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13. Charitable Lead Trusts, Part 3 of 3
VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning
13. CHARITABLE LEAD TRUSTS, Part 3 of 3
Links to previous sections of book are found at the end of each section.
|To this point the focus of the chapter has been on non-grantor Charitable Lead Trusts. A less common type of Charitable Lead Trust is a grantor Charitable Lead Trust. In a typical grantor Charitable Lead Trust the donor receives the remaining interest at the termination of the trust. Because of this, the trust is always considered to be owned by the donor. A grantor Charitable Lead Trust is not even a separate tax paying entity; it is simply an extension of the donor. If the trust earns income, the donor is treated as having earned the income. This trust is not used for estate and gift tax planning because the donor hasn’t transferred anything out of his or her estate.|
Instead, this trust is used for income tax planning purposes. Specifically, the donor is allowed to immediately deduct the present value of the future charitable gifts funded by the trust assets. This allows the donor to “pull forward” future charitable gifts and deduct them today (so long as the donor transfers sufficient assets into the trust to fund these gifts).The tax deduction for transfers to grantor Charitable Lead Trusts is limited to 30% of adjusted gross income, or 20% if funded with long-term capital gain property, because the gift is considered to be “for the use of” charity rather than “to” charity. This is because the Charitable Lead Trust itself is not a tax-exempt entity (unlike the Charitable Remainder Trust). Additionally, Regulation 1.170A-10(a)(1) and PLR 8824039 indicate that excess gifts “for the use of” charity cannot be carried forward, but IRS publication 526 and PLR 200010036 indicate that they can be.
Pulling forward tax deductions for future charitable gifts is particularly useful when the donor’s tax rates are high now, but will be lower later. A grantor Charitable Lead Trust allows the donor to take the deductions now, when they are more valuable, rather than later. This temporarily higher tax rate may result from a spike in income, perhaps due to the sale of an appreciated asset, a Roth conversion, or some other temporary income. Additionally, this difference in tax rates may occur as the result of a planned retirement where future income, and thus future tax rates, will be substantially lower after the retirement date.
Of course, the donor could simply make a large charitable gift during the year when income is high. Or, if the donor wishes to spread out the transfers to charity over many years, he or she could make a large transfer to a donor advised fund. Both of these approaches would also generate a large immediate income tax deduction. However, the grantor Charitable Lead Trust allows the donor to get the asset back after the expiration of the trust (or at least what remains of the asset after making the required payments to charity). Suppose the donor owns a large income-producing investment which generates $100,000 per year. Using a grantor Charitable Lead Trust, the donor could transfer the asset, use the income to pay for $100,000 annual charitable gifts, take an immediate tax deduction for all of the future $100,000 annual gifts, and then receive the asset back at the close of the trust. This could work especially well if the asset was desired to produce income in the future, for example in retirement planning, but would be better used to generate charitable tax deductions today. The other methods do not allow the donor to both keep the underlying asset and also take an immediate deduction for the future years of gifting.
A typical grantor Charitable Lead Trust follows the plan of the accompanying diagram because the donor retains the reversion rights. There are other rights that will also trigger this grantor trust treatment, but many violate other Charitable Lead Trust rules (such as rules against self-dealing) and therefore eliminate Charitable Lead Trust treatment and the tax deduction.
In rare cases a grantor Charitable Lead Trust may continue to exist beyond the death of the donor. (This might occur where the trust is set to run for, say, 10 years, but the donor dies before the end of the 10 year period.) This creates a problem because the donor can no longer be treated as the owner of the trust and taxed with the trust’s income. In such cases a grantor Charitable Lead Trust becomes its own separate tax paying entity (i.e., a complex trust) just like a non-grantor Charitable Lead Trust. This means that the trust is taxed with any income earned, but it can also deduct subsequent transfers to charity. However, to offset the fact that these anticipated gifts were already deducted by the donor, the deductions are recaptured on the donor’s final income tax return. In other words the donor’s original deduction, less the value of the amounts already paid to charity discounted to the year of the deduction, is treated as income in the year of recapture. This same result also occurs if the donor gives up his or her reversion rights (although the recapture will occur on the donor’s tax return in the year that the rights were given up rather than on the donor’s final tax return).
|Because the grantor Charitable Lead Trust allows for a deduction today for transfers to be made to charity in the future, the value of the deduction depends upon the prevailing §7520 interest rate. The size of the deduction is much larger during lower interest rate periods than during higher interest rate periods. For example, a Charitable Lead Trust funded to support $10,000 annual charitable gifts for the subsequent 20 years will generate a $163,514 deduction if the §7520 rate is 2.0%. (The annuity factor for a 20-year term certain annuity at a 2.0% interest rate on Table B “Term Certain Factors” found on the web at http://www.irs.gov/Retirement-Plans/Actuarial-Tables is 16.3514.) But, if the §7520 rate is 8.0%, the same transaction generates a deduction of only $98,181.|
|Grantor Charitable Lead Trusts and non-grantor Charitable Lead Trusts have opposing tax characteristics. A grantor Charitable Lead Trust is treated as if it is still owned by the donor. Thus the donor receives the charitable income tax deductions, but is also taxed with the income earned by the trust, and the assets in the trust are considered to be owned by the donor for gift and estate tax purposes. In contrast, a non-grantor Charitable Lead Trust is treated as a separate tax payer. Transfers to a non-grantor Charitable Lead Trust do not generate income tax deductions. The trust pays taxes on any income it earns and it takes deductions for any transfers it makes to charity. Most importantly for gift and estate tax planning purposes, any assets in a non-grantor Charitable Lead Trust are outside of the donor’s estate. Thus, the choice of the trust type will depend upon the tax goals of the donor.|
There is, however, a type of Charitable Lead Trust that proposes to combine the characteristics of a grantor and non-grantor trust. A “defective grantor trust” or “super grantor trust” or “super trust” purports to create a Charitable Lead Trust where the donor may take an immediate tax deduction for future charitable gifts from the trust, pay taxes on any income earned by the trust, but the trust assets will not be included in the donor’s estate. Thus, the estate and gift tax results are the same as with any non-grantor Charitable Lead Trust, but the donor is actually able to take a personal income tax deduction as if it were a grantor Charitable Lead Trust.
