User-Friendly Charitable Lead Trusts: Impact of IRS Rulings On Planning Flexibility

User-Friendly Charitable Lead Trusts: Impact of IRS Rulings On Planning Flexibility

Article posted in Charitable Lead Trust on 29 September 1999| comments
audience: National Publication | last updated: 16 September 2012
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Summary

Looking back on 1999, from a charitable ruling standpoint, it could be called the year of the charitable lead trust. And no wonder, with interest rates at 29 year lows, donors and advisors have taken advantage of a cyclical opportunity to maximize the value of their planned gifts. In this edition of Gift Planner's Digest, Indianapolis attorney and gift planning consultant Laura Hansen Dean takes a concise look at intervivos, testamentary, and hybrid/super charitable lead trusts and the rulings that have shaped their use.

by Laura Hansen Dean, J.D.

Interest in qualified testamentary charitable lead trusts and non-grantor, or "hybrid" or "super" intervivos (lifetime) charitable lead trusts (CLTs) dramatically increased during the winter of 1998-99 as the applicable federal midterm interest rate (AFR, see IRC §7520) used to calculate the relative values of the lead (charitable) interest and the remainder (non-charitable) interest dropped below 6.0% for the first time in the last decade, with a low of 5.4% in November and December 1998, 5.6% in January and February 1999, and 5.8% in March 1999. The impact of this significant drop in the AFR was that shorter trust terms or lower payout rates could still load most of the trust value in the lead portion of the trust, substantially reducing the value of the remainder interest subject to estate tax in testamentary lead trusts or gift tax in intervivos lead trusts. The estate tax charitable deduction, or gift tax charitable deduction, then shelters as much of the trust assets as possible from generating either estate or gift tax.

However, the application of the grantor trust rules and other requirements of qualified charitable lead trusts limit the donor's or the donor's heirs ongoing involvement in the administration of testamentary charitable lead trusts and intervivos non-grantor and hybrid/super charitable lead trusts, especially when compared to charitable remainder trusts. Individuals familiar and comfortable with charitable remainder trusts are usually intrigued by the ability to substantially reduce federal gift or estate taxation by creating and funding testamentary or intervivos non-grantor charitable lead trusts. However, the restrictions on the donor's and spouse's involvement in the administration of such trusts and rights and powers in such trusts have caused individuals and their professional advisors to view charitable lead trusts as much more inflexible than charitable remainder trusts.

It is the author's belief that testamentary and intervivos non-grantor and hybrid/super charitable lead trusts offer much greater planning flexibility than recognized by most charitable gift planners and professional advisors due to a 1995 revenue ruling and a series of private letter rulings issued during the 1990s by the Internal Revenue Service. As a result planners and advisors are encouraged to take a new look at these types of qualified charitable lead trusts.

Basics of Charitable Lead Trusts

Charitable lead trusts are statutorily created exceptions to the partial interest rule. IRC §170(f)(2)(B) provides for an income tax charitable deduction for partial interest gifts given to qualified charitable organizations so long as the charity's income interest is in the form of a guaranteed annuity interest or a guaranteed unitrust interest. IRC §2055(e)(2)(B) provides for an estate tax charitable deduction, and IRC § 2522(c)(2)(B) provides for a gift tax charitable deduction under the same conditions. The basic advantages of a CLT include:

  • Guaranteed "unitrust" or "annuity" payout to charity for the term of the trust.
     
  • No minimum 5% payout requirement.
     
  • No flip, net income, or net income with make-up lead unitrusts possible.
     
  • No 20-year maximum term of years.
     
  • Remainder (or reversion) to private individual(s) (reverse of charitable remainder trust).
     
  • Taxable complex trust with distribution deduction for amounts distributed to the charitable beneficiary(ies).

Testamentary

A testamentary CLT (by will or trust) pays income interest to the designated charity after death. The named individuals (usually heirs) get the trust assets at end of the trust term. Estate tax charitable deduction is given for the value of the charitable lead interest, and no additional estate tax is due at the end of the trust if the assets have appreciated.

