If you want to make a substantial gift to a charity, it may make sense to explore using a special kind of trust, called a charitable trust. It lets you donate generously to charity while giving you and your heirs a big tax break.

On the other hand, if you just want to leave property to family or friends and make a few minor charitable gifts, then a charitable trust probably isn't worth the bother.

In any case, you need to do some serious thinking before setting up a charitable trust. Charitable trusts are irrevocable. Once you create one and it becomes operational, you cannot change your mind and regain legal control of the trust property.

How It Works
The most common type of charitable trust is called a charitable remainder trust. Here's how it usually works.

First, you set up a trust and transfer to it the property you want to donate to a charity. The charity must be approved by the IRS, which usually means it has tax-exempt status under the Internal Revenue Code. (You can ask the IRS whether a particular charity is eligible.)

The charity serves as trustee of the trust and manages or invests the property so it will produce income for you. The charity pays you (or someone else you name) a portion of the income generated by the trust property for a certain number of years or for your whole life. You specify the payment period in the trust document. Then, at your death or the end of the period you set, the property goes to the charity.

What's in It for You
In addition to helping out your favorite charity, you get several big tax advantages from this arrangement.

Income Tax
You can take an income tax deduction, over five years, for the value of your gift to the charity. Where things get tricky is determining the amount of your deduction. The value of your gift is not simply the value of the property; the IRS deducts from that value the amount of income you're likely to receive from the property. For example, if you donate $100,000 but can expect (based on your life expectancy, interest rates, and how the trust document is set up) to get $25,000 in income back, the value of your gift is $75,000.

Estate Tax
When the trust property eventually goes to the charity outright (at your death or the end of the payment period you specified), it's no longer in your estate -- so it isn't subject to federal estate tax. (Most people don't need to worry about estate tax, however, which is assessed only on large estates. See Estate and Gift Tax FAQ.)

Capital Gain Tax
One of the most desirable aspects of a charitable trust is that it lets you turn appreciated property (property that has gone up significantly in value since you acquired it) into cash without paying tax on the profit. If you simply sold the property, you would have to pay capital gain tax on your profit. But charities, unlike individuals, don't have to pay capital gain tax. So if you give the property to the trust and the charity sells it, the proceeds stay in the trust and aren't taxed.

A charity usually sells any nonincome-producing asset in a charitable trust and uses the proceeds to buy property that will produce income for you.

Example: Toni owns stock worth $300,000. She paid $20,000 for it 20 years ago. She creates a charitable trust, naming Greenpeace as the charity beneficiary, and funds her trust with her stock. Greenpeace sells the stock for $300,000 and invests the money in a mutual fund. Toni will receive income from this $300,000 for her life.

Had Toni sold the stock herself, she would have had to pay capital gain tax on her $280,000 profit. But no capital gain tax is assessed against the charity.

Income for You
When you set up a charitable remainder trust, there are two basic ways to structure the payments you will receive.

Fixed Annuity
You can receive a fixed dollar amount (an annuity) each year. That way, if the trust has lower-than-expected income, you still receive the same annual income.

Once you set the amount and the trust is operational, you can't change it. For instance, if you direct that the charity pay you $10,000 a year for life, you can't later say, " Oops, I forgot about inflation. How about $15,000?"

Theoretically, you can make the payments as high as you want. Practically, however, there are limits. First, the higher the payments, the lower your income tax deduction. Second, high payments might eat into principal, possibly even using it all up before the payment term is over and leaving nothing for the charity. Third, a charity is unlikely to accept a gift if it is likely, or even possible, that all the trust property will be paid back to you.

Percentage of Trust Assets
It's common to set your annual payment as a percentage of the value of the current worth of the trust property. For example, your trust document could specify that you will receive 7% of the value of the trust assets yearly. Each year the trust assets will be reappraised, and you will receive 7% of that amount.

Because you receive a percentage, not a flat dollar amount, if inflation (or wise investment) pushes up the dollar value of the assets, your payments go up accordingly.

Under IRS rules, you must receive at least 5% of the value of the trust each year.

Making the Most of a Charitable Trust
Felix, age 60, earns a very comfortable salary and has assets worth $3 million, including stock that he bought years ago for $400,000. The stock has appreciated enormously -- it's now worth $1.6 million -- but pays very little in dividends.

If Felix sold the stock and bought income-producing assets, he would owe capital gain tax of $336,000. Instead, he sets up a charitable remainder trust with his alma mater as the charitable beneficiary. Felix funds the trust with the stock.

For income tax purposes, his donation to the charity is the full market value of the stock, less the amount Felix is likely to receive, based on his age and current interest rates. He takes this amount as a tax deduction over five years.

The charity, as trustee, sells the stock and receives a profit of $1.2 million, which is not taxed. The trustee reinvests this entire amount into a well-paying investment. The trust document requires Felix to be paid 6% of the trust value annually for life. This figure will be $72,600 the first year; it will change each year as the value of trust assets changes.

So far, Felix has avoided paying capital gain tax and turned an asset that paid little income into one that pays much more. But there is even more good news. Felix has also reduced his estate, and consequently the estate tax that will be due at his death. Felix has given money to the school instead of to Uncle Sam. And he has a guaranteed income for life.

If Felix lives 20 more years, the trust will pay him at least $72,600 x 20, or $1,452,000. If the trustee invests the original $1.6 million wisely, it -- and the payments to Felix -- should also increase significantly.

For Smaller Fry: Pooled Income Trusts
Another kind of charitable trust is the pooled income trust, which allows people of more modest means to take advantage of charitable tax deductions, donate to a favorite charity, and receive an income for life. These trusts are discussed in Pooled Charitable Trusts

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