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

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

Article posted in Charitable Lead Trust on 8 September 2015| comments
audience: National Publication, Jane Peebles, Attorney | last updated: 9 September 2015
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Summary

Jane Peebles concludes her series on CLATs.

By: Jane Peebles, J.D.

Click here if you missed Part 1 or Part 2.

VI. GST PLANNING WITH CHARITABLE LEAD TRUSTS

A. Designing a CLT for Lower Generations

Many clients do not want their children or grandchildren to have a current gift, but would like it deferred for a number of years.  A CLT for such a client to last for the desired deferral period (which may be the rest of the client’s life), may be ideal.  During the lead term, the CLT may be used to implement charitable gifts which the client would otherwise make in any event from his own funds.  For the client who routinely exceeds his percentage AGI limits for charitable gifts, the lead trust can effectively increase those limits.  Charitable distributions from the lead trust are 100% deductible by the CLT (up to the gross income of the trust) and are not taken into account in the client’s own contribution limits.

B. GST Tax and the CLUT

A CLT can be used as a creative vehicle to “leverage” the client’s generation-skipping transfer (“GST”) tax exemption and ultimately pass greater assets to future generations. 

A CLUT which provides for the remainder to pass to a skip person will not pay an additional GST tax if the present value of the remainder interest when the trust is funded is less than or equal to the settlor’s available GST tax exemption amount and sufficient GST tax exemption is timely allocated to the CLUT at inception to fully exempt the remainder.

1. For example, a CLUT is funded with $20 million, either during the settlor’s lifetime or on her death.  The remainder is to be paid (either outright or in further trust) to the settlor’s grandchildren.  Under the terms of the trust, the present value of the remainder interest is 20%.  Therefore, the value of the remainder interest is $4 million ($20,000,000 x 20%).

2. If the settlor has not previously utilized her GST tax exemption, the entire trust will pass to the grandchildren at the end of the charitable term without the imposition of a GST tax.  Therefore, if the investment performance of the trust assets (after taxes) is greater than the IRC Section 7520 rate on the date the trust was funded (or on the decedent’s date of death), the grandchildren will receive more than $4 million.  The charities receiving payments during the lead term will also benefit since the unitrust amount computed each year will increase.

3. The IRS has approved the use of a formula funding clause for a testamentary CLUT, designed to ensure the value of the remainder interest is equal to the settlor’s available GST exemption.1

C. GST Tax and the CLAT

A CLAT requires a more complicated computation.  The determination of the amount of the transfer subject to GST tax is not ascertainable until the termination of the lead interest.  At that time, the value of the trust passing to the skip persons is compared to the amount of the “adjusted GST exemption amount.” This is the amount allocated by the settlor to the trust at the time of funding, increased by the assumed appreciation in the assets at the IRC Section 7520 rate during the charitable lead period.  Therefore, if the trust assets outperform the IRC Section 7520 rate, the CLAT will be required to pay a GST tax at the termination of the charitable lead interest.  Although there is the potential for the payment of a GST tax at the termination of the lead interest, there also are potentially more benefits to the remainder interests.  Since the amount of the annuity payments to charity is fixed at the beginning of the trust, all appreciation during the charitable term will benefit the remainder.

D. Allocation of GST Exemption to a CLT

1. Allocation to CLUT.  A CLUT may be entirely exempted from the GST by allocating exemption to the noncharitable interest only.  For this purpose, the noncharitable interest is valued as of the date of transfer if allocation is timely, or as of the date of the allocation if allocation is late.

EXAMPLE 2:  David Doting creates a 6%, 20-year nongrantor inter vivos CLUT terminating in favor of his granddaughter.  The CLUT is funded with $1 million when the 7520 rate is 2.0%.  If GST exemption equal to the present value of the remainder interest as of the time of transfer is timely allocated to the CLUT, it will be fully exempt from GST.  If the internal rate of return is 6%, the value of the remainder at inception is $297,539.  David allocates that much GST exemption to the CLUT.  At the end of 20 years, charity has received $1.2 million and his granddaughter receives $1 million.