Intervivos Non-Grantor (Non-reversionary)

An intervivos non-grantor CLT pays income interest to the charity for the trust term and the named individuals get the trust assets at end of the trust term. The gift tax charitable deduction is available for the value of the charitable lead interest. The value of the lead trust is not included in the grantor's estate so any appreciation in value during the trust term escapes gift/estate taxation.

Intervivos Grantor (Reversionary)

A CLT that has an intervivos grantor pays income interest to charity for the trust term. The grantor or grantor's spouse gets the trust assets back at end of the trust term. Since the grantor is the owner of the trust, an income tax charitable deduction can be claimed for the value of the charitable lead interest, but the grantor is taxed on the income earned by the trust (tax-free investments used to try to avoid the phantom income problem).

If the grantor dies during the trust term, the then value of the charitable lead interest is deductible as an estate tax charitable deduction since the grantor is treated as "owner" of the trust. If the grantor outlives the trust term and the trust assets are returned to the grantor or the grantor's spouse, then the assets are part of the grantor's estate at his or her eventual death.

Intervivos Hybrid Or Super Charitable Lead Trust

This type of CLT pays income interest to the charity for the trust term. The named individuals get the trust assets at end of the trust term. Just enough administrative powers in the trust are retained for the trust to be considered a grantor trust for income tax purposes (usually a disinterested party is given the right to substitute the trust assets for assets of equal value). An income tax charitable deduction can be claimed for the value of the charitable lead interest, but the grantor is taxed on the income earned by the trust (tax-free investments used to try to avoid the phantom income problem).

However, not enough control or power is retained by the grantor or spouse to be considered a grantor trust for gift and estate tax purposes. The gift tax charitable deduction is for the value of the charitable lead interest, and the value of the lead trust is not included in the grantor's estate, so any appreciation in value during the trust term escapes gift/estate taxation.

Avoiding Characterization As A Grantor Trust For Gift And Estate Tax Purposes

lt is not necessary for the donor to be treated as the owner of the lead trust during its term in order to claim a gift or estate tax charitable deduction. In fact, retained rights or powers that make a lead trust a grantor trust1 must be avoided if the goal is: 1) in the case of a testamentary trust, the lead trust claims the largest possible estate tax charitable deduction for the value of the charitable income interest; or 2) in the case of an intervivos lead trust, keeping the value of the trust assets out of the donor's gross estate at his or her death, is to be accomplished.

Certain powers that cause the donor to be treated as owner under the grantor trust rules must not exist because their retention disqualifies the trust as a qualified charitable lead trust:

  • Power to revoke the trust by the donor or any other person-guaranteed annuity or unitrust interest must be irrevocable.2
     
  • Power to divert trust income to the grantor, grantor's spouse, or to support grantor's dependent children-no amounts other than guaranteed annuity interest or unitrust interest may be distributed for a private purpose until all charitable interests in the trust end.
     
  • Power to purchase or borrow trust corpus or income for less than adequate consideration-violates requirement that no amounts may be distributed for private purposes except the guaranteed annuity or unitrust interest until the charitable interests end and constitutes self-dealing, applicable to charitable lead trusts.3
     
  • Power to control the investment of the trust funds-constitutes self-dealing.
     
  • Power to prepay the charitable lead interest-violates the requirement that the charitable interest either be in the form of a guaranteed annuity interest or guaranteed unitrust interest-Rev. Rul. 88-27, and Ltr. Rul. 9734057, but see Ltr. Rul. 9844027 that allowed three lead annuity trusts to pay the full annuity amount, without discount, in advance. In the earlier rulings the total owed to the charitable beneficiaries would be paid in advance, but on a discounted basis.
     
  • Additionally, all qualified charitable lead trusts must contain the private foundation prohibitions against self-dealing,4 excess business holdings,5 jeopardizing investments,6 and taxable expenditures.7

Under the grantor trust rules, the grantor of an intervivos charitable lead trust will be treated as the owner of the charitable lead trust in the following situations, causing the value of the trust assets to be included in the grantor's gross estate at his or her death.