|The explanation for this result relates to a slight inconsistency in the tax code. The income tax rules defining grantor and non-grantor trusts are almost identical to the gift and estate tax rules defining grantor and non-grantor trusts. But, they are not perfectly identical. If a donor keeps the right to get trust property by substituting other property of equal value, this will trigger grantor treatment of the trust for income tax purposes. However, it does not trigger grantor treatment of the trust for gift and estate tax purposes. Thus an otherwise normal non-grantor Charitable Lead Trust can be converted into a “super grantor trust” by simply inserting this one right. This hybrid trust has not received clear approval from the IRS, but does appear to comply with the language of the tax code.|
|Charitable Lead Trusts are commonly funded with simple assets such as cash and publicly traded stocks and bonds. However, some assets can create complications or difficulties when transferred to a Charitable Lead Trust.|
|Although Charitable Lead Trusts are not private foundations, they are required to follow the private foundation rules against self-dealing, taxable expenditures, jeopardizing investments, and excess business holdings. Failing to follow these rules will result in the trust being disqualified as a Charitable Lead Trust. For example, the trust may not indefinitely hold too much ownership in a single business entity (no more than 20% ownership by the trust and all disqualified persons combined unless trust ownership is 2% or less). However, the trust may hold unlimited ownership in a business gifted to the trust for up to 5 years before it must sell the asset. Consequently, if a Charitable Lead Trust is established for a term of 5 years or less, it will not violate this rule. Another rule is that the donor may not transfer property to the trust with debt that is less than 10 years old because such transfer constitutes self-dealing. Also, the trust may not hold assets that are so risky as to jeopardize the charitable purposes of the trust. These rules are covered in detail in the chapter on private foundations.|
Unrelated business income arises when a trust owns business interests in a form that generates ordinary income such as a sole proprietorship, a partnership, or a limited partnership interest where the limited partnership is actively managing a business operation and not simply collecting passive income from investments. In a Charitable Remainder Trust, unrelated business income results in a harsh 100% excise tax. No such excise tax applies to Charitable Lead Trusts, allowing them to receive unrelated business income. When the trust is a grantor Charitable Lead Trust any such income is simply attributed to the donor and treated as if it had been received directly by the donor. However, special rules apply if a non-grantor Charitable Lead Trust receives unrelated business income. In this case, a non-grantor Charitable Lead Trust may deduct only 50% of this income when it is given to a public charity or 30% when it is given to a private foundation. This means that the trust cannot escape paying at least 50% or 70% of the unrelated business income tax, regardless of its charitable distributions.Why should such a rule exist? The idea of having an unrelated business income tax is that nonprofits should not be able to outcompete for-profits in non-charitable commercial enterprises simply because nonprofits pay no taxes. This would be unfair for regular businesses and would have a negative effect on tax revenues based upon regular commercial activity. If a non-grantor Charitable Lead Trust were allowed to operate a business and pay no tax on the earnings (because earnings were 100% distributed to a charity and resulted in a 100% tax deduction), the result would be the same as charging no unrelated business income tax. To avoid this result, contributions of unrelated business income are not fully deductible. As a result, a non-grantor Charitable Lead Trust must pay some unrelated business income tax, even if all unrelated business income is donated to charity. (Note that the trust’s ownership of a limited partnership interest will not generate unrelated business income if the limited partnership does not engage in the active management of a business, but simply holds passive investments and collects income from them. Thus, if a donor was using a limited partnership holding passive investments for the purpose of obtaining a valuation discount for estate tax purposes, such interests could be gifted to a Charitable Lead Trust.)
Subchapter S-corporation shares are most commonly held be people. These shares may not be held by another corporation, a partnership, or a Charitable Remainder Trust. (Doing so will cause the corporation to lose its subchapter S status and instead become a subchapter C-corporation.)
It is perfectly acceptable for a grantor Charitable Lead Trust to hold such shares because the trust is treated, for tax purposes, as being owned by the donor. Similarly the hybrid “super grantor” trust is also treated as a grantor trust for income tax purposes and could also hold subchapter S corporation shares. This is not the case, however, if the shares are held by a non-grantor Charitable Lead Trust. The non-grantor Charitable Lead Trust is a separate taxpayer from the donor. Because the trust is not a person, its ownership of subchapter S-corporation shares is not permitted under the subchapter S-corporation rules. There is one exception that permits a non-grantor Charitable Lead Trust to own such shares. This arises if the trust choses to make an ESBT (Electing Small Business Trusts) election. Such an election is usually undesirable for the non-grantor Charitable Lead Trust as any income earned from the shares may not be deducted as a charitable gift when transferred to charity.
|Charitable Lead Trusts can be complex vehicles (certainly much more complex than presented in this brief chapter), but this complexity should not prevent advisors and fundraiser from being familiar with their, potentially dramatic, tax benefits. Although relatively rare, these trusts represent a significant share of assets held in split interest charitable trusts and an even larger share of actual charitable distributions made from such trusts.|