Charitable Lead Trusts

Charitable Lead Trusts

Article posted in Charitable Lead Trust on 26 June 2003| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 16 September 2012
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Summary

In this edition of Gift Planner's Digest, Robert Lew and Darryl Ott, Esq. provide a concise overview of the variety of charitable lead trusts and provide eight creative case studies that illustrate their application.

by Robert Lew & Darryl D. Ott, Esq.

Robert Lew is the owner of Planning and Financial Advisors, a firm specializing in estate planning and insurance services located in San Francisco, California. Prior to his current position, he worked for over seven years for nonprofit organizations such as the American Red Cross. Lew has been active in planned giving for over seven years, and currently serves on the board of the Northern California Planned Giving Council where he has been the conference chair the past three years and is currently its vice president.

Darryl D. Ott of Morgan, Miller & Blair in Walnut Creek, California, has been involved with wealth transfer planning for high net worth individuals for nearly 30 years, and with charitable planned giving for over nine years. He is a member of the board of directors, and president of the Northern California Planned Giving Council, and has been a presenter to NCPG, and other national and local organizations on a variety of wealth transfer topics. Ott has a JD degree from the University of California, Hastings College of the Law, San Francisco, and is a Certified Specialist of Taxation Law with the California State Bar.


Charitable Lead Trusts

A qualified charitable lead trust (CLT)-qualified in the sense that its charitable gift portion is deductible for some or all of income, gift, and estate tax purposes is, in most respects, the conceptual opposite of the charitable remainder trust. The charitable lead trust technique involves the creation of a trust that will make its initial payments to charity for a specified term of years, or for a life or lives in being, and which, at the termination of the specified payment period, will distribute its remaining assets to noncharitable recipients (e.g., the donors, members of the donors' family, or other individuals). Thus, the charity has the initial, or "lead" interest in the trust, while the noncharitable recipients will take the remainder. There are two kinds of qualified charitable lead trusts: the charitable lead annuity trust (CLAT), and the charitable lead unitrust (CLUT). A CLAT is an irrevocable trust that may be established by a donor either intervivos, or upon death, and which specifies that an annual fixed dollar amount must be paid at least annually to charity until the termination of the specified term, at that point the trust assets pass to, or in trust, for the noncharitable recipients. Unlike the charitable remainder annuity trust, the annuity amount of a CLAT need not be at least 5% of the initial net fair market value of the assets transferred to the trust. A CLUT is an irrevocable trust that may be established by the donor either intervivos, or upon death, and which specifies that an annual "unitrust amount" must be paid at least annually to charity until the termination of the specified term, at that point the trust assets pass to or in trust for the noncharitable recipients. The annual "unitrust amount" must be equal to a specified percentage of the net fair market value of the CLUT's assets, as revalued each year. Unlike the charitable remainder unitrust, the specified percentage does not have to be at least 5% of the net fair market value of the trust assets.

Income Tax Consequences To Donors Of Transfers To CLTs

"Grantor Owned" Charitable Lead Trusts. Unlike charitable remainder trusts, an intervivos contribution to a qualified charitable lead trust (CLT) will not necessarily result in a charitable income tax deduction. For federal income tax purposes, the donor will be entitled to treat the charitable gift portion as a charitable contribution upon contribution of the property to the CLT only if thereafter the donor is treated as the "owner" of the charitable lead trust for income tax purposes pursuant to the "grantor trust" provisions of Code §671 1. This would be done, for example, if the donor or the donor's spouse retained the noncharitable remainder, and the value of the retained interest exceeded five percent. The income tax charitable contribution deduction is limited by the panorama of limitations imposed on the deduction of such contributions by individuals, relating to contribution base, type of property given, and type of charity to which it is given. Furthermore, if the donor obtains the income tax deduction at the inception of the trust, he or she will be required in subsequent taxable years to report all of the income realized by the CLT in his or her own personal income tax return, and will not get any further income tax deductions during the term of the CLT for the required payments made by the trust to charity. And, if the donor ceases to "own" the trust for income tax purposes at any time, most ordinarily because of his or her death, he or she will be required to recapture a portion of the charitable deduction that he or she previously obtained, and will be required to include it in income.

