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Uncle Sam Or Orphan Annie

Where do you want your money to go?

The long-lasting bull market has helped send the values of many entrepreneurs' portfolios soaring. If you're one of the lucky ones who's experienced a boost in investment holdings, you may be thinking of donating some of the proceeds to charity. But selling the stock could result in the payment of substantial capital gains taxes, which means you'll be left with less to donate.

There's a way, however, to convert the stock or property to cash for charity without incurring those taxes. It's called a charitable remainder trust (CRT), and it can benefit both the owner of the assets and the charitable organization designated to receive the assets.

Here's how it works: The owner of the stock transfers the assets he or she wants to donate to the trust, which then sells the assets without having to pay capital gains taxes. After the stock is sold, the assets can be reinvested by the trust, and the donor will receive a steady stream of trust income. In some situations, the individual setting up the CRT can be a trustee and direct investment decisions. Once the donor dies or after a specified period of time, the remaining assets are distributed to the charity.

The term of the trust can be set for the life of the individual or a fixed term not to exceed 20 years. In addition to eliminating capital gains taxes on the investment holdings, a CRT helps reduce the donor's income and estate taxes.

How? After the trust is established, the donor receives a current income tax deduction for the future value of the gift. It's also possible to carry the deduction forward for five years as long as your deduction exceeds your annual gross income. As an added benefit, federal and state taxes due on your estate upon your death are lowered because the assets donated have helped reduce the total value of the estate.

Take the example of a 45-year-old individual who is ready to establish a CRT with $1 million in assets. She decides to use an annuity-type CRT that will provide her with a stream of income every year. The annual sum she will receive is set at 7 percent of the initial fair market value of the trust, which means that for the next 20 years, she receives annual payments of $70,000.

The income she receives from the CRT is subject to income taxes. The type of tax paid depends on the type of income the CRT generates, says Andrew Robbins, a director at PricewaterhouseCoopers. Ordinary income comes out first, followed by capital gains, then tax-exempt income, followed by return of principal.

When the trust is established, the individual is able to claim a current income tax deduction for the remaining funds left in the trust at the end of the 20-year term--in this case, about $270,000. She has avoided paying capital gains taxes on the sale of the holdings and has received a sizable tax deduction.

Keep in mind there are some tradeoffs to establishing a CRT. One of the biggest: "You're losing control over the [amount you put] in the trust because all you get out of the trust is an income interest," says Robbins.

But there are advantages as well, notes Robbins. "[The donor] is likely to get a higher rate of return on her assets inside the CRT than she would have gotten outside the CRT because she's not paying income taxes on the whole amount," he says. And depending on the type of CRT established, the beneficiary might participate in additional returns.

Some donors setting up CRTs feel that because they're losing the stock or property that funds the trust, they must do something to replace this money so they're not diminishing what passes on to family members. As a result, they use some of the trust income and tax savings to purchase a life insurance policy equal to the value of the assets given to the CRT, says Robbins. Because of today's low capital gains rate, people interested in CRTs should be sure their intentions are charitable. If they aren't, those individuals may be financially better off by selling the property and paying the taxes.

As is the case with any advanced estate-planning strategy, if you're interested in establishing a CRT, get the assistance of a qualified advisor who has experience setting up CRTs.


Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.

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This article was originally published in the February 2000 print edition of Entrepreneur with the headline: Uncle Sam Or Orphan Annie.

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