The Charitable Lead Nonreversionary Trust

The Charitable Lead Nonreversionary Trust

An Estate Planner's Dream Come True
Article posted in Charitable Lead Trust on 4 August 1999| comments
audience: National Publication | last updated: 16 September 2012


Are you looking to gain a better understanding of charitable lead trusts and how they can be used to accomplish clients' estate planning and philanthropic objectives? Who better to convey these concepts than Stanley S. Weithorn? In this edition of Gift Planner's Digest, Mr. Weithorn uses four case studies to illustrate the significant and diverse planning objective that can be accomplish when CLTs are used in concert with other planning tools.

By Stanley S. Weithorn, Esq.

A charitable lead nonreversionary trust (CLT) is a type of trust that provides for payment of an income interest to charity for a term of years. At the conclusion of the trust term, the corpus is distributed to designated noncharitable beneficiaries, usually the children or grandchildren of the trust's creator. The advantages of such a trust are: 1) the grantor is not taxed on the trust income that is paid to charity (thus creating the effect of a 100% deduction) and; 2) the remainder interest in the trust may be given to desired noncharitable beneficiaries at a greatly reduced transfer tax cost.1

As an example of this concept, envision the creation of a $1 million CLT where the remaindermen would be the grantor's children. The grantor would not be deemed to own this trust and thus would not be entitled to an up-front charitable contribution deduction. However, because the grantor would not be taxed on the trust income, since he or she does not own the trust, the grantor will enjoy effectively a 100% deduction with respect to the income generated by the trust assets. Although the grantor would not be able to designate the charitable recipients each year, one could achieve nearly the same effect by establishing a "donor-advised fund," at an appropriate public charity, as the income beneficiary. The grantor and/or any individuals selected by the grantor would comprise a committee that would make recommendations as to the ultimate distributions to charitable organizations from the donor-advised fund. Because the grantor's children or grandchildren would be remaindermen, the grantor would be deemed to have made a gift to each of them; however, it is probable that the grantor would incur little or no actual out-of-pocket gift and/or generation skipping tax liability because of both the opportunity to use the available lifetime tax exemptions and other planning techniques. Perhaps, more importantly, the value of the trust assets (including all appreciation in those assets during the trust term) would be transferred to the grantor's children or grandchildren free of estate tax liability.

Characteristics Of The Charitable Lead Nonreversionary Trust

Term: The term of a CLT may be: 1) the life or lives of individuals in being; 2) a term of years (the most common selection); 3) a life plus a term of years;2 or 4) the lesser of a term of years or a period of lives plus a term of years.3

Determination of charitable beneficiaries: One or more charities may be specified in the trust-or the trustee may be empowered to select qualified organizations.4

Trustee: Any individual or entity may serve as a trustee of a CLT. However, if the grantor is named as a trustee, he or she cannot retain the power to select charitable beneficiaries each year.

Funding assets: Most assets are acceptable, except for indebted properties and interests in active (as opposed to passive) business interests.

Income tax treatment: CLTs are not tax exempt, so if net income exceeds the annual amount distributable to charity, that excess is income taxable to the CLT. However, because a CLT is entitled, under IRC § 642(c), to a 100% charitable contribution deduction, if the trustee is able to control the receipt of income (e.g., deferring the realization of potential capital gains) then income tax liability may be avoided entirely.

Beneficiaries of annuity trust or unitrust amount: Charities described in IRC §§ 170(c), 2055(a), and 2522(a) have an irrevocable right to a guaranteed annuity or unitrust payment at least annually.

Amounts payable to charitable beneficiaries: For an annuity trust, the amount payable is either a sum certain or a fixed percentage of the trust's initial assets value. For a unitrust, the amount payable is a fixed percentage of the net fair market value of the trusts assets, redetermined annually. The charitable remainder concept of a net income unitrust is not available for CLTs.5 Also, unlike charitable remainder trusts, CLTs are not required to pay out a statutorily specified minimum annuity or unitrust percentage.

Additions to CLT corpus: Additional corpus contributions may be made to unitrusts6 but not to annuity trusts.7 However, such additions are inadvisable even for unitrusts because each additional contribution starts the running of a new trust term.

