Basics immediately below. Details are further below.
Benefits of a Charitable Lead Trust (CLT):
Tax Efficiency:
Income Tax Deduction: Donors can receive an immediate charitable income tax deduction for the present value of the annuity payments to charity.
Estate and Gift Tax Benefits: Reduces the taxable estate, potentially lowering estate taxes.
Philanthropic Goals:
Support Charities: Provides a steady stream of income to chosen charities during the trust term.
Legacy: Establishes a lasting charitable legacy.
Wealth Transfer:
Remainder to Beneficiaries: After the trust term, remaining assets pass to non-charitable beneficiaries, often with reduced or no transfer taxes.
Appreciation Potential: Assets that appreciate in value can transfer to beneficiaries with minimal tax impact.
Mechanics of a Charitable Lead Trust (CLT):
Structure:
Grantor CLT: The donor retains some control and receives an income tax deduction but pays taxes on the trust’s income.
Nongrantor CLT: The trust itself is taxed, but the donor avoids income tax on the trust’s earnings.
Funding:
Assets: Typically funded with assets expected to appreciate, such as stocks or real estate.
Timing: Can be established during the donor’s lifetime or as a testamentary trust.
Payments:
Annuity or Unitrust: Pays a fixed annuity or a percentage of the trust’s value to charity annually.
Term: The trust term can be a set number of years or the lifetime of an individual.
Remainder:
Beneficiaries: At the end of the trust term, remaining assets pass to the donor’s heirs or other beneficiaries.
Tax Implications: The value of the remainder interest is subject to gift or estate tax, but often at a reduced rate due to the charitable deduction.
High-net-worth individuals often have a strong desire to give back and optimize their charitable contributions for tax purposes. The current environment offers a wealth of opportunities for charitable planning, from simple cash donations to complex trust structures. With historically low interest rates and volatile markets, unique opportunities arise for those with philanthropic goals. Tax advisers should enhance their knowledge of current charitable giving tools and techniques to better serve their clients. One often underutilized tool is the charitable lead trust (CLT).
Overview
Charitable Lead Trusts (CLTs) are a powerful tool for achieving both charitable giving and family wealth transfer goals in a tax-efficient manner. A CLT can be established during life or at death, under a revocable trust or will. The trust pays an income interest to a charitable organization, with the remainder interest going to a noncharitable beneficiary, such as the donor or the donor’s family. The income interest can be structured as a “guaranteed annuity” (CLAT) or a “unitrust interest” (CLUT).
For income tax purposes, CLTs can be either grantor trusts or nongrantor trusts. A grantor trust allows the donor to receive an upfront charitable income tax deduction but requires the donor to pay taxes on future trust income. A nongrantor trust creates a separate taxpaying entity that can take an unlimited charitable income tax deduction for income paid to charity, but the donor does not receive a charitable itemized income tax deduction.
The CLT consists of a charitable interest, which is fully deductible for gift and estate tax purposes, and a noncharitable remainder interest, which is taxable. The value of the charitable interest is calculated as the present value of the payments to the charity over the trust term. The taxable remainder interest is the difference between the trust’s initial value and the value of the charitable interest.
Comprehensive CLAT Example
Consider a donor, A, who wants to support her favorite charity and faces a large estate tax. She creates a 10-year CLAT funded with $10 million, making annual $1 million payments to the charity, with the remainder going to a trust for her son, S. Using the September 2021 Sec. 7520 rate of 1%, the present value of the charity’s annuity is $9,471,300. The remainder interest, payable to S’s trust, is valued at $528,700.
If the trust is a grantor trust, A receives a charitable income tax deduction of $9,471,300, subject to AGI limits, and makes a taxable gift of $528,700 to S’s trust. The investment growth of the CLAT benefits S’s trust. A nongrantor CLAT, while not providing an income tax deduction for A, offers significant transfer tax savings by removing assets from her taxable estate. If the CLAT grows at 5% annually, the remainder interest would be $3,711,054, passing to S’s trust at a gift tax value of $528,700.
