Charitable Lead Trusts: A Primer

Charitable Lead Trusts: A Primer

Article posted in Charitable Lead Trust on 21 November 2000| comments
audience: National Publication | last updated: 16 September 2012
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Summary

In this article, Daniel L. Daniels, Esquire, and David T. Leibell, Esquire review the basics of charitable lead trusts and some of the main issues involved in their use.

by Daniel L. Daniels, JD and David T. Leibell, JD

Daniel L. Daniels is a graduate of Dartmouth College and Harvard Law School. He is a partner in the Charitable Planning Group of Cummings & Lockwood, Stamford, Connecticut. A fellow of the American College of Trust and Estate Counsel, Daniels writes and lectures frequently on a variety of estate and charitable planning topics, including a recent speech on charitable lead trusts at the National Conference on Planned Giving.

David T. Leibell is a graduate of Trinity College and Fordham Law School with an LLM in Taxation from New York University. He is an associate in the Charitable Planning Group of Cummings & Lockwood, Stamford, Connecticut.

Cummings & Lockwood is a Connecticut- and Florida-based law firm with more than 60 of its 195 attorneys practicing exclusively in the area of estate, charitable planning, and administration. The authors are part of the firm's Charitable Planning Group chaired by Conrad Teitell. Web site: www.cl-law.com


Charitable Lead Trust (CLT) Vocabulary1

Charitable remainder trust in reverse. A CLT is often referred to as a charitable remainder trust in reverse because the usual roles of charitable and noncharitable beneficiaries are reversed. In a CLT, charity leads off by receiving an income interest for a certain period of time, after which noncharitable beneficiaries receive the remaining trust principal.

Lead interest. The lead interest in a CLT is charity's right to receive payments from the trust for a certain term. That right may take the form of the right to receive an annuity payment or a unitrust payment.2 An annuity payment is the right to receive a specified amount from the trust each year that does not change from year to year. A unitrust payment is the right to receive a specified percentage of the trust assets each year that necessarily will vary as the value of the trust changes from year to year.

Term. The term of a CLT is the length of time over which charity is to receive its annuity or unitrust payments. The term may be the life or lives of a permitted individual or individuals or a term of years or a combination of the two.3 In contrast to a charitable remainder trust, if the term of a CLT is measured by a term of years, that term need not be limited to 20 years.

Remainder interest. The remainder interest is the right of the noncharitable remainder beneficiaries to receive the remaining principal of the trust at the expiration of the charitable term. The remainder beneficiaries may be the grantor or other noncharitable beneficiaries.

Types Of CLTs

Qualified CLT. A qualified CLT is a CLT that meets various IRC requirements for deductibility of the lead interest for federal estate, gift, and/or income tax purposes.

A qualified CLT may be either a charitable lead annuity trust (CLAT) or a charitable lead unitrust (CLUT). A charitable lead annuity trust is a CLT in which charity is to receive a guaranteed annuity payment during the term of the trust. A charitable lead unitrust is a CLT in which charity is to receive a guaranteed unitrust interest during the term of the trust.

A qualified CLT may be either inter vivos or testamentary. An inter vivos charitable lead trust is a CLT created during the donor's lifetime. A testamentary charitable lead trust is a CLT created under the donor's will. An inter vivos CLT provides gift tax advantages and in some cases may also produce an income tax benefit. A testamentary CLT generally provides only estate tax advantages.

Unlike a charitable remainder trust, a CLT is not exempt from federal income tax. The manner in which trust income is taxed depends upon whether the CLT is a grantor CLT or a non-grantor CLT. A grantor charitable lead trust is a CLT of which the donor (grantor) is treated as the owner for federal income tax purposes because of certain powers that the grantor or parties related to the grantor retain over the trust. The donor is taxed on all of the income of a grantor CLT regardless of the fact that the income is never distributed to the donor. A non-grantor charitable lead trust is taxed as a standard complex trust for income tax purposes meaning, generally, that the trust is taxed on all of its net undistributed income and on all capital gains. However, a non-grantor CLT does generally receive a charitable income tax deduction for the annuity or unitrust payments made to charity each year. A grantor CLT does not receive such a deduction.

Non-qualified CLT. A non-qualified CLT is an irrevocable trust providing an income interest to charity that does not meet IRC requirements for estate, gift, or income tax deductibility. A non-qualified CLT generally is taxed as a complex trust for income tax purposes.

Lead Trust Benefits

Benefits to charities. A lead trust can enable a charity to "lock in" an immediate and possibly sizable gift. Charitable lead trusts tend to be used only by wealthy donors. Because the trust is a highly complex technique involving fairly significant legal and administrative costs, it generally is not cost effective unless funded with a large amount of assets--in our office, we generally advise against a lead trust with anything less than $1,000,000 in initial funding. Moreover, the trust agreement is irrevocable and, in contrast to a charitable remainder trust, often provides immediate payments to the charity.

Benefits to donors. In addition to providing a means for benefiting a favorite charity, a properly designed lead trust will produce an estate or gift tax deduction for the donor for the value of that portion of the trust designated for charity. In addition, if the lead trust is structured as a "grantor" trust for income tax purposes, the donor is permitted to take an immediate income tax deduction for the value of charity's interest in the trust. However, the benefit of the income tax deduction may be diluted by two factors: First, the donor will be subject to tax on all of the trust's income during the charitable term; second, if the donor dies or the trust otherwise loses its grantor trust status during the charitable term, then the benefit of the charitable income tax deduction is "recaptured" at that time.