Income tax deduction: The grantor/donor is not entitled to an income tax charitable contribution deduction on the funding of a nonreversionary CLT.8

Estate and gift tax deductions: The grantor/donor is entitled to both gift and estate tax charitable deductions equal to the value of the CLT's charitable interest as an offset for gift and estate tax purposes.9 However, where the grantor retains the right to designate charitable income beneficiaries annually, a gift takes place with each designation and, as a result, the imposition of gift tax will occur annually.10 Also, if the grantor dies while holding the power to designate charitable beneficiaries, the trust corpus will be included in his or her estate under IRC §§ 2036 or 2038.

Valuation of deductions for gift and/or estate tax purposes: "Valuation of charitable interests in all split-interest trusts is based upon an interest rate (rounded to the nearest 0.2%) that is 120% of the federal midterm rate in effect under IRC §1274(d)(i) for the month in which the valuation date occurs." If a charitable contribution is allowable for any part of the property transferred, the taxpayer may elect to use the rate for the month of the valuation or for either of the two months proceeding the month in which the valuation occurs.11 In instances where a taxpayer transfers more than one interest in the same property and, given the three choices available to the taxpayer, it is possible to select one that will be the same as the rate used for the earlier transfer, then the taxpayer must use the same rate with respect to each such transfer.12

Nonqualified trust: If the trust is not a guaranteed annuity or unitrust, no gift or estate tax deductions are allowed, and the liability for gift tax with respect to a completed gift of a charitable interest may be incurred. In the event of a donor's death during the trust term, the entire trust value (including the charitable interest) will be included in his or her estate.

Noncharitable interests: In general, no amount may be paid out for noncharitable purposes prior to the expiration of the charitable interest unless a provision for a definite noncharitable lead interest is created in the governing instrument and that provisions meets certain requirements.13

Prepayment: It had been unclear whether a clause allowing prepayment of the charitable income prior to the expiration of the trust term would jeopardize the donor's right to give and/or estate tax charitable deductions, as the IRS simply indicated that it would not rule in advance on the status of the annuity interest where such a clause was present.14 Subsequently, however, the IRS ruled that a charitable lead annuity interest does not qualify as a guaranteed annuity interest under IRC § 2522(c)(2)(B) if the trustee has the discretion to commute and prepay the charitable interest prior to the expiration of the specified term of the annuity.15

Governing instrument: The trust agreement must prohibit violation of the private foundation rules against self-dealing [IRC § 4941] and taxable expenditures [IRC § 4945(d)], and, if the charitable deduction allowable is in excess of 60% of the fair market value of the trust assets, against excess business holdings [IRC § 4943] and jeopardy investments [IRC § 4944]16 Intervivos charitable lead trust instruments also must have a provision exonerating the trust from any obligation to pay gift or estate taxes or any other charges, because a lead trust is prohibited from making payments for noncharitable purposes.

Primary use: The nonreversionary CLT is particularly useful for individuals desiring to transfer substantial property interests to others, on either a vivos or testamentary basis, with minimal gift or estate tax liability. Additionally, all trust appreciation from the date of funding escapes taxation and no part of the remainder value is includible in the donor's estate.

Use Of Family Limited Partnerships And Applicability Of Minority And Other Discounts

A major problem faced by affluent individuals in planning for the disposition of their estates is that the value of their assets generally continues to grow, sometimes dramatically, with a corresponding growth in transfer taxes ultimately payable. This conflicts with their desire to limit their heirs' exposure to estate and gift taxes that will be due upon the transfer of their assets during life and at death. Prior to 1987, which is when IRC §2036(c) became effective, a parent could retain an interest in future growth at a prescribed, or limited level, and yet "freeze" the value of the retained interest in the estate by use of multi-tier family limited partnerships. Although IRC § 2036(c) was repealed retroactively in 1990, it was replaced by IRC §§ 270 1-2704, whereunder the effectiveness of the multi-tier family partnership as a method of shifting future growth in appreciating assets to future generations was severely curtailed. Devices that had been commonly used, such as differing allocations within both distribution rights and extraordinary rights (including withdrawal, "put," and liquidation rights) were no longer viable. Thus, the partnership "freeze" of earlier years now yields no substantial economic benefit.

