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Charitable Lead Trust
Charitable lead trusts ("CLTs") are designed to provide income payments to at least one qualified charitable organization for a period measured by a fixed term of years, the lives of one or more individuals, or a combination of the two; after which, trust assets are paid to either the grantor or to one or more noncharitable beneficiaries named in the trust instrument. This comprehensive paper provides a complete technical overview of charitable lead trusts; how charitable deductions are determined for income, gift, estate and generation-skipping transfer tax purposes; the taxation of charitable lead trusts; income tax considerations for grantors and beneficiaries; and private foundation excise tax rules.
- Technical Overview
- Charitable Contribution Deduction
- Taxation of Charitable Lead Trusts
- Income Tax Considerations for Grantors and Beneficiaries
- Transfer Tax Considerations
- Private Foundation Excise Tax Rules
Charitable lead trusts ("CLTs") are designed to provide income payments to at least one qualified charitable organization for a period measured by a fixed term of years, the lives of one or more individuals, or a combination of the two; after which, trust assets are paid to either the grantor or to one or more noncharitable beneficiaries named in the trust instrument.1 Also referred to as a "charitable income trust," the term "charitable lead trust" is used more commonly because the payment of the income interest to charity leads or precedes the payment of the remainder interest.
In theory, charitable lead trusts can be thought of as the inverse of charitable remainder trusts. In practice, however, many of the rules that govern the operation and taxation of charitable lead trusts differ significantly from those for charitable remainder trusts. For example, CLTs are not tax-exempt entities as are charitable remainder trusts. The rules governing charitable remainder trusts are designed to protect the charitable remainder interest, whereas the rules governing charitable lead trusts protect the charitable income interest. When appropriate, we will compare and contrast these two vehicles.
Prior to 1969, an individual could establish a trust that would make payments to charity for a period of years, exclude the income earned by the trust during its operating life from his or her own income, claim a current income tax charitable contribution deduction for the present value of the income stream passing to charity, and, at the end of the term, receive the remainder interest.
Congress concluded, however, that allowing donors to exclude trust income and receive a charitable deduction gave them a double tax benefit. In response, the Tax Reform Act of 1969 mandated that in order for a gift of an income interest to charity to be deductible for income tax purposes, the income earned by the trust would have to be taxable to the grantor. Further, the income paid to charity would have to take the form of a guaranteed annuity or unitrust interest, and be payable at least annually.
After the 1969 Tax Reform Act, planners quickly concluded that if the trust was drafted so the grantor was not considered the owner of the trust's income, no charitable income tax deduction would be available. However, neither would the grantor be treated as the owner of the trust's income for income tax purposes. This exclusion of income was equivalent to a 100% income tax deduction. Further, even though the charitable income tax deduction was unavailable, such trusts could qualify for the gift and estate tax charitable deductions provided the lead interest consisted of a guaranteed annuity or unitrust amount.2 This type of trust came to be known as the "nongrantor" or "statutory" lead trust and would prove very useful for donors who desired to transfer assets to successor generations of the their family with little or no transfer tax cost.
The design of charitable lead trusts in use today is based on two main themes: 1) whether the trust income is considered owned by the grantor and therefore produces an income tax charitable deduction, and 2) whether the remainder interest reverts to the grantor or is paid to third parties such as members of the grantor's family.
There are four basic types of charitable lead trusts arising out of these themes:
- Qualified reversionary grantor trust
- Qualified nonreversionary grantor trust
- Qualified nonreversionary nongrantor trust
- Nonqualified reversionary nongrantor trust
Each type of trust produces different tax benefits that can be matched with the donor's personal and philanthropic planning objectives. Following is a more detailed description of these trusts and how they are typically utilized:
Qualified Reversionary Grantor Charitable Lead Trusts
Qualified reversionary grantor charitable lead trusts are created during the life of the donor for the purpose of paying an income interest to charity for a term defined in the trust instrument; after which, the remainder interest reverts to the grantor.
