By Sara Bailey and Kathryn Garrison for TCAJOB

Estate planning is never an easy topic to discuss, and incorporating taxes into the picture makes it an even less appealing topic.

Sara Bailey,

However, everyone should have an estate plan—even if it’s just a simple will. Those with large and complex estate and gift tax issues will need to spend more time and effort to ensure their estate plan reflects their desired legacy.

Many individuals already know what assets they’d like to transition to heirs and what they’d like to gift to charity, but haven’t thought about the most tax-efficient ways to structure these gifts and transitions. With the 2016 federal estate tax exemption amount at $5.45 million and the Washington state exemption at $2.079 million, reducing the assets included in your estate at death can greatly decrease the estate taxes owed.

Charitable trusts can provide an efficient tool for reducing taxable estate assets. They are particularly useful for individuals with large estates containing assets that are expected to appreciate (e.g. stocks) or that produce an income stream (e.g. rental real estate). Charitable lead trusts, or CLT, and charitable remainder trusts, or CRT, are two types that may reduce your estate tax liability while transitioning assets to your heirs—and accomplishing your charitable goals.

CLTs are established with a specified trust term and funded with a donor’s assets. When you transfer the assets to the trust, the grantor receives a charitable deduction based on the value of the income stream going to charity, discounted at the monthly Section 7520 interest rate (2.17 percent for January 2016). The current low-interest rate environment is favorable for charitable lead trusts because the discounted value of that income stream going to the charity – and your charitable deduction – can be quite large.

The taxable gift to your heirs is calculated by subtracting that charitable deduction from the amount contributed to the trust. The lower the Section 7520 interest rate, the larger the charitable deduction to the donor - and the smaller the remainder gift to heirs at the end of the trust term. It’s possible to set the trust up such that the value of the income stream going to charity is equal to the current fair market value of the gift, so the gift to heirs is effectively $0 for estate and gift tax purposes.

Kathryn Garrison,

As an example, assume you have a $3 million retail building that will likely appreciate significantly over the next 20 years while producing annual rental income. If you fund a CLT with that building, the annual income goes to charity. At the end of the 20-year term, the building itself goes to your heirs. If the value of the income stream going to charity equals the fair market value of the building, the charitable gift will completely offset the gift to your heirs. The gift at the end of the trust term is effectively $0 for estate and gift tax purposes.

Another type of CLT is a grantor trust. The difference here is that the assets you donate to the trust are returned to you, the grantor (instead of a beneficiary), at the end of the trust term. You may receive an up-front income tax deduction for the value of the income stream going to charity- but you will also pay tax on the income the trust earns each year. However, if the trust is invested in municipal bonds, that income is not taxable for federal tax purposes.

Let’s say you want to make a gift to a charity of $20,000 a year for 5 years. You contribute municipal bonds to a grantor lead trust. The bond income goes to charity for the term of the trust, you receive a charitable deduction for the present value of that income stream, and the bonds are returned to you at the end of the trust term.

CRTs are a useful tool if you want to make a charitable gift but need to provide an income stream to yourself or a beneficiary for a period of time. CRTs are established for a specified term and generally funded with appreciated assets. Once the trust is funded, the assets can be sold and reinvested, with no capital gains tax paid at the date of sale. As the donor, you may receive a tax deduction for the value of the gift to charity, and the remainder of the asset at the end of the trust term is excluded from your estate.

CRTs can be designed to provide either you or a designated beneficiary with income—which is paid out at least annually—over the term of the trust. The distributions are subject to tax so you haven’t avoided the taxes; you have deferred them out over the trust term. This allows the full proceeds from the asset sale to be reinvested so they can grow inside the CRT.

For example, assume you want to diversify $2 million of stock you originally purchased for $1 million. If you sell all the stock outright, you’re subject to $238,000 of capital gains and net investment income taxes. If you instead fund a CRT with the stock, then sell it within the trust, there’s no taxable gain at the date of sale. The entire $2 million can be reinvested in a diversified portfolio, deferring the tax over the trust term. Annual distributions to beneficiaries are taxable in the year received, and any number of individuals can be beneficiaries—an aging family member, a child in college, or you. Once the trust term ends, the remainder goes to charity.

The strategies involved in planning, setting up, and administering charitable trusts are complex, so work with an experienced attorney and CPA. The up-front planning can be daunting, but with the right team behind you, you can meet your charitable goals and transfer your assets while creating significant tax savings along the way.

[panel title="About Sara Bailey and Kathryn Garrison" style="info"]

Sara Bailey works closely with business owners and management on complex compliance and tax planning services and helps develop transition plans for closely-held businesses. She can be reached at 509-834-2463 or sara.bailey@mossadams.com.

Kathryn Garrison advises executives and high net worth individuals in the creation of highly personalized financial plans and comprehensive wealth strategies. She can be reached at 206-302-6752 or kathryn.garrison@mossadams.com.