Charitable Lead Trusts
Viewpoints on Financial Planning
The desire to leave a philanthropic legacy is an important value shared by many wealthy families. Nevertheless, donors often hope to accomplish multiple goals with the same dollars, providing for heirs while still leaving a sizable gift for charity. With some thought and careful planning, significant tax benefits might be realized as well. One vehicle designed to accomplish this multi-pronged objective is a charitable lead trust (CLT).
A CLT has historically played second fiddle to the more well-known charitable remainder trust (CRT), although it came into greater spotlight when the will of the late Jackie Kennedy Onassis became public. When Mrs. Onassis passed away in 1994, her will devised the largest portion of her estate to her children but the goal was for her children to disclaim or turn down a portion of their inheritance to a CLT designed to last 24 years for the benefit of her private foundation.
At the expiration of the trust term (2018), the remaining trust principal was to be devised to her grandchildren with no transfer tax consequences. This bequest would have generated an estate tax charitable deduction of over $50 million. Unfortunately, her two children (John and Caroline) failed to disclaim any portion of this bequest in favor of the CLT and the private foundation was never funded, thus negating the estate tax savings.
A CLT can be funded either during one’s lifetime or at death. Such trusts are particularly beneficial from a wealth transfer perspective in a low interest rate environment where the goal is to pass the remainder interest to family members.
One of the biggest benefits of a CLT is that the annual annuity payable to charity is very flexible. Unlike a CRT that has a minimum annual payout to the non-charitable beneficiary of 5% during the trust term, there is no such limitation with a CLT. Thus, a donor wishing to give a charity 3% annually can do so. However, the changing payout will impact either the charitable deduction or gift tax consequences on CLT inception.
FREQUENTLY ASKED QUESTIONS
1. What is a Charitable Lead Trust (CLT)?
A Charitable Lead Trust (CLT) can be created during one’s lifetime or at death. It provides for annual distributions to one or more charities (lead interest). This lead interest is payable for a set period equal to:
- Fixed term of years
- Lives of one or more non-charitable beneficiaries
- Shorter of a or b (above)
- Greater of a or b (above)
At the end of the trust term, assets remaining in trust pass either back to the donor (grantor CLT) or pass to heirs (non-grantor or family CLT). A CLT can also be a Charitable Lead Annuity Trust (CLAT) or a Charitable Lead Unitrust (CLUT).
A CLAT provides a fixed income stream payable to charity that is determined upon CLAT inception but this payment may increase in percentage terms if such increase is spelled out in the trust document (see FAQ #4).
Example: A $1 million transfer to a 6% CLAT for 10 years would provide charity with an annual income stream of $60,000 per annum for the 10-year term.
The required payout to charity in a CLUT is based upon a fixed percentage of the trust value determined on the annual valuation date in the trust document. Accordingly, the annual payout percentage would remain constant but the required payout would change annually up or down depending upon the value of the trust on the annual valuation date. Both a CLAT and a CLUT can be effective to fulfill a donor’s charitable objectives.
2. How do charitable lead grantor trusts differ from charitable lead non-grantor (family) trusts?
Lifetime CLTs can be either grantor or non-grantor trusts, whereas a testamentary CLT can only be a non-grantor trust. A grantor CLAT affords the donor an upfront income tax deduction. This charitable income tax deduction is equal to the present value of the charitable lead interest and is based on the Internal Revenue Code §7520 rate. The rate for January 2014 is 2.2%. A taxpayer can utilize the rate in the month of funding the CLT or either of the 2 prior months. The charitable income tax deduction is usable in the year the assets are irrevocably transferred to the trust (limited to a percentage of adjusted gross income) like any other charitable income tax deduction with a 5-year carry-forward of any unused deduction. The donor’s death during the charitable term of the grantor CLT would require a partial recapture of the income tax deduction. Any income generated or capital gains realized within the grantor CLT during the trust term would be taxed as income to the grantor—just as if the asset remained in the grantor’s name. This would be the case even though the grantor is not receiving any current cash flow.
Grantor CLT Example: Jean, age 60, is charitably inclined and does not need current income and is anticipating a sizable jump in her income this year. She establishes a $1 million grantor CLAT that will pay the local Humane Society $55,000 (5.5%) per annum for the next 10 years. Assuming a §7520 rate of 2.2% (January 2014), the current income tax deduction would total about $488,900 that she can utilize against her current income subject to the general charitable deduction rules. Assuming an 8% annual return, the value of the CLAT returned to Jean (grantor) at the end of the 10 years would be about $1.363 million.
With a non-grantor or family CLT, the trust’s charitable income tax deduction is taken annually on the income tax return for the trust in the amount of the actual annual annuity payment to charity without any adjusted gross income limitation. The donor does not receive any further income tax deduction. The family CLT will be taxed on any excess income at the trust level as it is a separate tax-paying entity and pays income taxes on its income (IRS Form 1041). The real benefit of a family or non-grantor CLT is that it can be structured to transfer assets to the next generation with reduced gift tax consequences since the remainder interest gift is valued at trust inception. Thus, the family CLT is best designed for those donors who have a significant charitable intent along with a wish to make a deferred gift to heirs with minimal tax consequences (estate freeze planning).
