Charitable Trusts (CRUT/CRAT/CLAT)
Charitable trusts may allow individuals to sell appreciated assets tax-deferred (to diversify), receive funds over time, and/or take a large up-front deduction
Strategy Overview
A Charitable Trust (CT) is a unique type of trust that has incremental benefits due to a partial included donation to charity. There are multiple different types of charitable trusts, but in general they (1) allow contributed appreciated assets to be sold immediately without a tax bill (taxes are deferred) to facilitate diversification, (2) provide a charitable donation tax benefit in the year of formation/contribution, and (3) provide some control over when a specified portion of the funds in the trust are distributed back to you (which is when taxes are due).
Tax Details
A charitable trust, as the name sounds, is a trust who has one or more charities as a beneficiary. The inclusion of a charity as a beneficiary enables the trust to have a few unique properties, as long as rules are followed. There are generally 3 popular types of charitable trusts:
Charitable Remainder Unitrusts (CRUT)
A CRUT is an irrevocable trust where property (for tech workers, typically highly appreciated stock) is contributed into the trust. A CRUT is typically set up in such a way that a percentage (between 5% and 50%) of the value of the trust is paid out/back to you each year for a predetermined number of years (typically at least 2, and no more than 20, unless you opt for the length to be the lifetime of someone). As the value of the assets in the trust change over time, so does the value of your annual payment. As implied in the name, after the specified payments have been made, the remaining funds are donated to the specified charity (or charities).
Requirement: To be a charitable trust (and get the associated benefits), the IRS requires that the trust be setup in such a way that (using their inputs/rules/calculations) at least 10% of the value of the assets initially contributed be provided to charity
Key tax benefit #1: As a charitable trust, taxation is deferred. For a tech worker with a highly appreciated concentration position, you can immediately sell your appreciated stock (once contributed into the CRUT) to diversify without an immediate tax bill
Key tax benefit #2: The estimated value of the funds that will be gifted to charity at the end of the trust (the remainder) are considered a charitable donation in the year the CRUT was formed/funded -> providing a tax deduction
Charity flexibility: When setting up a CRUT, you need to specify which charity the remainder will be given to. For additional control and flexibility, it's allowed (and common) to specify a Donor Advised Fund (that you create and control) as the charitable remainder beneficiary
(Optional) life insurance: As a estate planning bequeathment strategy, some individuals may opt to pair a CRUT with life insurance, wherein the trust distributions are used to pay the premiums on a life insurance policy
Key taxation flag: Distributions from a CRUTs are required to follow a "worst-in, first-out" (WIFO) tax distribution method. To the extent that the trust has ever generated any of the following (which has not been distributed), your distributions will be considered as follows:
Ordinary income (interest, dividends): Taxed at highest ordinary income rates.
Capital gains: Taxed at lower capital gains rates.
Tax-free return of basis: Not taxed since this is just getting your original investment back.
This ordering further optimizes the tax benefits, since the CRT pays out the "worst" income first from a rates perspective (ordinary income).
Charitable Remainder Annuity Trust (CRAT)
A CRAT is very similar to a CRUT. The key difference is that instead of the annual distribution payment being a percentage of the trust's assets (revalued each year), the trust specifies a fixed annuity payment for a number of years.
Charitable Lead Annuity Trust (CLAT)
CLAT's are a bit different from CRUTs and CRATs, wherein donations to a charity occur first (hence the "lead" in the name). Specifically, a CLAT is set up such that a pre-specified amount is donated to a charity of your choosing each year for a predetermined number of years. Then, at the end of the CLATs life, the beneficiary (which can be the donor, or another individual) receives the assets that remain. How taxation works depends on the sub-structure:
Grantor charitable lead trust. In a grantor charitable lead trust, the grantor gets an immediate income tax deduction (for charity) for the current present value of the future payments that the CLAT will make to the specified charitable beneficiary (subject to deduction limitations). As a trade off however, the trust's investment income is taxable to the grantor during the trust's term.
Non-grantor charitable lead trust. In a non-grantor charitable lead trust, the trust (not the grantor) is considered the owner of the trust assets. As such, the grantor cannot take an income tax deduction for the current present value of payments the CLAT will make to charity. The trust itself pays tax on its undistributed net income, and is also able to claim an unlimited income tax charitable deduction for its distributions to the charitable beneficiary.
For more details, you may consider reading:
Key Benefits
Potential ability to claim an upfront charitable deduction on your tax return when contributing assets into the trust. This can provide immediate tax savings in the year of the contribution.
For remainder trusts, ability to diversify concentrated stock positions in a more tax-efficient manner. You can contribute appreciated stock and the trust can sell it without incurring an immediate tax bill, allowing you to diversify into a broader portfolio.
Growth within the trust is predominately tax-deferred over time. This further compounds returns.
Capital gains distributions from a remainder trust can be offset by tax-loss-harvesting.
Potential "returns arbitrage" for CLATs. The tax deduction received from contributions to a charitable trust are determined up-front based on IRS rates. If the returns of the trust exceed those rates, you're like to extract more after-tax value.
Key Considerations/Flags
Complex to properly establish and administer based on your specific financial situation and goals. Requires assistance of experienced legal and tax advisors.
Lose control over contributed assets since the trust is an irrevocable gift. Outside of the rules you specified for the trust, you cannot get the assets you funded the trust with back.
For remainder trusts, the distributions paid out to you are worst-in-first-out (WIFO). Careful planning regarding the investments made within the remainder trust can help manage this.
Strategy: When to Consider This and When to Avoid It
🟢 When to Consider This Strategy:
You have a highly appreciated concentrated stock position with sizable embedded gains and desire to diversify immediately. A CRT allows diversifying while deferring taxes.
You are charitably inclined and would consider leaving assets to charity upon death regardless.
🔴 When to Not Use This Strategy:
You highly value maintaining control over your assets (vs contributing them irrevocably to a trust).
You do not have charitable intent or are unsure if you want to leave assets to charity.
Example
John has been with GoingPlaces, Inc. for 6 years and the company recently went public via IPO. John exercised 100,000 stock options years ago when the 409a was equal to his strike price of $0.10 per share. The value of the company is currently $30 per share. John sets up a CRUT (10-year target life) and contributes all 100,000 of his shares into it (targeting a minimum 10% remainder). Tax and planning benefits from this are:
John will have a $300,000 charitable tax deduction (in the year the CRUT was created/funded). This is calculated as 100,000 shares * $30/share * 10% remainder.
John can sell all 100,000 shares to diversify tax-deferred. John immediately sold all 100,000 of his shares once they were in the CRUT. Tax is not due (yet), so John is able to reinvest the $3 million into a diversified portfolio of his choosing.
John will receive a distribution of 10% of the value of the CRUT each year for 10 years. The distribution will be paid in cash, and the character of the info will follow the WIFO methodology. For example, if John reinvested the proceeds into a diversified portfolio of ETFs and has not sold any, WIFO would specify that the payout be long-term-capital-gains (realized via the sale of GoingPlaces stock) for most (likely all) 10 years.
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