By Bart L. Fooden, CFP, CPA

A charitable lead trust is created when an individual makes a gift to a trust that makes annual payments to charity for the term of the trust. The gifts to charity can be computed either on an annuity (based on the initial fair market value of trust property) or unitrust basis (as a percentage of the annual fair market value of trust property). At the end of the trust term, the property reverts to either the grantor or to another named noncharitable beneficiary.

Whether the grantor or nongrantor form of charitable lead trust is appropriate depends upon the objectives and personal financial situation of the client. The use of a charitable lead trust can provide significant income or estate planning opportunities while helping the client satisfy charitable giving desires.

The grantor-type trust is the more common type of charitable lead trust because it provides the grantor with a charitable deduction for income tax purposes when the trust is initially funded. The deduction is equivalent to the present value of the expected payments to a charitable organization during the trust term. During the term of the trust, the grantor is taxed on the income earned in the trust. At the end of the trust term, the trust property reverts to either the grantor or to another named beneficiary. If the grantor dies during the term of the trust, the property can be included in the grantor’s estate. If the grantor survives the trust and the property passes to someone other than the grantor at the end of the trust, a taxable gift of the trust property at its fair market value is made at that time.

The planner should consider a nongrantor charitable lead trust if the initial charitable deduction for income tax purposes is not the primary concern and the grantor wants to reduce the taxable estate for estate tax purposes. The grantor makes a gift to the trust, which is a taxable transfer at the time the trust is funded. The value of the gift for tax purposes is the present value of the eventual transfer of the property to a noncharitable beneficiary at the end of the trust term. Although no charitable income tax deduction is provided, the grantor has made a transfer of property at a significantly discounted value, and if the grantor should die during the trust, the property and any appreciation in the property during the term of the trust are out of the grantor’s estate.

However, the nongrantor charitable lead trust has potential income tax disadvantages. The trade-off for the absence of a charitable deduction is the discount in the value of the gift to the trust. But, the income earned by the trust is taxable at fiduciary income tax rates, which reach the highest tax brackets at relatively very low levels of taxable income. The taxpayer can use the same investment strategies in a grantor-type trust where the individual grantor is in a high tax bracket.

Educational or Medical Gifts

The educational and medical exclusions are methods for transferring substantial amounts of money without incurring a gift tax liability or utilizing the annual exclusion or unified credit of which many taxpayers may not be aware.

Tuition paid directly to a qualified domestic or foreign educational organization for the education or training of another individual does not constitute a taxable transfer under the Gift Tax Law [IRC section 2503(e)].

A qualifying educational organization is an organization described in IRC section 170(b)(1)(A)(ii), relating to charitable institutions, defined as “an educational organization which maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.”

The nontaxable transfer covers only tuition, not books, room and board, miscellaneous fees, supplies or similar expenses that are not direct tuition costs. Any nontuition payments would be treated as a taxable gift, which may be offset by the annual exclusion or unified credit. There is no limit on the amount of excludable tuition or the number or relationship of individuals benefited by the exclusion.

The tuition exclusion presents a planning opportunity for families to transfer wealth from one generation to another. A grandparent may pay the college tuition for her grandchildren and exclude all the tuition paid from the transfer tax computation. The tuition can be for undergraduate studies, graduate school, and postgraduate education at qualified institutions. The transferor must pay the tuition directly to the educational organization.

A similar exclusion is available for medical expenses paid on behalf of another individual. The medical care payment must meet the requirements of IRC section 213(d), the definition of medical care for income tax deduction purposes, and includes medical insurance paid on behalf of another. The payment must be made directly to the care provider.