"Non-Grantor Owned" Charitable Lead Trusts. If the CLT is not designed so as to make the donor the "owner" of the trust for income tax purposes under the "grantor trust" provisions of Code §671, then the donor receives no income tax deduction at any time for the value of the charitable lead interest. However, the trust itself will typically receive an income tax deduction for the charitable payments when made. The seemingly peculiar rule requiring the donor to be the "owner" of the trust for income tax purposes in order to get an up-front deduction for the charitable lead interest serves to preclude a double deduction for the charitable contributions, once by the donor, and then again by the trust.

Gift Tax Consequences To Donors Of Transfers To CLTs

Charitable Lead Interest. When donors create an intervivos qualified CLT, they make a gift for gift tax purposes, of the present value of the charitable lead interest in the amount computed using Treasury tables. Unlike the income tax charitable deduction, which is subject to percentage limitations, donors are entitled to an unlimited gift tax charitable deduction. The deduction is not automatic, however; a gift tax return must be filed. For purposes of the gift tax charitable deduction, there is no requirement that the donors be the "owners" of the trust for income tax purposes. This gift tax analysis applies in the same manner to either a "grantor owned" CLT or a "non-grantor owned" CLT, and must be applied as of the date of the creation of the CLT.

Noncharitable Remainder Interest. If the donors retain the noncharitable remainder interest for themselves, there are no further gift tax consequences. If the donors do not retain the noncharitable remainder, then they also make a gift of the actuarially computed present value of the remainder when they create the CLT. Such a gift is of a future interest; so, a gift tax return must be filed regardless of the value of the noncharitable interest.

Estate Tax Consequences To Donors Of Transfers To CLTs

Intervivos Charitable Lead Trusts. If the donors to an inter vivos CLT do not retain any power over the trust, or any part of the noncharitable remainder for themselves, then no part of the trust's assets should be included in their estates since the gift would have been completed when the contribution to the trust was made. If, however, they retain a power over the trust, for example to select the charitable recipients, the trust will be included in one or both of their estates pursuant to Code §2036 or §2038. In that event, their estates will be entitled to an unlimited estate tax deduction for the value of the charitable lead interest determined as of the date of their deaths. The then value of the noncharitable remainder will be subject to the estate tax. For purposes of the estate tax charitable deduction, there is no requirement that the donor be deemed to "own" the trust for income tax purposes under the grantor trust rules.

Testamentary Charitable Lead Trusts. As to a qualified CLT created by a donor upon his or her death, the value of the charitable lead interest qualifies for an unlimited estate tax charitable deduction calculated under the appropriate tax tables. There are no percentage limitations that apply to the appropriately calculated charitable deduction. The then value of the noncharitable remainder would be nondeductible, and would be subject to estate tax. For purposes of the estate tax charitable deduction in this case, the concept that the donor be deemed to "own" the trust for income tax purposes under the grantor trust rules obviously has no application.

Effect on Estate and Gift Tax Deduction of Applicable Federal Rate. The percentages in the tables that follow show the effect that changes in the Applicable Federal Rate (AFR) have on the amount of the unlimited federal estate, and gift tax deduction available to donors using charitable lead annuity trusts, and charitable lead unitrusts. The rate actually used in these calculations is the "7520 Rate," which is a rounded 120% of the AFR. The 7520 Rate is directly involved in the calculation of these deduction percentages for CLATs. Since there are three variables in the CLAT calculations (7520 Rate, term of years, and annuity payout rate), Table A reflects a CLAT payout rate of 8%, Table B a CLAT payout rate of 10%, and Table C a CLAT payout rate of 12%. With respect to CLUTs, the 7520 Rate is only involved in the calculation of the periodic adjustment factor that has a minimal effect on the deduction percentages. Only one table is included, Table D, for the unlimited federal estate and gift tax deduction percentages for CLUTs to be used as a comparison to the CLAT figures.

