A Practical Look at Charitable Lead Trusts, Part 1 of 3

A Practical Look at Charitable Lead Trusts, Part 1 of 3

Article posted in Charitable Lead Trust on 27 August 2015| comments
audience: National Publication, Jane Peebles, Attorney | last updated: 27 August 2015
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New contributing author Jane Peebles brings us the first of three articles on Charitable Lead Trusts.

By: Jane Peebles, J.D.[1]

I.  INTRODUCTION

A charitable lead trust makes payments to charity for a measuring life or a term of years or sanctioned combination thereof and then either reverts to the settlor or passes to or in trust for other individual beneficiaries.  Using a charitable lead trust (“CLT”), your client can:

  • Obtain an income tax deduction for the charitable interest.
  • Leverage his gift to his children or grandchildren and exclude the CLT property from his estate; or
  • Achieve all of these goals using a “Super CLT” that is a grantor trust not includible in the client’s estate.

CLTs have enjoyed increased popularity in recent years largely as a result of the generation-skipping planning they permit, low applicable federal interest rates under IRC Section 7520 (which make charitable lead annuity trusts more effective for leveraging of gifts), the 10% remainder requirement for charitable remainder trusts (which makes it difficult to structure a CRT to benefit grandchildren or children) and favorable tax treatment when the settlor’s private foundation is the CLT’s charitable beneficiary.

II.  WHEN TO CONSIDER A CHARITABLE LEAD TRUST

Assuming your client is philanthropically inclined, consider a charitable lead trust in the following circumstances:

A. Liquidity Event

Your client is selling her business and will recognize substantial capital gains.  She is not willing to part with her sudden riches permanently.  A transfer to a CLT that is a grantor trust after any sale of assets, such as closely-held stock, will produce a generous deduction while ensuring the return of the assets ultimately to the donor or her spouse.  In cases of reluctance to part with the principal, this technique is very viable.  A grantor CLT will allow her to (i) offset those gains with an income tax deduction in the year of sale and (ii) pay the tax on her gains over several years.  This effectively allows income averaging instead of a huge tax bill in the year of sale.  She gets the property back when the trust terminates.

B. IPO

Often planners advise clients about to undertake an initial public offering to place some of their shares in a charitable remainder trust.  This, however, is anathema to the shareholder who until now has had only paper wealth.  Why would he want to give it away? The thought of having only the income and none of the principal is a problem.  Some amount of the closely-held stock might be placed in a grantor CLT with a reversion to the donor.  This generates a lump sum deduction in the same year that the shareholder had gain on the closely-held stock.  Selling some of the new stock may be necessary to meet the payout commitment of the CLT, but ultimately receiving back the remainder interest after a period of years would be the selling point of this strategy.

C. Desire to Benefit Younger Generations in the Future

Your client has young children and wants to provide them with funds when they are in their 20’s or 30’s.  A nongrantor charitable lead annuity trust will allow her to pass assets down a generation at little or no gift tax cost.  A nongrantor charitable lead unitrust will also allow her to pass assets down to grandchildren at little generation-skipping transfer tax cost.

D. Client Already Maxing Out Charitable Deductions

If your client contributes substantial amounts to charity and cannot fully deduct his gifts because of the percentage limitations on income tax charitable deductions, consider a CLT that pays to his private foundation or to a donor advised fund that can, in turn, make grants to his favorite charities.  These distributions from the CLT are deductible by the CLT and are not subject to the percentage limitation.

III. BASIC TYPES OF AND REQUIREMENTS FOR THE CLT

A. General Description

A CLT provides for a “lead” interest to be paid to a charity or charities at least annually and then a remainder interest to be paid to one or more individuals and/or trusts upon termination of the lead interest.  The CLT is sometimes referred to as a “wait a while” trust since the individual heirs must wait a while to enjoy any benefit from the trust.

B. Two Types of Lead Interest

The CLT pays either an annuity amount or a unitrust amount to charity during its term, but not a net income payout.

1. Charitable Lead Unitrust.  The charitable lead unitrust (CLUT) pays charity a unitrust amount.  A unitrust payment is a fixed percentage of the fair market value of the trust as determined annually.  If the value of the CLUT goes up, the unitrust amount increases, and vice versa.

2. Charitable Lead Annuity Trust.  The charitable lead annuity trust (CLAT) provides an annuity for charity.  An annuity payment is typically a fixed dollar amount each year, expressed as a dollar amount or as a fraction or percentage of the trust’s initial value.