Donors creating grantor CLTs receive a charitable contribution income tax deduction in the year the trust is created for an amount equal to the net present value of the income interest passing to charity. In order to qualify for income tax deduction purposes, the grantor must treated as the owner of the trust's income under the grantor trust rules of IRC §§671 - 678. Accordingly, all income produced by the trust during the trust term, including amounts distributed to charity, is taxable to the grantor. On conclusion of the measuring term, the trust assets revert to the grantor or to the grantor's estate.
Qualified grantor lead trusts are particularly useful for donors who desire to make a multi-year charitable pledge and accelerate the charitable deductions, that would otherwise be produced over the pledge period, into the first year.3
Example 1: Mrs. Green is considering a $50,000 annual pledge to $include:c_donee$ for a period of five years. In the absence of a charitable lead trust, she can claim a charitable contribution income tax deduction for the payments to charity in each year they are actually made. As an alternative, Mrs. Green transfers $1,000,000 in tax-exempt bonds to a grantor charitable lead annuity trust. The trust is designed to pay $50,000 per year to charity for a period of five years; after which, the trust will terminate and return its assets back to Mrs. Green.
Under this scenario, Mrs. Green will receive a charitable contribution deduction equal to the present value of the income interest being transferred to charity. The total amount to be distributed to charity over the five-year period is $250,000. The present value of the income interest is calculated to be $205,524. The deduction can be used by the grantor subject to the percentage limitation and reduction rules of IRC §170.4
As mentioned previously, in order for the present value of the income interest to be deductible by the grantor for income tax purposes, the grantor must be treated as the owner of the trust. In other words, even though income is being paid to charity, it is considered as having been received by the grantor for income tax purposes.
In the context of this example, Mrs. Green will receive a charitable income tax deduction in the amount of $205,524 in year one. All income earned by the trust, including capital gains and amounts paid to charity, will be considered earned by and, therefore, included in Mrs. Green's gross income just as if the trust does not exist. However, because Mrs. Green transferred tax-exempt securities to the trust, however, she will not be required to include the interest from the bonds in her gross income. However, any gains from the sale or redemption of the bonds is produced will be taxable to Mrs. Green.
Qualified Nonreversionary Nongrantor Charitable Lead Trusts
Qualified nonreversionary nongrantor charitable lead trusts are the most common form and are created for the purposes of paying an income interest to charity for a defined measuring term with the remainder interest transferred to one or more noncharitable beneficiaries named in the trust instrument. The grantor's children and grandchildren are the most frequently named beneficiaries of these types of trusts.
As its name suggests, a nongrantor trust does not qualify under grantor trust rules; accordingly, the grantor does not receive a charitable income tax deduction; however, none of the income produced by the trust is taxable to the grantor. A qualified nongrantor CLT is taxed as a complex trust.
If the nongrantor trust is created on an inter vivos basis, the grantor receives a gift tax charitable deduction in an amount equal to the net present value of annuity or unitrust income interest payable to charity. If the trust is created on a testamentary basis, the settlor's estate receives an estate tax charitable deduction, also based on the net present value of the income interest. Depending on the combination of measuring term and income amount payable to charity, it is possible to produce a charitable gift or estate tax deduction that equals the amount transferred thereby creating a gift and estate tax-free transfer.
Example 2: Mrs. Peterson has an estate valued at $10 million. She is very committed to the mission of $include:c_donee$ and provides it with significant annual financial gifts. She is also interested in transferring assets to her children in the most tax-efficient manner possible.
Mrs. Peterson will transfer a $2,000,000 apartment complex to a charitable lead annuity trust. The trust will pay a $140,000 annuity amount to $include:c_donee$ for a period of fifteen years, ten months; after which, the trust assets will be distributed to the her children. Based on this scenario, Mrs. Peterson will receive a charitable contribution gift tax deduction in an amount of $1,375,000. The net taxable gift is $625,000 and can be offset by Mrs. Peterson's unified gift and estate tax credit. As a result, the children will receive the property, including any appreciation that occurs over the trust period; completely gift and estate tax free.
