Simple Structured Charitable Gifting Programs

Reprint - International Journal of Business Strategy, Jan, 2007 by Ronald C. Kettering

This study describes and evaluates three types of simple structured gifting strategies over various situations: charitable remainder trusts, charitable lead trusts, and charitable gift annuities. The results suggest that a properly structured gifting program not only provides needed support to charitable organizations, but also provides a source of income for individuals and beneficiaries with potential income, gift, and estate tax benefits.

Keywords: Charitable Lead Trust; Charitable Remainder Trust; Charitable Gift Annuity; CRT; CLT; CGA

1. INTRODUCTION

Financial advisors often suggest to prospective charitable donors that charitable gifts are more than merely giving money to a favorite cause. Donations can be structured in a manner whereby they might also provide present and future financial benefits for donors as well as charitable entities. Donors then achieve not only the satisfaction of sharing with others in need, but also possible financial goals with substantial potential tax savings. A properly structured gifting program can provide a source of income for individuals and beneficiaries along with potential income, gift, and estate tax benefits. Structured gifting programs provide winning situations for society in general.

Unlike direct requests or specific fundraising appeals where cash donations are one-time events, structured gifting programs involve cash, securities, or real estate contributions to various charitable giving vehicles. These simple vehicles typically take the form of either a charitable trust or a charitable gift annuity. Charitable trusts are generally in two forms: a charitable remainder trust or a charitable lead trust. A charitable remainder trust (CRT) is a trust that involves an irrevocable transfer of assets to the trust in accordance with the trust document in exchange for a stream of annual payments for a stated term not to exceed 20 years or for the beneficiary's lifetime. At the end of the trust's term, the charity receives the remainder interest in the property. A charitable lead trust (CLT) is essentially a reverse CRT with similar tax treatment whereby a donor transfers assets to a trust, but the charity receives the income during the donor's life and named beneficiaries receive the CLT's assets at the owner's death. On the other hand, a charitable gift annuity (CGA) is not a trust, but a contract with a charity that also involves an outright transfer of assets in return for a promise to receive a fixed, guaranteed annuity from the charity for the life of the beneficiary or beneficiaries. All three vehicles provide a means for all parties to benefit. Careful consideration must be given to a prospective donor's goals and objectives because there are both taxable and non-taxable consequences. The objective of this study is to examine the typical donor decision process by contrasting these simple gifting strategies and to present general conclusions as to when to use a particular strategy. The study can serve as a useful guide for financial advisors to use when helping prospective charitable donor clients.

2. LITERATURE REVIEW

A review of the literature reveals that very little empirical research has been done on these gifting vehicles. The literature consists of numerous descriptive articles with definitions, advantages, disadvantages, mechanics, and benefits of the three gifting programs [see, for example, Russolillo (1990), Myerberg (1992), and Lepkowski (2000)]. The search did find one empirical study on the topic where Wertlieb (1997) examined the lead trust used by Jacqueline Onassis and presented various alternatives at various assumed interest rates for the transfer of her estate to her grandchildren. He demonstrated that a charitable lead trust provides tremendous generation-skipping transfer tax leverage at a very low cost given the right circumstances.

The American Jobs Creation Act of 2004 and the Pension Protection Act of 2006 have added reporting and substantiation rules that apply to all charitable contributions. Trewin and Curatola (2007) review various changes in the rules of donations of all sorts including the exclusion for taxpayers to make qualified charitable contributions in tax years 2006 and 2007 from traditional or Roth IRAs.

3. DONOR DECISION PROCESS

Figure 1 illustrates a typical decision process that prospective donors face when they are deciding whether to make a donation. The first decision is to determine charitable intent on the part of the donor. Individuals are often told that structured donation strategies should be a part of an individual's over-all financial plan because the tax saving benefits will boost investment returns. If there were no charitable intent, then the prospective donor should look elsewhere because there are far superior investment alternatives available if one did not want to consider allowable donation tax benefits. On the other hand, if a donor finds a charitable plan that provides excessive returns, then the strategy may be subject to challenge by the Internal Revenue Service that there is a lack of charitable intent. Wertlieb (1997) documented that the IRS has argued many times that any trust primarily structured and operating to use a Section 664 (c) exemption from income tax for the benefit of the donor is not operating consistently with the requirement that it function exclusively as a charitable trust.

The second decision concerns the tax status of the donor's charitable cause. A tax deduction is allowed if the charity has tax-exempt status. Alternatively, if no tax deduction is desired, then the decision process ends. An individual can then give a donation to any cause that the person feels strongly about with only a concern for possible gift taxes.

