Creating a Temporary Private Foundation Using a Charitable Lead Trust

Creating a Temporary Private Foundation Using a Charitable Lead Trust

Case study posted in on 19 June 2008| 3 comments
audience: National Publication | last updated: 17 March 2014


One of the greatest planning challenges for many philanthropists is to balance their goals of providing for charity in the immediate term and family members long-term. In this case study, The Sharpe Group illustrates how a couple concerned about an uncertain gift and estate tax environment uses an inter vivos nongrantor nonrersionary charitable lead annuity trust as a "temporary" private foundation.

The Facts:

Mr. & Mrs. Fischer, ages 59 and 57, have decided that given changes in federal estate tax laws it is time to review their estate plans.  They are not as sure as they were a few years ago that federal estate taxes will be completely repealed and they would like to “hedge their bets.”

Mr. Fischer joined a natural resources company in his 20s and worked his way up to Chairman.  He retired last year after leading the company through a merger with a larger company.

The Fischers now have an estate totaling several million dollars.  Their income is now in the range of $500,000 per year and they have no need for additional income.

The Fischers have two children, age 25 and 27.  They have completed their education and are beginning their careers.  They have three grandchildren.

The Problem:

Their advisors have informed them that unless they "do something" they may eventually pay estate taxes of a few million dollars depending on the year of their death, future congressional action on the estate tax, and the growth of their assets and other factors.

They understand the estate tax is scheduled to be repealed in 2010 and that it will be gradually phased out between now and then.  They were very upset, however, to learn the gift tax is not scheduled to be repealed at any point and that apart from annual exemptions they can only give $1 million each away during their lifetimes.  

Given the outlook for budget deficits, they doubt the complete repeal of estate taxes will ever take place.  In the meantime, though, they want to make the most of the $1 million they can each give away during their lifetime free of gift tax.

Mr. Fischer does not like the idea of making his largest "gift of a lifetime" to the federal government.  He feels that he earned his wealth and should be allowed to pass it on to his heirs, but he feels very strongly that his children should be financially responsible.  As he puts it, he does not want to put them on "easy street." 

They have been told that beyond an annual giving program to their children and grandchildren, and gifts of their $1 million gift tax exemption amounts, that they should carefully consider charitable gifts as a primary component of their plans.

The Fischers received information from a charitable interest’s development program about the advantages of charitable remainder trusts.  They have rejected this idea because they do not need additional income that will simply serve to increase their income tax burden and further increase the value of their taxable estates.

One Possible Solution:

A team of advisors has convinced them the best solution would be to create a private foundation and begin to gradually transfer their assets to it.  At their death, the bulk of the remainder of their estate would pass through their wills and trusts to the foundation.

They would be trustees of the foundation along with their children during their lifetimes and their heirs would continue to be trustees at their death.  They have been told that their children could be paid reasonable salaries to run the foundation and they could have significant influence in the community through their ability to direct what could be hundreds of thousands of dollars per year in donations to their charitable interests in the community and elsewhere.

The Fischers are not completely comfortable with this plan, even though it serves to totally eliminate their estate tax burden.  They do not like the idea of largely disinheriting their children, but they have decided this may be the "best they can do" without paying what they consider to be confiscatory estate taxes.

An Alternative Solution:

Mrs. Fischer read an article in a newsletter about the benefits of charitable lead trusts.  They decide that this option may be something they should explore. 

The charitable lead trust is essentially the reverse of a charitable remainder trust.  Under the terms of this arrangement, assets are placed in a trust and payments are made to charity for a period of time before the funds in the trust are eventually returned to the donor(s) or their heirs.  Because of the charitable “lead” interest, it is possible to greatly reduce or eliminate gift or estate taxes that might otherwise be due.

Suppose they were to create a charitable lead annuity trust today and fund it with $5 million.  Suppose the trust were established in the form of a charitable lead annuity trust that paid 8%, or $400,000 per year to the charity for 10 years to fund a campaign gift of  $4 million. 