Table A

CLATs Payout Rate -- 8%   7520 Rate  
Term of Trust 6% 7.2% 8.4% 9.6% 10.8% 12%
10 58.9 55.7 52.7 50.0 47.5 45.2
12 67.1 62.9 59.0 55.6 52.4 49.6
15 77.7 72.0 66.8 62.3 58.2 54.5
18 86.6 79.3 73.0 67.3 62.4 58.0
20 91.8 83.4 76.3 70.0 64.5 59.8


Table B

CLATs Payout Rate -- 10%   7520 Rate  
Term of Trust 6% 7.2% 8.4% 9.6% 10.8% 12%
10 73.6 69.6 65.9 62.5 59.4 56.5
12 83.8 78.6 73.8 69.5 65.5 61.9
15 97.1 89.9 83.5 77.8 72.7 68.1
18 100.00 99.2 91.2 84.2 78.0 72.5
20 100.00 100.00 95.3 87.5 80.7 74.7


Table C

CLATs Payout Rate -- 12%   7520 Rate  
Term of Trust 6% 7.2% 8.4% 9.6% 10.8% 12%
10 88.3 83.5 79.1 75.0 71.3 67.8
12 100.00 94.3 88.6 83.4 78.7 74.3
15 100.00 100.00 100.00 93.4 87.3 81.7
18 100.00 100.00 100.00 100.00 93.6 87.0
20 100.00 100.00 100.00 100.00 96.8 89.6


Table D

CLUTs Payout Rate - 10%     7520 Rate  
Term of Trust 6% 7.2% 8.4% 9.6% 10.8% 12%
10 65.1 65.1 65.1 65.1 65.1 65.1
12 71.8 71.8 71.8 71.8 71.8 71.8
15 79.4 79.4 79.4 79.4 79.4 79.4
18 85.0 85.0 85.0 85.0 85.0 85.0
20 87.8 87.8 87.8 87.8 87.8 87.8


Income Taxation Of CLTs

"Grantor Owned" Charitable Lead Trusts. As described above, a donor will be entitled to a charitable income tax deduction at the inception of a "grantor owned" CLT for the value of the charitable lead interest only if thereafter the lead interest is deemed "owned" by the donor for income tax purposes. In such a case, to the extent the donor is considered the "owner" of all, or a portion of the trust, items of income, deductions, and credits attributable to such portion will be taken into account by the donor in his or her own income tax returns for all subsequent taxable years of the CLT, and the CLT will not be required to report such income.

"Non-Grantor Owned" Charitable Lead Trusts. As to any CLT that is not considered to be "owned" by the donor for income tax purposes, such as an inter vivos CLT with respect to which the donor retained no powers or interests described in Code §671 or any testamentary CLT, the CLT is subject to tax under the normal rules of Code Subchapter J. It is not exempt from tax as are charitable remainder trusts. Such a CLT is, however, entitled to the unlimited charitable deduction for any amount of gross income that is, pursuant to the governing instrument, paid for charitable purposes specified in Code §170(c). In order to insure that the charitable distributions are being made out of gross income pursuant to the governing instrument, the instrument should specify that the charitable payments be made first from ordinary income, second from net short term capital gains, next from net long term capital gains, then from unrelated business taxable income, from tax-exempt income, and finally, from trust corpus. This "source of payment" provision is not free from controversy with the IRS, but should be included anyway in the trust document for the CLT. The "throwback rules" of Code §665 apply to CLTs. However, accumulated income used to satisfy the required charitable payments would not be considered to be accumulation distributions. Furthermore, in contrast to charitable remainder trusts, Code §644 applies to inter vivos CLTs, and that section generally taxes capital gains on property sold by a trust, even a CLT, within two years after the transfer of the property to the trust at the donor's rates.

Unrelated Business Taxable Income. Code §681 disallows the Code §642 deduction for the payments to the charities to the extent that the payment is allocable to the unrelated business taxable income (UBTI) of the CLT. A CLT's UBTI consists of: 1) its gross income derived from an unrelated trade or business (as defined in Code §513) regularly carried on by it-less the deductions attributable to such business; and 2) a portion of its gross income derived from debt-financed property-less a portion of the expenses attributable to such income. For this purpose, "acquisition indebtedness" includes the CLT's indebtedness incurred to purchase or improve the property. It also includes any mortgage to which the property was subject at the time of its acquisition even if acquired by gift from the CLT's creator (the donor), and even if the CLT does not assume the mortgage. If the CLT acquires the property by gift, any mortgage to which the property is subject is not treated as acquisition indebtedness if the transferor held the property for at least five years before the transfer, if the mortgage was placed on the property at least five years before the transfer, and if the CLT does not assume the mortgage. If the CLT acquires the property by bequest, any mortgage to which it is subject is not treated as acquisition indebtedness for 10 years after the testator's death if the CLT does not assume the mortgage.

