Kelly Greene for the Wall St. Journal writes: If you're looking for a way to ease the impact of the new 3.8% tax on investment income, charity could be the answer.
The new tax, which took effect Jan. 1 after being passed by Congress in 2010 to help fund the health-care overhaul, applies to the net investment income of most individuals with more than $200,000 in adjusted gross income and married couples filing joint tax returns with more than $250,000.
Only investment income, including dividends, interest and capital gains, above those thresholds is taxed. The 3.8% rate comes on top of other taxes owed.
Congressional researchers and a number of think tanks estimate that 3.5 million families could get hit with the additional levy this year, with the number expected to double to seven million within a decade.
To get around the tax whammy, you could set up a "charitable-remainder trust" with an asset that has escalated in value—such as a vacation home, highly appreciated stock or artwork—and receive annual payments. Whatever is left when you die goes to the nonprofit group of your choice.
Once the property is in the trust, the trust can sell it without triggering the 3.8% tax or any regular income tax. Payments made to the trust's beneficiary—either yourself or another person—would be subject to any tax owed for investment income, but they likely would be made in smaller amounts and stretched over a longer time period.
Households with investment income subject to the new levy generally are either retirees who live largely off their investments or families with a windfall from a property sale, inheritance or another asset transfer, says Richard Fox, a partner at Philadelphia law firm Dilworth Paxson, where he heads the philanthropic and nonprofit practice.
The strategy could keep the income of families in such situations below the thresholds that trigger the new tax—or at least spread the tax across decades, rather than being hit with it all at once, he says.
Tax pros are bracing for a wave of clients who are unpleasantly surprised by the new levy. Already, Mr. Fox has worked with a family who put their New York condominium, worth "a few million dollars," into a charitable-remainder trust specifically to sidestep the 3.8% levy, he says.
"More and more people are discovering this is a big tax they hadn't really anticipated," says Robert Napier, an estate-planning partner at law firm Harrison & Held in Chicago.
He is steering more clients toward the trusts to keep assets from triggering the new tax—after shunning the strategy for more than a decade. "In the 1990s, in one year alone I built 35 charitable-remainder trusts, because tax rates were higher," Mr. Napier says. Then, from 2000 to 2012, he helped terminate more charitable-remainder trusts than he built.
"Now, the pendulum has swung again because the rates are higher," he says. "If your marginal rates are pushing 50%, why not do what you can to defer income until the pendulum swings back?"
But the strategy can be tricky. If you are considering using it to mitigate the investment-income tax, here are some things to keep in mind.
Would you make a donation anyway?
If you aren't already "philanthropically inclined," this might not be the right strategy for you, Mr. Fox says. If, going forward, you are bothered by the idea of a charity getting money rather than your children, then the move isn't worth it.
But increasing numbers of older Americans are indeed choosing to give away a portion of their wealth. In the upper echelons, for example, more than 100 billionaires have signed the "Giving Pledge" campaign started by Warren Buffett and Bill Gates three years ago.
If you decide to donate property to a trust, make sure you do so before putting the asset up for sale. Otherwise, the Internal Revenue Service could disqualify any tax savings.
Pick the right tool.
For people looking to liquidate a highly appreciated asset worth as little as $25,000, buying a "charitable gift annuity"—with which you make a donation to a nonprofit in exchange for lifetime fixed annuity payments—would be a lower-cost alternative.
For a charitable-remainder trust to make sense, the asset funding it should be worth at least $1 million. "You have to set up the trust, and you may need an appraisal for what you're contributing," Mr. Fox says.
So-called charitable lead trusts also are popular among the ultrarich. Jacqueline Kennedy Onassis famously set one up for her children, although they wound up eventually unwinding the plan.
With a lead trust, payments go to charity each year, and what is left at the end of the trust's term goes to the heirs, typically children or grandchildren.
The advantage of the lead trusts is that they can shift investment income to the charity, which isn't subject to the tax, from the trust itself.
Take the payments on time and for the right amount.
Charitable-remainder trusts set up as annuities have to pay out a set amount each year, at least 5% of the trust's initial value. When set up as so-called unitrusts, the vehicles pay out a set percentage of the present value, also at least 5%, which means payments can fluctuate depending on the underlying investment's performance.
Sometimes, trustees mistakenly pay the same amount each year out of unitrusts—or forget to make the payments at all. "It could disqualify your trust," Mr. Fox says. "It's very important to make sure you have a lawyer, accountant or trustee who's familiar with these things. You don't want them blowing up on you."
