Recently I was asked by some of the readers of this blog to walk through the basics of donor-advised funds, and you can find that post here. Next up: charitable trusts.
The key fact to understand when talking about a charitable trust is that it is a legal entity. The concept of a legal entity is not well understood by the average person. A corporation is a legal entity and a partnership is a legal entity but an unincorporated business—you and a couple of friends washing windows for money—is not a legal entity.
Think of a legal entity as a fence comprised of laws and regulations that encircles your enterprise. When you have an incorporated business, your business (it could be a window washing business) operates inside of the fenced-in area and you cannot operate outside of the rules and regulations represented by the fence. Also, the fence provides you some useful protection. Your unincorporated window washing business does not operate within that fence and while it is not subject to the laws and regulations of a corporation, it also does not have any of the protections afforded by corporate laws.
When a donor makes a financial gift directly to a charity, they have made a transfer of funds to the charity but they have not created any form of legal entity. If the donor makes a restricted gift to a charity, they have created a form of contractual relationship between themselves and the charity, but still they have not created a legal entity.
On the other hand, when a donor creates a charitable trust and gives their financial gift to the trust, they have created and funded a legal entity. This entity is surrounded by a fence of laws and regulations within which it must operate and the fence provides the trust with some protections. The biggest thing to realize when you are dealing with a charitable trust is to understand that you have entered the gate of a fenced-in area and you must pay attention to the requirements of the fence—trust law.
Many individuals use charitable trusts to leave all or a portion of their estate to charity when they die. Charitable trusts may be set up during a donor's life (the lawyers call this an inter vivos trust) or as a part of their will establishing a trust at the time of their death (the lawyers call this a testamentary trust).
There are two basic types of charitable trusts. The first type is a "lead" trust, in which the charity is paid first, and after the trust terminates, the remainder goes to the trust beneficiaries, such as the donor’s heirs. The second type is a "remainder" trust, in which the charity is paid last after termination of the trust, and after the trust beneficiaries have received payments. This is called a unitrust. Payments may be a fixed amount, a series of annuity payments, or payments based on a percentage of principle. This information is not important to your understanding of trusts, but I wanted to include it in case you came across the terms lead trust or unitrust. As I said, there is a great deal of needless confusion over terminology.
Like the corporation, because a trust is a legal entity, it operates according to laws, rules and regulations and it operates separately and apart from the individual who established the trust and separately and apart from the trust beneficiary.
An individual who creates a charitable trust during his or her lifetime into which they put $50,000 to be donated to ABC Charity upon their death, and which also pays the donor the income earned by the $50,000 for the remainder of their life, has created a legal entity that is empowered to do exactly that. The trust will have a trustee who is responsible for carrying out the terms of the trust. This person will have to prudently invest the $50,000 and make the payments to the donor (the initial trust beneficiary) over the donor’s lifetime. Then, upon the donor’s death, the trustee must make the final payment to ABC charity of everything that is remaining in the trust. At that point, the legal entity ends.
Alternatively, the donor could donate $50,000 to a charitable trust whose terms require the trustee to invest the money and then upon the death of the donor, the trustee is to distribute a portion of the trust assets to the named charity with the remainder to be distributed to the heirs of the donor. The trust also ends after all of the distributions have been made.
The provisions of both of the trusts described above are carried out according to the instructions written in the trust document. There is no need to wait for a reading of the donor’s will or to go to probate court. Because the trust is a separate legal entity, the instructions contained in the trust are carried out by the trustee as soon as the conditions specified in the trust occur.
Sometimes, an individual will create a charitable trust that is designed to remain in effect after their death. In such a trust, the legal entity will continue to operate and distribute income to charities in accordance with the terms of the trust rather than ending the trust via a final distribution to a charitable beneficiary. While the charitable beneficiary will continue to receive the income benefits generated by the trust principal, the trust will always remain outside of the control of the charity. The IRS calls these types of trusts private foundations.
A trust is not a tax-exempt entity and is treated as a private foundation subject to private foundation excise taxes. In most states, charitable trusts are subject to the control of the attorney general who is charged with assuring that the assets of the trust are used for charitable purposes.
In some cases, donors establish a charitable trust administered by a trustee personally selected by them. This is an alternative to making a large donation directly to a charity. The donor may believe that his or her hand-selected trustee is more in-tune with his or her charitable wishes than the management of the charitable beneficiary and the trustee is available to make annual gifts from the trust to the charity or to divert funding to other charities if the intended charity is no longer operating in a manner the trustee believes would please the original donor.
In summary: Think of a charitable trust as an intermediate legal entity that operates for a period of time between the initial donation by the donor and the ultimate receipt of funds by the charity. In some cases, the charity may never receive the trust principal and the trust continues on a permanent basis. The charitable trust is a legal entity that is monitored by the state attorney general and must function according to established charitable trust laws and regulations. Donors usually have some personal or income tax reason for using a charitable trust as their philanthropic vehicle. From a charity’s viewpoint, it is preferable to be the direct recipient of a donor’s gift rather than being the beneficiary of a charitable trust.