Charitable lead trusts (CLTs) offer a tax advantaged way to transfer property to family members after a term during which fixed amounts are payable to one or more charities. CLTs can provide for the payment to charity to be in the form of either a fixed amount (an annuity form of trust) or a fixed percentage of the annually determined value of the assets of the trust (a unitrust). CLTs almost always take the form of an annuity trust (a so-called CLAT), because it generally offers a greater overall benefit. The amount payable to a charity from a CLAT will remain fixed even though the value of the property increases. In contrast, the payments to charity will increase if the value of property held in a CLUT increases. In either case, at the end of the term of a CLT the remaining assets are distributed to the beneficiaries designated in the trust--most often the grantor's descendants. Unfortunately, favorable tax results are not available if the grantor retains the right to change the charitable beneficiary.
Tax Planning Principles
The creation of a CLAT results in an overall tax benefit if the value of the trust property increases at a rate greater than the rate that was used to value the interest given to charity. Accordingly, it is generally best (1) to fund a CLAT with property that is expected to increase substantially in value and (2) to create a CLAT when a low rate is used to calculate the actuarial value of the charitable annuity. (The monthly-determined annual rates that are used for this purpose have been relatively low in recent months.) The creation of a CLAT is also particularly attractive if the value of the property transferred to the CLAT qualifies for a substantial valuation discount. For example, interests in family limited partnerships (FLPs) or limited liability companies (LLCs) are often valued by appraisers using discounts of 25% or more. In addition, appraisers of fractional interests in real property often apply discounts of at least 20% to take into account the limitations associated with a fractional ownership interest.
General Tax Aspects of Gifts to CLATs
The transfer of property to a CLAT involves both a gift to the charitable beneficiary and a gift to the remaindermen of the trust (usually the grantor's children or grandchildren). Importantly, a gift or estate tax charitable deduction is allowable for the actuarially determined value of the gift to the charity, which can substantially reduce, or entirely eliminate, the tax cost of the transfer.
Gift Tax. If a CLAT is properly planned and drafted, a charitable gift tax deduction is allowable for the actuarially determined value of the charitable annuity. The excess of the value of the property transferred to the trust over the value of the charitable annuity is treated as a gift to the remaindermen that is subject to the gift tax. In this connection note that the value of the gift to the noncharitable beneficiaries does not qualify for the $13,000 per donee annual gift tax exclusion. The payout rate and duration of CLATs are often planned so the value of the noncharitable gift element is relatively small. As mentioned above, favorable gift tax treatment is not available if the grantor retains the right to change the designation of the charity that is to receive the annuity payments.
Estate Tax. The property of a properly planned and administered CLAT is not includible in the grantor's estate. The result is the same whether or not the grantor survives the charitable term.
Income Tax. A current income tax deduction is allowable for the actuarially determined value of the charitable annuity if the income of the trust will be taxed to the grantor as it is received. Conversely, no income tax deduction is allowable if the income of the trust is not taxed to the grantor. Unlike charitable remainder trusts, CLATs are not exempt from the federal income tax. Accordingly, if the income of a CLAT is not taxed to the grantor, the trust is entitled to deduct any income that is distributed to charity. The balance of the income of a CLAT, including capital gains, is taxed to the trust. CLATs are generally planned so their income will not be taxable to the grantor.
Generation-Skipping Transfer Tax (GSTT). Property transferred to a CLAT is subject to the GSTT. A special rule prevents the grantor from leveraging the benefit of the amount of the GSTT exemption that is allocated to the noncharitable interest in a CLAT. In particular, the inclusion ratio for a CLAT is deferred until the charitable interest terminates. The ratio is then determined by increasing the numerator (the amount of exemption allocated to the transfer) by the interest rate that was initially used to value the charitable and noncharitable interests. The denominator is the value of all of the property of the trust when the charitable annuity terminates. Thus, the allocation of the exemption cannot shelter the amount by which the value of the trust property appreciates in excess of the rate that was initially used in valuing the interests. CLATs are often planned in ways that minimize the amount that may be subject to the GSTT.