(a) For instance, take Example 2 above (6%, 20 year CLUT funded with $1 million) and assume the CLUT terminated in favor of a long-term trust for David’s granddaughter (with or without his daughter also as a beneficiary).  If $295,334 of GST exemption were timely allocated, and the CLUT had a total return of at least 6%, a minimum of $1 million would pass to the lower generation beneficiaries at the end of the lead term.

(b) Note that inherent in the unitrust structure is the fact that any increase in the value of the trust will inure to the benefit of charity as well as family.  Thus the CLUT does not present the opportunity for leveraging the family gift that the CLAT, with a fixed payout, presents if the trust grows at a rate faster than the IRC Section 7520 rate assumed at the time of the gift.

(c) In Example 2 above, the highly discounted gift to family for both gift and GST tax purposes does not mean that value has passed to the family outside the transfer tax system (as is the object of the exercise with a GRAT and, to a lesser extent, with a CLAT), but rather that the untaxed value has gone to charity.  Family would have had a great deal more at the end of the 20 years if the $1 million had simply been contributed to a family trust rather than to a CLUT.


EXAMPLE 2:  DAVID DOTING

2. Allocation to CLAT.  Although GST exemption may be allocated to a CLAT as of the time of the transfer, per IRC Section 2642(e) the inclusion ratio will be determined on the basis of the ratio of the value of the GST exemption allocated, increased by the IRC section 7520 rate used to determine the gift or estate tax charitable deduction from the effective date of the allocation to the end of the lead term, compounded annually (the “adjusted GST exemption amount”), to the value of the trust at the end of the lead term.  In order to ensure a zero inclusion ratio for a CLAT, one can wait until the end of the lead term to allocate GST exemption.  Otherwise, to try to ensure that the CLAT will have an inclusion ratio of zero, and thus be fully exempt from GST, one must make one’s best guess as to what the value of the remainder will be at the termination of the CLAT and then allocate to the trust that amount of GST exemption which, at a growth rate equal to the applicable IRC Section 7520 rate from the effective date of the allocation, will give rise to the predicted value of the CLAT at the end of the lead term.

(a) Combining a CLAT with generation-skipping is more problematic because of the likelihood one will have a fractional inclusion ratio at the end of the term, contrary to one of the fundamental precepts of GST planning.  However, the CLAT has the potential for leveraging the family gift for gift tax purposes, which will appeal to some donors.

(b) If a CLAT is to be used and it is contemplated that additional GST exemption will not be allocated after the initial allocation, the damage from the fractional inclusion ratio will be minimized if all remaindermen at the end of the lead term are skip persons (i.e., grandchildren or lower generations), as opposed to a multigenerational trust which includes children as beneficiaries.  In that way, if insufficient GST exemption is allocated to fully exempt the trust at the end of the lead term, there will be a one-time GST tax hit at the end of the lead term, which will be a taxable termination, as opposed to a GST tax every time a distribution is made to a skip person.

EXAMPLE 3:  Gerry Generous establishes a 5% 20-year nongrantor CLAT funded with $1 million when IRC Section 7520 rate is 2.0%.  At inception, the remainder is valued at $182,430 and $182,430 of GST exemption is allocated to it.  This will give rise to an adjusted GST exemption amount at the end of the lead term ($182,430 at 2.0% for 20 years) of $271,081.  Assume the actual value of the trust at the end of the lead term is $1,367,856.  No GST exemption has been allocated to 80.2%, and the trust terminates in favor of a trust for Gerry’s grandchildren for life.  There will be a taxable termination at the end of the lead term, and the trust will be subject to GST tax at an effective rate of 32.1% (80.2% x 40%) at that time, but all future distributions to the grandchild will be free of GST tax (or any other transfer tax).

(c) By contrast, if the CLAT had terminated in favor of a trust for the settlor’s child and grandchild, no GST tax would be due at the end of the lead term, but all distributions to grandchildren would be subject to GST tax (at 32.1%) as taxable distributions.  In addition, there would be a taxable termination at the child’s death, when the entire trust would be subject to GST tax at 32.1%.  Thereafter, future distributions to the grandchildren from the trust would not be subject to GST tax.