(a)   A properly designed CLAT can also provide for annuity payments to charity that increase over the years.  Unequal annuity payments, such as 2% for the first three years then increasing to 5%, are permissible, as long as the value of the lead interest is ascertainable at the inception of the CLT.[2]

(b)   In PLR 201216045, the IRS approved a testamentary CLAT providing for annuity payouts that would increase by 20% for each year of the 10-year CLAT term.  The ascending charitable payout allowed the trust to be invested so that the annuity payments could be made for the full 10 years.  The percentage payout was by formula designed to result in a zeroed out remainder.  The formula was needed because the drafter could not predict what the AFR would be at the client’s death.[3]

(c)   The validity of so-called “shark-fin” CLATs has been hotly debated in recent years.  With a shark-fin CLAT, the payouts to charity are substantially back end-loaded.  If this works, it permits the transfer of very significant wealth to the next generation with limited estate or gift tax liability.  But the IRS has not ruled on whether this works.  One version of shark-fin being heavily promoted provides for a very low charitable payout over the life of the settlor, which is also the term of the non-grantor CLAT.  Most of the funds in the CLAT are used to buy a single-premium life insurance policy on the settlor.  The trustee uses the rest of the funds to buy tax-free municipal bonds to make nominal annual payments to charity during the settlor’s life.  When the settlor dies and the CLAT terminates, a portion of the life insurance proceeds funds the back end-loaded charitable payout, and the remainder of the proceeds, together with any other assets then in the CLAT, passes to the next generation.

The basis for the back end loading is Revenue Procedures 2007-45 and 2007-46[4], which contain sample CLAT forms with annotations indicating that a CLAT may provide for an annuity amount that is initially expressed as a fixed dollar amount “but increases over the annuity period.”  The shark-fin design would be a very efficient asset transfer vehicle if it worked.  However, the fact that de minimis payments to charity are made during the CLAT term and the final, big payment is triggered by the settlor’s death may cause the CLAT not to qualify as a CLAT at all because the post-mortem payment is not an annuity payment.

If the strategy does not work:

·          For a testamentary CLAT, the entire amount transferred is included in the settlor’s gross estate;

·          For an inter vivos nongrantor CLAT, the entire amount transferred is a taxable gift; and

·          No income tax deduction is available for an inter vivos grantor CLAT.

C. No Term of Years Limitation

There is no term of years limitation for the charitable lead trust as for the charitable remainder trust and, therefore, effective planning for grandchildren can be accomplished using terms in excess of 20 years by careful choice of assets that produce enough growth for the preservation of the grandchildren’s future interest in the trust assets while meeting the payment obligation to the charity during the trust term.

D. Payment for Life or Lives

The payment to the charity may be structured on the basis of a specified term of years (with no limit to the term) or on the basis of a life or lives in being at the inception of the CLT.  Most CLTs are nevertheless structured as term trusts.  Regulations limit the measuring lives that can be used to (i) the settlor, (ii) his or her spouse, (iii) descendants of the settlor and (iv)  spouses of such descendants.[5]  The lead payments may also be over a term of years plus a life or lives in being.[6]

E. No Minimum or Maximum Distribution Amount

In contrast to the charitable remainder trust, the CLT can pay any amount to charity and is not subject to a minimum 5% payout.  Generally, because family members will receive the remainder interest, the payout is kept within reason so as to preserve the original principal and to achieve some growth of principal.  Balancing the tax avoidance goals of the settlor and the desire to have the assets grow sufficiently for the ultimate family remainder beneficiaries is a large part of the planning process.

F. No Limitation as to Remainderman

There is no limitation as to who may receive the remainder interest.  Trusts for grandchildren frequently receive the remainder and even a “supplemental needs” trust for a disabled beneficiary could be used.  However, keep in mind that if the settlor or spouse of the settlor receives the remainder interest, the CLT is likely to be a grantor trust.  This is acceptable only if intended since the planning uses for grantor and nongrantor trusts are vastly different.

G. Grantor Versus Nongrantor Trust Status

Either a CLAT or a CLUT may be deemed a grantor trust or a nongrantor trust.

1. Grantor CLTs.  A grantor CLT provides the settlor with an immediate charitable income tax deduction for the present value of the annuity or unitrust amounts to be paid to charity.  The grantor CLT is not permitted to claim a charitable deduction under IRC Section 642(c) for its distributions to charity.