Note should be taken of the fact that there was pending before the last Congress an additional restrictive proposal designed to wipe out the valuation discounts for gifts of interests in "portfolio type" limited partnerships (that is, partnerships the corpus of which is comprised primarily of publicly-traded securities). This proposal, which was considered to have little chance of passage, made no legislative progress in the last session. In the meanwhile, the courts have acted favorably toward taxpayers seeking to discount gifts of interests in "portfolio type" limited partnerships. The political winds, of course, could change, but at least at this time the use of such family limited partnerships in connection with estate planning seems to be a reasonable approach to adopt.

The use of a family limited partnership (including, of course, its equivalents, the limited liability partnership and the limited liability company) presents a very viable planning device because the various valuation discounts for factors such as minority interests, lack of control, and lack of marketability are still available.17 The major breakthrough came in a ruling18 in which the Internal Revenue Service reversed an earlier position (that it had litigated and lost many times) and agreed to allow minority discounts for transfers between family members even if, based on the combined holdings of those family members, control of the entity exists within the family unit both before and after the transfers. Thus, a minority interest discount is permitted where the donor owned 100% of the property or entity immediately before giving individual interests (of less than a majority in each case) to various family members. In Rev. Rul. 93-12, the donor gave away all of his interest in the entity. However, it seems clear that the retention of an interest by a donor would not remove the transaction from the ruling's protection. The amount of the discounts allowed in recent cases has run from 15% to 45% and higher, with a portion of the discount generally described as a minority interest discount, a discount for lack of control, or a discount for lack of marketability of the interest owned and/or the underlying asset held by the particular partnership or corporation. A qualified appraiser must substantiate the discount.

Before proceeding, the concept of "control" of the partnership should be addressed. Initially, the creators of a partnership probably will name themselves as general partners for the purpose of controlling the activities of the entity with their children (either directly or through their trusts) becoming limited partners. By giving their children, and any other transferees, only limited partnership interests, the desired control is secured. While that result may be desirable, if the survivor of a married couple who created the partnership is the only general partner at the spouse's death, the IRS is likely to attempt to deny any minority discount for that remaining interest, even though it is less than 50%, because of the retention of defacto control. Thus, for the members of the founding generation to guarantee that their estates will be entitled to minority discounts, particularly if the amount involved eventually becomes substantial enough as their children age and mature, they could, over time, give a majority share of their general partnership interests to their children. Alternatively, they could convert the children's interests to general partnership status if they can accept the fact that these children, voting as a block, eventually could outvote the partnership's founders. If the founders elect to retain control indefinitely, then it is quite probable that their estates will not be entitled to a minority discount and might even have their interests valued at a premium. However, even under those circumstances, a lack of marketability discount of between 10% and 15% should be available to their respective estates.

The family limited partnership (FLP) may be utilized even more productively by the effectuation of somewhat more intricate plans. For example, instead of passing a percentage of the partnership directly to children or to their trusts, the founding partners could transfer some or all of that interest to a charitable lead annuity trust (CLAT) for the eventual benefit of their children (or trusts for those children), or to a charitable lead unitrust (CLUT) for the eventual benefit of their grandchildren (or trusts for those grandchildren), thereby generating greater leverage for transfer tax saving purposes. One could even transfer some or all such interests to a grantor retained annuity trust (GRAT) for the eventual benefit of those same individuals.

Transfers to CLATs, CLUTs, and GRATs in the FLP context effect two related tax benefits in addition to the customary reduction of transfer tax. First, the 15% to 45% discount for lack of control and/or lack of marketability will reduce the deemed value of the remainder directed to heirs, with the result that the donor incurs a smaller gift tax liability. Second, because the value (but not the size) of the asset transferred is reduced, the return realized on the asset will, for transfer tax calculation purposes, be a larger percentage, thereby further increasing the value of the present interest and decreasing the tax on the remainder gift to heirs.

The following section of this article is comprised of four case studies that illustrate these techniques by example.