Although the deduction for distributions of UBI is disallowed under IRC §681, section 512(b)(11) provides partial mitigation. Specifically, this section permits the trust to deduct payments of UBI actually made to charity subject to the percentage limitation rules applicable to individual taxpayers. Accordingly, if the distributions consist of cash payable to a public charity as described in IRC §170(b)(1)(A), the trust can deduct distributions of UBI to the extent of 50% of the trust's contribution base. If the payments are made to a private non-operating foundation, the percentage limitation is 30%.

Testamentary Planning Using CLTs. Code §1014 provides that at the death of a taxpayer, the basis of the assets then owned by the decedent is increased to their value as of the date of the taxpayer's death. As a result, all of the potential capital gains previously associated with those assets is "forgiven." So even though a CLT is a taxable entity, it will only be the increase in value of the assets transferred into the CLT over their value as of the date of death of the donor that will be subject to income taxation. In many situations, this "stepped-up" basis rule is a major benefit for wealth transfer planning when the donors use testamentary CLTs.

The Qualified But "Defective" Charitable Lead Trust

In General. Can a donor obtain an income tax deduction at the inception of a CLT because the CLT is a "grantor owned" CLT, and also obtain a gift tax deduction for the noncharitable gift to the remainder beneficiaries of the CLT? The answer is yes; therefore, the CLT is a qualified but "defective" charitable lead trust.

Specific Authority. There are at least three Private Letter Rulings (9224029, 9247024, and 9407014) issued by the Internal Revenue Service that recognize that a donor can obtain a federal income tax deduction for the present value of the charitable lead trust interest, and that the CLT will also qualify as a charitable lead trust for purposes of the gift tax charitable deductions laws for the same asset transfer.

Specific Applications. The opportunities for this "dual" qualification of a CLT are substantial, but at this point mostly unexplored. Case study number four describes a specific application.

The Non-Qualified Charitable Lead Trust

In General. A non-qualified charitable lead trust (NQCLT) is any trust that pays an income interest or an annuity interest to charity, and that is not either a qualified CLAT or a qualified CLUT. Any transfers to a NQCLT will generally be fully subject to gift tax or estate tax, and will not entitle the transferor to an income tax deduction, estate, or gift tax deduction.

Donors Retained Right to Select Charitable Beneficiaries. If the creator of the NQCLT retains the right to designate the charities to receive the income of the NQCLT each year, the gift of the income interest will not be a completed gift, the corpus of the NQCLT valued as of the date of the creator's death will be included in the creator's estate for federal estate tax purposes, and the transfer will not create any income tax deduction for the creator as of the date of the transfer to the NQCLT.

Transfers Eligible for Annual Exclusion. If a donor creates a NQCLT to pay income currently to a particular charitable organization, the right to receive the income should be a present interest in property and, therefore, should be eligible for the annual gift tax exclusion that allows any transferor to make gifts of present interests of $10,000 per year to as many donees as he/she desires without creating the need for the filing of a federal gift tax return. If the donor does not retain any other rights in the NQCLT, no portion of the trust would be included in his/her estate for federal estate tax purposes. The donor will not receive an income tax deduction when the NQCLT is created.

Conclusion. The circumstances set out above are not the only situations when a NQCLT might be appropriately used. So, when is it appropriate to use a NQCLT instead of a qualified CLT? The jury is out! The circumstances will have to be very unusual, probably with very highly motivated, and charitably inclined donors, and with very large dollar amounts to warrant the use of a NQCLT.

Private Foundation Provisions, Excess Business Holdings, And Other Self-Dealing Concerns

Private Foundation Provisions. CLTs are subject to many of the private foundation provisions contained in Code §507-termination tax; Code §508(e)-governing instrument language; Code §4941-self-dealing; and Code §4945-taxable expenditures. In the normal course of operation of a CLT, Code §507 termination tax should not be applicable since it is not assessed "by reason of any payment to a beneficiary that is directed by the terms of the governing instrument of the trust, and is not discretionary with the trustee?." Code §508(e) governing instrument language provision is applicable to CLTs, but it is easy enough to comply with this requirement by careful review of Code §508(e), and the inclusion of the appropriate language in the trust instrument.