(d) If it is realistic to expect that any shortfall between the adjusted GST exemption and the actual value of the CLAT at the end of the lead term will be covered by an additional allocation of GST exemption, a multigenerational trust including the child as beneficiary should be used, because a late allocation at the end of the lead term or at any time prior to the first distribution to the grandchild will be effective to make the trust fully GST-exempt.  For instance, in Example 3 above, if the CLAT terminated in favor of a long-term trust for the settlor’s child and grandchild, a late allocation of $1,185,426 ($1,367,856 [the value of the remainder when the CLAT ends] - $182,430 [the present value of the remainder on funding]) at the end of the lead term would fully exempt the trust.  However, if the CLAT terminated in favor of skip person trusts or of grandchildren directly, allocation of GST exemption would have to occur before the termination of the lead interest, which makes it more difficult to achieve the desired result.

(e) If the predeceased child exception is available (because a child has died leaving children either before or after the trust is established), the GST tax drops out entirely as a planning constraint.  A CLAT or CLUT can terminate in favor of such a grandchild (or a trust for such a grandchild), and no GST tax will be due either on termination of the lead term or on any subsequent distributions to the grandchild.  (Distributions to great-grandchildren, however, would continue to be subject to tax absent an allocation of GST exemption.) The recent expansion of the predeceased child exception to apply to taxable terminations and taxable terminations as well as direct skips has added this feature for CLTs.

(f) The key point to remember, if you know at the inception of the CLT that the predeceased child exception is available and there are also living children, is to isolate the share of the grandchild eligible for the exception in a separate trust, with another trust providing for any other grandchildren.  For instance, suppose a client has three grandchildren, GC 1, GC 2, and GC 3, with only GC-3 eligible for the predeceased child exception.  If the client establishes a CLUT terminating in favor of his grandchildren in equal shares, in order to exempt the property passing to GC 1 and GC 2 from GST tax, he will have to allocate enough GST exemption to exempt the entire trust, even though the portion so allocated to GC 3’s share would be wasted.  By contrast, if he set up two CLUTs, one terminating in favor of GC 1 and GC2 and the other terminating in favor of GC 3, he would have to allocate GST exemption only to the trust for GC 1 and GC 2.

EXAMPLE 3:  GERRY GENEROUS

3. A CLT for the life of a client whose actual life expectancy is less than his life expectancy under the IRS tables used for this purpose can be a highly advantageous (i.e., leveraged) vehicle for family giving, with or without a GST component.

EXAMPLE 4: 6% nongrantor CLUT for life of Marty Party, age 60, terminating in favor of grandchildren, funded with $1 million.  The value of the non-deductible remainder is $324,050.  The CLUT can be fully exempted from GST tax by allocation of $324,050 of GST exemption.  If Marty dies after five years and the CLUT in the interim has had a total return of 6%, the grandchildren will receive $1 million only five years later, and the charity will have received only $300,000.  By comparison, the value of the non-deductible remainder for a 6%, five-year CLUT funded with $1 million, which is what the trust turned out to be, would be $1 million. 


EXAMPLE 4:  MARTY PARTY

  • The IRS actuarial tables cannot be used if the measuring life for the CLT is “terminally ill,” i.e., is known to have an incurable illness or other deteriorating physical condition and there is at least a 50% probability of death within one year.  However, if the individual survives for at least 18 months, the individual will be presumed not to have been terminally ill unless the contrary is established by clear and convincing evidence.2
  • Where a CLT has a term based on a measuring life, the person whose measuring life is used must be either a lineal ancestor or spouse of a lineal ancestor of the individual remainder beneficiaries, if there is less than a 15% probability that individuals who are not lineal descendants will receive any trust corpus, as computed on the date of transfer to the trust.3

4. Where there are concerns of an entirely different nature, such as generation skipping tax for the grandchildren but not for children, consider two CLTs.  In addition to the need to consider the tax issues, the need for different timing of distributions of the remainder (i.e., for younger and older remaindermen) should also be taken into account.  Some practitioners recommend using separate shares in one CLT as opposed to two CLTs.  This is not a tax question as the regulations seem to specifically permit separate shares; thus, it is a question of style and of trust administration convenience.

