13. Charitable Lead Trusts, Part 1 of 3

13. Charitable Lead Trusts, Part 1 of 3

Article posted in General on 16 June 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 6 July 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

13. CHARITABLE LEAD TRUSTS, Part 1 of 3

Links to previous sections of book are found at the end of each section.

In both Charitable Remainder Trusts and Charitable Lead Trusts the donor makes a gift to the trust which then holds the asset, makes regular payments, and finally distributes the remaining amount at the end of the term of the trust.  Unlike Charitable Remainder Trusts, which provide payments to the donor or another person followed by the remaining amount going to charity, the Charitable Lead Trust provides payments to charity followed by the remaining amount going to the donor or another person.
The Charitable Lead Trust is a mirror image of the Charitable Remainder Trust where the charitable and non-charitable beneficiaries change places.  Just as with a Charitable Remainder Trust there are two types of permitted payments from a Charitable Lead Trust, the fixed dollar annuity and the fixed percentage unitrust.  If the Charitable Lead Trust pays a preset dollar amount to charity each year, it is a Charitable Lead Annuity Trust (CLAT).  If the Charitable Lead Trust pays a set percentage of all trust assets each year, it is a Charitable Lead Unitrust (CLUT).  The Charitable Remainder Trust also permitted variations that could lower the ongoing payments, such as a Net Income Charitable Remainder Trust (NICRUT), Net Income with Makeup Charitable Remainder Trust (NIMCRUT), or flip-Charitable Remainder Unitrust (flip-CRUT).  None of these options are available with a Charitable Lead Trust, because the ongoing payments in a Charitable Lead Trust go to the charity, and therefore may not be reduced.
As a sophisticated charitable planning instrument, Charitable Lead Trusts can provide benefits to charities and to donors and their families.  In general, charities like charitable planning because, ultimately, these plans are expected to benefit charities.  Charitable Lead Trusts are particularly attractive to charities because they immediately generate income for the charity.  In contrast, Charitable Remainder Trusts generate future benefit for charity, where that future may be delayed by many decades and, depending upon the longevity of the donor, may be significantly diminished compared with initial expectations.
Not only do Charitable Lead Trusts begin generating income for the charity immediately, but that stream of gift income is secured.  At least annually, payments must be made to the charity for the duration of the Charitable Lead Trust.  Better still for the charity – and unlike a Charitable Remainder Trust – the donor typically may not retain the right to change the named charity in the most common form of the Charitable Lead Trust (called a non-grantor Charitable Lead Trust).  Although it is possible for a trustee who is not the donor to decide how the ongoing payments will be divided among several listed charities (PLR 200240027), this is a rare provision.  Thus, in the great majority of cases the charity is assured of receiving its ongoing payments, even if the relationship with the donor subsequently changes.
Charities enjoy Charitable Lead Trusts because of the immediate, secured payments coming to the charity.  However, aside from tax benefits, there are no obvious reasons for donors to use a Charitable Lead Trust.  Charitable Lead Trusts do not provide income to the donor, or donor’s family, as Charitable Remainder Trusts or Charitable Gift Annuities can.  Thus, they don’t fit into typical planning for retirement or for planned educational expenses. 
Instead, the use of Charitable Lead Trusts is primarily motivated by tax benefits.  The most common type of Charitable Lead Trust, called a non-grantor Charitable Lead Trust, is used predominantly as a method for reducing gift and estate taxes.  However, there are some circumstances where this trust can also be used for income tax benefits as well.  The less common grantor Charitable Lead Trust is used to capture income tax benefits, but not gift and estate tax benefits.
Charitable planners are more likely to work with Charitable Remainder Trusts than Charitable Lead Trusts simply because Charitable Remainder Trusts are much more common.  Charitable Lead Trusts account for only 6% of all split-interest charitable trusts.  (Split interest charitable trusts are Charitable Remainder Trusts, Charitable Lead Trusts, and Pooled Income Funds.)  Seeing what a small fraction of total split interest charitable trusts that Charitable Lead Trusts represent might lead one to believe that Charitable Lead Trusts are insignificant in charitable planning.  However, this idea is mistaken.
Although Charitable Lead Trusts are less numerous that Charitable Remainder Trusts, they are much larger.  The typical Charitable Lead Trust holds more than 3½ times the assets of the typical Charitable Remainder Trust.  Thus, although their numbers are relatively small, when they arise Charitable Lead Trusts often represent significant wealth.
As a result of their larger size, Charitable Lead Trusts hold 18% of all assets amongst split interest charitable trusts, even though they constitute only 6% of such trusts.  Thus, while Charitable Lead Trusts are less common, they do represent an important segment of charitable planning.