Once it is determined that a donor has a charitable intent and desires a tax deduction, the donor must then decide if an annual income stream to the donor or a charitable entity is desired over a defined number of years or lifetime. If the donor wants the income stream coming to either him/her or a beneficiary, then the individual may choose either a charitable remainder trust or a charitable gift annuity as viable simple gift vehicles. Conversely, if an income stream is not desired, the donor can either make an outright donation or allow the charitable entity to get the annual income stream by using a charitable lead trust. Each of the gift vehicles has advantages and disadvantages. The choice often is determined by individual circumstances.

4. STRATEGY BASICS

Charitable trusts are tax-exempt entities created in 1969 under IRC Section 664 to help charities and not-for-profit organizations generate needed revenue for their intended causes. The intention of Congress was to allow taxpayers to reduce estate taxes, eliminate capital gains, get an income tax deduction, and benefit charities. At the same time, the trusts would provide either a remainder interest or an income interest to a charitable organization.

Both charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) are irrevocable trusts that maintain both income beneficiaries and charitable beneficiaries. Even though both are irrevocable, the grantor may change the charitable beneficiaries at any time and even serve as a trustee with full investment control of the assets inside the trust.

There is an income recipient with both CRTs and CLTs; therefore, the income interest format of a trust when established must be defined as either an annuity trust or a unitrust. Both types require a distribution of at least five percent of the trust assets to the income recipient. The difference between the two is when the assets are valued. Under an annuity trust arrangement, the trust pays a fixed percentage of the initial value of the assets each year to the income recipient regardless of investment performance. This arrangement might appeal to donors who may be concerned about market fluctuations. On the other hand, the cumulative effects of inflation can limit this form. The unitrust form requires that a fixed percentage of the annual value of trust assets must be paid to the income recipient. This arrangement might appeal to donors with a longer time horizon who may expect market values to rise over time.

A donor is allowed an income tax deduction at the time a CRT is established. The amount of the deduction is equal to the present value of the remainder interest to the charity. Unlike a CRT, not all lead trusts entitle a donor to an income tax deduction at the time the CLT is established. A grantor lead trust entitles a donor to a one-time charitable income tax deduction equal to the present value of the income stream that will be paid to the charity. All income earned in the trust in subsequent years will be taxable to the donor with no charitable deduction. A nongrantor lead trust does not entitle a donor to an income tax deduction. All income earned each year is taxable to the trust, but the obligation is offset by the distributions made to charity. These designations are determined when the trust is established.

A charitable gift annuity (CGA) is not a trust and unlike commercial annuities offered by insurance companies, CGAs are directly offered by various charitable organizations. They are very simple and have been used for many years. The donor enters into a contract with a charity, in return for a donation of cash or other assets, to receive a fixed annuity for life. The payments are fixed and will not increase or decrease, regardless of economic conditions. The charity is contractually obligated to make the payments, even if it must reach into its general funds to do so. These contracts became very popular in the early 2000s when interest rates were very low resulting in CGAs being viable alternatives to fixed-income investments. Most charities use the gift annuity rates offered by the American Council on Gift annuities to determine the size of the annuity payments. The gift annuity rates are lower than those used by insurance companies to purchasers of commercial annuities so that a major portion of a donation will be available for charitable purposes.

As with CRTs and grantor CLTs, a charitable deduction for a portion of the original gift is allowed at the time a CGA is established. The deduction is equal to the value of the donated assets less the present value of the payments that will be made to the donor or beneficiary during a lifetime. IRS tables, amounts contributed, and gift annuity rates determine the present value of these payments. In addition, part of each payment will be tax-free until the life expectancy of the beneficiary is reached and then the entire amount of each payment will be considered ordinary income. The charity will send a Form 1099-R to the annuitant each year. Many charities offer CGAs. A potential downside of CGAs is that the payments are only as strong as the charitable organization.

5. STRATEGY EVALUATION

The decision as to which strategy to use in any given situation is the final decision that a donor must make in the decision process. Each of the strategies could be selected for all situations and both the donor and the charity will benefit, but most situations generally present a best choice alternative. The CRT and the CGA are similar in that the donor gets an income stream and the charity gets the remainder interest, hence, a donor will often have two best alternatives. The CRT and the CLT are also similar in that both are trusts and both must take either an annuity form or a unitrust form. The donor, usually with a recommendation from a financial advisor, must select the appropriate donation vehicle once it is decided to use a structured program instead of merely making a direct contribution to a particular cause.