Case Studies Featuring The Charitable Lead Nonreversionary Trust

Case 1. Superior Investment Acumen Benefits Both Charity And The Family

Facts and problem: Roger, a highly successful investment advisor would like to transfer substantial assets to trusts for his five grandchildren (ages six months to eight years). He lacks liquidity and so would like to pass on a portion of his highly appreciated publicly traded securities portfolio. Although Roger has the sum of $1 million per grandchild's trust in mind, he does not want to pay gift tax on the $3,700,000 that will exceed his and his wife's lifetime transfer tax exemptions or generation skipping tax on the $3 million that will exceed their exemptions under that tax if he makes direct gifts of the $5 million total to his grandchildren's trusts.

Solution: Roger attains his objective by activating a two-step plan. First, he and his wife create a family limited partnership (FLP) that he funds with a corpus of $12.5 million comprised of appreciated and appreciating securities. Second, he transfers a 40% FLP interest to a newly created charitable lead nonreversionary unitrust (CLUT).19 The stocks selected were those that Roger believed would produce a high total return (dividends plus capital growth) at least equal to the CLUT's specified payout.

The CLUT is required by its terms to distribute an annual unitrust amount of 12% of its value (as redetermined once each year) to charity for a term of 12 years. The payout to charity will be in the form of cash only, as will be discussed below. Because the transfer is of a minority interest in the FLP, which is an illiquid asset, a 25% valuation discount is achieved that reduces the value of the transfer for tax purposes to $3.75 million. Based on Roger's investment performance over recent years, he may reasonably anticipate that under his guidance, total return (dividends plus capital growth) on the securities over the term will average more than 9% per year of the full value of the FLP, or $450,000, which is 12% of the CLUT's discounted value. Thus, it seems clear that the CLUT's corpus (a 40% interest in the FLP) eventually payable to his grandchildren's trusts not only will not be diminished from its true value because of the annual CLUT payout requirement but will, in fact, appreciate to a value in excess of the initial $5 million if Roger is able to perform with this portfolio as he has with his clients' portfolios, averaging a total return of 12.5% over the last five years.

Because Roger will not have retained either a reversionary interest in the trust corpus or any significant power over the assets, he will not be deemed to own this trust.20 Therefore, although Roger will not be entitled to an income tax charitable contribution deduction for the value of the income interest that will pass to charity, he also will not be taxed on the income earned by the trust. Consequently, because the income generated by the corpus will be removed from Roger's income stream, the income tax consequence of creating the trust will be equivalent to a 100% deduction with respect to income produced annually by the assets transferred to the CLUT.

While Roger will not be taxed on the trust's income, the CLUT itself is a taxable entity and may incur income tax. In general, this type of trust is allowed to deduct from its gross income the amount of charitable distributions required to be made that will greatly reduce or may totally eliminate its taxable income.

The game plan is for the trustee to distribute an annual unitrust amount to the designated charity or charities in the form of cash (provided first by dividend, interest, or other ordinary income distributed by the FLP to the CLUT during that particular year and, second, by the proceeds of sale of appreciated FLP assets (or interests in such assets) also distributed by the FLP to the CLUT to cover the balance) equal in aggregate value to the specified 12% payout (that, of course, continues to be based on the CLUT corpus as revalued annually so that the "real" payout rate is always 9%, that is, 12% less the 25% discount). As FLP property is sold, each such sale will result in taxable gain to the CLUT, which gain will be offset (up to 100%) to the extent of the charitable distribution for that year under IRC §642(c).

The commitment to transfer the CLUT's remainder interest to trusts for Roger's grandchildren ordinarily would give rise to both a gift tax and a generation skipping tax. The value of the remainder interest that is subject to such taxes (after giving effect to previously unused unified transfer tax and generation skipping tax exemptions) is equal to the value of the property placed in the CLUT minus the discounted present value of the stream of unitrust payments to be made to charity throughout the duration of the CLUT. As already explained, because an unmarketable minority interest (40%) in the FLP was transferred to the CLUT, the full $5 million allocable share of the FLP is subject to a valuation discount (in this case 25%) so that the apparent $5 million interest is deemed to be worth only $3.75 million. Then, the CLUT's 12% annual payout rate combined with a trust term of 12 years will reduce even further the value of the remainder gift to the designated beneficiaries. The actuarial value of a current gift where possession of the assets is to be affected following a 12-year trust term where the charitable payout for that term has been at the rate of 12% is deemed to be only $892,050 (based on the federal midterm rate of 6.4% for June 1999) even though it is anticipated that at least $5 million ultimately will be distributed to those noncharitable beneficiaries. Thus, to all intents and purposes, Roger and his wife have kept portions of their lifetime exemptions intact under both the unified transfer tax ($357,950) and the generation skipping tax ($1,107,950), while accomplishing the overriding goal of affecting asset transfers to trusts for the grandchildren.

