When it comes to strategic tax planning and management, one of the best ways to mitigate future tax on your investment gains or create tax savings to offset current year tax liability from investment sales or large income realization events such as a Roth conversion or business sale is through philanthropic and charitable giving.
There are many charitable tools available depending on your personal financial circumstances, amount of money you want to give, timing of charitable giving, and last but not least, complexity of implementation.
To rank our most common charitable strategies from simple to complex, they would be:
Qualified Charitable Distributions (QCDs) From Retirement Accounts
Donor Advised Funds (DAFs)
Charitable Trusts (CRTs & CLTs)
The selection of your right charitable giving plan really depend on your age, your charitable intent, your net worth, along with the timing & types of investments that will be used to fund these charitable vehicles.
For some of our clients, using a blended approach of two or more of these tools helps create the optimal lifetime giving plan.
In today's post, we are going to focus on Charitable Trusts.
In determining whether a charitable trust is appropriate for you, the first question to ask is do you actually have charitable intent?
This question might sound silly to ask, but I can't tell you how many people have asked me about charitable giving as a tax savings scheme, but have no actual charitable intent. They may have heard about some "to-good-to-be-true" tax savings trust on the internet from a promoter who is promising that the tax savings will be so substantial that the strategy makes sense whether you have charitable intent or not.
While the tax savings of some of these strategies can be substantial, I have typically found that if you don't have charitable intent, then these strategies could disappoint you as there has to be some amount of your money that goes to charity to make any of them legit.
With that being said, there are some structures in which you can have your cake and eat it too.
What I mean is that if properly structured, some of the money that you would have otherwise paid to the IRS or state income tax agencies via taxes could be redirected to the charities of your choice all while saving yourself money in the meantime.
In many cases it is a win-win!
You win because you have more net after-tax wealth or income than had you done no charitable planning and the charity wins because they get funding to do very important work.
So, if you have charitable intent, the next question is whether you have sold the asset yet or not sold the asset. This essentially boils down to if the income event has occurred yet or not.
If you haven’t sold your assets yet and you’ve got a big gain coming, a Charitable Remainder Unitrust (CRUT) will likely provide the biggest returns.
If you have sold your assets or already received a large amount of ordinary income this year, consider looking more closely at a Charitable Lead Annuity Trust (CLAT).
Before we talk about the different use cases for CRUTs and CLATs, lets go through a quick recap of both structures:
A refresher on how Charitable Remainder Trusts (CRTs) work:
- You gift appreciated assets to the trust and typically receive a charitable deduction of ~10% of the value you gifted to the trust.
- You can seed the trust with nearly any asset — public stock, private/startup equity, real estate, or crypto, for example. You cannot use unexercised incentive stock options - a question I am asked frequently.
- The trust is tax exempt so when you sell the asset, the trust does not pay taxes; this enables you to reinvest and grow the amount that you would otherwise pay in taxes.
- Every year, you are entitled to a distribution of a certain percent of trust assets; you pay taxes only when you receive the distributions.
- Celebrate — You successfully deferred your taxes and were able to reinvest what would have been taxed to keep those assets compounding and working for you. You've also lowered your effective tax rate by smoothing out your income realization over a number of years instead of realizing a massive gain — and taking a massive tax hit in one year.
If you are approaching or in retirement, this strategy could produce a higher retirement income stream for you. For example, if you had a $2,000,000 asset with $1,000,000 of long term capital gains and sold it, after tax you might have around $1,700,000. At a 4% retirement income withdrawal rate, that would produce $68,000 of retirement income.
If you transferred that same $2,000,000 into a CRUT and then sold it, you would still have all $2,000,000 working for you. At a 4% withdrawal rate, that would be $80,000 of pre-tax income back to you. Of course you would owe income tax on a portion of the $80,000, but many times you are still ahead of the game because you are spreading that tax over many years into the future at a lower marginal rate.
As a reminder, at least 10% of your contribution into a CRT must pass on to charity at the expiration of the CRT. CRTs can be established to last a predetermined time period no longer than either 20 years or the life of one or more of the income beneficiaries.
A refresher on how Charitable Lead Annuity Trusts (CLATs) work:
- You gift assets or cash to the trust and get a charitable deduction up to the entire value you donated (enabling you to write off all or nearly all of your taxes).
- You can seed the trust with nearly any asset — public equities, real estate, crypto, or even cash — and reinvest the gains in other assets throughout the term of the trust.
- Every year, the trust donates a predetermined amount to a recognized charity, such as the American Cancer Society, or your own Donor Advised Fund (DAF). You are liable for the taxes on the income generated inside the trust (though we do our best to minimize this tax exposure).
- At the end of the trust's term (a predetermined number of years), the trust gives its largest donation to charity and you receive the majority of the trust assets back assuming certain investment rates of return were achieved. Professional investment management of a CLAT is critical to ensure risk and volatility are managed effectively to match the charitable distributions each year.
- Celebrate — You successfully deferred your taxes and were able to reinvest what would have been taxes to keep those assets compounding and working for you!
Someone might want to consider a combination of a CLAT and Roth Conversions simultaneously. The CLAT can make charitable distributions to your own Donor Advised Fund and that Donor Advised Fund can remain invested and allow for you to make charitable grants at your discretion over your lifetime. The deduction from the CLAT could be used to offset the tax on the Roth conversion, creating tax-free income for you and your family. At the expiration of the CLAT, you could have residual funds from the CLAT passed back to you or your family to support the latter part of your retirement.
Key differences between CRUTs and CLATs:
- CRUT: Best suited for individuals with highly appreciated assets who are aiming to mitigate their tax exposure BEFORE a major liquidity event.
