How a charitable lead trust works
At their most basic level, a charitable lead trust works in the following way: The grantor, or person establishing the charitable lead trust, makes a contribution to fund the trust which is set up to operate for a fixed term such as a set number of years or the life of one or more people. Payments from the trust are disbursed to the selected charity or charities as either a fixed annuity payment or a percentage of the trust, depending on how the trust has been structured. Finally, at the end of the term, the remaining assets are distributed to non-charitable beneficiaries, often family members. Charitable trusts are usually complicated and subject to specific IRS rules, so anyone considering establishing a charitable trust, including a charitable lead trust, should consult with their legal or tax advisor.
1. Make a contribution to fund the trust. Depending on the type of charitable lead trust you select, you may be eligible to take an immediate partial tax deduction with cash contributions. The calculation of the income tax deduction takes into consideration the term of the trust, the projected lead payments, and IRS interest rate that is used to assume a certain rate of growth of trust assets.
Certain assets such as publicly traded stock, real estate, private business interests and private company stock could also be contributed, but come with added considerations about tax treatment and to may need to be sold to ensure enough revenue to fund the trust payments.
2. Payments are sent to the charity. The charitable lead trust provides payments on at least an annual basis to at least one qualified charitable organization for a fixed number of years, the lifespan of one or more individuals, or a combination of the two. Unlike charitable remainder trusts, charitable lead trusts are not held to the same mandatory time limit of 20 years if you select the fixed term option. Also, there is no required minimum or maximum payment to the charitable beneficiaries, so long as payments are made at least annually.
3. After the specified trust term, the remaining charitable lead trust assets are distributed to the designated non-charitable beneficiaries. Once the term of the charitable lead trust ends, the principal is distributed to you or the other designated beneficiaries in a manner that can minimize or even eliminate transfer taxes.
The word “lead” in charitable lead trust refers to a “lead interest” in the trust, which is the charity’s right to receive payments for the trust for the specified term. If established as a charitable lead annuity trust, the charity will receive a specified amount from the trust each year that typically remains the same from year to year. If established as a charitable lead unitrust, the charity will have the right to receive a specified percentage of the trust assets each year, and the precise amount of the payment to the charity can vary from year to year accordingly. The choice of annuity vs. unitrust payments may have implications for the value of the remaining assets at the end of the trust term.
There are two overall types of charitable lead trust that affect its tax treatment—grantor and non-grantor trusts. Tax planning and other goals of the individual establishing the trust should guide the choice between these categories, as each provides distinct advantages and possible drawbacks.
Grantor charitable lead trust: In a grantor charitable lead trust, the grantor can take an immediate income tax charitable deduction for the present value of the future payments that will be made to the charitable beneficiary, subject to applicable deduction limitations depending on whether the beneficiary is a public charity or a private foundation. However, this benefit should be considered in conjunction with the fact that the trust's investment income is taxable to the grantor during the trust's term.
Non-grantor charitable lead trust: With non-grantor charitable lead trust, the trust—and not the grantor—is considered the owner of the trust assets. Accordingly, the grantor is not eligible to take an income tax deduction for the present value of the lead interest to charity. It is the trust itself that pays tax on its undistributed net income, and the trust is able to claim an unlimited income tax charitable deduction for its distributions to the charitable beneficiary. However, this trust structure offers greater benefits for transfer tax purposes.
Notably, both grantor and non-grantor trusts can be structured to be “reversionary,” meaning that the remainder assets revert to the individual(s) establishing the trust or “non-reversionary,” meaning that the remainder assets will be distributed to a beneficiary other than the originators. These choices will have additional impact on tax treatment.