Probably the most important provision is contained in Code §4941, which contains the prohibitions against self-dealing. The prohibited acts of self-dealing are: 1) the sale, exchange, or lease of property between a CLT, and a disqualified person; 2) the lending of money or other extension of credit between a CLT, and a disqualified person; 3) the furnishing of goods, services, or facilities between a CLT, and a disqualified person; 4) the payment of compensation (or payment or reimbursement of expenses) by a CLT to a disqualified person; 5) the transfer to, or for the benefit of, or use by, a disqualified person of the income or assets of a CLT; and 6)the agreement by a CLT to make any payment of money or other property, to a government official.

The provisions of Code §4945 are the final requirement applicable to CLTs. This section imposes an excise tax on each "taxable expenditure" made by a CLT that includes, in part, amounts paid or incurred by a CLT: 1) to influence legislation; 2) to influence the outcome of a public election or carry on voter registration drives; or 3) for any purpose that is not within the usual religious, charitable, scientific, literary, and educational purposes as contemplated in the Code.

Excess Business Holdings And Jeopardy Investments. With respect to excess business holdings (Code §4943), and jeopardy investments (Code §4944), the rules for CLTs contain a significant exception that is important for wealth transfer planning. A CLT has excess business holdings to the extent that it, together with all disqualified persons, own in the aggregate more than 20% of the voting stock of the incorporated business enterprise (or corresponding interests in non-incorporated business enterprises). In general, where a CLT acquires excess business holdings by gift or bequest, the CLT has five years from the date it acquires such holdings to dispose of them.

Code §4944 imposes an excise tax on a CLT for investing any amount in such a manner as to jeopardize the carrying out of its exempt purposes. However, Code §4947(b)(3)(A) provides that a CLT does not have to comply with the excess business holdings or jeopardy investments requirements if: 1) all of the "income interest," and none of the remainder interest of the CLT is devoted solely to the general charitable purposes described in Code §170(c)(2)(B); and 2) the value of the charitable lead interest (i.e., the amount of the charitable deduction) at the time of the creation of the CLT is not more than 60% of the value of the assets transferred at such time to the CLT. This exception is particularly important in planning the estate of a donor who owns a highly valued, successful, family involved, appreciating business enterprise, or significant real estate holdings, which he or she desires to have continue in the family.

Trustees. The trustee of a CLT can be an institution such as a bank or other corporate entity, or an individual who is independent (as defined in the Code) from the donors. The donors themselves can be the trustees of a non-grantor owned CLT, and not cause the corpus of the CLT to be included in the donor's estate so long as the donor as trustee possesses only routine administrative powers. Also members of the donor's family (other than the donor's spouse) can serve as trustee of a non-grantor owned CLT, even in those situations where these same family members also control the assets that are held by the CLT such as a closely held corporation. Special care, however, must be exercised if the donors or family members are trustees of the CLT, and a potential beneficiary of the CLT is a private foundation controlled by the donors or their family.

Generation Skipping Transfer Taxation of CLTs

In General. The impact of the generation skipping transfer (GST) tax must be carefully considered in the use of any wealth transfer plan, and particularly with the multigenerational charitable gift planning that is so easily, at least potentially, involved with gifts to CLTs. The purpose of the GST tax under Chapter 13 of the Code is to prevent a donor from transferring wealth to a person who is two or more generations below the transferor without the imposition of a transfer tax at the intervening generation. Because the GST tax is imposed on any "generation skipping" transfer, or distribution at the maximum marginal estate tax rate then in effect, and may be imposed in addition to any estate tax otherwise payable by the transferor, the GST tax can be extremely costly, and must be minimized or avoided if at all possible, or, at the very least, it must be anticipated. 2 Determining the impact of the GST tax on a given sophisticated charitable giving technique in a specific situation generally requires a two-fold analysis. First, it should be determined whether the GST tax might ever apply to the technique on the specific set of facts. Second, if it might, should the donor attempt to minimize that tax by the allocation of some of his or her $1,000,000 GST exemption to the transfer, and if so, how?