Finally, because the generation skipping transfer tax applies only once to each subject transaction, the grandchildren's trusts, as drafted, provided for those trusts to be maintained through the lives of the grandchildren and to be distributed thereafter to the great-grandchildren. This can be accomplished without further application of the generation skipping transfer tax.

Case 2. Enriching Charity And Children At The Same Time

Facts: Dave and Phyllis are a couple in their early 50s who have done quite well. Dave is an inventor who has "hit the jackpot" once and has earned some significant income as the result of his other, less dramatic, inventions. Phyllis, in earlier years was, of all things, a very sought-after and well-paid fashion model, and most of her earnings helped Dave function independently until his big breakthrough. Just a few years ago, her extremely wealthy 94-year-old grandmother died and, since Phyllis' mother (an only child) had predeceased Phyllis, Phyllis received a considerable bequest. Dave's inventive success and Phyllis' inheritance have allowed them to do something near and dear to their hearts; that is, to give very substantial sums to their favorite charities. Dave and Phyllis have an average annual adjusted gross income of about $2 million. They have been contributing to charity about $1.2 million each year, leaving them, at this point, with unused but still viable contribution carryovers aggregating approximately $500,000.

Problem: Dave and Phyllis now are attempting to solve two seemingly unrelated problems:

  1. significant portions of their charitable gifts are not qualifying for contribution deductibility due to the fact that their donations consistently exceed even the 50% of "contribution base" limitation and, since they never stop giving, the intended benefit of the five-year excess contributions carryover never comes into play; and
  2. they have not done anything to create an asset base for their two children: Dave, Jr. (age 25) who is a beginning resident in cardiac surgery and expects to be in training for at least another seven years and Monica (age 23) who is in a graduate program leading to a Ph.D. in clinical psychology in about six more years, after which she hopes to teach psychology at a major university. Their needs, certainly through the end of their respective education and training programs and probably thereafter (to the extent required), clearly will be taken care of by their parents, but both children-based on the nature of the careers that they have chosen-are a long way from financial viability. Thus, a "nest egg" that might become available to them in the not too distant future would relieve them from the problem of looking to their parents for assistance on virtually a day-to-day basis.

Solution: Dave and Phyllis establish a charitable lead nonreversionary annuity trust (CLAT), funded with $3 million, primarily in highly-appreciated stocks that pay an insignificant dividend, and designed to pay out $300,000 annually (in quarterly installments) to charity for a period of 10 years. The investment program to be utilized by the trustee will parallel the one described in Case 1 above so that no significant taxable income is likely to result to the trust. At the end of the 10-year-period the trust will terminate and its assets will be distributed equally to Dave, Jr. and Monica.

The charitable giving aspect of the trust actually will affect a net cash benefit to Dave and Phyllis. They had been giving $1.2 million to charity annually but not enjoying deductibility for the final $200,000 because it exceeded the 50% of contribution base limitation. As noted above, they now have $500,000 of viable carryovers. Thus, the plan is to donate only $900,000 in each future year because the charitable lead trust will be donating the desired balance of $300,000. That means (the plan was structured to achieve this result) that the $500,000 of viable contribution carryovers will be able to be used at the rate of roughly $100,000 annually for the next five years, thereby reviving a tax benefit that Dave and Phyllis had been surrendering for many years. Of course, the $300,000 in contributions coming from the lead trust does not impact the percentage limitations to which Dave and Phyllis are subject because the CLAT is a separate taxpayer. Thus, the first problem has been solved.