Benefits to family members. A donor is considered to have made a taxable gift to a lead trust equal to the initial value of the assets contributed to the trust less the value of charity's interest in the trust. The value of charity's interest in the trust is computed by reference to a discount rate promulgated each month by the Treasury under section 7520 of the Code. If the assets in the lead trust perform at a rate greater than the section 7520 rate, the family will receive assets in excess of that which was reported to the IRS as a taxable gift.

Example A: In April 2000, when the assumed discount rate is 8%, Donor contributes $1,000,000 to a 20-year charitable lead trust paying an annuity of $101,800 per year. The value of charity's interest in the trust would be just under $1,000,000 ($999,483), meaning that the taxable gift to the remainder beneficiaries would be $517. If the trust assets perform at a rate of less than 8% per year for the 20-year term, there will be nothing left in the trust for the remainder beneficiaries. However, if the trust assets perform at a rate better than 8%, then the remainder beneficiaries will receive the following.

Assumed Annual Rate of Return
Amount Received By Remainder Beneficiaries
9%
$ 396,311
10%
$ 896,905
15%
$5,937,781

These benefits are magnified if the trust can be designed to eliminate or reduce generation-skipping transfer tax. However, at least in the case of a charitable lead annuity trust, structuring the trust to avoid application of the generation-skipping transfer tax is problematic.

Estate And Gift Tax Deductibility

Denial of deduction for gifts to "split interest" trusts. IRC §§ 2055(e)(2) and 2522(c)(2) generally deny a gift or estate tax charitable deduction for gifts to trusts in which charity has only a partial interest. These code sections were enacted in 1969 in response to certain perceived abuses concerning charitable trusts. For example, under a pre-1970 charitable trust, a donor might provide for all of the trust income to be paid to charity for a certain period of years, with the remainder payable to his/her children. Prior to 1970, the law would have permitted a charitable deduction for the value of charity's income interest at a fixed assumed discount rate. However, the trustee would be free to invest the trust in such a way as to produce income less the assumed discount rate, with the result that the charitable deduction would be overvalued and the taxable gift to the children undervalued. In response, IRC §§ 2055(e)(2) and 2522(c)(2) deny a deduction for such split interest trusts unless charity's interest in the trust takes the form of a guaranteed payment, i.e., either a guaranteed annuity interest or a guaranteed unitrust interest.

Guaranteed annuity interest. IRC §§ 2055(e)(2)(B) and 2522(c)(2)(B) and the regulations thereunder4 set forth the following requirements in order for an interest to qualify as a guaranteed annuity interest:

1) Charity must have the irrevocable right, granted under the governing instrument, to receive a fixed amount payable at least annually.

2) The annuity amount can be described as a percentage of the assets initially contributed to the trust.5 This method of describing the annuity amount can be particularly useful for hard-to-value assets, such as real estate or closely held stock because the annuity amount automatically adjusts if the value of the contributed property is adjusted in an IRS audit.

Example B: Donor contributes closely held stock appraised at $1,000,000 to a 20-year charitable lead trust directing the payment of an annuity of 10.18% of the value of the assets initially contributed to the trust "as finally determined for federal gift tax purposes." Using the April 2000 discount rate of 8% and the appraised value of the trust assets, the annuity amount would be $101,800 per year and the value of charity's interest in the trust would be just under $1,000,000 ($999,483), resulting in a taxable gift to the remainder beneficiaries of $517. On audit, the valuation of the property contributed to the CLAT is adjusted to $2,000,000. If the annuity amount were described simply as "$101,800 per year" then the taxable gift to the children would increase to $1,000,517, possibly generating an unexpected federal gift tax. However, because the annuity is described as a set percentage of the initial value of the trust assets as finally determined for federal gift tax purposes, the result of the valuation adjustment on audit is simply an increase in the annuity amount from $101,800 to $203,600 and an increase in the taxable gift from $517 to $1,034. The charitable deduction likewise would increase to $1,998,966.

3) Under Treas. Reg. §§ 20.2055-2(e)(2)(vi) and 25.2522(c)-3(c)(2)(vi), the annuity interest must be a guaranteed annuity interest "in every respect." Accordingly, the trust agreement cannot provide that charity is to receive a payment equal to the lesser of a sum certain or a fixed percentage of the net fair market value of the trust assets. However, it is permissible for the trust agreement to provide for a varying annuity amount as long as the amounts to be paid are ascertainable on the date of the initial transfer to the trust. Assuming that the value of the trust assets is likely to appreciate over the life of the trust, it is advantageous to the trust remainder beneficiaries for the annuity payments to charity to be "end-loaded" as shown in the following example.

Example C: Compare two scenarios. In the first, in April 2000, Joe Generous contributes securities worth $1,000,000 to a 20-year charitable lead trust directing level annuity payments of $101,853 per year. In the second scenario, also in April 2000, Martha McGiver contributes securities worth $1,000,000 to a 20-year lead trust but the trust agreement does not direct level annuity payments. Instead, it provides for an initial annuity payment of $16,609 with each successive payment to be an amount equal to the prior year's payment multiplied by 120%. In both scenarios, using the April 2000 discount rate of 8%, charity's interest in the trust would be worth just under $1,000,000, meaning that the taxable gift to the remainder beneficiaries would be near zero. However, if the trust assets perform at a rate greater than 8% per year, the remainder beneficiaries of the McGiver trust will receive $1,382,134 more than the remainder beneficiaries of the Generous trust as shown in the charts below.