(a)   If the client experiences a large gain such as from the sale of a major asset, the proceeds can be used to fund a grantor CLT in order to create a lump-sum deduction for the settlor in the same year.  The price of the income tax deduction at inception is that the settlor of a grantor CLT must report all of the net income realized by the CLT each year on his personal income tax return.[7]

(b)   If the settlor dies during the term of the CLT or otherwise ceases to be deemed the owner of the CLT for income tax purposes, all or part of the income tax charitable deduction is recaptured.[8]

(c)   If the settlor or the settlor’s spouse retains a reversionary interest, the CLT will generally be a grantor trust.  Any retention of a power listed in IRC Sections 671 to 679 will cause the trust to be a grantor trust.  For example, reversionary interests, power to control beneficial enjoyment, retention of administrative powers not in a fiduciary capacity, power to revoke, using the income for the benefit of the settlor, or foreign trusts with U.S. beneficiaries are some of the reasons a trust may be deemed a grantor trust.  Drafters commonly cause CLT grantor trust status by allowing a non-adverse party, in a non-fiduciary capacity and without the consent of the trustee, to acquire the trust corpus by substituting other assets of equivalent value.[9]

(d)   Where the tax rate of the transferor in the year of transfer is expected to be considerably higher than the following years’ will be, either by tax law change or by individual circumstance, such as retirement, it may be beneficial to establish a grantor CLT, take a lump-sum deduction and invest the tax savings, recognizing income at a lower taxable rate in subsequent years, when the grantor’s marginal income tax bracket is lower.

(e)   Private letter rulings have permitted trustees to invest, in trustee discretion, in tax-exempt investments, provided the trustee has total control to “uninvest” in such an asset.  Thus, when the grantor trust rules require inclusion on the Form 1040 of the settlor, there is no taxable income, but there was a deduction.  Eventually, the settlor receives his assets back (or the value of the trust remainder) at the end of the trust term.

2. Nongrantor CLTs.  A nongrantor CLT offers no income tax deduction to the settlor but can offer substantial gift or estate tax savings.

(a)   Taxable Trust.  A nongrantor CLT is a taxable trust.  To the extent the CLT realizes income (including capital gains) in the year in excess of the charitable deduction allowed to it for the lead interest distributions for that year, the trust is required to pay income taxes on the excess, computed using standard trust tax rates.

(b)   Deduction for Charitable Distributions.  The CLT is entitled to an IRC Section 642(c) income tax charitable deduction for the amount it pays to charity from gross income each year.  The trust’s charitable deduction is not limited to a percentage of its AGI unless it has unrelated business income.  However, the CLT cannot carry forward excess charitable deduction amounts to future years.[10]

·          While the charitable lead interests may be satisfied by in kind distributions at date of distribution values,[11] the trust gets no Section 642(c) deduction for such distributions as they are not made from gross income.[12]  However, if the CLT realizes capital gains on the in‑kind distribution because it is made with appreciated assets, the deduction will be allowed.[13]

(c)   Offsetting Income with Future Year’s Deduction.  If income realized by the CLT is greater than the current year’s charitable distributions, IRC Section 642(c)(1) allows the trustee to elect to “borrow” some of the next year’s charitable deduction to offset the extra income in the current year.  Any amounts so “borrowed” cannot be used by the trust again as a deduction in the subsequent year.

(d)   No Four-Tier System.  The “four-tier” system applicable to CRTs does not apply to CLTs.  Instead, each payment to charity is treated as having been made ratably from ordinary income, long-term capital gains, tax-free income and principal of the CLT.  Nevertheless, drafters have made numerous attempts to obtain IRS approval of its application, seeing no valid grounds for the IRS to disallow it.  The IRS has consistently taken the position that a CLT’s charitable distribution will be treated as coming ratably from each type of trust income.[14] Final Treasury Regulations under IRC Section 642(c) effective April 16, 2012 confirm that Treasury will not respect such income ordering under IRC Sections 642 and 643 unless it has economic substance independent of income tax consequences.[15]  Application of a four-tier system would distribute the highest cost income to the charity (which does not care) and leave the lowest rate income in the trust[16].

(e)   Discounted Remainder Interest.  The major tax savings offered by a nongrantor CLT is the reduction of estate or gift tax due to the discounted value of the remainder interest.  The value of the remainder is computed when the CLT is funded, using IRS tables.  The present value of the charitable lead interest is deductible for gift or estate tax purposes, and that of the remainder is subject to gift or estate tax.  The value of each is affected by the amount to be paid to charity each year, the term of the trust and the Section 7520 interest rate in effect when the CLT is funded.

(f)   Lower Generation Beneficiaries.  The simple wealth shift trust is the most common use of the nongrantor CLT.  Many individuals would rather pay tax (or utilize gift tax exemption) on the present value of the remainder interest than on the whole value of the asset.  The penalty is making the noncharitable recipient wait for the trust to terminate.  For that reason, it is best used for children or grandchildren who would have received a delayed gift anyway and therefore would have waited for their trust distribution.