CLTs will frequently be structured in such a way that the GST tax may have relevance. CLTs are often designed to pass to or into trusts for descendants of the donors at the termination of their charitable lead terms. Consequently, if any of the descendants that the CLT terminates in favor of, are skip persons (e.g., grandchildren) or if any of the trusts that assets of the CLT pass into might benefit skip persons, there is likely to be a generation skipping transfer at the end of the term of the CLT or thereafter. 3

Thus, upon the creation of the CLT, the donor, or his or her executor, or trustee, should always consider allocating some or all of his or her $1,000,000 GST exemption to the CLT to reduce the GST tax rate to zero on any future transfers subject to the GST tax. The donor can reduce the GST tax rate to zero by allocating sufficient GST exemption to the transfer so that its "applicable fraction," which in a sense defines the exempt portion of the CLT, is one. The applicable fraction is determined differently for CLUTs, and CLATs.

The allocation of the GST exemption to CLUTs is fairly straightforward. Unfortunately, the Code makes the allocation of the GST exemption to CLATs very complicated and, by design, not as favorable to the donors as for CLUTs. It is important, however, for wealth transfer planners to understand the impact, and the general magnitude of the GST tax on various transfers to CLUTs and, particularly, CLATs, so that they can advise their clients appropriately.

CLUTs. The allocation of the GST exemption to CLUTs is governed by the same set of rules governing the allocation of the GST exemption to charitable remainder trusts, and most other transfers. That is, the donor can allocate the GST exemption to a CLUT that is created intervivos, and is a completed gift for gift tax purposes at the time the gift tax return for the transfer is filed or thereafter.4 If the CLUT is created under a testamentary disposition at the donor's death, the executor can make the allocation on the federal estate tax return.5 Under the Code, a special rule covers the timing of the allocation of the GST exemption to gifts which, though technically completed during lifetime, are of property that will be included in the donor's gross estate at death. 6 As to such transfers, the allocation cannot be made until the earlier of the transferor's death or the occurrence of an event such that the property will no longer be included in the transferor's gross estate.

To determine the amount of the GST exemption that must be allocated to the CLUT so that its "applicable fraction" is one, resulting in a GST tax rate of zero, one should first compute the denominator of the applicable fraction. The denominator is equal to the value of the property transferred to the trust (generally valued at its gift tax value, if the allocation is made on a gift tax return; at its estate tax value, if the allocation is made on the estate tax return; and valued at its fair market value at the time of allocation, if the allocation is made at any other time), less any federal estate tax or state death tax recovered from the trust attributable to the property, and less any charitable deduction allowed with respect to the property for estate or gift tax purposes under Code §2055 or §2522.7 As a practical matter, the denominator will typically be the fair market value of the property put into the CLUT less the value of the CLUT's charitable lead interest calculated under the Service's tables. The amount of the GST exemption that should be allocated to the transfer to the CLUT as the numerator of the applicable fraction, therefore, will be, to the extent possible, an amount equal to the denominator as so computed that then results in an applicable fraction equal to one, and a GST tax rate equal to zero so long as the denominator of the applicable fraction does not exceed the $1,000,000 GST exemption. 8

CLATs. The rules governing the determination of the applicable fraction of CLATs had been the same as those for CLUTs. However, Code §2642(e), added in 1988, now provides a unique set of rules for the determination of the applicable fraction of CLATs for transfers occurring after October 13, 1987. Code §2642(e) does not affect the time that the GST exemption must be allocated to the CLAT. Thus, the grantor will typically allocate the GST exemption to the CLAT when the CLAT is created (i.e., on the gift tax return if the gift to the CLAT is made intervivos, and on the estate tax return if the CLAT is created at death). However, it provides that the applicable fraction will not be determined at the time the GST exemption is allocated to the CLAT but will instead be determined at the time of the actual termination of the charitable lead interest. The denominator of the applicable fraction will be the value of all the property actually left in the CLAT immediately after the termination of the charitable lead annuity. The numerator will be the "adjusted GST exemption," which is defined as the amount of the GST exemption that had been allocated to the CLAT increased for the actual period of the CLAT by interest determined at the interest rate that had been used for determining the gift or estate tax deduction for the CLAT. [Code §2642(e)(2)] Therefore, for transfers occurring after October 13, 1987, only if this numerator equals the denominator as determined at the date of the termination of the CLAT will the applicable fraction of the CLAT be considered to be one, thereby causing the GST tax rate to be zero.