Standard CLAT (Joe Generous)


Year   Beginning
Principal
  12.00%
Growth
  Annual
Payment
  Remainder
1   $1,000,000   $120,000   $101,853   $1,018,147
2   $1,018,147   $122,178   $101,853   $1,038,472
3   $1,038,472   $124,617   $101,853   $1,061,236
4   $1,061,236   $127,348   $101,853   $1,086,732
5   $1,086,732   $130,408   $101,853   $1,115,287
6   $1,115,287   $133,834   $101,853   $1,147,269
7   $1,147,269   $137,672   $101,853   $1,183,088
8   $1,183,088   $141,971   $101,853   $1,223,206
9   $1,223,206   $146,785   $101,853   $1,268,138
10   $1,268,138   $152,177   $101,853   $1,318,462
11   $1,318,462   $158,215   $101,853   $1,374,825
12   $1,374,825   $164,979   $101,853   $1,437,951
13   $1,437,951   $172,554   $101,853   $1,508,653
14   $1,508,653   $181,038   $101,853   $1,587,838
15   $1,587,838   $190,541   $101,853   $1,676,526
16   $1,676,526   $201,183   $101,853   $1,775,857
17   $1,775,857   $213,103   $101,853   $1,887,107
18   $1,887,107   $226,453   $101,853   $2,011,707
19   $2,011,707   $241,405   $101,853   $2,151,259
20   $2,151,259   $258,151   $101,853   $2,307,557
Summary: $1,000,000   $3,344,612   $2,037,060   $2,307,557


End-Loaded CLAT (Martha McGiver)
Year   Beginning
Principal
  12.00%
Growth
  Annual
Payment
  Remainder
1   $1,000,000   $120,000   $16,609   $1,103,391
2   $1,103,391   $132,407   $19,931   $1,215,868
3   $1,215,868   $145,904   $23,917   $1,337,855
4   $1,337,855   $160,543   $28,700   $1,469,698
5   $1,469,698   $176,364   $34,440   $1,611,621
6   $1,611,621   $193,395   $41,328   $1,763,688
7   $1,763,688   $211,643   $49,594   $1,925,737
8   $1,925,737   $231,088   $59,512   $2,097,313
9   $2,097,313   $251,678   $71,415   $2,277,576
10   $2,277,576   $273,309   $85,698   $2,465,187
11   $2,465,187   $295,822   $102,837   $2,658,172
12   $2,658,172   $318,981   $123,405   $2,853,748
13   $2,853,748   $342,450   $148,086   $3,048,112
14   $3,048,112   $365,773   $177,703   $3,236,182
15   $3,236,182   $388,342   $213,243   $3,411,281
16   $3,411,281   $409,354   $255,892   $3,564,743
17   $3,564,743   $427,769   $307,071   $3,685,441
18   $3,685,441   $442,253   $368,485   $3,759,209
19   $3,759,209   $451,105   $442,182   $3,768,133
20   $3,768,133   $452,176   $530,618   $3,689,691
Summary: $1,000,000   $5,790,356   $3,100,666   $3,689,691


4) The governing instrument may permit any income in excess of the annuity amount to be paid to charity, but this will not increase the amount of the charitable deduction.6 Otherwise, the governing instrument generally should prohibit payments to anyone other than the charitable beneficiaries during the charitable term.

Guaranteed unitrust interest. IRC §§ 2055(e)(2)(B) and 2522(c)(2)(B) and the regulations thereunder7 set forth the following requirements in order for an interest to qualify as a guaranteed unitrust interest.

1) Charity must have the irrevocable right, granted under the governing instrument, to receive a fixed percentage of the fair market value of the trust assets valued on the same day (or the average of several days) each year, provided that the same valuation date or dates are used each year. Where the governing instrument does not specify the valuation date or dates, the trustee must select the date or dates on the first form 1041 that the trust is required to file.8

2) Under Treas. Reg. §§ 20.2055-2(e)(2)(vii); 25.2522(c)-3(c)(2)(vii), the unitrust interest must be a guaranteed unitrust interest "in every respect." Accordingly, the trust agreement cannot provide that charity is to receive a payment equal to the lesser of a sum certain or a fixed percentage of the net fair market value of the trust assets.

3) The governing instrument may permit any income in excess of the unitrust amount to be paid to charity, but this will not increase the amount of the charitable deduction.9 However, in the case of a charitable lead unitrust, payment of excess income to the charity actually reduces the charitable deduction because the diversion of income to charity in excess of the unitrust amount is deemed to reduce the base of assets upon which the unitrust payment is computed for future years.10

4) The opportunity to transfer appreciation to noncharitable remainderpersons is not as great with a unitrust as with an annuity trust because the unitrust creates what is in effect a partnership between the charitable and noncharitable beneficiaries while the annuity trust "freezes" charity's interest at a particular value and assigns all appreciation beyond that value to the noncharitable remainder beneficiary.

5) The unitrust payment must be made regardless of whether or not trust income is sufficient; a "net income with makeup" variety is not available.11

Term of the lead interest.12

  • Term of years: No 20-year maximum.
  • Life or lives in being at the time trust is created.
  • Life or lives in being plus a term of years. For example, in Rev. Rul. 85-49, 1985-1 C.B. 330, the IRS approved a CLT with a term of three lives plus a term of years.
  • It is unclear whether lead interest for the shorter of a life in being or a term of years would be permitted.

