The Charitable Lead Trust: Don't Forget The Donor!

The Charitable Lead Trust: Don't Forget The Donor!

Article posted in Practice on 11 May 2000| comments
audience: National Publication | last updated: 18 May 2011
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Summary

Would you like to hear about marketing charitable lead trusts from the planned giving officer's viewpoint? In this edition of Gift Planner's Digest, Brown University's Marjorie Houston provides a general overview of nongrantor CLTs and why discussing family issues is just as important as discussing technical ones.

by Marjorie A. Houston

During this past year we have seen the IRS monthly discount rate as low as 6.4% with the current May rate 7.8%, making this a favorable climate for charitable lead trusts (CLT). Among its many uses, the CLT is a good vehicle for a donor to use to satisfy charitable intentions, and at the same time, pass along assets to the next generation at a minimal gift tax cost. The CLT, however, is not as much about saving taxes as it is about family. The donor is giving up something to make the gift, and so is the family. Helping the donor to understand the concept is important; listening to the needs and concerns of the donor is even more so.

Following are some questions and answers regarding the CLT that help flush out the technicalities and address the basic concerns of donors. However, providing the technicalities for the donor is not enough because the gift can derail on the emotional issues more than the technical ones. Know the donor's hot buttons-providing for children, explaining the gift to a spouse, paying gift tax, and/or paying capital gains tax.

How do you alleviate these issues while helping the donor understand the technical ones? You address and readdress the hot buttons! Make the explanations simple and targeted to addressing the emotional concerns. Involve the family members where appropriate and early in the process. Understand the other options available to the donor for making gifts to family members that achieve many of the same objectives, such as the Grantor Retained Annuity Trust or the Family Limited Partnership, and how they can be used to enhance charitable plans. The donor is hearing about these options from a variety of sources. Acknowledge them and bring the conversation back to the donor's desire to provide for the family while providing for charity. Most important, remain an objective partner in the process, listen to the donor, address the donor's needs, and MAKE IT SIMPLE! In the end, the donor will be the one who closes the gift.

What Is A Charitable Lead Trust And How Does It Work?

A CLT is an irrevocable trust, created during life or at death, that gives charity the first or leading interest-rather than the remainder interest-in the trust, and thereafter passes to, or continues in, trust for others, such as children or grandchildren. It is a separately invested trust created by transferring cash, marketable securities, or income-producing property to a trustee.

The trustee may be one or more individuals, a bank, charity, or a combination of these. The donor designates the charity as the beneficiary of income for a specified period of years, or for a period measured by a person's lifetime. If the trust is structured as a "nongrantor" trust, upon completion of the measuring period, the assets are paid to the beneficiaries designated in the trust instrument.

A unique feature of a charitable lead trust is that the donor may tailor the charity's income interest. A charitable lead unitrust pays an annual income equal to a percentage of the value of the principal, as valued annually. The percentage payout is selected when the trust is created. A charitable lead annuity trust pays a fixed amount annually to charity. The fixed dollar amount is specified when the trust is established.

How Can A Donor Benefit From The Charitable Lead Trust?

The gift and estate tax law provides for a deduction for the present value of the lead interest in the trust committed to charity. The gift or bequest, in the form of the CLT, is equal only to the remainder value of the trust assets that pass to the noncharitable beneficiaries after the CLT ends. The value of the remainder interest passing to the beneficiaries is subject to gift or estate tax at the time the trust is created.

The value of the taxable gift is determined by subtracting the value of the interest committed to charity from the fair market value of the property at the time it is transferred to the charitable lead trust. At this time, any available unified credit, which will reach $1 million by 2006, is applied to offset any gift tax obligation.

Briefly, three components influence the charitable lead trust: 1) the amount paid to charity; 2) the length of time the trust is established; and 3) the prevailing IRS discount rate at the time the trust is established. The discount rate is the percentage by which the government determines money will grow over time, based on the mid-term government bond rate. The rate fluctuates monthly. The combination of the three variables determines the value of the gift to the beneficiaries, and therefore, the amount of the taxable transfer.

Can You Arrange A Charitable Lead Trust So That The Gift Or Estate Tax Is Zero?

Through a charitable lead annuity trust, you can equalize the charitable deduction and the entire value of the property transferred to the trust. In this case, the taxable gift or bequest made upon creating the charitable lead annuity trust is zero and no gift or estate tax is assessed.