5. The choice of the form of the CLT, annuity or unitrust, may be influenced by the application of the GST tax considerations.  See discussion above regarding application problems of using the annuity form for grandchildren, due to the recalculation for GST purposes at the end of the CLT term.  This may cause additional tax to be assessed at the end of the trust term.  Thus, for the grandchildren, a unitrust version may be better.  However, the choice must be made in light of the earnings of the asset in relation to its probable increase in value over the trust term.  If the asset used will produce a fixed income over time but increase in value, the payout to the charitable beneficiaries may become impossible to meet.  All the nice paper planning in the world will not help a poorly-designed investment in the trust.  Thus, while considering the unitrust for the grandchildren for tax concerns, keep in mind the practical requirements of trust administration, such as the values, and if the values become truly out of sync, the taxation to the trust entity on the gain if the trust must sell to generate more income to meet the payout.

(a) The trust could, with the right asset, liquidate only enough to meet the current payment, paying tax only on that small piece.

(b) Or it could distribute some portion or all of some asset to meet its distribution requirement, understanding that to do so causes taxation just as if it had sold the asset and distributed the proceeds.

EXAMPLE 5: Penny Provider, age 60, has three children, ages 25, 28 and 32.  All are “getting started”; one child, the middle one, is married, two are not.  Penny is ambivalent about the married child’s spouse, and concerned about whom the other two might marry.  Due to prior gifts to custodial accounts, each child received about $500,000 upon reaching age 21, and Penny does not want her children to have anything more for now.  She wants to be sure funds are available to educate her future grandchildren, but she does not want them “spoiled,” as she thinks her own children arguably were by reason of the funds that they received at age 21.  During Penny’s lifetime, she can pay for her grandchildren’s education directly without gift tax consequences, but she wants to be sure that funds continue to be available for this purpose after her death.  In addition, ultimately she wants to pass her wealth on to her children; she just doesn’t want to do so in a way that she feels will be contrary to their own best interests.

Penny has income of $500,000 per year and gives on average $50,000 per year to charity.  She contemplates continuing this level of regular charitable giving, and she will probably also want to make larger, one-time gifts to her favorite charities over time.

Penny establishes a 5% nongrantor CLUT and funds it with $1 million.  Distribution of the unitrust amount will be made annually to charities selected by the trustees (which do not include Penny).  The term of the trust is the rest of Penny’s life, after which the trust will terminate in favor of three separate, discretionary trusts -- one for each child and that child’s children.

During Penny’s lifetime, the trust will be the vehicle through which Penny’s regular charitable gifts may be made.  Since the income of the CLUT and the charitable distributions made by the CLUT will be removed from Penny’s contribution base, with the CLUT she can make larger deductible contributions than would be possible without it.  At Penny’s death, the trust becomes a flexible vehicle for children and grandchildren, to be sure the grandchildren’s educational costs are met and to dispense funds to or for the children as appropriate.  Assuming the trust has a total return (after tax) of 7% per year, and Penny lives for another 20 years, at Penny’s death there will be over $1.5 million available for the children and grandchildren, and almost $1.3 million will have been distributed to charity.

If Penny is married and gift splits with her husband, no gift tax will be payable assuming each has enough available lifetime gift tax exemption available.  GST exemption can (and should) be allocated to the trust in a timely manner.

EXAMPLE 5:  PENNY PROVIDER


EXAMPLE 6: Charlie Charitable, age 70, has a net worth of roughly $20 million, of which $5 million is liquid.  The balance is illiquid assets consisting primarily of partnership interests, an art collection and real estate.  Indeed, because of the nature of his assets, Charlie can never do more than roughly estimate his net worth.  Charlie is concerned about how his estate could raise the cash necessary to pay the estate tax at his death (at 40% when the planning was done), since his estate would not be eligible for the various relief options available for closely held businesses.

Charlie has one living child, age 42, with two children, and one deceased child who left three children, all of whom are still living.  His living child is a successful lawyer and able to provide well for his own family.  The children of the deceased child are likewise well provided for by their surviving parent.  Charlie wants his family to inherit the wealth that he has accumulated, but he is comfortable with their waiting to receive their inheritance.  Charlie has always been a generous donor to charity.  Charlie feels that his estate could comfortably afford to pay an estate tax of $2.2 million, and he also feels that his illiquid assets will grow overall at a rate of greater than 6% per year.  Charlie’s full GST exemption is available.