Proposed Regulations Relating To Term Of CLTs

Existing regulations relating to charitable lead trusts do not require that the measuring life be a grantor or remainderperson of the trust. As a result, some taxpayers selected as a measuring life an individual who is seriously ill but not so ill as to cause the section 7520 valuation tables to be inapplicable.13 Accordingly, the valuation of the charitable interest is based on the actuarial tables under section 7520. These tables set forth the average life expectancy of all individuals as the same age of the individual who is the measuring life; however, due to illness, such individual is not likely to survive to the average date. If the seriously ill individual dies prior to the average date, the amount charity receives may be significantly less than the amount on which the gift or estate tax charitable deduction was based. Likewise, the amount transferred to the noncharitable remainder beneficiaries would be much greater than the section 7520 valuation tables would indicate.

Based on the belief that "this kind of adverse selection of an unrelated measuring life to artificially inflate the charitable deduction is contrary to Congressional intent," the IRS has issued proposed regulations providing, in substance, that the permissible term for guaranteed annuity interests and unitrust interests is either a specified term of years, or the life of "certain" individuals living at the date of the transfer. Under the proposed regulations, the individuals who may be used as measuring lives are:

1) the donor;

2) the donor's spouse; and/or

3) a lineal ancestor of all of the remainder beneficiaries.

The proposed regulations are effective for inter vivos charitable lead trusts made on or after April 4, 2000. They are effective for testamentary lead trusts where the decedent dies on or after April 4, 2000 unless either:

1) if the decedent dies within six months after the regulations are published as final regulations without having republished his/her will or amending his/her revocable trust, as the case may be; or

2) if on April 4, 2000, the decedent was under a mental disability to change the disposition of his/her property and either does not regain competence before the date of death or dies prior to the later or 90 days after the date on which he/she does regain competence or six months after the date the regulations are published as final regulations without having republished his/her will or amending his/her revocable trust, as the case may be.

The IRS will not disallow the charitable deduction for a CLT whose measuring life does not comply with the proposed regulations if the CLT is reformed into a lead interest payable for a specified term of years.

The term of years to be used is computed by identifying the factor for valuing the annuity or unitrust interest for the named individual's measuring life and then identifying the term of years (rounded up to the nearest whole year) that corresponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S (7.4) contained in IRS Publication 1457, Alpha volume, for the life of an individual age 40 is 12.0587. Based on Table B (7.4) of Publication 1457, the factor 12.0587 corresponds to an annuity for a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years.

For inter vivos CLTs, the reformation must be commenced prior to the later of: 1) the date that is six months after the regulations become final; or 2) October 15 of the year following the year in which the transfer is made. For testamentary CLTs, the reformation must be commenced prior to the later of: 1) the date that is six months after the regulations become final; or 2) the date prescribed by IRC § 2055(e)(3)(c)(iii).

The proposed regulation also clarifies the status of rule against perpetuity "savings" clauses in CLTs. Under the proposed regulation, an interest payable for a specified term of years can qualify as a guaranteed annuity or unitrust interest even if the governing instrument contains a savings clause intended to comply with the relevant rule against perpetuities provided that the savings clause utilizes a vesting period of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. The proposed regulations do not indicate the appropriate interest rate to be used in valuing the respective interests of the charity and the noncharitable remainder beneficiaries in the event the trust is so terminated.

Issues raised by the proposed regulations.14 Nieces and nephews apparently are excluded as potential remainder beneficiaries. The proposed regulations require that the measuring life be a "lineal ancestor" of all remainder beneficiaries. This phrasing excludes collaterals such as nieces and nephews.

"Family disaster" clauses may disqualify the trust. Many well-drafted CLTs provide that if the presumptive remainder beneficiaries are deceased, the contingent takers will be the grantor's heirs at law. Since the grantor's heirs at law could include collaterals, the mere inclusion of such a clause would appear to disqualify the trust.

Flexibility in remainder interest planning is discouraged. Suppose the remainder beneficiary of a given CLT is a trust for the benefit of a child of the grantor and that the child is given a testamentary power of appointment. If the power of appointment is exercisable in favor of anyone other than the grantor, the grantor's spouse or a descendant of the grantor, the proposed regulations apparently would disqualify the trust.

The requirements that the measuring lives chosen for any rule against perpetuities savings clause be selected so as to maximize, rather than limit, the duration of the trust injects an element of uncertainty in the drafting of CLT instruments.

Private Foundation Prohibitions

The governing instrument must prohibit certain transactions described in the private foundation excise tax provisions of the Code as follows.

Self-dealing under IRC § 4941. Self-dealing is defined generally to mean certain transactions between a CLT and a "disqualified person." A disqualified person is the donor, his or her spouse, descendants and their spouses, the donor's ancestors, the trustees of the CLT, as well as corporations, partnerships, and trusts in which the donor and his/her family, or the trustee and his/her family hold 35% or more of the voting power, profits interest or beneficial interest, as the case may be. Acts of self-dealing include the following:

  • Any sale, exchange, or lease of property between the CLT and a disqualified person, except: 1) certain general stock redemptions for fair market value; and 2) a lease from a disqualified person to the CLT at no charge.
  • Any loan or extension of credit between a CLT and a disqualified person, except that a disqualified person may make interest-free loans to the CLT. However, interest-free loans to the CLT to enable the CLT to pay charity its annuity or unitrust interest will disqualify the CLT.
  • Any furnishing of goods, services, or facilities between the CLT and a disqualified person, except that a disqualified person may furnish such items to a CLT at no charge.
  • Any payment of compensation by the CLT to a disqualified person, except for reasonable and necessary services such as compensation of trustees, lawyers, investment advisers, and banks. It is less clear whether or not payments to disqualified persons for brokerage or management fees with respect to commercial real estate owned by the CLT will be excepted from self-dealing treatment.
  • Any transfer by the CLT of its income or assets to or for the benefit of a disqualified person.

