A charitable lead trust is a philanthropic and estate planning tool. A donor can transfer assets, such as cash, stocks and artwork, to a trust for a set term of years. Each year, payments are made from the trust to the donor's designated charity/charities.
It is called a lead trust because the charity/charities is/are entitled to the lead (or first) interest in the trust asset, and the noncharitable beneficiary receives the remainder (or second-in-line) interest.
Once the trust's term expires, what is left goes to the donor's heirs. Handling assets in this way can shelter the assets' appreciation from estate taxes.
The IRS sets the rate that assets are expected to grow in the trust. This rate is called the "hurdle" rate by estate planners because any gains beyond it can usually pass to the heirs tax-free. The rate is adjusted monthly by the IRS, but remains locked in for the length of the trust.
Two Types of Charitable Lead Trusts
Charitable lead trusts are of two types: charitable lead annuity trusts and charitable lead unitrusts. In the first type, the donor sets a fixed annual gift for the charities named. In the unitrust, the charities receive a percentage of the trust's value each year. This means that those benefits will fluctuate based on the trust's investment returns or losses.
Annuity trusts are the most popular because the charitable payments are fixed. In the unitrust assets grow and the percentage going to charity uses up more and more money, thus leaving less for the heirs.
How Taxes Work With a Charitable Lead Trust
A donor who establishes either type of trust can take an upfront income-tax deduction based on the trust's payments to charity. The donor may opt to forgo that deduction, however, because it requires the donor to pay taxes on the trust's investment gains.
Downsides to a Charitable Lead Trust
Charitable lead trusts are irrevocable. Once you put assets or cash in, they cannot be taken out. If the trust's assets go down in value, the amount left for heirs could be less, because the trust must make its charitable payment no matter what the market is doing.
The money going to the heirs is a taxable gift, and lowers your estate-tax exemption.
Market timing is important when setting up a Charitable Lead Trust. Consult an estate planner to make sure it is in your best interest, and that of your heirs.
