A Practical Look at Charitable Lead Trusts, Part 2 of 3

A Practical Look at Charitable Lead Trusts, Part 2 of 3

Article posted in Charitable Lead Trust on 2 September 2015| comments
audience: National Publication, Jane Peebles, Attorney | last updated: 8 September 2015


Attorney Jane Peebles continues her examination of Lead Trusts.

By: Jane Peebles, J.D.

Click here if you missed Part 1.


1. Benefits of Private Foundation as Lead Beneficiary.  If your client regularly contributes substantial amounts to charity and the percentage limitations on charitable deductions result in her being unable to fully deduct her gifts, she should consider setting up a CLT that pays to a private foundation that, in turn, makes grants to her favorite charities.

(a) The value of lead distributions from a CLT of which a private foundation is the charitable beneficiary need not be included when calculating the foundation’s 5% minimum distribution.1  Prior to the 1994 Ann Jackson case, in order for the private foundation to meet the 5% payout requirement, it had to distribute a substantial portion of the CLT payments per Treasury Regulation Section 53.4942(a) 2.  In the Ann Jackson case, the 9th Circuit ruled this regulation, and its rule that the value of the lead distributions had to be included for purposes of computing the 5% payout amount, to be invalid.  This permits a significantly greater benefit to the foundation and provides a method to build the value of the foundation in order to meet a client’s philanthropic goals.

(b) If the charitable beneficiary is a private foundation, the IRS has ruled that amounts distributed to it by a CLT will be subject to the 2% excise tax on private foundation net investment income only if they are “gross investment income,” i.e., dividends, interest, rents and royalties.  Capital gains distributed by a CLT will apparently not be taxed to a private foundation which holds the lead interest.2

2. Settlor and Private Foundation Grantmaking Decisions.  If the income beneficiary of the CLT is a private foundation established by the settlor, and if the CLT is not intended to be includable in the settlor’s estate for estate tax purposes, the settlor should not participate in grantmaking decisions of the foundation’s board with respect to amounts received from the CLT.  The IRS takes the position that this results in inclusion of the CLT in the settlor’s estate under Section 2036(a) if he dies during the term of the trust.3

(a) The simplest solution is to block the settlor from sitting on the foundation’s board.

(b) It seems, however, that the settlor of a CLT can name his private foundation as the lead beneficiary and remain a trustee or director of the foundation if he can be insulated from making grant decisions regarding the funds received from the CLT.

(c) In PLRs 199908002 and 200138018, the IRS ruled that no part of a CLT would be includible in the settlor’s gross estate, even though he was an officer of the private foundation that was the lead beneficiary, where the funds received by the foundation from the CLT had to be held in a segregated fund as to which he had no vote.  This ruling did not state whether the settlor was also a founder of the foundation.  One also finds analogous strategies in the context of qualified disclaimers of property which then passes to a foundation.  One requirement for a valid disclaimer under IRC Section 2518(b) is that the disclaimant may not retain any benefits from the property.  If disclaimed property passes to a private foundation, the disclaimer will be ineffective if the disclaimant is a director, trustee or other disqualified person with respect to the foundation and has the power to name charitable recipients. 4 Treas. Reg. Section 25.2518-2(e)(1)(i).  Private letter rulings have approved creative strategies which allow the disclaimant to continue to be actively involved with the foundation without tainting the disclaimer.

• PLR 9319022: Separate the foundation into two distinct entities, with the disclaimant prohibited from serving in any capacity on the board of the foundation which receives the disclaimed property.
• PLRs 9317039 and 9320008: Create a separate and segregated fund within the foundation, to be the recipient of the disclaimed property, with the disclaimant prohibited by the bylaws from participating in grantmaking decisions as to those funds.
• PLR 9532027: Create a donor advised fund equivalent within the foundation, to receive the disclaimed property.  The disclaimant may make recommendations regarding charitable grants from this fund; however, his recommendations may be accepted or rejected by the other directors.

3. An alternative to paying the CLT lead interest to a family foundation is to set up a donor advised fund at a community foundation and designate that fund as the charitable beneficiary.  The settlor’s family may then act as the advisory board without anyone’s running afoul of IRC Section 2036.  This allows more flexibility in the timing of distributions to charities.  It also allows accumulation of distributions for several years in order to facilitate a large grant.

