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Tax Benefits of a Charitable Remainder Trust

There is often curiosity surrounding the tax benefits, implications, and motivations behind establishing a charitable remainder trust. In this article, we aim to inform you that there are various avenues available for managing your finances effectively.

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A charitable remainder trust is a tax-exempt irrevocable trust designed to reduce the taxable income of individuals and support charities.

We closely examine charitable remainder trusts to ensure they:

  • Correctly report trust income and distributions to beneficiaries
  • File all required tax documents
  • Follow all applicable tax laws and rules

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How a Charitable Remainder Trust Works

A charitable remainder trust is an arrangement where a person (donor) transfers cash, property, or other assets into an irrevocable trust. The trust's basis in the transferred assets is the same as the basis that it would be in the hands of the donor for assets transferred to the trust during the donor's lifetime. 

The trust pays income to at least one living beneficiary for a specific term of up to 20 years or the lifetime of one or more beneficiaries. When the payment term ends, the remainder of the trust is donated to one or more qualified U.S. charitable organizations. 

The amount donated to charity must be at least 10% of the initial net fair market value of all property placed in the trust. It's important to note that charitable remainder trusts are irrevocable, meaning that assets that go into the trust cannot be taken back.

Charitable remainder trusts can offer many benefits, including:

  • Help you plan major donations to charities you support
  • Provide a predictable income for life or over a specific time period
  • Allow you to defer income taxes on the sale of assets transferred to the trust
  • May allow you a partial charitable deduction based on the value of the charitable interest in the trust.

 

Charitable Remainder Trusts Explanation

There are two main types of charitable remainder trusts, which determine how beneficiaries are paid. These trusts can be established either during the donor's lifetime (inter vivos) or after their death (testamentary)

1. Charitable Remainder Annuity Trusts

A charitable remainder annuity trust (CRAT) provides a fixed dollar amount annually. The amount is determined at least 5% and at most 50% of the value of the corpus (property in the trust) when the trust is initially established.

2. Charitable Remainder Unitrust

A charitable remainder unit trust (CRUT) distributes a portion of the trust's value annually to beneficiaries who are not affiliated with a charity. The annual payments typically range from 5% to 50% of the fair market value of the assets, which are evaluated on an annual basis.

 

About the taxation of charitable remainder trusts

Payments received from a charitable remainder trust are taxable for non-charitable beneficiaries. These payments must be reported to them on Schedule K-1 (Form 1041), which shows the beneficiary's share of income, deductions, and credits. 

The payments made to non-charitable beneficiaries are taxed as distributions of the trust's income and gains. The order of taxation for these payments is as follows:

  1. Ordinary income: Payments are initially treated as ordinary income, taking into account any ordinary income the trust had for the year and undistributed ordinary income from previous years. If the trust's ordinary income is sufficient to cover all payments, the entire payment will be subject to ordinary income tax. Beneficiaries are required to report these payments as ordinary income, as indicated on Schedule K-1.

  2. Capital gains: Once the trust has used up all of its ordinary income, payments are subject to taxation as capital gains, based on the sale or disposal of the trust's capital assets. These payments are taxed as capital gains, up to the amount of capital gain income generated by the trust in the current year and any capital gain income that has not been distributed from previous years.

  3. Other income: Once all ordinary income and capital gains in the trust are fully distributed, payments are characterized as other income to the extent of the trust's current year and accumulated other income. This includes tax-exempt income.

  4. Corpus: After all current-year and accumulated income and gains are fully distributed, payments would lastly be considered corpus or "principal" of the trust not subject to tax.
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Tax Filings for Charitable Remainder Trusts

Each year, Charitable Remainder Trusts are required to submit Form 5227, which is the Split-Interest Trust Information Return. This form:

  • Reports financial activities, including the disposition of the trust's assets
  • Accounts for current-year and accumulated trust income
  • Documents deductions
  • Accounts for and characterizes distributions or payments from the trust
  • Includes as an attachment Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, and Credits, characterizing and reporting payments to each beneficiary
  • Determines if the trust owes excise taxes for prohibited transactions.

Beneficiaries of charitable remainder trusts must report payments received from the trust on their personal income tax returns. This information is reflected on Schedule K-1 (Form 1041), which shows the beneficiary's share of income, deductions, and credits.

You may be interested in Gift Tax Planning and Compliance

 

How we can assist you

At H&CO, our experienced team of tax professionals understands the complexities of income tax preparation and is dedicated to guiding you through the process. With offices in Miami, Coral Gables, Aventura, Tampa, and Fort Lauderdale, our CPAs are readily available to assist you with all your income tax planning and tax preparation needs.

To learn more about our accounting firm services take a look at our individual tax servicesbusiness tax servicesinternational tax servicesexpatriate tax servicesSAP Business Oneentity managementhuman capital, and audit and assurance services.  

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