the taxes on trusts are typically calculated using preferential capital gains rates, rather than the ones that individuals use. Additionally, like individuals, trusts can offset capital gains through capital losses.
This means that trusts can avoid capital gains tax in some circumstances, but in some situations an individual might still have some capital gains tax liability. One important rule to help avoid capital gains tax is that the trust must have held the asset for at least one year before selling it. The trust cannot take advantage of the capital gains tax discount if it sells the asset without having held it for a year.
What Are the Disadvantages of a Charitable Remainder Trust?
While a charitable remainder trust has many benefits, it does have some disadvantages that are important to consider before creating one. An experienced estate planning and business attorney with Von Rock Law may be able to assist you in determining whether the benefits outweigh the drawbacks for your circumstances.
Reduced Control of Assets
This kind of trust is an irrevocable trust. Once assets are placed in the charitable remainder trust, they cannot be taken back out. This means that the donor is giving up some control over the assets by giving that control to the trust. If they opt to hire a professional trustee, then they are giving up all control over the assets.
Additionally, because the assets cannot be returned to the donor, donors must carefully consider their own financial needs and the needs of their beneficiaries to ensure they retain enough assets to meet those needs even if the income from the trust is not what they anticipated.
Possibility of Lower Income
One area of concern for setting up a charitable remainder trust to avoid capital gains tax is determining how long the trust should last and the payout rate. Donors will need to decide whether they want the trust to last for a set number of years before giving the remainder of the assets to the charity, or whether they want the trust to last until their death before turning the remaining assets over to the charity.
In addition, projections for income from the trust assume that the trust assets will perform as expected. If they do not, donors could find themselves with a lower income from the trust than they anticipated. Therefore, it is critical that donors consider their other income sources and make sure that they are not relying completely on the income from the trust.
Strict IRS Regulations
While all trusts have regulations, the Internal Revenue Service (IRS) has especially strict regulations around CRTs to ensure that people use them for the intended purpose. Any violation of the IRS rules can result in harsh tax consequences.
Some of these rules include:
- Donors may not borrow from the trust.
- Donors are not allowed to use trust funds to pay personal expenses.
- The trust cannot transfer the charitable remainder interest to an organization that is not a tax-exempt organization.
- The trust may not give non-charitable beneficiaries any payment other than the prescribed annual income payment (self-dealing).
Limited Assets Are Eligible
A charitable remainder trust is designed to generate an income for its donor and the designated charitable organizations the donor specifies. Because of this, only assets that will produce an income can be added to these trusts. This means that assets such as personal property or artwork cannot be added.
The types of assets that can be added include:
- Real estate
- Publicly traded securities
- Certain closely held stocks (excludes S-Corp stock)
- Certain additional complex assets
Can Be Expensive to Set Up and Administer
A charitable remainder trust can be expensive to set up and administer. Factors in the overall costs involved include the legal fees many donors pay to secure the assistance of an attorney in setting it up, the complexity of the CRT, the geographic location where the CRT is being established, and any fees that may be paid to a professional trustee. Additionally, there may be termination fees if the donor decides to abolish the CRT before its specified expiration.
How Do You Treat Capital Gains in a Trust?
Individuals pay capital gains tax because capital gains are considered part of their income. For the purposes of a charitable remainder trust, capital gains are not considered income. Instead, capital gains are considered as contributions to the principal.
When certain assets are sold and a gain is realized, the trust then pays capital gains tax on that gain. While a trust can help avoid capital gains tax, it is not a guarantee. The IRS states that once a charitable remainder trust’s ordinary income is exhausted, payments are then taxed as capital gains based on the disposition or sale of the capital assets in the trust.
Are You Considering a Charitable Remainder Trust As Part of Your Estate?
If you think a charitable remainder trust may be something you want to include in your estate plan, whether to avoid capital gains tax or as part of your plan for charitable giving, it is important to be clear on what you are doing. While this type of trust can help you avoid capital gains tax, there are some drawbacks that may mean another option could be better for a particular estate. Examples of alternatives might include donor-advised funds (DAF) or charitable gift annuities. If you are ready to explore your options and learn more about creating a CRT, the knowledgeable attorneys with Von Rock Law may be able to assist you. Call our office at (866) 720-0195 to schedule your personalized consultation today.