(g)   Zeroing Out the Remainder.  When the AFR is low, it is fairly easy to “zero out” the remainder of a CLAT.  The CLAT term and payout are set so that the gift tax charitable deduction fully offsets the value of the gift to the CLAT on funding.  Therefore, for a testamentary CLAT, there is no inclusion in the gross estate, and for an inter vivos CLAT, there is no taxable gift.  PLR 9631021 allowed a decedent’s daughter to choose, during the disclaimer period, between a CLAT paying the AFR plus 1% or one paying the AFR plus 2%, in each case with a term just long enough to zero out the value of the remainder.  The funding of a zeroed out testamentary CLAT may also be set by formula.[17]

(h)   Double Discounts.  The nongrantor CLT offers double discounts when funded with interests in the family business.  The transfer tax is imposed on the wealth shift of the remainder interest, which is already only a portion of the total asset value of the lead trust.  When this is combined with minority and lack of marketability discounts, an enormous amount of wealth can be transferred at very small tax cost.

(i)   CLUT for GSTT Planning.  The CLUT allows the settlor to leverage his GST exemption highly effectively.  Often, those who can wait for the distribution are the grandchildren due to their younger ages.  Because only the value of the remainder must be covered by the client’s GST exemption, the value of the CLT itself can be significantly higher.

H. The “Super CLT”

The IRS has approved a CLT design which offers grantor trust status and exclusion of the CLT assets from the grantor’s gross estate.  The trick is to use a grantor trust taint (such as giving a non-adverse person other than the settlor hold the IRC Section 675(4)(c) ability in a non-fiduciary capacity to acquire the corpus by substituting assets of equivalent value) that does not cause inclusion in the gross estate.[18]

I. The Charitable Beneficiaries

1. Types of Charities that Can Benefit.  Private foundations, support foundations, community foundations and other charitable receptacles such as donor advised funds can receive the CLT distributions.

2. Power to Change the Charities.  The charities to receive the lead interest may be named irrevocably in the trust document or may be amendable by the settlor, the trustee or another.[19]

(a)   A power in the settlor to change the charitable beneficiaries of a nongrantor CLT should fall within the exception of IRC section 674(b)(2) for naming charities without risk of a nongrantor CLT being deemed to be a grantor trust.

(b)   If the settlor retains this power, however, the gift of the lead interest is incomplete for gift tax purposes,[20] and IRC Section 2036(a)(2) will cause inclusion of the remaining lead interest in the settlor’s estate if she dies during the term of the CLT.  In other words, the transfer tax benefits of the CLT are lost.  This power could be given to an independent special trustee trusted by the settlor.

J. Trustees and Trustee Powers

1. Grantor as Trustee

(a)   The grantor can act as trustee of a nongrantor CLT without causing inclusion of the corpus in his gross estate as long as the grantor holds only routine administrative powers.  However, the corpus will be includible in the gross estate under IRC Section 2036 or 2038 if the grantor retains the power to designate the income or remainder beneficiaries.

(b)   The grantor can act as trustee with the power to designate the income or remainder beneficiaries if the trust is a grantor CLT and the corpus will be includible in his gross estate in any event, such as due to a retained reversionary interest.

2. Grantor’s Family Member as Trustee

(a)   A member of the grantor’s family other than the grantor’s spouse can act as trustee of a nongrantor CLT.  The spouse can act as long as not granted any power that would cause grantor trust status due to IRC Section 672(e).

(b)   Family members may act even where the trustees otherwise control the assets which are held in the trust, such as closely held stock.

(c)   Any compensation paid to a family member trustee should not exceed reasonable compensation, or such excess compensation might be deemed a current noncharitable distribution and thus disqualify the CLT.

3. Trustee’s Sprinkle Power

(a)   An independent trustee of a CLT may safely have the power to sprinkle the annuity or unitrust payment among qualifying charitable beneficiaries.  It should also be safe to allow an independent trustee to sprinkle the remainder among a class of individual beneficiaries upon termination of the lead interest.

(b)   If the grantor or the grantor’s spouse held the power to sprinkle corpus, the grantor would be treated as the owner for income tax purposes under IRC Section 674(a).  Moreover, a sprinkle power held by the grantor (but not his or her spouse) will cause inclusion of the corpus in the grantor’s gross estate under IRC Sections 2036(a)(2) and 2038(a)(1).