As a result, if the donor allocates an amount of GST exemption to the CLAT at its inception that is equal to the portion of the CLAT not qualifying for the charitable gift, or estate tax deduction, the numerator will precisely equal the denominator at the CLAT's termination only when the actual rate of return realized by the investments in the CLAT, and the actual term of the lead interest of the CLAT are exactly equal to those assumed for purposes of computing the gift or estate tax deduction. The actual term of the lead interest will be equal to the assumed term for term-of-years CLATs. The actual term will hardly ever be the assumed term for a CLAT for the life or lives of individuals. The actual rate of return will seldom be equal to the assumed rate. Of course, the donor could have allocated more or less GST exemption to the CLAT, but Code §2642(e) makes it impossible to allocate enough, and just enough, GST exemption to a CLAT to render it fully exempt from the GST tax. Determining the correct amount of GST exemption to allocate to a CLAT will require guesswork as to the CLAT's actual term, and actual rate of return. If it turns out that not enough of the GST exemption was allocated, the CLAT will be subject to the GST tax if a taxable distribution or taxable termination occurs. If it turns out an unnecessarily high amount of GST exemption was allocated, some of the exemption will have been wasted on the CLAT when perhaps it could have been better used elsewhere. Of course, if the amount of the assets transferred to the CLAT at its inception is so large, it will not be possible to "shelter" enough of the value of the assets of the CLAT at its termination from the GST tax if some, or all, of the beneficiaries at such time are skip persons.

This special rule for CLATs was designed to insure that donors could not use the GST exemption in a way that would "leverage" greater asset values to their descendants. However, leveraging is possible only when the assumed rates of return used in the calculation of the gift, and estate tax deductions are in excess of the actual rates of return realized by the CLAT. With the requirement to keep the rates of return current through the use of the "applicable federal rates," the special rules of Code §2642(e), and all the uncertainty they create, hardly seem necessary, or justifiable.

Specific Numerical GST Tax Examples

Table E sets forth the maximum value of the assets that may be transferred to a CLUT by the donors as an intervivos gift, or at their death without creating even any potential of a GST tax becoming payable at the termination of the CLUT. The basic underlying assumption, of course, used in the preparation of this Table is that all of the noncharitable beneficiaries of the remainder interest distributable from the CLUT are skip persons. If some of the noncharitable beneficiaries of the CLUT at its termination are non-skip persons, then, for that reason alone, there would not be any GST tax payable as to that portion of the remainder of the CLUT.

Table E: GST Tax Example-CLUT

CLUT Deduction Percentage Maximum GST Exemption Maximum Value Of Assets Transferable To CLUT With No Potential GST Tax
60% 1,000,000 2,500,000
70% 1,000,000 3,333,333
80% 1,000,000 5,000,000
85% 1,000,000 6,666,667
90% 1,000,000 10,000,000
95% 1,000,000 20,000,000
98% 1,000,000 50,000,000
100% 1,000,000 Infinite


Table F sets forth the varying amounts of GST tax that would be payable using the various assumptions as to the amount of the assets transferred to the CLAT, the CLAT payout rate, and term, the federal estate, and gift tax deduction determined from these factors, and the actual composite (interest, dividend, and capital gain) investment return realized by the CLAT assets throughout its term. The basic underlying assumption, used in the preparation of this Table is that all of the noncharitable beneficiaries of the remainder interest distributable from the CLAT are skip persons. If some of the noncharitable beneficiaries of the CLAT at its termination are non-skip persons, then, for that reason alone, there would not be any GST tax payable as to that portion of the remainder of the CLAT. For purposes of calculating all of the figures in Table B, the applicable federal rate is assumed to be 7%, which translates to a 7520 Rate of 8.4%.