Lifetime Family CLAT Example: Jill, age 50, is charitably inclined and desires to provide a gift to her teenage children 10 years hence. She establishes a $1 million non-grantor CLAT that will pay the local hospital $55,000 (5.5%) per annum for the next 10 years. Assuming a §7520 rate of 2.2% (January 2014), she would receive no charitable income tax deduction but would be treated as making a taxable gift of about $511,100. While the $14,000 annual gift exclusion would not be available for this gift as it is not of a present interest, Jill can utilize her $5.34 million gift/estate exemption (2014) to offset any federal gift taxes (state gift taxes may be payable in some states). Assuming an 8% annual return, the value of the CLAT that would pass to her children as remainder beneficiaries at the end of the 10 years (2024) would be about $1.363 million—substantially greater than the taxable gift of $511,100 reported at trust inception.
3. What key requirements must be met to establish and manage a charitable lead trust?
- The transfer to the CLT must be irrevocable.
- The guaranteed annuity payable to charity must be paid at least annually and can be made in either cash or in kind. This would be true regardless of whether there is adequate trust income generated in the applicable year.
- Additional contributions to a CLAT are prohibited but no such prohibition exists for a CLUT.
4. When should one utilize a CLAT or a CLUT?
Certainly, a CLAT is simpler to set up and administer as the trust assets need to be valued only at the time of trust inception. The annual annuity payable to charity can increase over the term of the trust but any such change must be spelled out in the trust document. Conversely, a CLAT does not allow additional contributions to the trust in future years. A CLUT permits additional contributions but the trust itself must be revalued every year. This can be expensive if the CLUT holds assets that are difficult to value. The annuity payout in a CLUT is equal to a fixed percentage of trust value on the annual valuation date and thus can and generally will fluctuate in dollar terms on an annual basis.
If the objective is to maximize the value of property passing to heirs, a CLAT works best where the remainder beneficiaries are the children of the donor and the trust assets are expected to appreciate at a rate greater than the annual payout to charity. If the ultimate beneficiaries of the CLT were grandchildren or other heirs more than one generation lower than the donor, a CLUT would be preferable as it would allow the donor to allocate his or her generation-skipping exemption ($5.34 million in 2014) upon funding the CLT.
5. In what situations is a CLT most effective?
- Donor has a significant charitable intent
- Donor (grantor trust) or heirs (non-grantor trust) do not need current income from the trust property
- Donor is looking for a tax-efficient means of making a future transfer to heirs (non-grantor trust)
- Donor is facing income or estate tax exposure and is looking for appropriate tax reduction strategies
6. What is the impact of testamentary vs. lifetime funding and establishment of a CLT?
First of all, it is important that donors coordinate their CLT planning with their other estate planning documents, whether it is to be created during their lifetime or at death. Lifetime CLTs can provide the donor with either an income tax deduction (grantor CLT) or gift tax consequence on trust inception (family CLT). CLTs that are created at death are always non-grantor trusts and afford an estate tax charitable deduction equal to the present value of the charity’s lead interest.
The charitable estate tax deduction is equal to the present value of the charitable lead interest based on the Internal Revenue Code §7520 rate (2.2% in January 2014). This can provide significant estate tax savings and also reduce the taxable value of the remainder interest passing to heirs at the end of the trust term. The assets passing to the testamentary CLT will also receive a stepped-up basis for income tax purposes, as opposed to a carryover basis used for a lifetime funded CLT.
CLAT Example: In his will, Joe provides for a $1 million, 6%, 15-year CLAT to his alma mater. The remainder beneficiaries are his children. The allowable estate tax charitable deduction would be about $759,550 and the taxable transfer to his children would total about $240,450 (January 2014—2.2% §7520 rate). Assuming an 8% annual return for the CLAT, the children would receive about $1.543 million upon CLAT termination in 2029. Raising the annual payout rate to 7.899%, or $78,990 per annum, would increase the charitable estate tax deduction to $1 million and make the taxable transfer value to his children zero. Based on the same 8% annual return assumption for the 15-year trust term would leave about $1.027 million to Joe’s remainder beneficiaries (children) with no transfer tax cost.
A CLT is a tax-efficient planned giving vehicle with excellent flexibility that can be tailored to the needs of wealthy individuals and/or families. It allows a donor to make a significant transfer to charity through the guaranteed annuity stream while retaining the ability to control the ultimate disposition of the trust upon the expiration of the charity’s annuity interest, either back to the donor or to his or her heirs. If the donor is looking for income tax planning, a grantor CLT would be best; in situations where the goal is to pass the remainder interest to heirs, a non-grantor or family CLT would be better.