For example, on a trust established for 15 years, with a 6% payout rate, the donor would pay tax on 45 cents of each dollar given to his/her children, assuming that the portfolio has an annual total return of at least the charitable payout. If the asset doubles in that time period, the donor effectively will have paid tax on 23 cents or less on a future value. Moreover, based on certain of the foregoing assumptions (e.g., the trust growth is significantly greater than the IRS discount rate), the donor could almost certainly pass more to his/her family than if the asset were passed directly during lifetime or at death.

The chart below demonstrates the portion of a dollar subject to gift tax when placed in a charitable lead trust.

Income Term of Trust
Percent income earned on trust 10 years 15 years 20 years
5% 0.65 0.54 0.47
6% 0.58 0.45 0.36
7% 0.51 0.36 0.26
8% 0.44 0.27 0.15
9% 0.37 0.18 0.05
10% 0.30 0.09 0


Based on a 7.0% discount rate


Will The Donor Be Subject To Capital Gains Tax?

The most significant benefit of the inter vivos nongrantor charitable lead trust is that the asset is removed from the taxable estate. Any gift tax is due when the trust is established. If the trust is funded with a nonincome-producing asset, the trustee must sell or distributed trust assets annually to make the annuity payment, and the trust pays a capital gains tax for the sale. However, a corresponding tax deduction for the trust is applied because the trust is making payments to a charitable entity. The taxes paid are offset, therefore, essentially nullifying the tax effect to the trust.

Can The Donor Serve As Trustee For The Charitable Lead Trust?

With a charitable lead trust, the donor can either specify the charity or charities that receive payments from the trust, or leave the selection up to the trustees each year. If the charity or charities are selected annually by the trustee of the CLT, the donor cannot be a trustee solely holding that power or else the CLT property can be included in the gross estate. The donor has, however, the unqualified right to remove or replace an independent trustee or give that power to his/her spouse or other related person. This gives the donor enormous influence over the operation of a charitable lead trust.

Is A Charitable Lead Trust Right For Your Client?

Because of the administrative and start-up costs involved in setting up a charitable lead trust, the donor should not consider establishing a trust for less than $250,000. If the donor wishes to give charity the income stream from assets for a set period of time, but wants the capital value of marketable or income-producing assets to remain in the family, then a charitable lead trust may be right gift planning tool. If the donor wishes to pass assets to his/her children or other persons at a discounted value and a reduced gift tax liability, then a charitable lead trust may be the right answer. If the donor wants to remove assets from his/her taxable estate, but still have them pass to heirs during lifetime or at death, then a charitable lead trust may again be the right answer.

Most Frequently Asked Questions Of Paramount Interest To Donors

1) How do I determine the right number of years for my charitable lead trust?

The term is based on how soon you want your heirs to receive the assets and how much gift or estate tax you are willing to pay. A proven rule is to establish the trust for 10, 15, or 20 years if the assets at the end of the term are to benefit your children. If the assets are going to grandchildren, a 20- or 25-year-term is appropriate.

2) Is it still possible to zero out the remainder going to charity?

There are several planning issues to consider, such as the availability of your unified credit. While it is still possible, alternative strategies should be reviewed-such as the step charitable lead annuity trust or setting a higher pay-out rate to charity over the term of the trust.

3) What investment issues should I consider?

You should have confidence in your managers to be able to produce a total average annualized return over the life of the trust that beats the annuity or unitrust rate. This will cause the trust to grow and add to the remainder being transferred to your remainder beneficiaries.

4) Are there risks I should consider?

You should have a degree of comfort that some or all of the charitable pay-out will be taken from the trust's capital gains or principal, particularly if the funding asset either does not appreciate as anticipated or the portfolio is subject to market corrections.

5) What type of asset should I consider in funding the charitable lead trust?

Ideally, the CLT is funded using a single appreciated security with high potential for growth over time, a diversified stock and bond portfolio, or an asset that is considered grossly undervalued. The ideal asset is income producing real estate.

6) What kind of results can I expect?

In most cases, the lead annuity trust can provide more for the children than doing nothing or leaving your assets in your estate. The lead annuity trust also produces more for children than an equivalent outright gift to children coupled with an outright gift to charity.

7) How do I know if a CLT is right for me?

If you have an estate valued between $3 and $5 million, have children or grandchildren, and you and your family do not need immediate access to the income or principal, a charitable lead trust may prove an effective tool for you to make a charitable gift and satisfy some family planning issues. You will want to consider a minimum trust of $250,000 and fund it with an asset that is likely to appreciate over time.

Conclusion

Donors are receiving information on charitable estate planning from many sources. Charities and donor advisors should be prepared to help the donor decipher what is best for the donor, the family, and the charity. Understanding the options available will be the key to making the gift a pleasant experience for your donor.

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