Charitable contributions play a crucial role in addressing important needs within our communities, and the U.S. tax code recognizes their value by providing various incentives. By understanding tax strategies related to charitable giving, individuals can maximize their impact while also receiving significant tax advantages. This article will discuss some lesser-known aspects of direct charitable giving and common charitable planning strategies using trusts.

Qualified Charitable Distribution (QCD)

A QCD is a direct contribution from a taxpayer’s IRA to a qualified public charity. A properly structured QCD can be counted toward satisfying a taxpayer’s required minimum distribution (RMD) for the year while avoiding recognition of taxable income. Excluding a QCD from taxable income may reduce the negative impact on certain tax credits and deductions limited by adjusted gross income, including Social Security and Medicare. Lastly, QCDs don't require a taxpayer to itemize deductions, which can be useful in the current environment of higher standard deductions.

Who can make a QCD?

An individual taxpayer who has reached age 70 ½ can make a QCD from an IRA in an amount of up to $100,000 per year. However, QCDs are limited to the amount that would have otherwise been taxable as ordinary income. In order to benefit in any given year, the QCD must come out of the IRA by the annual RMD deadline, which is typically Dec. 31.

Please note that not all charities are qualified recipients of a QCD. The charity must be a qualified 501(c)(3) public charity. This means private foundations, donor-advised funds, and supporting organizations do not qualify.

Income Tax Planning via Charitable Donations Reported on Schedule A

The Internal Revenue Code Section 170(c) is more generous in terms of deductions for contributions made to an organization treated as a Public Charity (PC) than those made to one treated as a Private Nonoperating Foundation (PF), although both types of organizations are 501(c)(3)s. The policy reason for this is that a PC receives substantial support from the public to carry out its mission; examples include national community foundations, schools, and even hospitals. 

PFs, conversely, are almost always NOT considered publicly supported as they usually are funded primarily by a few generous donors. A family foundation is a common example of a PF. You can verify whether an organization is a PC or a PF on the IRS website.

Cash donations (made by check, debit card, or credit card) to a PC, a donor-advised fund, or a private operating foundation are limited to 60% of the donor’s adjusted gross income (AGI) [Section 170(b)(1)(G)]. Under current law, the 60% limitation will be reduced to 50% as of Jan. 1, 2026. Cash donations made to any other type of charity (including most PFs) are limited to 30% of the donor’s AGI [Section 170(b)(1)(B)]. In both cases, any excess can be carried over for five years.

On the other hand, noncash donations (i.e., donations of property) depend generally on the type of property donated.

Ordinary income property (e.g., property held for less than one year) would result in a deduction limited to the lesser of: donor’s tax basis in the property; the property’s fair market value; or 50% (30% if to a PF) of the donor’s AGI, reduced by their cash contribution.

Donations of property that are not ordinary income property are generally measured as the fair market value (FMV) of the donated property (net of the FMV of anything received in return) and are limited to:

• 30% of the donor's AGI in the case of a donation to a PC, and
• 20% in the case of a PF

Any excess contribution will be subject to the same five-year carryover mentioned above.

In certain cases, the 30% limitation can be increased to 50% where the donor elects to decrease the net donation made by the amount of the property's FMV that exceeds its adjusted basis (built-in gain). This essentially reduces the donation to the property’s basis (further reduced, of course, by the FMV of anything received in return).

Income tax deductions are also prioritized by character. Imagine a cylinder filled with water and the lines represent the AGI limitations:

• CASH gifts to public charities are SAND and fill the cylinder first, regardless of timing [IRC Sec. 170(a)]
• CASH GIFTS to private foundations are WATER [IRC Sec. 170(b)(1)(B)], which will rise above the sand regardless of timing
• NON-CASH GIFTS to public charities are OIL [IRC Sec. 170(b)(1)(C)], which will float to above the water. Exception: property qualifying under IRC Sec. 170(e)(1)(B) (property deducted at cost basis rather than FMV)
• NON-CASH GIFTS to private foundations are PING PONG BALLS [IRC Sec. 170(b)(1)(D)], which will float on the oil, regardless of timing
  

If a taxpayer makes cash donations to public charities in the amount equal to 40% of their AGI and makes noncash donations in the same tax year, the cash gifts will crowd out the noncash gifts and the taxpayer will receive no additional tax benefit that tax year.

Planning with Charitable Trusts

A charitable trust is an irrevocable trust established for tax planning and charitable purposes. A transfer to a charitable trust removes some or all of the assets from the grantor’s taxable estate for estate tax purposes. One of the beneficiaries must be a qualified 501(c)(3) charitable organization.