EXAMPLE 1: Hank Hystok, age 40, with children ages 8 and 10, wants to establish his own private foundation with an initial funding of $1 million.  His assets consist largely of low basis, low yielding stock, which he regularly gives to his alma mater and other favorite charities - a practice he would like to continue in addition to funding the foundation.  Hank’s annual income (before gains) is $500,000, and his gifts of stock to public charities typically use up most of his 30% contribution limit for such gifts.  Thus, a contribution to a private foundation would give rise to little or no deduction except if Hank stopped making his other charitable gifts.  A contribution of appreciated publicly traded securities to a private foundation gives rise to a deduction based on the fair market value of the securities, but still subject to the lower percentage limitations.

Hank establishes a 5.768% 20 year nongrantor CLAT and funds it with $1 million of low basis stock when the AFR is 2.0%.  At the end of the 20 years, the trust terminates in favor of the children.  Stock will be sold off as needed to fund the annuity payout, or distribution will be made in kind to the extent income is not available.  By the end of the 20 year lead term, the foundation will have received roughly $1.2 million --a little more than the desired funding.  If the stock grows by at least 5% per year, as it has historically, around $630,000 will be available for the children at the end of the twenty years.  If the stock does not meet this growth target, the children will take correspondingly less, which is alright with Hank since the primary purpose of the trust is to fund the foundation in an income tax efficient manner.  Hank is confident the stock will grow at least 2.0% - the rate assumed by the IRS in determining the gift tax consequences of the gift.

None of the trust will be treated as a taxable gift as the remainder is zeroed out on these numbers.  If it were not, there would still be no gift tax assuming Hank had enough lifetime gift tax exemption available to shield the initial value of the remainder interest.  GST exemption should not be allocated to the trust, and the trust should be drafted in such a way as to ensure that it will not give rise to any generation-skipping transfers, since the children will be the remainder beneficiaries.  A CLAT is used since the dividends are low, and ability to pay a unitrust amount would become a problem as a CLUT increased in value.

The funding of the CLAT with low basis stock will result in a reduction of Hank’s annual income.  Hank can continue to claim deductions for gifts of stock directly to his favorite public charities, up to 30% of his adjusted gross income per year, while funding his foundation through the lead trust.


A. Business Transfers

1. Business to Children: Declaring Dividends to Pay CLT Payout to Foundation or Charity as CLT Recipient.  If a business interest such as closely-held C corporation stock is transferred to a CLT, it will be necessary to declare dividends to fund the payout to the charitable recipient(s).  This must be analyzed from the point of view of the ongoing (for the term of the trust) cost of the nondeductible dividends to the corporation plus the tax, if any, on the transfer of the value of the remainder interest to the children versus the cost of the estate or gift tax if the stock is gifted directly to the children at a later date, plus the potential estate tax (or gift tax) on projected appreciation in the value of the stock.

2. Sale or Redemption of Stock held by the CLT.  If no dividends are to be declared for some reason, such as too many other shareholders who may also have to receive dividends, then the CLT may be able to redeem some of the shares of the corporation for cash or notes in order to meet the required payout.  An installment note for a stock redemption should be acceptable as within the IRC Section 4941(d) exception from self-dealing for corporate redemptions.  A recent position of the IRS is that the one exemption from self-dealing does not cover both acts.  This is a dubious position under the IRC Section 4941(d) exceptions, but the IRS ruling office is on a self-dealing binge lately.

(a) The redemption will result in a “phantom shift” to children in total percentage ownership because the denominator has decreased in size relative to their holdings.

(b) The redemption must be offered to all shareholders owning the same class of stock, however.  This may call for a recapitalization in certain instances where there are dissident shareholders who may find this an opportunity to cash in their stock, or if too many shareholders cash in for the cash flow of the company.

(c) Perhaps the ESOP could purchase stock from the CLT if the ESOP is not a disqualified person with respect to the trust and if the CLT is not a disqualified person with respect to the plan, and provided that the stock is qualifying employer securities under ERISA rules.  The rules of both sides of the transaction, the ESOP and the CLT, must be reviewed.

3. Shifting Appreciation to Lower Generations Who Intend to Own/Run the Business.  Either of the two above techniques will help to accomplish the shift, not only of the underlying stock at its reduced remainder (and perhaps minority) value at the time of the creation of the CLT, but also the future value of the stock held by the CLT to be distributed later to the children.