In general, the trust agreement must prohibit the trust from holding excess business holdings as defined in IRC § 4943 and jeopardy investments as defined in IRC § 4944. A CLT will be deemed to have excess business holdings if the CLT, together with all of its disqualified persons, owns more than 20% of the voting stock of a corporation or an equivalent interest in a non-corporate entity engaged in a trade or business. A CLT with excess business holdings is granted five years to reduce the holdings (of the CLT and all disqualified persons combined) to no more than 2%. The excess business holdings prohibition does not apply if the value of the charitable interest in the trust is less than 60% of the total value of the trust, and if no property is distributable to charity at the end of the charitable term.

In general, the trust agreement must prohibit the trust from retaining or investing in investments that jeopardize the charitable purpose of the trust under IRC § 4944.

The jeopardy investment prohibition does not apply if the value of the charitable interest in the trust is less than 60% of the total value of the trust, and if no property is distributable to charity at the end of the charitable term.

Combined Charitable And Private Interests

The governing instrument generally should prohibit payments to anyone other than the charitable beneficiaries during the charitable term. However, payments to noncharitable beneficiaries may be permitted in the following circumstances.

Payment of annuity amount to both charitable and noncharitable beneficiaries. The trust can pay amounts concurrently to both charitable and noncharitable beneficiaries if either of the following two tests is met.

1) If the separate share rule applies. The separate share rule applies if: 1) the trust requires that payments to the noncharitable beneficiary be made from a segregated group of assets devoted exclusively to the noncharitable beneficiary's use; 2)the trust is required to account separately for items of income and deduction attributable to each of the segregated amounts; and 3) the trust can be treated as two separate trusts, one whose income and remainder interests are devoted exclusively to noncharitable purposes, and one that is considered a charitable trust under IRC § 4947(a)(1) or (2).

2) Even if the separate share rule does not apply, the trust nonetheless may permit payments to both charitable and noncharitable beneficiaries if the trust agreement provides for the payment of a guaranteed annuity or unitrust amount to both charitable and noncharitable beneficiaries.15

Preceding private interest. Suppose a donor transfers $1,000,000 to a CLT to pay $115,000 per year to an individual for five years followed by an annuity of $115,000 per year to a charity for the next five years. Under the estate and gift tax regulations the charitable annuity would not qualify as a guaranteed annuity interest.16 However, the estate tax version of these regulations was held invalid in Estate of Boeshore, 78 T.C. 523 (1982). The IRS acquiesced in the result of Boeshore.

Other Governing Instrument Requirements

The governing instrument should prohibit prepayment (sometimes called commutation) of the lead interest.17 The rationale for disqualification has to do with the trustee's ability to manipulate the value of charity's interest if interest rates change between the date the trust is funded and the date of the prepayment. For example, if a prepayment were based on one interest rate while the market interest rate was lower, the charitable organization, upon investing the prepaid amount at the market interest rate, would receive less than the amount that was implicit in valuing the prepayment amount.18

Although not a "governing instrument requirement" from the standpoint of federal law, the trust should have a rule against perpetuities savings clause as a matter of state law if the trust is established under the laws of a state that still follows the rule. Although the IRS has approved a rule against perpetuities savings clause privately, PLR 8033091, query whether or not the clause might be deemed an impermissible commutation power under the rationale of Rev. Rul. 88-27 and GCM 39676. The proposed regulations described above appear to provide a safe harbor for a rule against perpetuities saving clause, provided that the vesting period chosen must be 21 years after the deaths of measuring lives "who are selected to maximize, rather than limit, the term of the trust." As an example, the explanation to the proposed regulations recites that an annuity or unitrust interest that will terminate on the earlier of 30 years or 21 years after the death of the last surviving of the descendants of any grandparent of the donor living at the creation of the interest will be treated as payable for the specified term of years.

In the context of charitable remainder trusts, the IRS has ruled that the governing instrument must contain provisions mandating that any death taxes be the responsibility of the noncharitable beneficiaries.19 Although there is no similar revenue service ruling applicable to charitable lead trusts, prudence dictates that the governing instrument of a CLT contain provisions exempting the charitable interest from the payment of any death taxes attributable to the trust. If death taxes were payable from the charitable interest, the taxes could jeopardize the payment of the annuity in the case of a CLAT and would reduce the size of the unitrust amount in the case of a CLUT. For this reason, it is likely that the IRS would impose a death tax governing instrument on CLTs similar to that imposed upon charitable remainder trusts.20

Are additional contributions to CLATs and CLUTS allowed? It is well known that post-creation additions to a charitable remainder annuity trust are prohibited while post-creation additions to a charitable remainder unitrust are permitted.21

CLATs. The CLT regulations are silent as to whether additions to CLATs are permitted or prohibited. An early private ruling, as well as an authoritative commentator, initially concluded that additions to a CLAT should be prohibited.22 However, a more recent technical advice memorandum indicates that post-creation additions to a CLAT are permissible.23 However, an addition to a CLAT would not generate an additional tax deduction because the addition could not act to increase the size of the annuity amount payable to charity.