(c)   A sprinkle power retained by the grantor or his or her spouse with respect to the annuity or unitrust payments will not cause the grantor to be treated as the owner for income tax purposes,[21] but the retention of this power by the grantor (but not his or her spouse) will cause inclusion in the gross estate under IRC Sections 2036(a)(2) and 2038(a)(1).

(d)   Even if the grantor is not the trustee, if the trustee holds sprinkle powers and the grantor can freely discharge the trustee and appoint another, including the grantor or any trustee that is related or subordinate to the grantor, the corpus will be includible in the grantor’s estate under IRC Section 2036.

K. Application of Private Foundation Rules

1. Excise Tax Provisions.  The excise tax provisions applicable to private foundations under IRC Sections 4941 to 4945 also apply to CLTs.  Therefore, the trust document should include specific prohibitions against their violation as required by IRC Sections 4947(a)(c) and 508(e).

2. Excess Business Holdings.  If the value of the charitable interest exceeds 60% of the value of the trust at inception, IRC Sections 4943 (excess business holdings) and 4944 (jeopardizing investments) may apply.[22]

(a)   If the CLT holds more than a 20% voting interest in a business entity, there are excess business holdings.  If the excess business holding rules of IRC Section 4943 do apply, the trust is allowed a maximum of five years to divest itself of the “excess” received at funding.

·          In PLR 9819031, the IRS approved issuance of a new class of nonvoting stock of a closely held C corporation, with a fixed rate dividend for 15 years, to fund CLTs.  After 15 years, the stock was to revert to voting stock.  This avoided the excess business holdings problem and provided cash flow for the charitable lead distributions.

(b)   The 60% rule is obviously to avoid “packing” the value into the charitable income interest and zeroing out the remainder where family business interests are passed down to lower generations at little or no transfer tax cost.  A formula clause may set the payment rate for a testamentary CLT so the charitable interest does not exceed 60% of the CLT’s total value, and excess business holdings are avoided.[23]

(c)   If the jeopardizing investment rules of IRC Section 4944 apply, the exception for assets that are “gratuitously transferred” to the trust, e.g. at funding, does not apply.  The CLT may not either acquire or retain such assets.[24]



[1] Jane Peebles, a Law Corporation is a principal in the Los Angeles law firm of Karlin & Peebles, LLP.

[2] PLR 9112009.

[3] Annuity amounts ascending in this manner are expressly permitted for GRATs.  Treas. Reg. 25-2702-3(b)(1)(ii)(A).

[4] Rev. Procs. 2007-45 and 2007-46 contain CLAT forms; Rev. Procs. 2008-45 and 2008-46 contain CLUT forms.

[5] See Treas. Reg. Sections 1.170A-6(c)(2), 1.170A-6(e); 20.2055-2(e); 25.2522(c)-3(c).

[6] Rev. Rul. 85-49, 1985-1C.B. 330, approving a term that ended on the first to occur of 30 years after funding or 21 years after the death of the last to die of a class of lives in being.

[7] Section 170(f)(2)(B). Unless otherwise indicated, all references to “Section” are to the Internal Revenue Code of 1986, as amended.

[8] Treas. Reg. Section 1.170A-6(c)(A).

[9] Such a power to acquire trust assets causes the CLT to be a grantor trust notwithstanding the use of the term “reacquire” in Section 675(4).   See PLR 9642039.  Moreover, the power to “acquire” is the only grantor trust taint included in the Rev. Proc. 2007-45 form of inter vivos grantor CLAT and Rev. Proc. 2008-45 form of inter vivos grantor CLUT.

[10] The payments are considered “for the use of” the lead beneficiary.  PLR 8824039.

[11] Treas. Reg. Section 1.664-1(d)(5).

[12] See PLR 8931029.

[13] Rev. Rul. 83075, 1983-1C.B. 114; PLR 9201029.

[14] PLR 9821030, 9808035, PLR 9808031, 9348012, 9233038, 9052013 and 8931029.

[15] 76 F.R. 22483 (April 13, 2012).

[16] PLR 9233038; PLR 8727072.

[17] PLR 9128051; PLR 9118040; PLR 9631021; PLR 9840036.

[18] See PLRs 9810019, 9642039, 9407014, 9247024 and 9224029.

[19] PLR 9331015.

[20] Rev. Rul. 77-32, 1977-2 C.B. 353.

[21] Section 674(b)(4).

[22] Sections 4947(a)(2) and 494(b)(3)(A).

[23] PLR 9128051, PLR 9118040.

[24] Treas. Reg. Section 20.2055-2(e)(2)(vi)(e).

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