A “Split Interest Trust” divides the beneficial interests between an income interest – the right to receive the income from the trust for a fixed period of time – and a remainder interest – the right to receive the remaining assets at the end of the income term.

There are two main kinds of charitable trusts: a Charitable Lead Trust and a Charitable Remainder Trust. High net worth individuals often use Split Interest Trusts to transfer wealth to heirs in a gift tax efficient way while also serving a charitable mission.

In a Charitable Lead Trust (CLT) the income interest goes to a named charity for a fixed period of time and when the trust term expires, the remainder interest is distributed to a noncharitable beneficiary. In a Charitable Lead Annuity Trust (CLAT) the income beneficiary receives a fixed dollar amount which is established at the inception of the trust. This is most often represented as a percentage of initial contribution. In a Charitable Lead Unitrust (CLUT) the income beneficiary receives a percentage of the value calculated as of a specific date, and there is a variable benefit.

Split Interest Trusts rely on the time value of money to be a successful strategy, and CLTs tend to work best as an estate planning tool in a low interest rate environment. The lower the interest rate, the smaller the amount that must be paid to the charities leaving more value in the trust at the end of the term for the taxpayer/spouse/descendants.

For example, if the assumed growth rate per the IRS is 1% and the taxpayer expects the trust assets to grow at an annual rate of 4%, the taxpayer gets a significant charitable deduction but retains the majority of the growth for noncharitable beneficiaries:

What assets should be used?

• High basis assets such as cash
• Assets with high potential for growth over time
• Assets that are considered grossly undervalued

Tax reporting for CLTs

CLTs file two tax returns:

• Form 1041 – due 4/15, extension with form 7004, deadline is 9/30, electronic filing both.
• Form 5227 – due 4/15, subject to public inspection, extension with form 8868, deadline is 10/15, electronic filing became available for 2023. A Form 709 will likely be required for the year of funding.

In a grantor CLT, the donor or donor’s spouse is usually the remainder beneficiary. The income can be included on the grantor’s income tax return (even though there is an annual payment made to the charity). The donor gets an immediate tax deduction (subject to AGI 30% limitation) for the present value of the future payments to the charity and the donor reports all the trust income on her 1040. For a grantor CLT, no gift return is needed unless there are other gifts being reported. Many CLTs are designed to avoid gift tax.

In a non-grantor CLT, the grantor’s descendants (or other noncharitable beneficiaries) are the remainder beneficiaries. No income tax charitable deduction is allowed to the grantor at funding, as income would no longer be taxable to the grantor on his personal tax return. However, the taxpayer does receive a gift tax charitable deduction for the portion attributable to the charitable beneficiary. A non-grantor CLT reports income and takes the charitable deduction on Form 1041. If income does not exceed the payments made to the charity in that year, the CLT will not owe income taxes. An income-producing property may be a good choice for a non-grantor CLT. A non-grantor CLT can also be used to make a deductible contribution to a foreign charity which could not be done as an individual.

For a non-grantor CLT, the taxable gift is reduced by the present value (PV) of the payments to the charity over the term of the CLT. Most CLTs are set up so that the PV of the payments equals the amount gifted to the trust. This is known as a zeroed-out CLAT (similar to a grantor retained annuity trust except the payments go to charity rather than to the grantor). For a non-grantor CLT, you should report the transfer of both the remainder interest (no annual exclusion available since it is not a present interest) and charitable interests.

A Charitable Remainder Trust (CRT) is a tax-exempt entity and provides an annual income to one or more noncharitable beneficiaries for a term of years or for life. The remainder interest in the trust passes to one or more charitable organizations.

The grantor of an inter vivos (i.e., lifetime) CRT can receive an income tax charitable deduction in the year property is contributed to the trust. If this is funded with cash, the donor can deduct up to 60% of AGI. If appreciated assets are given, up to 30% of AGI may be deducted with a carryover period up to five additional years. The deduction is equal to the present value of the remainder interest that will ultimately pass to charity. There may be a taxable gift at the time of the trust funding. The value of the gift is calculated using the PV of the future income payments.

When a CRT is set up during a person’s lifetime, the assets are removed from the donor’s estate. For a fixed period, either the donor or their heirs receive annual payments for the rest of their lives (as income beneficiaries). The remainder is then transferred to the charity as the remainder beneficiary.