- CLAT: Best suited for individuals who are looking to mitigate tax exposure AFTER a major liquidity event, such as selling start-up equity or crypto portfolio, receiving a cash bonus, or just making a high salary.
- CRUT: You are entitled to a distribution of a set percentage of trust assets every year the trust operates, while the charitable beneficiary receives whatever is left in the trust at the end of the term.
- CLAT: Distributes a set amount to a charitable beneficiary every year and you receive whatever is left in the trust at the end of the term.
- CRUT: You typically receive a charitable deduction equal to ~10% of the value you gift to the trust.
- CLAT: You can receive a charitable deduction up to 100% of the value of assets you gift to the trust.
Tax Exempt Status:
- CRUT: Gains inside the CRUT are tax exempt (outside of a few edge cases).
- CLAT: The trust is not tax exempt and you are taxed on gains inside the trust (though we work with you to minimize those taxes).
When should I use each type of trust?
The biggest question for most clients is when they should use each strategy. The answer, in most cases, depends on one main factor: Is your big win still in the future, or is it in the past?
CRUTs: A good fit for highly appreciated assets you haven't sold yet
Simply put, if you have a large unrealized capital gain and haven't sold your assets yet, you can place those assets into a CRUT to defer and reduce your taxes. This is true for a simple reason: A CRUT is a tax-exempt account much like an IRA. It allows you to delay the taxes you owe on your capital gains — an incredible tool to turbocharge your returns — but it's the CRUT itself that is tax exempt — not you — so that tax benefit applies only if the assets are already in the CRUT when you sell them. Otherwise, you're the one receiving the gains, and you're the one who will be taxed.
CLATs: Well suited for ordinary income and already realized income
If it's too late for a CRUT — say you made a large amount of money this year because you didn't know about the available strategies when you sold your stock, or you exercised some highly appreciated options, received RSUs, or are just paying a high tax rate on your regular income or bonus, you can put those assets into a CLAT, potentially eliminate your tax bill by taking a large deduction now, and reinvesting what you would have paid in taxes.
CRUT common use cases: Highly appreciated assets with unrealized gains
Startup equity. If you hold company stock — whether you received common shares or you've already exercised your options — you can move your shares into a CRUT before you sell them. In the case of an IPO, SPAC, or direct listing, that's simple: You can work with us and an attorney to draft your CRUT and transfer your assets whenever you're ready. If there's a chance your company is going to be acquired in a private transaction, though, time is of the essence: If you sell your shares as part of that deal before moving them into a trust, it is too late to use a CRUT (but you could use a CLAT).
Public company stock, mutual funds or ETFs. This one's a lot like startup equity, but you're more in control of the timing. Get your Tesla, Amazon, Apple or Google shares — or any other post-tax investment that has appreciated significantly since you bought it — into a CRUT, and then you can sell, diversify your portfolio, and defer the (often massive) tax bill you would have otherwise received.
Crypto. If you're holding crypto that's appreciated greatly in value and you haven't sold yet, you can move those assets into a CRUT, make the sale, and pay no taxes today. This gives you more capital to reinvest in the market and compound at a faster rate.
Real Estate. Do you have a home that has appreciated beyond the $250,000 / $500,000 IRS primary home exemption or real estate investments with substantial capital gains. As a tax savings strategy, you could contribute a portion of your real estate to a CRUT prior to the sale. Upon the sale, you would personally realize capital gains for the portion of the home you own as an individual, but the portion owned by the CRUT could be sold income tax free with the proceeds reinvested to compound at a faster rate until you receive them as distributions. This essentially allows you to defer and spread the tax out instead of taking a large income tax hit in a single year.
CLAT common use cases: Ordinary income, assets already sold, and unexercised options
The common thread when it comes to CLATs is that they can save you a huge headache if you are already paying a lot in taxes.
Ordinary income. Ordinary income comes in many forms. A big bonus from your employer is ordinary income. Your salary, of course, qualifies too. If you received a windfall this year and don't want to deal with the resulting tax bill, you can put your income into a CLAT and write off as much as 100% of those taxes.
The key benefit of a CRUT is that you can defer taxes on income you earn inside the trust. However, that move doesn't work for ordinary income, because there's no way to realize the income inside the trust — if you get paid for your work, that income comes to you and a CRUT cannot reduce your taxes on this income.
RSUs: When you receive RSUs from your company, they count as ordinary income, and clients use CLATs to avoid the potential ordinary tax rate of up to 50%.
Assets you've already sold. Another form of income that doesn't qualify for a CRUT is income that you've already realized — that is, income from the sale of an asset that happened in the past. Common scenarios we've seen are:
- Equity: Your company is acquired in a surprise deal or before you have a chance to move your assets into a trust
- Crypto / NFTs: With the massive volatility of Crypto, moves can happen very fast and people have been taking gains opportunistically without much forward planning. In addition, some early Crypto investors who sold as we started to experience this market correction may now have a large tax liability on their gains.
Unexercised options. When you exercise appreciated options you have to pay ordinary income tax rates on the difference between your strike price you were issued the options at and the current fair market value. Clients use CLATs to write-off that ordinary income from their exercise. There are complex rules around incentive stock options and charitable giving that must be navigated appropriately. As a note, you cannot fund a CRT with unexercised incentive stock options.
Fortunately, there's a solution available no matter your timing: If you haven't sold your assets yet and you've got a big gain coming, a CRUT will likely provide the biggest returns. If you have sold your assets or already received a large amount of ordinary income this year, consider looking more closely at a CLAT.
Interested in seeing what structure could work for you? You can respond to this email directly and a member of our team will be in touch, or click here to schedule an introductory meeting with Dave Alison to learn more about how we can help you!
Dave Alison, CFP®, EA, BPC