For those who represent charities, the most important figure may be not the frequency of the trusts, or even the assets held, but the actual dollars transferred to charity from split interest charitable trusts.  In this category, Charitable Lead Trusts are quite significant, generating 37% of all transfers to charity.  So, this infrequently used charitable planning vehicle, accounting for only 6% of all charitable split interest vehicles, results in charitable transfers of more than half the size of all Charitable Remainder Trusts.  What accounts for this massive difference in actual charitable payouts?  Where Charitable Remainder Trusts are annually paying out less than 2% of all their assets, Charitable Lead Trusts pay out more than 5.3%.  As discussed in the chapter on Charitable Remainder Trusts, those charitable vehicles typically transfer assets to charity only after the death of the donor.  The charitable deductions for Charitable Remainder Trusts are based upon donors living to their actuarial life expectancy.  However, Charitable Remainder Trust donors, on average, live much longer than their actuarial life expectancy.  This occurs for three reasons.  First, those known to have shortened life expectancies for medical reasons do not typically establish new Charitable Remainder Trusts, or otherwise convert assets into annuity payments.  Thus, one tail of the life expectancy distribution is essentially cut off.  (This is why, for example, the insurance industry uses a different life expectancy table for those who purchase annuities than for the general population.)  Next, greater wealth is associated with a longer life span.  Those who establish Charitable Remainder Trusts tend to be at the highest end of the wealth spectrum, and thus live longer than their actuarial expectations.  Finally, those with a charitable estate plan tend to live longer than others of their same wealth category (see James, R.N., III (2013) American Charitable Bequest Demographics for evidence on this).  Taken together, these all point to Charitable Remainder Trust donors living far longer than the standard actuarial expectations would predict.  When these donors serve as the measuring life prior to the charitable remainder payout, as is typically the case, this will result in far more non-charitable payments – and a much later and smaller charitable distribution – at the end.  Charitable distributions from Charitable Lead Trusts do not suffer from these same longevity issues.  The typical Charitable Lead Trust pays out to charity for a fixed number of years, beginning immediately.  These fixed term trusts are not affected by longevity expectations.  Those Charitable Lead Trusts that exist for a donor’s lifetime generate more charitable transfers when the donor lives beyond life expectancy, not less.
As shown in the accompanying chart, Charitable Remainder Trusts tend to most frequently benefit nonprofit organizations classified as “public/societal benefit,” with substantial amounts also going to education and health related organizations.  Charitable Lead Trusts have the same first and second most common beneficiary types as do Charitable Remainder Trusts.  However, Charitable Lead Trusts are much more heavily concentrated in giving to nonprofit organizations classified as “public/societal benefit,” as these receive over 70% of all charitable transfers from Charitable Lead Trusts.  This might reflect a greater tendency for Charitable Lead Trusts to pay into private family foundations, which are most commonly classified as general “public/societal benefit” organizations rather than as topic-specific nonprofit organizations.  As estate size increases among charitable estates, the tendency to leave money not to public charities but to private family foundations grows dramatically.  Charitable Lead Trusts are predominantly used as an estate tax avoidance technique for the wealthy, making the association between Charitable Lead Trusts and private foundation beneficiaries plausible.  Charitable Remainder Trusts, in contrast, hold fewer assets on average and may be used for a variety of tax and financial reasons by those whose estates are too small to generate estate taxation.
Although it is convenient to think of Charitable Lead Trusts as simply a mirror image of Charitable Remainder Trusts where the charitable and non-charitable beneficiaries switch places, there are other differences.  Unlike a Charitable Remainder Trust, a Charitable Lead Trust is not a tax-exempt entity.  If a Charitable Remainder Trust sells a highly appreciated asset, it pays no capital gains tax, because it is a tax-exempt entity.  If a Charitable Lead Trust sells the same asset, it must pay capital gains tax, because it is not a tax-exempt entity.  However, just as with other taxpayers, a Charitable Lead Trust may reduce its taxable income by making transfers to charity which results in a charitable deduction.  Unlike other taxpayers, a Charitable Lead Trust can typically deduct up to 100% of its income (other than unrelated business income) if it makes sufficient charitable gifts.
