What it means
The order of payments is what distinguishes this structure. The individual receives the income first, for life or for a term of up to 20 years, and the charity receives whatever is left at the end.
The typical candidate holds an asset that has risen sharply in value but produces little income, such as founder shares or a long held rental property. Selling directly triggers capital gains tax on the whole gain, whereas the trust, being tax exempt, can sell and reinvest the full proceeds.
Two forms are used. A charitable remainder annuity trust pays a fixed dollar amount each year, while a unitrust pays a set percentage of the assets revalued annually, so payments move up and down with the portfolio.
The upfront deduction is the present value of what the charity is projected to receive, not the amount contributed. Rules generally require that projected remainder to be at least 10% of the funding value, which puts a ceiling on how much income the donor can take.
The main drawback is that the decision is effectively irrevocable. Payments to the recipient are also taxable as they arrive, under ordering rules that push the most heavily taxed categories of income out of the trust first.
In practice
Real-world examples.
Example
A retiring dentist owns a surgery building bought for $150,000 that is now worth $900,000. She funds a unitrust paying 5%, receives $45,000 in the first year, and the building is sold inside the trust without an immediate capital gains bill.
Example
A founder transfers $2,000,000 of company shares into a remainder trust well before a sale is agreed. Timing matters: had the sale already been contractually arranged, the gain would have been attributed back to him despite the transfer.
Example
A couple funds a $500,000 annuity trust paying 6%, that is $30,000 a year for life, with a university as the remainder beneficiary. The fixed payment suits them because they want certainty rather than payments that fall in a weak market.
Formula
Calculation
Annuity factor = (1 - (1 + r)^-n) / r
Present value of payments to the income beneficiary = annual payment x annuity factor
Charitable deduction = amount contributed - present value of those payments
A donor transfers shares worth $1,000,000, originally bought for $200,000, into a 15 year charitable remainder annuity trust paying 5% a year, that is $50,000, with a prescribed discount rate of 4%.
The annuity factor is (1 - 1.04^-15) / 0.04 = 11.1184, so the present value of the donor's income stream is $50,000 x 11.1184 = $555,920. The charitable deduction is $1,000,000 - $555,920 = $444,080, worth $444,080 x 0.35 = $155,428 of tax saved at a 35% marginal rate.
Compare that with an outright sale. Selling the shares would have taxed the $1,000,000 - $200,000 = $800,000 gain at, say, 20%, costing $160,000 and leaving $840,000 to reinvest, whereas the trust keeps the full $1,000,000 working and still pays the donor 15 x $50,000 = $750,000 over the term.Case study
Seen in the real world.
This is an illustrative and fictional scenario. Vera Colcannon, an invented retiring engineer, held listed shares worth $1,500,000 that she had bought for $300,000. She wanted income, disliked the tax bill an outright sale would create, and intended to leave money to a research charity in any case.
She funded a 20 year charitable remainder annuity trust paying 5%, that is $75,000 a year. With a prescribed discount rate of 4% the annuity factor was (1 - 1.04^-20) / 0.04 = 13.59, so the present value of her payments was $75,000 x 13.59 = $1,019,250 and the charitable deduction was $1,500,000 - $1,019,250 = $480,750. That remainder was 32% of the funding value, comfortably above the 10% minimum, and the deduction saved $480,750 x 0.35 = $168,262.50 at her marginal rate.
Over the full term she expected to receive 20 x $75,000 = $1,500,000, the same figure she put in, with the charity taking whatever the portfolio had grown to beyond that. The fictional trade off was clear to her from the start: she gave up the ability to change her mind, and in exchange she kept the whole $1,500,000 invested instead of the $1,260,000 an immediate sale at a 20% rate would have left her.
Watch out
Common mistakes.
- Believing the capital gains tax disappears entirely, when much of it resurfaces gradually in the tax treatment of the payments received.
- Transferring an asset after a sale has already been agreed, which causes the gain to be taxed to the donor anyway.
- Setting the payout rate so high that the projected remainder falls below the 10% minimum and the trust fails to qualify.
Questions
People also ask.
How is the charitable deduction calculated?
It is the amount contributed minus the present value of the payments the income beneficiary is expected to receive, using a prescribed discount rate.
Can the trust be cancelled if circumstances change?
No, it is effectively irrevocable, which is why the decision should assume the income stream and the charitable remainder are both permanent.
What is the difference between an annuity trust and a unitrust?
An annuity trust pays a fixed dollar amount each year, while a unitrust pays a percentage of the assets revalued annually, so payments vary with investment performance.
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