What Is a Split-Interest Trust and How Does It Work?

A split-interest trust is a legal arrangement that divides the beneficial interests in assets between charitable and non-charitable purposes. This structure creates two types of beneficiaries who receive benefits at different times. One party holds the “lead” or “income” interest, entitling them to payments for a specified period, while the other holds the “remainder” interest, giving them a claim to the assets left in the trust after the lead interest expires. This dual-beneficiary structure is established through an irrevocable legal document, meaning it generally cannot be modified or terminated after its creation.

Core Components and Parties Involved

The individual who creates and funds the trust is the grantor or settlor. This person transfers assets—such as cash, securities, or real estate—into the trust and dictates its terms within a formal trust document. The grantor’s instructions outline how the trust will be managed and its assets distributed.

The trust’s assets are managed by a trustee, who has a fiduciary duty to administer the trust according to the grantor’s wishes. This responsibility includes investing assets, making payments, and handling administrative tasks like record-keeping and tax filings. The trustee can be an individual, a bank, or a trust company.

The recipients of the trust’s benefits are the income beneficiary, who receives payments during the trust’s term, and the remainder beneficiary, who receives the principal when the term ends.

Charitable Remainder Trusts

Charitable Remainder Trusts (CRTs) provide an income stream to a non-charitable beneficiary first, with the remaining assets ultimately passing to a qualified charity. The non-charitable beneficiary, often the grantor or a family member, receives payments for their lifetime or a term of up to 20 years. At the end of this term, the designated charity receives the remainder of the trust’s assets.

The income payments must be made at least annually, and the payout rate must be between 5% and 50% of the trust’s assets. The structure of these payments determines the specific type of CRT, which falls into two categories: the Charitable Remainder Annuity Trust or the Charitable Remainder Unitrust.

Charitable Remainder Annuity Trust

A Charitable Remainder Annuity Trust (CRAT) provides a fixed income stream to the non-charitable beneficiary. The annual payment is a specific dollar amount based on a percentage of the initial fair market value of the assets used to fund the trust. Because the payment is based on the initial value, the distribution remains constant throughout the trust’s term, regardless of investment performance. No additional contributions can be made to a CRAT after it has been initially funded.

Charitable Remainder Unitrust

A Charitable Remainder Unitrust (CRUT) offers a more flexible payment structure. The annual payment to the non-charitable beneficiary is a fixed percentage of the trust’s fair market value, which is recalculated each year. This means the annual distribution amount will fluctuate with the trust’s investment performance. Unlike a CRAT, the grantor can make additional contributions to the CRUT after its initial funding, which allows the income stream to potentially grow over time.

Charitable Lead Trusts

Charitable Lead Trusts (CLTs) operate as the inverse of CRTs. In a CLT, the income or “lead” interest is paid to a qualified charity for a specified term. After this period concludes, the remaining assets are transferred to non-charitable beneficiaries, such as the grantor’s family members. This structure allows a grantor to provide an immediate income stream to a charity while preserving the underlying assets for heirs. The mechanics of the payments to the charity define the two main forms of CLTs.

Charitable Lead Annuity Trust

A Charitable Lead Annuity Trust (CLAT) makes a fixed annual payment to a charity, calculated as a percentage of the initial value of the assets placed into the trust. The annuity payment does not change, providing the charity with a predictable source of funding. Because the payment is fixed, any appreciation in the trust’s assets above the annuity amount benefits the non-charitable remainder beneficiaries. This structure also simplifies administration, as the assets do not need to be revalued annually.

Charitable Lead Unitrust

A Charitable Lead Unitrust (CLUT) provides the designated charity with a variable annual payment. The payment is a fixed percentage of the trust’s assets, which are revalued annually. If the value of the trust’s assets increases, the payment to the charity also increases for that year, and vice versa. This structure allows the charity to share in the investment growth of the trust’s assets. The choice between a CLAT and a CLUT depends on the grantor’s goals regarding payment stability versus growth potential for the charity.

Tax Treatment and Reporting Requirements

The creation and operation of a split-interest trust involve specific tax considerations and compliance obligations. These rules govern the tax deductions available to the grantor, the tax liability of the beneficiaries receiving distributions, and the annual reporting duties of the trust itself.

Grantor’s Tax Implications

When a grantor funds a split-interest trust, they may be eligible for an immediate charitable tax deduction. The value of this deduction is the present value of the interest that will go to charity, not the full amount of the assets transferred. For a CRT, the deduction is based on the present value of the remainder interest; for a CLT, it is based on the present value of the lead interest payments. This calculation uses IRS actuarial tables and the Section 7520 interest rate. For CRTs, the 10 percent remainder requirement mandates the charity must be projected to receive at least 10 percent of the initial gift’s value.

Beneficiary Tax Implications

The tax treatment of distributions depends on the beneficiary. For non-charitable beneficiaries of a Charitable Remainder Trust, distributions are taxed according to a four-tier accounting system. Payments are characterized in the following order:

• Ordinary income
• Capital gains
• Tax-exempt income
• A non-taxable return of principal

The beneficiary pays taxes based on the character of the income earned by the trust. Distributions made from a Charitable Lead Trust to a qualified charity are not subject to income tax for the charitable recipient.

Trust Reporting

Split-interest trusts have an annual filing requirement with the IRS, for which the trustee must file Form 5227, Split-Interest Trust Information Return. This form reports the trust’s financial activities for the year, including its income, expenses, and distributions. It also helps the IRS verify that the trust is complying with the Internal Revenue Code. For calendar-year trusts, this form is due by April 15 of the following year, and failure to file on time can result in significant penalties.