CLUTs. The CLT regulations are silent as to whether additions to CLUTs are permitted or prohibited. However, the charitable remainder unitrust regulations permit additions and provide a scheme for determining the additional resulting charitable deduction. Moreover, at least two private rulings from the IRS have approved CLUTs with governing instruments permitting additions and providing for calculation of the additional charitable deduction in a manner consistent with the charitable remainder trust regulations.24

Incomplete gift to a CLT. If the lead trust permits the trustee to sprinkle the lead payments among various charities, the donor should not be a trustee. This will avoid incomplete gift treatment.25 Similarly, if the donor's private foundation is the recipient of the lead interest and the donor serves as a trustee of the private foundation, incomplete gift status may result as well.26 However, the donor's private foundation can be named as the lead recipient notwithstanding the donor's status as a trustee of the foundation if the governing instrument of the foundation provides that funds paid to it by the CLT are to be segregated into a separate account in which the donor-trustee will have no distribution authority.27

Income Tax Deductibility

The donor of a qualified charitable lead trust is generally entitled to a charitable income tax deduction only if: 1) the trust meets the guaranteed annuity or unitrust interest and governing instrument requirements described above; and 2) the trust is a grantor trust for income tax purposes.28

If the lead interest is held by a public charity, the income tax deduction generally is subject to the 30% deductibility ceiling and a five-year carryforward. If the charitable interest is held by a private foundation, then the 20% deductibility ceiling generally applies. The IRS has ruled privately in PLR 8824039 that the five-year carryforward is not available for a CLT benefiting a private foundation, but this result has been roundly criticized.

Obtaining Grantor Trust Status

IRC §§ 671 through 679 treat the grantor as the owner of that portion of the trust over which the grantor or certain related parties hold an interest or power. It is possible for a trust to be treated as a grantor trust for income tax purposes without being included in the grantor's estate for estate tax purposes. Pitfall: Use of reacquisition power under IRC § 675.29

Is an income tax deduction beneficial? Reconsider Example B. In that example, the donor contributed $1,000,000 to a CLAT that would pay charity an annuity amount of $101,800 per year for 20 years. As shown in the charts below, assuming constant income tax rates, the benefit of the charitable deduction may be eliminated over time as a result of the grantor's being taxed on the income of the trust each year.

Benefit of Tax Deduction Assuming Constant Income Tax Rates
Income tax deduction in Example B $999,487.41
Donor's assumed tax bracket 39.6%
Benefit of income tax deduction $395,797
Less present value of income tax on annuity payments (see below) $0
Year Payment   Income Tax (39.6%)
1 $101,800   $40,313
2 $101,800   $40,313
3 $101,800   $40,313
4 $101,800   $40,313
5 $101,800   $40,313
6 $101,800   $40,313
7 $101,800   $40,313
8 $101,800   $40,313
9 $101,800   $40,313
10 $101,800   $40,313
11 $101,800   $40,313
12 $101,800   $40,313
13 $101,800   $40,313
14 $101,800   $40,313
15 $101,800   $40,313
16 $101,800   $40,313
17 $101,800   $40,313
18 $101,800   $40,313
19 $101,800   $40,313
20 $101,800   $40,313
Total $2,036,000   $806,256
Present Value of
Payments at 8%
Discount Rate
$999,487   $395,797

Benefit of Tax Deduction Assuming Donor in Lower Bracket After Gift

Income tax deduction in Example B $999,487.41
Donor's assumed tax bracket 31.0%
Benefit of income tax deduction $395,797
Less present value of income tax on annuity payments (see below) ($309,841)
Net benefit of 5.0 income tax deduction $85,956
Year Payment   Income Tax (39.6%)
1 $101,800   $40,313
2 $101,800   $40,313
3 $101,800   $40,313
4 $101,800   $40,313
5 $101,800   $40,313
6 $101,800   $40,313
7 $101,800   $40,313
8 $101,800   $40,313
9 $101,800   $40,313
10 $101,800   $40,313
11 $101,800   $40,313
12 $101,800   $40,313
13 $101,800   $40,313
14 $101,800   $40,313
15 $101,800   $40,313
16 $101,800   $40,313
17 $101,800   $40,313
18 $101,800   $40,313
19 $101,800   $40,313
20 $101,800   $40,313
Total $2,036,000   $806,256
Present Value of
Payments at 8%
Discount Rate
$999,487   $395,797

Income Taxation Of The Charitable Lead Trust

Grantor trusts. Unlike a charitable remainder trust, a CLT is not a tax-exempt entity. Distribution of appreciated property in satisfaction of annuity or unitrust amount will be treated as if the property had been sold and then distributed to the charity, thereby causing the grantor to recognize gain.30

Recapture trap. If grantor trust status ceases prior to the end of the lead term, then the grantor will be forced to recognize income in an amount equal to the difference between:

1) The total deduction the grantor received upon creating the trust; minus

2) The present value, on the date of the trust's creation, of all amounts that were required to be, and actually were, paid to the charitable organization pursuant to the terms of the trust before grantor trust status ceased.31

Non-grantor trusts. Unlike a charitable remainder trust, a CLT is not a tax-exempt entity. A non-grantor CLT is generally taxed under the usual rules for the taxation of income of complex trusts, with certain exceptions. Unlike a typical complex trust, a non-grantor CLT will not receive a distribution deduction under IRC § 661.32 However, the CLT does receive a deduction for amounts of gross income that are paid to charity, but only to the extent that such payments are made pursuant to the terms of the governing instrument.33 To the extent a lead payment is not made out of gross income, it is not deductible.