To preserve the maximum degree of flexibility for Dave and Phyllis in connection with the selection of the ultimate charitable recipients of the lead trust annual distributions, the trust instrument names the Whistle Stop Community Foundation (a publicly-supported charity) as the trust's charitable income beneficiary. All distributions from the CLAT to the community foundation are credited to the "Dave and Phyllis Donor Advised Fund" maintained by the community foundation. What is the purpose of this step? To keep the lead trust assets out of the estates of Dave and Phyllis, they must have no authority to name, from year to year, the charitable distributees of the lead trust. However, by creating this two-step structure, Dave and Phyllis are provided the means to "advise" the Whistle Stop Community Foundation as to charities they would like to see benefited each year. Generally, the suggestions of "advisers" are complied with by the charity maintaining and supervising various advised funds, even though the charity is the legal owner of all advised fund assets and thus can expend them in any way it chooses.

The second problem is to establish an asset base for Dave, Jr. and Monica within the reasonably foreseeable future. That will be accomplished by the passage, 10 years from the initiation of the CLAT, of all of its assets equally to the two of them. The amount distributable to them should be at least $3 million and, with good investment management, should grow even larger despite the $300,000 (10 % of the initial corpus value) annual payout obligation of the trust. Dave, Jr. and Monica will take a carryover basis in the assets distributed to them.

Why use the CLAT as the vehicle of passage for the $3 million? Simply because, due to the 10-year-deferral of possession, the promise of future delivery of assets that Dave, Jr. and Monica get on the date of the trust's creation and funding is worth substantially less than $3 million when it comes to valuing the gifts made to the children for gift tax purposes. In fact, bringing this example up to date, the federal discount factor used for that determination (6.4% for June 1999) would give rise to a gift to the noncharitable beneficiaries equal to $781,867. Considering that both Dave and Phyllis still had their full $650,000 lifetime exemptions, the use of a portion of the aggregate $1.3 million totally covered the gifts without any out-of-pocket tax payment.

Case 3. Charity Is Enriched As A Major Asset Is Moved Between Generations Without Tax Liability

Facts: Harold, a New York resident, age 68, and his brother, Ivan, acquired a hotel property in New York City in 1976. Each took a one-half undivided interest in the property. Some years after Harold's first wife and the mother of his three adult children died, he remarried and has provided for his new wife in a manner that does not involve undivided interest passed to his executor, who continues to hold that interest. In the late 1980s, Harold and Ivan's executor entered into a triple net lease of the hotel property with a hotel management company for a term of 20 years with additional 10-year renewals. The management company renovated the hotel property that had been vacant and now operates it as a major luxury hotel. As of 1992, the property was generating slightly in excess of $4 million annually in net rental income and its full value was estimated at close to $50 million. Harold has had a family foundation for some years and has used it primarily as a conduit for his annual six to seven figure gift to publicly supported charities.

Problem: Harold, an individual with a potential estate of close to a billion dollars, who had no need for his share of the property's rental income, was interested in transferring his undivided interest in the hotel property to his three children at a minimal transfer tax cost.

Solution: A charitable lead annuity trust was proposed as a way of reducing the value of the transfer to the children. The lead trust concept was particularly appealing to Harold because of the existence of his family foundation, to which the charitable interest could be paid. It also was suggested that a minority interest discount approach be used to reduce the valuation of the property interest designed for transfer to the lead trust.

It was decided first to transfer a 1% interest in the property (2% of Harold's interest) to his three children outright and some time thereafter to transfer a 49% interest in the property (98% of Harold's interest) to a newly created charitable lead annuity trust.

An appraisal was obtained valuing the total hotel property (that was debt free) at $45 million. This appraisal then applied a 30% minority interest discount to Harold's partial interest, which produced a value for that interest of $15,750,000. The 49% of the total property transferred to the charitable lead annuity trust therefore had an initial funding value of $15,435,000 and the 1% of the total property transferred to the three children had a value of $315,000, which gift was covered by Harold's unified credit.