  • The grantor or spouse has more than a 5% reversionary interest in the trust assets8 or in the income from more than 5% of the trust assets.9
     
  • The grantor, spouse, or nonadverse party has powers over the beneficial interest in the trust.10 This includes the power to change the charitable beneficiaries or to designate annually which charities will receive distributions from the trust.
     
  • The grantor, spouse, or nonadverse party has certain administrative powers over the trust that can be exercised primarily for the benefit of the grantor rather the beneficiaries of the trust.11
     
  • The grantor, spouse, or nonadverse party has the power to revoke the trust.12
     
  • The grantor, spouse, or nonadverse party has the power to distribute or accumulate trust income to, or for the benefit of, the grantor or the grantor's spouse, or for the payment of life insurance premiums on the life of the grantor or spouse.13

Therefore, to create a qualified intervivos charitable lead trust in which the donor is not treated as the owner in order to accomplish maximum gift or estate tax savings, the donor may not:

  • serve as trustee, or name a related or subordinate party as sole trustee;
     
  • control the investment of the trust assets;
     
  • purchase or borrow trust assets or income for less than adequate consideration;
     
  • retain the right to amend, add, delete, or substitute the charitable beneficiaries or change the allocation of the annual distribution among several charitable beneficiaries;
     
  • retain the right to name the charitable beneficiaries on an annual basis; and
     
  • generally, fund the lead trust with assets that give the lead trust more than a 20% voting interest in a business entity, unless the charitable value of the trust does not exceed 60% of the total value of the trust assets on the date of contribution.
     

The inability to serve as trustee of the lead trust and therefore inability to control the investments of the trust assets, inability to retain the right to change the charitable beneficiaries, difficulty in funding lead trusts with significant voting interests in business entities, and difficulty in projecting the percentage of the trust treated as the charitable interest in testamentary lead trusts have led many donors, charitable gift planners, and professional advisors to conclude that non-grantor charitable lead trusts are inflexible vehicles. However, rulings issued by the Internal Revenue Service during the 1990s suggest more flexibility in these matters.

IRS Rulings That Have Increased Planning Flexibility Without Characterization As A Grantor Trust

The Trustee

Retention of power to remove and replace an independent trustee- In Rev. Rul. 95-58, (revoking Rev. Ruls. 79-353 and 81-51, and modifying 77-182), the Internal Revenue Service held that the decedent-grantor's unqualified power to remove an independent trustee with a successor independent trustee did not amount to retaining discretionary control over the income of a trust. Previously in Rev. Rul. 79-353, modified by Rev. Rul. 81-51, the IRS had held that the power to remove the trustee amounted to the power to control the enjoyment of the trust property under IRC §2036(a) and amounted to the power to alter, amend, remove, or terminate the trust under IRC §2038(a)(l). When applicable, both sections cause the value of the trust to be included in the decedent's gross estate. The IRS changed its position due to court cases, including Estate of Wall v. Commissioner, 101 T.C. 300 (1003) and Estate of Vak v. Commissioner, 973 F.2d 1409 (8th Cir., 1992), reversing T.C. Memo 1991-503.

In Wall, a corporate fiduciary was named as the initial trustee and was given broad discretionary powers of distribution. The decedent retained the right to remove and replace the corporate trustee. The court said this retained power did not equal the power to affect the beneficial enjoyment of the trust as contemplated in IRC §§2036 and 2038.

In Estate of Vak v. Commissioner, family members of the decedent were named as trustees and were given discretionary powers of distribution. The decedent reserved the right to replace the initial trustees with trustees who were not related or subordinate to the decedent. The court held the gift was complete when funded, not when the right to remove and appoint successor trustees was relinquished.

Clearly, the grantor's unqualified right to remove and replace an independent trustee gives donor--grantors enormous influence over the operation of charitable lead trusts, including the ability to influence the investment of the trust assets. A natural extension of the ruling seems to be the ability to give the power to remove and replace an independent trustee to one's spouse or other related persons.