If one of the trusts, CRT or CLT, is used, the donor must decide either annuity form or unitrust form and it is typically a choice where there are no losers. The annuity form locks the income recipient into a fixed income amount each and every year without any worry about possible market fluctuations. On the other hand, during periods of inflation, the income recipient side of the annuity trust suffers, so the unitrust form would be a better choice for the income recipient. The remainder side of the trust generally gets the opposite effect. The donor makes the choice regardless of the type of trust and since there is no real preferred method of the two, the situations evaluated will simply suggest CRT or CLT.

Table 1 summarizes the results of this research over various situations commonly encountered by a typical prospective donor as to the selection of the appropriate charitable vehicle.

The obvious first situation is whether the donor wants to receive a stream of income from donated assets and if so, either a CRT or CGA would have to be used. The donor gets a deduction for the contribution and the assets given are removed from the donor's estate. If the donor does not need or want a stream of income, then a CLT would be used. The assets are removed from the donor's estate and the charity benefits from the income over the trust's life. The property is then transferred at the end of the charitable term to the donor's beneficiaries, hopefully at a value greater than the value of the trust when funded.

Donors often contribute non-cash assets usually in the form of securities or real property. As long as the cost-basis of the non-cash assets approximates the FMV of the assets, then all three vehicles would be suitable strategies depending on the donor's preference as to income/remainder recipient. The vehicles are valuable tools when the cost-basis and FMV are different. When a donor has appreciated assets with a low cost-basis, then either the CRT or CGA allow the donor to remove the assets from the donor's estate at the FMV with a charitable deduction and no immediate capital gains obligations. The technique works best for older individuals who find themselves in a position of holding low yielding, highly appreciated assets and wanting more current income. When a donor has assets with a FMV lower than the cost-basis, then a CLT allows these assets to be removed from the donor's estate with a current or yearly charitable deduction, depending on whether the CLT is a grantor or nongrantor trust. The low FMV of the assets then will have the life of the CLT to appreciate when the property will be transferred to the beneficiary, while at the same time, providing an income stream to the charity.

Expenses should be included in the decision process. Trusts are more expensive to set up and administer; therefore, the cheapest vehicle is a CGA. The simplicity and standardization of CGAs allow charities to set up CGAs in a streamlined fashion with very little cost and no cost to the donor. All three vehicles offer various levels of flexibility, but trusts can be individually designed to a donor's desires. CGAs allow some flexibility as to how a donor receives payments and whether to include a spouse.

CGAs offered by large charities would be viewed as safer than most trusts. CGAs are contracts that are backed by the charity. The advantage of a CGA is that the charity must pay the annuitant even if he/she outlives his/her actuarial life. Some charities reinsure their gift annuities to ensure that they can meet obligations to donors. On the other hand, CGAs offered by some smaller charities would be far riskier than trusts. The returns of CGAs are known and certain when the CGA is made. Trusts, with their unitrust form allow returns to be higher because the assets are revalued each year, but also lower.

6. CONCLUSION

The facts, circumstances, and donor preferences must be thoroughly analyzed with each situation to determine which arrangement will provide the best outcome. There are no losers since one entity is the donor and the other is the charity.

The benefits offered by all three vehicles analyzed in this study are apparent. Each is an effective tool for charities to attract donor contributions. The vehicles are often combined with other strategies such as purchasing life insurance outside of a donor's estate to replace assets given to a CRT. The first step in the decision process implied charitable intent on the part of the donor. This study demonstrates that the simple vehicles evaluated in this study present a compelling argument for their use, even if there were no intent.

REFERENCES

• Lepkowski, Sonja, "Charitable Remainder Annuity Trust or Charitable Gift Annuity", The CPA Journal, Vol. 70 (1), 2000, 60-61.
• Myerberg, Neal P., "Advantages of Planned Giving", The CPA Journal, Vol. 62 (9), 1992, 26-32.
• Russolillo, Raymond G., "The Charitable Remainder Trust--A Three-Way Tax Winner", The CPA Journal, Vol. 60 (10), 1990, 84-86.
• Trewin, Janet, and Curatola, Anthony P., "Charitable Contributions by Individuals and the Pension Protection Act", Strategic Finance, Vol. 88 (10), 2007, 14-16, 61.
• Wertlieb, Frederick J., "Generation-Skipping Transfer Tax Planning and the Charitable Lead Trust", Journal of the American Society of CLU & ChFC, Vol. 51 (2), 1997, 70-77.
• Ronald C. Kettering, Columbus State University, Columbus, Georgia, USA

AUTHOR PROFILE

Ronald C. Kettering earned his D.B.A. at Louisiana Tech University in 1977. Currently he is a professor of accounting at Columbus State University in Columbus, Georgia

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Copyright (c) 2007 International Academy of Business and Economics

Copyright (c) 2008 Gale, Cengage Learning

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