The value of the remainder interest in the charitable lead trust, which will pass to Harold's children in 10 years, was determined to be zero for gift tax purposes, as follows:

The annual payout to the charity (Harold's foundation) was fixed at 49% of the then total annual rent, or $2,205,000. Taking into account the 30% discount applied in valuing the 49% of the total property used to fund the trust, the annual annuity payout was 14.29% of the value of the trust corpus. Utilizing the monthly IRS discount rate (120% of the federal midterm rate) for February 1992, 7.6%, a trust term of 10 years was selected to "zero-out" the remainder interest for gift tax purposes.

In summary, Harold was able to remove from his estate by transfers to both charity and his children an extremely valuable and constantly appreciating (if for no reason other than the regular increases in rent provided for in the triple net lease) asset for essentially no gift tax cost. Also, as the rental income increases, the increments above the $2,205,000 received by the lead trust each year, after being taxed (since lead trusts are not tax exempt but do enjoy a 100% charitable contribution deduction), will be accumulated for the eventual benefit of the remainder beneficiaries?the children. Further, the charity, Harold's private foundation will receive $22,050,000 over a 10-year-trust term to be used as determined by the trustees, not including Harold.21

Now to compare this plan to a "no action" mode. If Harold were to retain the property through his life expectancy (for example, 17 years), collect the income, accumulate, and reinvest the after-tax income in 6.5% tax exempt municipal bonds, he would have assets (the hotel property and the accumulated income therefrom) with a value of approximately $59.3 million at his death (assuming that his half of the hotel property continues to be worth only $22.5 million). The children, after a 60% estate tax (federal and state),22 would inherit $23,720,000. If Harold uses the lead trust concept and the children receive the property after 10 years, and they thereafter accumulate and reinvest the after-tax rental income in 6.5% tax-exempt municipal bonds during the balance of Harold's life expectancy, they will have $33.1 million in asset value at his death, an increase of more than $9 million over the "no action" mode. If, however, as is anticipated, the hotel property appreciates, then the benefit goes up by 60% of the appreciation (since the estate tax imposed on that amount on Harold's death would have been avoided).

Case 4. Everyone Wins Including Children And Grandchildren And Charity

Facts: Rex and Midge (both age 66) have four children and an impressive 10 grandchildren. Rex has just retired, and after he and Midge reviewed the level of their income-producing assets they concluded that they could divest themselves of $2 million of principal in favor of their children and grandchildren and still not feel a pinch so long as their income over the next 10 years could be kept at the level of prior years. As part of the picture, they intended to continue to contribute about $100,000 annually to charity, as they had been doing in past years.

Problem: How could these transfers be affected while avoiding significant gift tax liability?

Solution: First, Rex and Midge transferred $2 million to a newly formed family limited partnership (FLP). The initial partners were Rex and Midge, each with a 49% limited partnership interest. The other 2%, constituting the general partner's interests, were divided, as gifts from Rex and Midge, equally among their four children. (.5% to each)

Next, Rex gave his 49% interest in the FLP to a charitable lead unitrust designed to distribute a 10% unitrust amount to charity for 10 years and then, upon the expiration of the 10-year-term, the CLUT would, according to its provisions, convert to a noncharitable trust for the sole benefit of his 10 grandchildren. The CLUT payout to charity was directed to the local community foundation and was designed to fulfill the intention of Rex and Midge to continue providing about $100,000 annually to charity.

Simultaneously, Midge gave her 49% interest in the FLP to a grantor retained annuity trust23 designed to distribute a 10% annuity trust interest to Midge for 10 years and then, if Midge survives the full 10-year-term, the GRAT would, according to its provisions, terminate with its assets being distributed equally to her four children.

Due to the lack of liquidity, marketability, and control, the appraisal of these two transferred blocks of 49% limited partnership interests were discounted by 30%, reducing their value, in each case, from $980,000 to $686,000. That figure then was subject to a "time value of money" discount based on IRS tables for the 10-year deferral of possession period. The annual payout rate for both the CLUT and the GRAT was set at 10%. But, due to the 30% valuation discount, all that is needed to avoid invasion of the corpus of either trust is a true 7% return, which should be easy to attain since it relates to "total return" (income plus capital appreciation).

