Charitable Trusts

Taxation Of Charitable Remainder Trusts

IRS Taxation Of Charitable Remainder Trusts

IRS Income Tax Deduction For Principal of Charitable Remainder Trusts

The federal tax deduction you are eligible to receive when you create a charitable remainder trust is computed using a formula created by the IRS. This formula takes a number of variables into account, including how old the owner and income beneficiaries are, the amount of income paid by the trust, and a standard IRS index called the Applicable Federal Rate, or AFR. The older the donor and beneficiaries are, the greater a deduction you can take for setting up the trust. This makes sense, as trusts created by older people will likely pay out less income to beneficiaries and will revert to charitable donations sooner. Also, if the term is for a set number of years rather than the lifetime of the donor or beneficiaries, the deduction will most often be larger.

Immunity from Capital Gains Taxes

Charitable Remainder Trust assets are immune from capital gains taxes. This includes appreciated assets that are donated to the fund. That means that a person may give highly appreciated assets such as stocks, bonds, or real estate, to the trust, and be insulated from ever having to pay capital gains taxes on the profits. Further, the income tax deduction he or she receives will still be based on the final, fully realized value of the asset. This is obviously a substantial benefit, not to be overlooked.

Further, any profits made from capital gains beyond the income paid to the beneficiaries is immune from capital gains tax as well. Thus there is the potential to increase the size of the trust principal (corpus) over time, completely tax free. This can result in higher and higher income from the trust in the case of charitable remainder unitrusts.

Taxes on Income to Income Beneficiaries

For federal taxes, the IRS has set up a system of tiers for taxation rates of income to beneficiaries of charitable remainder trusts (or unitrusts). In general, the trust itself pays no taxes on income it generates, with a few exceptions, such as income generated with leverage (this is regarded as a type of "unrelated business taxable income," or UBTI). The income paid to the beneficiary is taxed in different ways depending on how the income of the trust was made. Distributions from the trust are taxed according to the following tiers:
  • Ordinary income — This is generally interest income, but can also include rent paid on real estate, and sometimes dividends.
  • Capital Gains — Income generated from sale of appreciated assets, such as stocks, bonds, or real estate.
  • Tax-Exempt income — This is income from tax-advantaged investments like tax-free bonds, annuities, and the like.
  • Return of principal (or corpus) — Income taken directly from the principal, or corpus of the trust.
Generally all income from one tier must be reported and exhausted before income from the next tier down can be reported. For example, if your trust generates $10,000 of interest income and $100,000 of tax-free income, and you draw $10,000 from it, you must report all $10,000 as ordinary income on your taxes, even though it's only a small portion of the overall income made by the trust. Thus for planning purposes it's generally best to assume that most of the income you take from the trust will be taxed by the IRS as ordinary income. Note that these tax rules are set forth by Congress and the IRS, and may not apply to your state income taxes. Many states mirror the federal rules, but not all. The different states all have different tax policies, so you will need to look into those policies as well when making decisions regarding these types of trusts.

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