The Fischers would enjoy a gift tax deduction of $3 million, leaving a taxable gift of $2 million in the year the trust is created. Their combined gift tax exemption amounting to $2 million would be sufficient to completely offset the taxable gift, resulting in a gift of $5 million (more or less, depending on the performance of the trust assets) to their children in ten years at a "cost" of their $2 million exemption amount. (If they had already used their $2 million lifetime exemption amount, the trust could run for 19 years and there would be no tax due.)

If they wished, the Fischers could direct that $175,000 of the annual lead trust payment amount be used to begin funding a regular gift in support of programs at the charity, with the remainder devoted to building an endowment fund (or donor advised fund) over time to perpetuate their gift.  If the endowment fund earned a total return of 8% each year and paid out 4%, when the lead trust terminates in 10 years there would be a permanent endowment in place sufficient to largely replace the annual payments in perpetuity.

The net result is to provide an income stream of $3.75 million to the charity for current and/or future use, and provide a tax-free gift to their children of $5 million in ten years when they are in their late 30s.  They have, in effect, temporarily "disinherited" their children in a way that fulfills their charitable intentions and eliminates a significant potential estate tax liability.

In this case, the charitable lead trust functions, in effect, much like a “temporary private foundation” that accomplishes much the same result as a private foundation without permanently disinheriting heirs.

If they wish, the Fischers can continue their annual giving program to their children, and leave the remainder of their estate to them.  They might also decide to fund another lead trust in a few years that would provide an additional inheritance in the future for their children or grandchildren while continuing the charitable payments for a number of years.

Disclaimer: This case study is intended to provide information of a general nature only and is not intended to provide legal, accounting, investment or other professional advice. Persons mentioned within this case study are fictional with any resemblance to real persons, living or dead, coincidental. Tax law rates and federal discount rates used in examples are based on those rates in effect at the time of publishing. Those viewing this case study should always check for latest tax and other relevant state and federal laws and regulations prior to completing charitable gifts.

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Creating a Temporary Private Foundation Using a CLT

There was one member comment when I read the article on using a CLT as a temporary PF. The heading of the message is "Lead trust to pay off pledge." I am not certain whether the comment message heading is accurate with regard to the actual comment but there is an issue here that should be noted. CLTs and CRTs are treated the same as PFs when it comes to acts of self dealing. In the PF arena, using the PF to satisfy a personal pledge to a charity may result in penalties if that act is construed to be self dealing. I am not clear whether the pledge must be binding or whether the result is the same if the pledge is non-binding. I would think these facts to be quite realistic when clients inform a charity they will fund a program and then direct thier CLT or PF to pay it. A caveat upon this practice should be offered to clients.

Using a CLT to Pay a Pledge

John, Your eyes were not fooling you. The original case study stated a portion of the CLT payments would be used to pay a campaign pledge. One of our readers questioned whether the use of trust assets to pay an obligation of a disqualified person might be an act of self-dealing. Since the law is not settled on that issue and it was not the focus of the case study, we decided to simply replace "pledge" with "gift".

Creating a Temporary Private Foundation Using a Charitable Lead

This is a good case study. Obviously, the donor can use this technique to make a large gift commitment to charity over the period of the trust term. In several cases we have seen that the same fact pattern was present as was illustrated in this example, but that the donor did not want to give all of the trust's annual distributions to one charity. The solution was a donor advised fund at a community foundation (like The Columbus Foundation) rather than to a private foundation. This solution has all of the benefits of the private foundation with fewer complexities and with greater operational efficiency at a lower cost. The donor and their family members may serve as fund advisors and make grant recommendations to the charities of their choice whenever they wish. And, they are provided the gift of time to enable them to manage the flow of grants from the donor advised fund to charitable recipients without being forced to annually determine what charities receive that year's trust distributions. We have several examples of donors who are using this technique to provide a family charitable legacy for their children and grandchildren in addition to whatever wealth they are transferring to their heirs through the use of a lead trust and other methods.

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