Principal-Returning Gift Options
Giving the Fruit and Keeping the Tree
For a variety of reasons, it may make sense for some donors to give the “fruits” of their assets, but not the assets. Charitable lead trusts are most frequently used to accomplish such a goal. Although there are several varieties of charitable lead trusts, the most common form is used to transfer a business (at a discounted value) to the next generation. With proper planning, such gifts yield “win/win” results for donors, family members, and Luther Seminary.
Without proper planning, property passing from parents to children may be subject to income, gift and estate taxes. Children may then receive less than half of the property’s value and the property may need to be sold to pay the taxes. In addition, transferring property to grandchildren may subject the gift to an additional tax – the generation-skipping tax. Moreover, transferring assets to others during lifetime may result in large future taxation as well because the gift recipients are also given the donor’s tax basis, thereby creating a capital gains problem for the new owner.
Charitable Lead Trusts
Charitable Lead Trusts offer ways of transferring property at a discount from one generation to the next. In a lead trust, property is irrevocably transferred to a trust which pays an income stream to the seminary either for a period of years, for the donor’s lifetime, or for another person’s lifetime. The donor’s children are normally named as beneficiaries at the end of the trust term. A gift tax return is prepared at the time the trust is created. Because the children have to wait for the expiration of the income stream, the value of the assets ultimately transferred to them is discounted. The larger the payment stream and the longer the payment term, the greater the discount. At the end of the trust’s term, the corpus (principal and asset appreciation) is distributed to the trust’s remainder beneficiaries – normally the donor’s children.
If the donor is considered to be the owner of the lead trust, the trust is referred to as a grantor lead trust, and (i) the donor receives an income tax deduction when the trust is created, and (ii) income earned in the trust and paid to the charity is taxed to the donor annually. If the donor is not considered to be the owner, the trust is referred to as a non-grantor trust, and (i) the donor receives no income tax deduction, and (ii) the income earned in the trust is not taxed to the donor. Any income earned in the trust, but not taxed to the donor, will be taxed to the trust.
Three factors affect the size of the charitable contribution resulting from the creation of a charitable lead trust: duration of the trust, the amount paid to the charity, and the federal discount rate in effect at the time the trust is established. The longer the trust term and the larger the amount paid to charity, the larger the charitable deduction. Also, the lower the federal discount rate, the larger the deduction.
Trust payments to the charity must either be for a fixed dollar amount – a charitable lead annuity trust, or for a fixed percentage of the trust assets revalued annually – a charitable lead unitrust.
Mary, age 55, wishes to transfer growth stock to her two children and to make a large multi-year gift to Luther Seminary. She transfers growth stock valued at $1,000,000 to a non-grantor charitable lead annuity trust. The trust will pay 7% ($70,000) to the seminary annually for 7 years. After that time the trust will terminate and the principal will be distributed equally to her two children. The stock is currently generating 3% dividends and 5% growth annually.
Mary must report a taxable gift to her children of $582,940. The difference ($1,000,000 less $582,940) is a gift tax charitable deduction. The trust pays $70,000 annually for 7 years to Luther Seminary, for a total gift of $490,000 over the entire period. When the trust terminates, the principal, having grown to $1,089,228, is distributed to her two children. Mary effectively has transferred $1,089,228 to her children while subjecting only $582,940 to gift tax.
4.2% discount rate used for calculations