Charlie provides under his estate plan for the residue of his estate to go into a 6% CLAT, with a term determined by a formula.  The term is the number of years required in order to give rise to a taxable estate, taking into account all other taxable dispositions, the estate tax on which will be $2.2 million.  Suppose the testamentary CLAT were the only taxable disposition under the estate plan.  This formula would call for a taxable estate (assuming a 40% tax rate) of $5,000,000.  Of this amount $2.1 million would go for estate taxes, and the balance ($2.8 million) would be the present value of the remainder interest in the CLAT.

The CLAT permits Charlie to preserve his estate for the eventual use of his family while keeping his estate taxes manageable.  In addition, since because of the formula his taxable estate will be a constant regardless of the value of his assets, the IRS has little incentive to challenge the values used for federal estate tax purposes.

GST implications of the CLAT must be carefully considered and taken into account in the planning process.  The CLAT should be subdivided per the estate plan into two separate trusts, one for the children of the deceased child and the other for the living child and that child’s issue.  GST exemption would be allocated solely to the trust terminating in favor of the family of the living child since the children of Charlie’s deceased child enjoy the benefit of the “predeceased child rule.”

NOTE: If the plan is to fund a testamentary CLT by formula, growth in value of the settlor’s assets must be monitored so that the CLT does not end up running for a term too long to be acceptable in light of when the settlor wants the family to receive the property.

VII. CONCLUSION

For a client who makes regular charitable contributions and has unneeded income, exploring the idea of a CLT has merit because a CLT provides the opportunity to improve the economic benefits for the client while preserving assets for the family.  Careful consideration of the GST implications must be factored in if grandchildren or lower generation beneficiaries are to benefit.  If the client’s private foundation is to be the lead beneficiary, and the CLT is intended to be a nongrantor trust, the client must be adequately insulated from grantmaking decisions but may still fund the foundation in a tax efficient manner and remain actively involved in its operations.

United States Internal Revenue Service (IRS) Circular 230 disclosure:

To ensure compliance with requirements imposed by the IRS, we inform you that, unless and to the extent we otherwise state, any U.S. federal tax advice contained in this outline (including any attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.



EXHIBIT A

CLT FILING REQUIREMENTS

1. Charitable lead trusts are calendar year taxpayers.

2. A nongrantor CLT must file federal Forms 1041 and 5227 by April 15 of the following year.  A Form 1041 A may also be required for amounts accumulated for charitable purposes.

3. State requirements vary.  Some states require that a CLT be registered with the Attorney General.  In California, no registration with the Attorney General is required, but the CLT must file Forms 541, 541A and 541B.


EXHIBIT B

UNRELATED BUSINESS INCOME
AND THE CLT

In addition to being taxable, a CLT is also subject to rules regarding unrelated business income (UBI).  This includes both the operational form of UBI from having carried on a trade or business and the form arising from holding or selling debt-financed property.  Debt-financed income requires that the property be income producing, and that the debt be “acquisition indebtedness”.  Acquisition indebtedness is debt incurred for the acquisition or improvement of the trust property.

The reason this is important is that another Section, IRC Section 681, limits the CLT’s charitable deduction under 642(c) where the trust has unrelated business income.  The limitation is that the percentage limitations of IRC Section 170(b) apply to the trust as if the trust were an individual.  As a result, the trust’s charitable deduction will be limited to a percentage of its AGI rather than permitted for the full value of the year’s charitable distributions.  The effect of this is to make the trust pay tax out of its resources even though most or all of its current income was required to be distributed to the charity (depending upon the annuity or unitrust payout rate versus the trust earnings).  Clearly, this could cause an incursion on principal and be disadvantageous to the remainder beneficiaries.

  • 1. PLR 9532007.
  • 2. Treas. Reg. Section 25.7520-3(b)(3).
  • 3. Treas. Reg. Sections 1.170A 6, 20.2055-2 and 25.2522(c) 3.

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