CRTs are often funded with highly appreciated assets as they defer income taxes. Assets are transferred to the CRT - then the sale takes place inside the trust (no tax on the sale). Gains are deferred and paid to the beneficiary through distributions on a K-1 over the term of the trust. Examples include appreciated securities, real estate, art, or business interests.

CRTs must meet certain statutory requirements from IRC Sec 664(d)(1) including: a fixed amount or percentage of the value of the trust is paid annually to the noncharitable beneficiary. The payment must be at least 5% and no more than 50% of the fair market value of the trust property.

All noncharitable beneficiaries must be living when the property is transferred to the trust. The payment must be made for a term of years (not to exceed 20) or for the life (lives) of the designated living beneficiary(ies). The payments can be in the form of a joint and survivor annuity.

CRAT vs. CRUT

A CRAT payment amount is fixed, while a CRUT payment will fluctuate from year to year since it is based upon the FMV of the assets as of a certain date. In a short tax year, unitrust payments would be prorated based upon the number of days in the short year as compared to the total number of days in the full taxable year. Payment of distribution to the beneficiary should be made by year end or “within a reasonable period of time after the end of the year” – this is loosely defined by the IRS.

Charitable transfers into a CRT at death produce an estate tax deduction rather than an income tax deduction to the decedent.

The trust must include provisions that prevent it from violating certain private foundation rules such as engaging in acts of self-dealing; it cannot make taxable expenditures for noncharitable purposes. The value of the remainder interest passing to the charity must be at least 10% of the initial FMV of all property for the CRT. Except for the payments to the noncharitable beneficiary, the trust can only make payments to the qualified charitable organization (i.e., no one has the power to invade, alter, or amend the trust). When the income interest terminates, the remaining trust assets must be paid to one or more qualified charities.

CRUTs (but not CRATs) are allowed to make additional contributions, so the value passing to the charity must be 10% of the value of contributed property as of the date of each contribution.

Types of CRUTs:

• STAN CRUT – (Standard CRUT) fixed % of trust assets paid to the beneficiary.
• NICRUT – pays the lesser of trust accounting income or the fixed % without a make-up provision.
• NIMCRUT – pays the lesser of trust accounting income or fixed % with a make-up provision.
• FLIP-CRUT – the conversion of an income exception method (b or c) to a Standard CRUT.
  

Tax Reporting for CRTs

CRTs are generally tax-exempt trusts (except to the extent unrelated business income tax applies). However, the distributions from CRTs to the noncharitable beneficiaries are NOT tax-exempt. Noncharitable beneficiaries receive a K-1.

• Form 5227 – due 4/15, subject to public inspection, extension with form 8868, deadline is 10/15 and electronic filing available for 2023. The first-time filing of a 5227 needs to include a certified copy of the trust agreement.
• Form 709 – filed when a CRT is funded. Filing a gift tax return is highly recommended, even if the donor/spouse is the income beneficiary, for the purpose of running the statute on the valuation of the asset and providing adequate disclosure.

The gift tax reporting should include details of the transfer such as: a valuation report of an ownership interest in an entity, the present value of the remainder interest, interest rate used, donor’s age, and other relevant factors as outlined in the trust agreement.

Example of a CRUT Gift Description for Form 709

• Transfer of 20,000 units of ABC LLC to XYZ CRUT dated 12/31/2019
• Payout to the taxpayer is 5% of the FMV of the trust’s property as of the first day of each taxable year
• The trust terminates on the date of the death of the survivor of the taxpayer or spouse
• The remainder is payable at that time to 123 Charity
• Based on these factors and an IRC Sec. 7520 rate as of the date of transfer to the CRUT of 2%, the present value of the remainder interest is calculated

Charitable Giving via Complex Trusts

IRC Sec. 642(c) controls the charitable income tax deduction for trusts. The requirements are strict, but the deduction is far more favorable than the deduction permitted under IRC Sec. 170 in that there is no AGI limitation (including for taxable capital gain). In order for a trust to take the income tax deduction under 642(c), the governing instrument must provide for charitable contributions out of income. Tax advisors should be critical of whether a trust or an estate can take a charitable deduction under 642(c), as this usually requires a charity to be part of the beneficiary class.

Estates can deduct income accumulated for charitable distributions, but the charitable beneficiary does not receive a K-1.

In Conclusion

By leveraging deductions, tax credits, and other incentives, individuals can make a positive impact on their communities while optimizing their own financial well-being and that of their beneficiaries. Remember that seeking professional advice is essential to tailor these strategies to a taxpayer’s specific circumstances and to maximize the benefits of charitable contributions.