Children as co-trustees-Ltr. Rul. 974800914 and Ltr. Rul. 9331015 were both intervivos charitable lead trust cases. In Ltr. Rul. 9748009, a child of the grantor served as a co-trustee of a charitable lead annuity trust (CLAT). The trustees were given the power to select the annual charitable beneficiaries and apportion the annual payout among the selected charitable organizations. The trust qualified for the gift tax charitable deduction because the trust document provided that the trustees could not select charitable beneficiaries where the grantor or a trustee was a director or officer, or where the grantor or trustee had the power to direct the disposition of funds received by the charitable organization.

In Ltr. Rul. 9331015, the grantor's son or another child could serve as co-trustee with a corporate fiduciary as the other co-trustee. The co-trustees, acting unanimously, could select the charitable recipients among publicly supported charities on an annual basis and apportion the payout among the selected charitable organizations. However, the trustees could not select charitable organizations where the grantor or a trustee had the power to direct the disposition of the funds received by the charitable organization. The trust qualified for the gift tax charitable deduction.

Change Or Modifications Of Charitable Recipients

Distributions to an "advise and consent" fund-Ltr. Rul. 9633027 allowed distributions from an intervivos lead unitrust to be made to an "advise and consent" fund at a foundation, with the independent trustee of the lead trust the fund advisor. All successor trustees must also be independent and not related to, or subordinate to, the grantor. The grantor retained the power to remove any trustee and replace him or her with an independent successor trustee. The IRS held the trust was not a grantor trust since neither the grantor nor any trustee may be an officer, director, or trustee of the foundation holding the advise and consent fund.

Independent trustee power to change charitable beneficiaries-Ltr. Rul. 9532007 (referring to Rev. Rul. 78-101) allowed that an independent trustee's power to replace the charitable beneficiaries in a testamentary charitable lead unitrust (CLUT) did not disqualify the trust. The trustees' power to replace the charitable beneficiaries did not amount to a general power of appointment under IRC §2041, so the trust assets would not be included in the trustees' gross estate.

Trustee consultation with grantor's children regarding annual selection of charitable beneficiaries-In Ltr. Rul. 9304020 it was decided that an independent trustee who "consulted" with the grantor's children regarding the selection of the annual charitable beneficiaries from a lifetime CLAT did not result in a "grantor" trust. The right to "consult" with the trustee is precatory language, not mandatory language. The trust assets would not be included in the childrens' gross estates either since the right to consult did not amount to a general power of appointment under IRC §2041 or to the rights contained in IRC §§2035 through 2038.

Trustee's right to name charitable beneficiaries-Ltr. Rul. 9808031 allowed that a corporate fiduciary trustee of a lifetime CLUT had sole discretion to make distributions to a private foundation, or to either of two charities in lieu of the private foundation. Neither the grantor, spouse, nor any beneficiaries of the trust could serve as trustee or select a successor trustee.

Ltr. Rul. 9801013 gave the trustees (grantor's children and grandchildren) of a testamentary CLUT the right to name charitable beneficiaries, and this right did not disqualify the trust so long as distributions could not be made to charitable organizations for which a trustee had the power to direct the disposition of the funds received by a charitable organization.

Ltr. Rul. 9748009 allowed the grantor's children serving as co-trustees to name charitable beneficiaries each year from an intervivos CLAT, except to a charity of which they or the grantor are officer, trustee, or fiduciary. The CLAT qualified for the gift tax charitable deduction and the trust assets would not be included in the grantor's or the childrens' gross estates.

Distributions to private foundations-In Ltr. Rul. 9823005, both the grantor and the independent trustee of an intervivos charitable lead trust were trustees of the private foundation. The distributions from the lead trust would be placed in a segregated pool of funds over which the trustees of the lead trust would have no control. The trust qualified for the gift tax charitable deduction and was not a grantor trust.

Ltr. Rul. 9821030 allowed distributions to a private foundation with grantor's spouse, daughters, and one of the independent trustees of the intervivos lead trust serving as trustees of the private foundation. Neither the grantor nor spouse could be named as trustee of the lead trust. So long as there was no express or implied understanding between the donor and the officers and directors of the private foundation regarding disposition of distributions from the lead trust, the lead trust assets could not be induced in the donor's gross estate at death.