B. Transfers of Real Estate

1. Personal.  The self-dealing rules apply and therefore the donor(s) would not be able to live in the property.  However, if the house were no longer to be occupied by the donors and if it were to be rented at a rate sufficient to maintain the CLT payout, this asset may be suitable to use and then distribute out to the children, similar to a qualified personal residence trust.

2. Investment.  Passive investment property such as apartment buildings or office buildings that have adequate yield may also be suitable for a CLT.  Keep in mind that if the property is sold, the CLT pays tax on the gain, or the grantor does if it is a grantor trust.

3. Commercial.  The same concerns as for CRTs exist here -- possible unrelated business income as a result of the operation of the property, such as farmland or other business, or leases that appear to share the burdens of ownership on a percentage of net rentals.  A CLT’s deduction for lead distributions of UBI is subject to the charitable deduction percentage limitations.

4. Encumbered Real Estate.  In PLR 9241064, the IRS addressed the question of the transfer of encumbered real estate to a CLT.  It held that because the transfer was “subject to” debt which was more than five years old on property held at least five years and not assumed by the CLT, no UBI would result from debt-financed income.  It also stated that no self-dealing occurred because the debt was 10 years old and thus came within an exception in IRC Section 4941(d)(2)(A).

C. Bonds/Notes

Bonds and notes that are producing sufficient income to meet the payout requirement are acceptable transfers unless the donor is the maker of the note.  This would likely be self-dealing.

D. Tangibles/Collections

This non-income producing property is an unlikely candidate for a transfer to the CLT (either grantor or nongrantor) unless the grantor understands that the sale of such an asset will cause the recognition of gain by either the trust or the grantor, as the case may be.  If an undivided interest in the item is transferred in satisfaction of the payout requirement, this is deemed to be a sale by the trust and gain will be recognized.

E. Intangibles

1. Partnership Interests and LLC Memberships.  Because these properties are pass-through entities, any income, whether or not distributed, is part of the income of the CLT.  While there is some discussion of using a partnership to control the timing of income in combination with a re-definition of income in the trust agreement, the partnership tax laws cause recognition of income to the partner whether or not the income or gain is distributed, so a clause as is used for deferred annuities alone may not work.  In addition, the nature of the income may be unrelated business income and may limit the trust’s ability to claim the IRC Section 642(c) trust charitable deduction for meeting its payout in accordance with IRC Section 681.  See, though, PLR 9810019, approving a CLAT funded with LP units, where all partnership income was passive income.  Also see PLR 9402026.

2. Life Insurance/Annuities.  The redefinition of income as used in the CRT (an exempt entity) arena to include income earned within a commercial annuity in fiduciary income only when the trustee actually takes a withdrawal of income used to characterize the income received as income that is not available for distribution under state law does not work for nongrantor CLTs.  Because the CLT is a taxable entity, it will be deemed to have income on the annuity under IRC Section 72(u) because it is a nonnatural entity holding the annuity.  Certain types of life insurance may have a different result.

3. Intellectual Property -- Copyrights, Trademarks, Patents.  Intellectual property is an asset capable of being transferred and valued.  This property may also generate sufficient income in the form of royalties to sustain the required payout of a CLT.  Thus, this type of asset should be considered.  However, if the owner of the intellectual property is the transferor, it is not deemed to be a capital asset generating capital gain on its transfer, but rather ordinary income.  If the creator of the asset transfers it, any income tax deduction (grantor trust version) would be necessarily reduced to basis under Section 170(e)(1)(A) (one of the “reduction rules”).

G. Income in Respect of a Decedent

IRD that will be paid out over a number of years after death (such as the remaining years of a 20-year lottery payout) and subject to tax at ordinary income rates could be assigned to a testamentary CLT.  The IRD would be offset by the CLT’s charitable deduction to the extent it were distributed to charity.  Other CLT assets could be held in tax-free investments.

  • 1. The Ann Jackson Family Foundation v. Comm’r, 97 T.C. #35 (1991), 15 F.3d 917 (9th Cir. 1994). See PLR 9633027.
  • 2. PLR 9724005.
  • 3. Revson Estate v. United States, 51 C1. Ct. 362 (1984).
  • 4. Treas. Reg. Section 25.2518-2(e)(1)(i).

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