Table F: GST Tax Example-CLAT

  Assets Into CLAT Payout Rate Term Deduction % Actual
Composite Invest-
ment
Return
GST Exemption Allocated At Formation Future Value Of CLAT Assets GST Tax
1 4,000,000 10 15 86.1 10 957,568 4,000,000 0
2 4,000,000 10 15 86.1 11 1,000,000 4,584,838 224,174
3 4,000,000 10 15 86.1 12 1,000,000 5,224,939 576,230
4 4,000,000 11.5 15 99.1 11.5 781,514 4,000,000 0
5 4,000,000 11.5 15 99.1 12.5 903,986 4,626,841 0
6 4,000,000 11.5 15 99.1 13.5 1,000,000 5,313,490 107.372
7 8,000,000 11.5 15 99.1 11.5 1,000,000 8,000,000 1,584,953
8 8,000,000 11.5 15 99.1 12.5 1,000,000 9,253,682 2,274,478
9 8,000,000 11.5 15 99.1 13.5 1,000,000 10,626,979 3,029,791


Real Life Case Studies and Specific Applications for CLTs

In each of the case studies, the following assumptions have been used, unless a differing assumption is stated in the particular case study.

Description Assumption
Combined Federal and State Ordinary Income Tax Rate 40%
Combined Federal and State Capital Gain Tax Rate 27%
Inflation/Present Value Interest Rate 3.5%
Before Tax Total Rate of Investment Return 8%
7520 Interest Rate 7.2%
Federal Estate and Gift Tax Exemption Equivalents ($650,000) Unused
Federal Generation Skipping Transfer Tax Exemption Unused

  1. Case Study One: Grandma
  2. Case Study Two: Thank You
  3. Case Study Three: Family Farm
  4. Case Study Four: Silicon Student
  5. Case Study Five: Before I Die
  6. Case Study Six: Founders Stock
  7. Case Study Seven: Name That Building
  8. Case Study Eight: I Could Have Had a V-8!

Conclusion

The use of sophisticated charitable giving techniques seems to be coming of age with a broad spectrum of innovative nonprofit development officers, and professional advisers who are forward thinking, and who are connecting with donors that are open to planning techniques that create true win-win situations for the donors, their families, and the ever more needy charities. The limitations imposed in recent years on other tax deferral techniques, the personal computer, and an ever-increasing responsibility upon the private sector to assist charities with the human issues concerning our society are combining to create significant opportunities for individual donors and charities. Officers of charities and professional advisers working closely together can provide immense assistance to their donors by first helping them develop a family financial philosophy that is the doorway to a better understanding of the importance of all of the planned giving tools. CLTs provide a broad spectrum of very powerful planning options that have been available for some time but that can now be better analyzed, understood, and applied for the mutual benefit of the donors and the charities. Planned giving professionals, attorneys, certified public accountants, insurance professionals, and financial planners will now all be called upon to develop new uses for these sophisticated techniques, and to find more and more applications that create new, and substantial opportunities for donors and charitable recipients.


Case Study One: Grandma

(Testamentary, CLAT, and Non-Grantor)

A grandmother, age 75, has assets worth $1,000,000. Her children are all doing well, and she would like her assets to benefit both her grandchildren and her community. Her husband died many years ago. She still has not used her federal estate tax unified exemption equivalent of $650,000.

Grandma can establish, at her death, through her living trust a 7.8%, seven-year charitable lead annuity trust with the $1,000,000 principal to pass to her grandchildren at the end of the term of the CLAT. At a 7520 Rate of 7.2%, the present value of the future gift to the grandchildren will be about $582,552, which is below her unified exemption equivalent limit, thereby allowing the assets to pass to her grandchildren without any estate taxes. If the total return (interest, dividends and capital growth) within the CLAT is 8% annually, the grandchildren will receive $1,009,711 without any estate taxes and without any generation skipping transfer taxes

Financial Results:
  7.8% CLAT No CLT - Direct To Grandchildren
Estate Size $1,000,000 $1,000,000
Estate Tax Deduction $417,448 0
Estate Tax $0 $134,500
Generation Skipping Tax $0 $0
Net To Grandchildren In Seven Years $1,009,711 $1,201,7001
Difference To Grandchildren ($/%) ($191,989)(16.0%) -
Amount To Charity $546,000 $0
Total Wealth Controlled $1,555,711 $1,201,700
Difference In Total Wealth Controlled ($/%) $354,01129.5% -

  1. Assumes that $865,500 is invested and yields an annual after tax total return of 4.8% for 7 years.back

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7520 Rates: Nov 2.2% Oct 2.2% Sep 2.2%

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