In Ltr. Rul. 9810019, the charitable beneficiary was a private foundation with the grantor and the two independent trustees of the intervivos hybrid charitable lead trust also serving as trustees of the private foundation. It was decided that acting as trustees of the private foundation did not amount to the right to designate the recipients of the trust income, so it was not a grantor trust for gift tax purposes, and trust property would not be included in the donor's gross estate under IRC §2036.

Ltr. Rul. 9808031 allowed a private foundation to be one of three possible recipients from a charitable lead trust. The grantor was not a trustee of the private foundation.

In Ann Jackson Family Foundation v. Commissioner, 97 T.C. 534, the Tax Court clarified that the private foundation was required to distribute 5% of what it received annually from the lead trust, not 5% of the value of the lead trust.

Funding Charitable Lead Trusts With Voting Rights Equity, Mortgage Property, And Subchapter S Stock

In Ltr. Rul. 199908002, the IRS approved a plan to fund an intervivos, hybrid CLUT and CLAT with subchapter S stock. The recipient charity of both trusts was a private foundation of which the grantor was a director and officer. The payout from the trusts would be held in a segregated pool with control given to officers and directors other than the grantor. The trust assets would not be included in the grantor's estate because the grantor could not serve as trustee of either trust, and the remainder either continued to be held by the trustee under a separate trust article for the benefit of the grantor's descendants, then alive (CLUT), or went to the grantor's descendants living at the trust termination (CLAT), or if no descendants were living at the trust termination, to qualified charitable organizations selected by the trustee, or if none were chosen after six months after trust termination, to the private foundation. The IRS stated that after the grantor's death, both trusts could elect to be treated as "electing small business trusts" under IRC §1361(e)(1). Effective January 1, 1998, an electing small business trust is an eligible shareholder of a subchapter S corporation.

The IRS approved issuance of a new class of non-voting stock from a closely held C corporation with a fixed rate dividend for 15 years, specifically to fund intervivos charitable lead trusts in Ltr. Rul. 9819031. At the end of 15 years, the new stock will convert to a class of non-voting stock already in existence. So long as the exchange of one class of stock for the new class did not amount to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings/profits, then the issuance of the new shares did not amount to a taxable distribution to the company shareholders. The accepted business reason for the plan was to reduce the amount the company would have to spend to meet the redemption obligations from deceased shareholders' estates under an IRC §303 redemption. Not only did this solve the excess business holdings issue by funding with non-voting stock, but it also dealt with the potential cash flow problem by providing for a fixed rate dividend for the new class of stock.

In Ltr. Rul. 9810019, the IRS approved an intervivos charitable lead annuity trust funded with limited partnership units and found no excess business holdings because all the income earned by the lead trust was passive income.

The IRS approved an intervivos lead trust funded with limited partnership interests in Ltr. Rul. 9402026. An asset of the limited partnership was mortgaged real estate encumbered by a non-recourse debt. None of the partners or the partnership was personally liable for the debt. Funding the lead trust with the limited partnership units was not self-dealing because the mere transfer to the CLAT did not amount to self-dealing.

Use Of Formula Clauses To Define Terms Of Charitable Lead Trusts

Term of lead trust-Ltr. Rul. 9840036 allowed that a testamentary lead trust to last a term "sufficient to produce an initial value for the remainder interest that comes closet to, but does not exceed, the survivor's available GST exemption. If GST has been repealed, the trust will run for a term of years sufficient to produce a charitable deduction of 80% of the value of property funding the lead trust, based on the charitable mid-term federal rate for the month preceding the survivor settlor's death." The value of the property to be placed in the lead trust was equal to the lesser of $5 million or 25% of the adjusted gross estate.

In Ltr. Rul. 9823005, the term of an intervivos lead trust was 20 years or until the death of the survivor of the taxpayer and the taxpayer's wife.