There is no requirement that payment be made from current year's gross income. Treasury regulations permit deduction for "an amount paid during the taxable year in respect of gross income received in a previous taxable year, but only if no deduction was allowed for the amount so paid." 34 The deduction may be claimed either in the year the lead payment was made or, if the trustee so elects, in the year following the year of payment.35

Denial of IRC § 642(c) deduction for unrelated business taxable income (UBTI). IRC § 681 generally disallows a charitable income tax deduction to the extent that a payment to charity consists of UBTI.36 However, if the lead interest is held by a domestic charity, payment will be deductible to the extent it does not exceed deductibility ceilings applicable to individuals. The deductibility ceilings are applied against the UBTI, not the trust's entire income.37

Sourcing rules can result in lower than expected deductibility. See PLR 9750020, in which IRS ignored provisions of a CLT allocating distributions first to ordinary income, then to net short-term capital gain, then to net long term-capital gain, then to UBTI, then to tax-exempt income and then to corpus. This ruling does not appear to have any basis in the language of IRC § 642(c).

Distribution of appreciated property in satisfaction of annuity or unitrust amount will be treated as if the property had been sold and then distributed to the charity, thereby causing the trust to recognize gain.38

Generation-Skipping Transfer Tax Savings Techniques

General rules.39 The generation-skipping transfer tax (GST tax) is a 55% tax on property transferred to skip persons (persons at least two generations below the donor, e.g., grandchildren and their descendants).

A CLT is not subject to GST tax until the charitable lead interest expires. When charity's interest terminates, any trust property passing to a skip person is subject to the GST tax unless the trust is exempt.

Each donor has a $1,030,000 exemption from the GST tax to allocate to transfers during life or at death. An allocation of exemption either makes the entire trust exempt from GST tax or reduces the applicable GST tax rate to less than 55%.

Annuity trust versus unitrust. If, on funding of a CLUT, the donor allocates GST exemption to the CLUT equal to the gift tax value of the remainder interest, the CLUT thereafter is exempt from GST tax, regardless of the amount of property remaining in the CLUT at the termination of the charitable interest.

A donor cannot allocate GST exemption to a CLAT on funding and know whether or not the CLAT will be exempt from GST tax at the termination of the charitable interest. Any GST exemption allocated to the CLAT grows at the IRS discount rate used to value the charitable gift at the time the CLAT was created. This is known as the "adjusted GST exemption." When the charitable interest terminates, if the adjusted GST exemption is less than the then value of the trust property, property distributed from the trust to skip persons will be subject to GST tax at a rate equal to the GST tax rate then in effect (currently 55%) multiplied by a fraction, the numerator of which is the CLAT's adjusted GST exemption amount and the denominator of which is the value of the CLAT at the end of the charitable term.40 Moreover, if the trust property grows at a rate lower than the IRS discount rate used to value the charitable gift, then the amount of GST exemption allocated will be greater than the value of the trust. However, the excess exemption is not restored to the grantor.41

Computing The Charitable Deduction

The charitable deduction is for the present value of the charitable interest computed under the rules of, and using the discount rate promulgated under, section 7520. The discount rate under section 7520 is a rate equal to 120% of the federal midterm rate under IRC § 1274(d)(1) for the month of transfer or, if the donor or the donor's executors so elect, either of the two months preceding the month of transfer.42

Terminally ill measuring life. See above for newly proposed regulations relating to the use of a measuring life that is not related to the donor. Even if the measuring life is an individual related to the donor, the section 7520 tables and valuation method may not be used if the death of that individual is imminent. Under Treas. Reg. §§ 1.7520-3(b)(3), 20.7520-3(b)(3) and 25.7520-3(b)(3), the section 7520 tables will not apply if the individual has an incurable illness or other deteriorating physical condition that causes there to be at least a 50% probability that the individual will die within one year. If the individual survives for 18 months or longer after the creation of the CLT, then there is a presumption against terminal illness.

Limitations on the value of charitable interest. If the value of charity's interest exceeds the value of the property contributed to the trust, then the value under section 7520 will be limited to the value of the property contributed to the trust.43

In addition, under Rev. Rul. 77-454, 1977-2 C.B. 351, if the charitable term is measured by reference to the life of an individual and payment of the annuity would exhaust the trust fund prior to the expiration of the charitable term if the trust fund produced a rate of return equal to the assumed section 7520 discount rate, then the value of the annuity will be limited to an annuity for the shorter of the measuring life or the term of years over which the trust could be expected to make the annuity payments if the trust produced a rate of return equal to the assumed section 7520 discount rate. The Rev. Rul. 77-454 rules do not apply to CLUTs.

Conclusion

Charitable lead trusts can be a wonderful way for a donor to benefit his/her favorite charity and simultaneously transfer appreciation on the given assets to family tax free. In some cases, the donor can achieve an income tax deduction as well. Although a CLT is not for everyone, for the very wealthy donor, it may be one of the most powerful tools of all those available to make a significant reduction in estate and gift taxes while also locking in a large, presently accessible gift for charity.