As will be discussed, nonreversionary nongrantor CLTs can also be used to leverage the generation-skipping transfer tax exemption for transfers to grandchildren and other skip persons. The benefits of wealth transfer can be amplified by funding the trust with assets that qualify for valuation discounts such as units in family limited partnerships and other types of minority fractional interests in property.
Qualified Nonreversionary Grantor Lead Trusts
The qualified nonreversionary grantor lead trust is a more recently approved variation that produces both income and gift tax deductions. Simply stated, it similar to a nongrantor nonreversionary lead trust in that it qualifies for a charitable gift tax deduction; however, it contains an intentional drafting defect (i.e., a right held by the grantor or nonadverse party to the grantor to reacquire trust property by substituting other property of equivalent value) that causes the grantor to be considered as the owner of the trust's income. This latter component also qualifies the transfer for charitable income tax deduction purposes.
Provided the grantor does not retain any rights that would otherwise cause the gift to be considered incomplete for gift tax purposes, the taxable transfer to the heirs becomes complete when the trust is established. Further, assuming the grantor retains no estate tax interests or strings, no portion of the trust is includible in the grantor's estate.
Example 3: The facts are same as in Example 1 except that Mrs. Green would like her son to be the remainder beneficiary. If Mrs. Green is treated as the income tax owner under the grantor trust rules, she will be entitled to a charitable income tax deduction for the present value of the income stream to charity -- $205,524. If the trust is a qualified charitable lead trust, she will also be entitled to a charitable gift tax deduction in the same amount for the present value of the income stream to charity. However, the present value of the son's remainder interest will be a taxable gift to her for gift tax purposes. The amount of the gift is determined by subtracting the present value of the income interest from the fair market value of the property transferred to the trust ($1,000,000 - $205,524 = $794,476). The trust assets should not be includable in her gross estate if she retains no applicable power or right.
Nonqualified Nongrantor Reversionary Lead Trust
In order to qualify for income, gift, and estate tax deduction purposes, a charitable lead trust must pay a guaranteed annuity or unitrust amount. Nonqualified charitable lead trusts are designed to violate this rule and, therefore, produce no income, gift, or estate tax deductions. Gift and estate tax deductions are immaterial because the trust will revert to the grantor. The trust will, however, be able to claim gift tax deductions for income amounts transferred to charity as they occur.
What is important to these types of trusts is fact that although no income tax deduction is available, neither is any of the trust's income taxable to the grantor. These trusts are taxable as complex trusts for which they can claim a deduction against their taxable income for amount distributed to charity.
Example 4: Mr. Smith owns a portfolio of corporate bonds. He desires to make a gift of income to charity and reduce his personal income taxes. Mr. Smith will transfer $500,000 in bonds to a charitable lead annuity trust. The trust will pay $35,000 annually to charity for a period of ten years; after which, the remainder interest will revert to Mr. Smith. The present value of the annuity interest is immaterial because no deduction is created. However, Mr. Smith will not have to include the interest income produced by the bonds on his personal tax return. Depending on the other elements of his income tax structure, an exclusion of this amount may drop Mr. Smith into a lower marginal income tax bracket.
When compared to a reversionary grantor trust, Mr. Smith will also benefit from avoiding the compliance and percentage limitation issues associated with claiming the charitable contribution income tax deduction.
It is possible for a CLT to provide for payment of the lead or income interest to both charitable and non-charitable beneficiaries.back
IRC §§2055(e)(2)(B) and 2522(c)(2)(B)back
As discussed supra, it is possible that using a charitable lead annuity trust to satisfy a legally-binding charitable pledge could have undesired consequences; we refer here to a non-binding charitable pledge.back
Gifts of an income interest via a charitable lead trust are considered gifts "for the use of" rather than "to" charity. If the income is payable to a 50%-type charitable organization (a public charity as described in IRC §170(b)(1)(A)), the deduction is subject to the 30% limitation. If the income is payable to a 30%-type organization (a private nonoperating foundation), the deduction is subject to the 20% limitation. Any excess deduction can be carried forward an additional five years.back