Grantor Trust vs. Nongrantor Trust
A grantor CLT can be advantageous in a high-income year, with the benefit compounding if the donor’s tax bracket lowers in subsequent years. However, the recapture of the charitable deduction applies if the donor dies before the trust term ends. A nongrantor CLT may be more attractive for donors expecting to remain in a high tax bracket, as the trust can take a charitable deduction for its income, effectively shifting income from the donor to the charity. However, the donor does not receive a charitable income tax deduction for the gift to the trust.
Low-Interest-Rate Environment
One of the perks of funding a Charitable Lead Trust (CLT) during your lifetime is locking in a low interest rate. This can lead to larger net wealth transfers. If the assets in the CLT outperform the Sec. 7520 rate, the excess earnings go to the remainder beneficiaries without any transfer tax. For example, if the Sec. 7520 rate jumps from 1% to 3%, the value of the charity’s lead annuity interest drops to $8,530,200, increasing the taxable gift to the remainder beneficiary from $528,700 to $1,469,800.
As interest rates rise, the value of the lead annuity interest decreases. Higher rates often signal greater inflation expectations, making future fixed payments less valuable. This makes CLTs particularly attractive in a low-interest-rate environment.
Maximizing Charitable Deductions for Donors
Some taxpayers face limits on their tax-deductible charitable contributions due to AGI restrictions or carryover deductions. A potential solution is transferring income-producing assets to a nongrantor CLT, which can offset 100% of its income with an unlimited charitable deduction under Sec. 642.
When donating assets to a grantor CLAT, the donor gets a charitable deduction equal to the value of the assets transferred but retains the taxable income until the end of the CLAT term. In contrast, donating to a nongrantor CLAT means the donor loses the upfront deduction but is relieved of future tax on the income from the donated assets. If the donor can’t fully use the charitable deduction due to AGI limits, it’s more advantageous to forgo the deduction and exclude 100% of the CLAT’s income from the date of funding.
The Right Assets
The best assets for funding a CLT are those with high appreciation potential and cash flows, making it likely to exceed the Sec. 7520 rate while facilitating annual distributions to charity. Funding the CLT with temporarily depressed assets can shift rebound appreciation from the taxable estate to the remainder beneficiary without additional transfer taxes. Consider cash flows, as in-kind distributions to satisfy the trust’s annuity trigger gains when using appreciated assets.
Increasing Annuity Payments
To mitigate the risk of exhausting the trust prematurely if investments underperform, consider increasing annuity payments. Smaller payments in the early years allow more assets to remain invested, potentially magnifying outperformance. A more aggressive approach is the “shark fin” CLAT, which provides larger payments in the latter years. However, the IRS hasn’t approved such structures, so proceed with caution.
Testamentary Charitable Bequests
For those with substantial illiquid estates, a zeroed-out testamentary CLT can eliminate estate tax at death, benefiting both charity and family. After using the basic exclusion and GST exemption amounts for long-term dynastic trusts, the remainder can fund a zeroed-out CLT, which is entitled to a full estate tax charitable deduction. When the CLT terminates, all appreciation passes to the heirs free of estate tax.
GST Tax Issues
Unfavorable rules for determining the inclusion ratio for CLATs under Sec. 2642(e) mean that if assets grow faster than the Sec. 7520 rate, more GST tax exemption needs to be allocated at the trust’s termination. This “adjusted exemption” doesn’t allow leveraging the GST tax exemption and could waste it if the trust grows more slowly than the Sec. 7520 rate. When GST tax is a concern, CLUTs are preferable to avoid a taxable distribution or mixed inclusion ratio.
Opportunity for Trusted Tax Advisers
Philanthropy is a top priority for many high-net-worth individuals. While charitable giving is personal, it presents an opportunity for tax advisers to introduce tax-efficient strategies. Understanding the tax benefits of CLTs allows advisers to provide thoughtful, consultative advice to charitably inclined clients.
Works Cited
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