Endnotes


  1. Copyright © 2000 by Daniel L. Daniels and David T. Leibell. The authors gratefully acknowledge the assistance of Conrad Teitell, Chairman of Cummings & Lockwood's Charitable Planning Group, for his comments about this article. The Internal Revenue Code (IRC) provisions relating to CLTs are found at IRC §§ 2055(e)(2)(B), estate tax; § 2522 (c)(2)(B), gift tax; and § 170(f)(2)(B), income tax and the Treasury Regulations thereunder.back

  2. In rare instances, the lead interest may simply be the right to receive the income from the trust. However, this type of lead interest does not create a tax qualified charitable lead trust and, therefore, is not discussed in this article.back

  3. Under newly proposed regulations, the permissible measuring lives would be limited to the grantor, spouse, and/or a lineal ancestor of all remainder beneficiaries.back

  4. Treas. Reg. §§ 20.2055-2(e)(2)(vi) and (vii); 25.2522(c)-3(c)(2)(vi) and (vii).back

  5. Treas. Reg. §§ 20.2055-2(e)(2)(vi); 25.2522(c)-3(c)(2)(vi).back

  6. Treas. Reg. §§ 20.2055-2(e)(2)(vi)(d) and (vii)(d); 25.2522(c)-3(c)(2)(vi)(d) and (vii)(d).back

  7. Treas. Reg. §§ 20.2055-2(e)(2)(vi) and (vii); 25.2522(c)-3(c)(2)(vi) and (vii).back

  8. Treas. Reg. §§ 20.2055-2(e)(2)(vii); 25.2522(c)-3(c)(2)(vii).back

  9. Treas. Reg. §§ 20.2055-2(e)(2)(vii)(d); 25.2522(c)-3(c)(2)(vii)(d).back

  10. Rev. Rul. 78-183, 1978-1 C.B. 302.back

  11. Rev. Rul. 77-300, 1977-2 C.B. 352.back

  12. Treas. Reg. §§ 20.2055-2(e)(2)(vi)(a) and vii(a); 25.2522(c)(2)(vi)(a) and (vii)(a).back

  13. Treas. Reg. §§ 20.7520-3(b)(3) and (4); 25.7520-3(b)(3) and (4).back

  14. For an excellent discussion of these issues and others, see "Proposed Regulations Curb Lead Trust Abuse," Stewart, Schumacher and Martin, Charitable Giving and Solicitation, April 18, 2000.back

  15. Treas. Reg. §§ 20.2055-2(e)(2)(vi)(f); 25.2522(c)-2(c)(2)(f).back

  16. Treas. Reg. §§ 20.2055-2(e)(2)(vi)(f); 25.2522-2(c)(2)(f).back

  17. Rev. Rul. 88-27, 1988-1 C.B. 331.back

  18. GCM 39676.back

  19. Rev. Rul. 82-128, 1982-2 C.B. 71.back

  20. See PLR 9348012 for an example of such a governing instrument provision.back

  21. Treas. Reg. § 1.664-2(b).back

  22. PLR 8213127; Teitell, Charitable Lead Trusts 1-15 (1990).back

  23. TAM 9506001.back

  24. PLRs 8043077; 7938099.back

  25. Treas. Reg. § 25.2511-2(b) and (c); Rev. Rul. 77-275, 1977-2 C.B. 346.back

  26. PLR 1999-08-002; PLR 1999-03-045.back

  27. Id.back

  28. IRC §170(f)(2)(B); Treas. Reg. § 1.170A-6(c).back

  29. See PLRs 9407014; 9810019; 9648045; 9416009; 9352007; 9352004; 9253010; 9248016.back

  30. Kenan v. Comm'r, 114 F. 2d 217 (2d Cir. 1940); Suisman v. Eaton, 115 F. Supp. 113 (D. Conn. 1935), aff'd per curiam 83 F.2d 1019 (2d Cir. 1936), cert. den., 299 U.S. 573 (1936).back

  31. IRC §170(f)(2)(B); Treas. Reg. § 1.170A-6(c)(4).back

  32. Treas. Reg. § 1.663(a)-2.back

  33. IRC § 642(c); Rebecca K. Crown Income Charitable Fund, 8 F.3d 571 (7th Cir. 1993), aff'g 98 T.C. 327 (1982).back

  34. Treas. Reg. § 1.642(c)-1(b).back

  35. IRC § 642(c); Treas. Reg. § 1.642(c)-1(b).back

  36. Treas. Reg. § 1.642(c)-3(d).back

  37. IRC § 512(b)(11).back

  38. Kenan v. Comm'r, 114 F.2d 217 (2d Cir. 1940); Suisman v. Eaton, 115 F. Supp. 113 (D. Conn. 1935), aff'd per curiam 83 F.2d 1019 (2d Cir. 1936), cert. den., 299 U.S. 573 (1936). However, the trust will be entitled to a section 642(c) deduction with respect to this gain. Rev. Rul. 83-75, 1983-1 C.B. 114.back

  39. See IRC §§ 2601 et seq.back

  40. IRC § 2642(e); Treas. Reg. § 26.2642-3.back

  41. Treas. Reg. § 26.2642-3(c).back

  42. IRC § 7520.back

  43. Treas. Reg. § 1.7520-3(b)(2)(i), 20.7520-3(b)(2)(i), 25.7520-3(b)(2)(i).back

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