In Ltr. Rul. 9801013, a testamentary lead trust to last the shorter of 118 years or 20 years after the death of the last of eight persons alive at the grantor's death, ranging in age for 0 to 51.

In all these rulings, the trusts were held to be qualified charitable lead trusts because the formula makes the term ascertainable and determinable as of the date of the creation of the trust.

Payout rate of the lead trust-Ltr. Rul. 9631021 allowed the decedent's daughter to choose, during the nine-month disclaimer period, among two alternative charitable lead annuity trusts, one paying the AFR plus 1% and one paying the AFR plus 2%, with the trust term equaling the period of time needed using the chosen payout rate to cause the charitable value of the lead trust to equal the total value of the trust. If the power was not exercised, one-fourth of the residue of the estate would be distributed directly to the charities named.

Avoidance of excess business holdings prohibition-Ltr. Rul. 9128051 allowed the use of a formula clause to set the payout rate for a testamentary charitable lead annuity trust so that the charitable value would not exceed 60% of the total value of the assets transferred to the trust. The trust term was 20 years.

In both of the rulings above, the interests given to charity were found to be guaranteed annuity interests because the payout amount was ascertainable and determinable at the time the trusts were created under the formula.

Allocation of GST exemption-Ltr. Rul. 9840036 allowed the use of a formula clause in a testamentary 8% CLUT to determine the term of the trust to produce "an initial value for the remainder interest that comes closest to, but does not exceed, the survivor's available GST exemption."

Ltr. Rul. 9532007 allowed the use of a formula clause in a testamentary CLUT to determine the amount of the family trust assets used to fund the CLUT. The trustee was directed to "allocate sufficient assets to unitrust 1 to totally exhaust the decedent-settlor's unused generation skipping transfer tax exemption as defined in IRC §2631."

Conclusion

Testamentary and intervivos non-grantor and hybrid/super charitable lead trusts offer much greater planning flexibility than recognized by most charitable gift planners and donor advisors. Planners and advisors should review these types of qualified charitable lead trusts and see how they can be used as a successful gift planning tool.

The author is indebted to Kathryn L. Sperlak, J.D., R&R Newkirk, Chicago, Illinois, for her invaluable research assistance and encouragement.

Table: Charitable Lead Trusts


PGDC Editor's Note: For additional rulings affecting charitable lead trusts, see:

Ltr. Rul. 199917068 - Testamentary CLUT/GST
Ltr. Rul. 199922007 - Service Approves Super-CLUT
Ltr. Rul. 199927010 - Non-grantor CLAT Approved
Ltr. Rul. 199927031 - Formula Testamentary CLTs Qualify for Estate Tax Deductions
Ltr. Rul. 199930036 - Charitable Lead Annuity Trust Partition Valid
Ltr. Rul. 199936010 - Qualified CLUT Reformation and Bequest
Ltr. Rul. 199936031 - Super Grantor CLAT Approved
Ltr. Rul. 199936038 - Charitable Lead Unitrust Approved


Footnotes


  1. While true in most states, the Alaska Trust Act, effective April 2, 1997, allows for the creation of trusts that cannot be reached by creditors. In a charitable lead trust created under this Act, a grantor can receive distributions from the remainder of a charitable lead trust without causing the trust assets to be included in the grantor's gross estate because the original transfer is considered to be complete and therefore not subject to inclusion under IRC § 2035 et seq. Rev. Rul. 76-103 provided that transfers to trusts are complete when the assets are no longer subject to the claims of creditors.back

  2. IRC §1.170A-6(c)(2)(i)(A); (ii)(A)back

  3. IRC §4941(d)back

  4. IRC §4941(d)(4)back

  5. IRC §4943(c)back

  6. IRC §4944back

  7. IRC §4945(d)back

  8. Supra at endnote 1back

  9. IRC §673(a)back

  10. IRC §674(a)back

  11. IRC §675back

  12. IRC §676back

  13. IRC §677back

  14. Private letter rulings may be relied upon only by the recipients and cannot be cited as precedents.back

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