The "double discounting" to which these transfers were subject affects a tremendous reduction in the taxable value of the two sets of remainder interests: for grandchildren and for children. Consequently, the lifetime exemptions available to Rex and Midge (in the aggregate) under both the unified transfer tax and the generation skipping transfer tax covered, with some to spare, the taxable amounts in both cases.


  1. The charitable lead grantor trust is an entirely different vehicle and is not discussed in this article at all.back

  2. Treas. Reg. § 25.2522(c)-3 (c)(2)(v)(a).back

  3. Rev. Rul. 85-49, 1985-1 C.B. 330.back

  4. See Rev. Rul. 78-101, 1978-1 C.B. 301.back

  5. Rev. Rul. 77-330, 1977-2 C.B. 352.back

  6. Treas. Reg. § 1.664-3(b).back

  7. Treas. Reg. § 1.664-2(b).back

  8. IRC § 170(f)(2)(B). All "Section" references are to sections of the Internal Revenue Code of 1986.back

  9. IRC §§ 252(a) and 2055(a). See Treas. Reg. §§ 20.2055-1(a), 25.2522(a)-1(a).back

  10. Rev. Rul. 77-275, 1977-2 C.B. 346.back

  11. The federal midterm rate is usually equal to the average rate of federal marketable obligations with remaining periods of more than three but less than nine years.back

  12. All valuations are based on the tables set forth in IRS Publication 1457(8-89), Actuarial Values Alpha Volume, and IRS Publication 1458(8-89), Actuarial Values Beta Volume. Caveat: When creating a charitable remainder trust or a charitable lead trust, the federal midterm rate in effect under IRC § 1274(d) for the current month and the two immediately preceding months must be considered. The taxpayer's evaluation of which rate to use will differ depending on whether the charitable contribution is of a remainder interest or a lead interest.back

  13. Treas. Reg. §§ 1 770A-6(c)(2)(i)(E) and -6(c)(2)(ii)(D). See also Rev. Rul. 88-82, 1988-2 C.B. 336.back

  14. See § 3.01 of Rev. Proc. 88-3, 1988-1 IRB 579.back

  15. Rev. Rul. 88-27, 1988-1 C.B. 331. Interestingly, in informal discussions with the author of that revenue ruling, it was stated that if the full amount of the unpaid annuity installments were paid on an accelerated basis, without discount, the IRS would have no objection.back

  16. See IRC §§ 508, 4947(a)(2), (b)(3)(A); Treas. Reg. §§ 53.4847. -1, -2. See also Rev. Rul. 88-82, 1988-2 C.B. 336.back

  17. The committee reports accompanying Section 2701 of the Internal Revenue Code of 1986 explicitly recognize the applicability of "discounts" for valuation purposes. See Senate Committee Report, 101st Congress, 2d Session (1990), p. 61.back

  18. Rev. Rul. 93-12, 1993-1 C.B. 202.back

  19. The CLUT is selected over the generally more favorable CLAT because the remainder beneficiaries are trusts for grandchildren that bring the generation skipping transfer (GST) tax into play. As a result, the CLUT, which receives better treatment under the GST tax than does the CLAT, becomes the preferred route to follow.back

  20. Although Roger is the managing partner of the FLP, an independent trustee governs the CLUT.back

  21. Harold resigned his trusteeship before engaging in this transaction in order to avoid the risk outlined in the case of Estate of Revson v. U.S., 5 Ct. Cl. 362 (1948). In that case, the grantor remained on the board of his private foundation even after it had been named as the charitable beneficiary of his CLT. He died during the term of the CLT and the government argued, successfully, that the full value of the CLT should be included in his gross estate for tax purposes.back

  22. Under New York law as it existed in 1992. Now, New York has repealed its extra 5% estate tax levy.back

  23. The grantor retained annuity trust is the only noncharitable vehicle discussed in this article. It has been inserted to demonstrate how charitable and noncharitable planning techniques can be used in concert with each other. The GRAT is quite similar to the CLAT with two very significant differences: 1) the recipient of the annuity payments is the grantor himself or herself rather than a charity; and 2) the plan will not succeed unless the grantor survives through the end of the trust term.back

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