Example. The following example illustrates how a client might use a CLAT to transfer the remainder interest in a valuable asset to family members in a way that substantially eliminates gift tax costs:
Mother (M), a widow, owns a commercial building worth $3 million that generates an annual net income of $210,000. The basis of the building was stepped up to $2.5 million when Father (F) died two years ago. M might consider transferring the building to a family limited partnership (FLP) or limited liability company (LLC) in exchange for ownership units. M or her designee would manage the FLP or LLC. M might transfer 90% of the ownership units to a CLAT of which her two children A and B are entitled to receive the property at the end of the charitable term. For gift tax purposes the units would be discounted by, perhaps, 30%, which would decrease the amount of the gifts to A and B. The total value of the property transferred would be $1,890,000 ($3,000,000 x 70% (discounted value) x 90% (percentage transferred). If the annual rate prescribed by the IRS for gift tax purposes is 5.0% (the applicable rate, which changes monthly, has fluctuated between 1.8% and 8% since 2000), the CLAT had a payout rate of 10% per year and a term of 10 years, the charitable gift would have a value of $1,459,401 and the gifts to A and B would have a total value of $430,599. If the FLP units continue to generate a 10% return, the income will be sufficient to pay the charitable annuity. The CLAT will not be required to pay any income tax if its income does not exceed the sum of its administrative expenses and charitable distributions. Accordingly, at the end of the term A and B are likely to receive the principal value of the building plus any excess income that is accrued within the CLAT.
Designating a Beneficiary
A CLAT may designate one or more charitable beneficiaries or allow the trustee to choose among a group of designated charities. Although the grantor cannot retain the right to change the designation of the charitable beneficiary, the IRS has ruled that a gift tax charitable deduction is allowable although the trustees are given the power to apportion the charitable annuity among qualified charitable beneficiaries. The deduction is allowable although the donor's child is a cotrustee of the trust.
The IRS has ruled that a CLAT may provide that income in excess of the amount needed to make the required payments to charity may be accumulated for distribution to noncharities upon termination of the trust. However, no charitable deduction is available if the trust provides for current distribution of excess income to noncharitable beneficiaries.
A CLAT is often used to transfer appreciating property to family members at a substantially reduced tax cost. As indicated above, the gift or estate tax imposed on a transfer to the remaindermen of a CLAT is based on the value of the assets transferred to the trust less the actuarially determined value of the charitable interest. No further gift or estate tax is imposed when the appreciated remainder is distributed to the designated beneficiaries.
Clients whose future income will be in lower tax brackets may wish to create CLATs contributions to which qualify for current income tax deductions. The advantage of a present charitable deduction may substantially outweigh the disadvantage of being taxed on the current income of the CLAT. That is, the grantor may reap an overall tax benefit by being able to deduct the present value of future payments to the charity, while the income to fund the payments is only taxed to the grantor as the income is received by the CLAT.
No Commutation of Charitable Interest
The charitable interest in a CLAT cannot be eliminated by pre-paying the charities the value of their interests. Thus, the IRS has ruled that no charitable deduction is allowable with respect to a CLAT that gives the trustee the power to commute and prepay the charitable beneficiary the value of the future annuity payments which it is entitled to receive. The conclusion is based on the definition of a "guaranteed annuity," which requires the payment of a determinable amount for a specified term. The right of the trustee to commute and prepay the annuity deprives the charitable beneficiary of the right to receive payments of a fixed amount over a specified term.
CLAT Payments to Private Foundation
A private foundation may be the beneficiary of a charitable lead trust, which allows the grantor's family to control the distributions to charity that are made by the foundation. The approach can be used where the donor wishes to combine the benefits of a CLAT with a distributive mechanism that allows the corpus of the foundation to grow substantially over time.
© 2011 Perkins Coie LLP