Because a Charitable Lead Trust is not a tax-exempt entity, some guidelines are more flexible than with a Charitable Remainder Trust.  For example, Charitable Remainder Trusts can make payments for life or for up to 20 years.  In contrast, Charitable Lead Trusts can make payments for life or for up to an unlimited number of years.  The annual payments in a Charitable Remainder Annuity Trust must be between 5% and 50% of the initial trust assets.  Annual payments in a Charitable Lead Annuity Trust can be as small or as large as desired.  Further, Charitable Lead Annuity Trusts, unlike Charitable Remainder Annuity Trusts, do not have to be concerned with the risk of exhaustion being greater than 5%.  A Charitable Remainder Unitrust must pay between 5% and 50% of all trust assets each year, whereas a Charitable Lead Unitrust can payout any desired percentage.  There is no requirement for a minimum of a 10% charitable deduction (present value of projected amount going to charity) as with Charitable Remainder Trusts.  In fact, the most common type of Charitable Lead Trust (the non-grantor Charitable Lead Trust) generates no charitable income tax deduction to the grantor regardless of its terms.  This freedom in options comes because a Charitable Lead Trust, unlike a Charitable Remainder Trust, is not a tax-exempt entity.
The most common type of Charitable Lead Trust is a non-grantor Charitable Lead Trust.  The term non-grantor means that the Charitable Lead Trust is not owned or controlled by the donor (a.k.a. the grantor).  Although the donor typically establishes all of the rules for the Charitable Lead Trust, once established the trust is irrevocable.  Because this trust is usually an estate tax avoidance mechanism, it is critical for the intended tax results that transfers to a non-grantor Charitable Lead Trust stay outside of the donor’s estate.  Once these assets are outside of the donor’s estate, none of them should return to – or be controlled by – the donor, so that the trust and all its assets stay outside of the donor’s estate.  The assets in a Charitable Lead Trust fund annual payments to a charity and then, at the end of the term of the trust, are paid to the heirs or other beneficiaries selected by the donor.  The payments to charity (either predetermined dollar amounts or a predetermined percentage of trust assets) typically occur for a fixed number of years, but can continue for a life or multiple lives.
The primary purpose of non-grantor Charitable Lead Trusts is to reduce gift and estate taxes.  Anything placed into a non-grantor Charitable Lead Trust is no longer owned or controlled by the donor.  Although the donor typically creates the rules for the trust, the donor cannot change those rules once the trust is created.  Unlike a Charitable Remainder Trust, the donor should not directly manage or control the assets of a non-grantor Charitable Lead Trust.  This is avoided in order to ensure that all assets are excluded from the donor’s estate.  This focus on excluding the assets from the donor’s estate is not typically a concern with standard Charitable Remainder Trusts.  Why not?  If a donor receives income from a Charitable Remainder Trust for her for life with the remainder going to charity at her death, the fact that the remaining assets are going to charity means that the inclusion of the assets in her estate is irrelevant.  The assets come into the estate and then the assets are exempted from taxation because they are transferred to a charity.  This is not the case with a non-grantor Charitable Lead Trust.  Here the assets are distributed to family members, or other non-charitable beneficiaries, at the termination of the trust.  If any assets are included in the donor’s estate, perhaps because the donor exercised too much control over the assets, then the assets are taxed in the donor’s estate.
The fundamental tax advantage gained from a non-grantor Charitable Lead Trust is that when a donor makes transfers to the trust he or she pays gift taxes on the projected amount of the ultimate transfer to the heirs (i.e., any non-charitable beneficiaries), not on the actual amount of the transfer to heirs.  The actual amount transferred to heirs at the termination of a non-grantor Charitable Lead Trust is not subject to gift or estate taxation.  This difference between the projected amount and the actual amount transferred to heirs creates an opportunity for tax reduced transfers.
The key benefit for gift and estate tax planning purposes is that if the actual amount transferred to family members is higher than the projected amount, the difference between these two numbers is transferred without any gift or estate taxation.  This part of the transfer to children, or others, is made free of estate and gift taxation.
Gift taxes must be paid on the projected remainder that will be transferred to heirs (i.e., any non-charitable beneficiaries).  This projection is based on the assumption that the assets in a Charitable Lead Trust will grow at the initial §7520 interest rate for the life of the trust.  Any growth that occurs above the §7520 interest rate is therefore transferred free from gift or estate taxes.  Of course, if the investments in the trust return less than the §7520 interest rate, then this advantage could become a disadvantage because the initial gift tax would have been based upon a projected transfer larger than the actual transfer ultimately made to the heirs (unless the projected transfer was $0).
At the time of the transfer to a non-grantor Charitable Lead Trust, the donor must pay gift taxes on the value of the transfer less the present value of the payments projected to go to charity.  The projected value of the amount going to charity is not taxed.  The rest, which is the present value of the projected amount going to heirs or other people, is taxed.  Thus, calculating the taxable part of the transfer can be determined by estimating the non-taxable part of the transfer, i.e., the present value of the projected payments to charity.

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