By: John Pitlosh CFP®, MST
Do you want to help your favorite charity now when it needs you most?
Are you concerned the estate tax will come back with a vengeance?
Are you concerned about a cap on future charitable contributions?
Do you want to take advantage of low interest rates?
For the serious charitable donor that answered yes to all of these questions, you might want to consider adding a charitable lead trust (CLT) to your existing planning. A CLT is a split interest trust that creates a current income stream for your favorite charity over a specified number of years, while giving the donor a trade off benefit in the form of a current income, gift, or estate tax deduction on assets donated to the trust. In the right circumstances, a CLT’s unique set of benefits can significantly improve an individual’s planning by more effectively integrating their charitable goals with their other financial objectives.
For those of you that are familiar with the more common Charitable Remainder Trust (CRT), a CLT is essentially a CRT in reverse. While a Charitable Lead Trust is a split interest irrevocable trust like a CRT, the initial income stream from the CLT’s assets goes to the charitable beneficiary first, and only after the income stream has run its course do the remainder assets inside the trust go to the specified non-charitable beneficiaries.
Like a CRT, a Charitable Lead Trust must make an annual payout between 5% and 50%; however, there is a lot more flexibility regarding the term of the initial income stream, because the charitable beneficiary is the initial benefactor of the trust. The only limitation on the CLT is that it requires that a term based on the life of an individual must be based on individuals that are alive at trust inception.
There are two primary types of CLT’s: a Charitable Lead Annuity Trust (CLAT) and a Charitable Lead Unitrust (CLUT). The primary difference between the two trusts involves how the annual payout is determined. A CLAT will pay out a fixed dollar amount every year based on the initial percentage that was selected when the trust was initially funded, while a CLUT will pay out a fixed percentage each year based on the value of the trust assets in that year.
Interest Rate X-Factor:
The tax deduction for a CLT is calculated using government tables that consider the fair market value of the contributed assets, the term of the trust, the amount and frequency of payments to the charity, as well as the current IRS 7520 interest rate. While an individual’s deduction would logically increase if the trust makes larger annuity payments to the charity for longer periods of time, interestingly, the opposite correlation occurs with interest rates—lower interest rates equal larger deductions.
The lower the IRS 7520 rate is, the higher the present value calculation for the stream of payments to the charitable beneficiary. Theoretically, this means a lower percentage of the assets will go to the non-charitable beneficiary, and thus, you will receive a larger charitable deduction for the contribution to the trust. If the trust assets are able to outpace the annuity payments to the charity at a time when interest rates are low, then you will have maximized the deduction while not cutting into the principal of the trust.
Example 1: An individual making a $500,000 transfer to a 12 year non-grantor CLAT with an annual payout of 6.5% when 7520 rates were 6.2% in August of 2007 would have resulted in a taxable gift of $230,487 and a charitable deduction of $269,513.
Example 2: An individual making a $500,000 transfer to a 12 year non-grantor CLAT with an annual payout of 6.5% when 7520 rates were 3.2% in April of 2010 would have resulted in a taxable gift of $180,324 and a charitable deduction of $319,676…A deduction difference of roughly $50,000!
CLAT or CLUT:
As a general rule, if you want to maximize the benefit to the non-charitable beneficiary and you are donating assets to the trust that you expect to outpace the annuity payments, then a CLAT is the more appropriate structure. By fixing the annuity payments at the beginning of the trust term you don’t have to worry about the revaluation of the trust assets forcing out larger annuity payments as the assets continue to grow. However, if you expect the trust assets to decline over the term of the trust, then revaluing the annuity payment in a CLUT should leave more behind for the non-charitable beneficiaries.
The Right Deduction for You:
The type of deduction you receive is based on how the trust is drafted, and the type of trust that you draft will ultimately depend on the type of planning you are trying to achieve. In general, there are two main versions of CLTs, a grantor trust version and a non-grantor trust version.
Grantor CLT – For starters, a grantor trust is a trust in which the donor is treated as the owner of the trust for income tax purposes. The grantor version of the CLT is designed to give the donor an immediate tax deduction for funding the trust, but the trust assets revert back to the donor after the charitable annuity runs its term. The front-loading of the charitable deduction is recaptured over the term of the charitable annuity as the donor is taxed on all the income generated by the CLT; this includes income or appreciated assets paid out to the charity. Given the tax consequences associated with this version of the CLT, tax-exempt municipal bonds are commonly used. The grantor CLT is useful when an individual has a large one-time income event like the exercise of stock options or a large bonus.
Non-Grantor CLT – The non-grantor version of the CLT is designed to give the donor an immediate gift tax deduction equal to the present value of the charitable lead interest, and shift the trust assets to someone other than the donor, usually family. The consequence to the donor of using a non-grantor trust is that the donor is not entitled to an income tax deduction; however, the donor is able to remove appreciating assets from their estate at a minimal gift tax cost. Further, a non-grantor CLT can be used to circumvent the percentage limitations on charitable deductions. Unlike individuals, trusts are not subject to percentage limitations on charitable deductions, so this can be a significant boost to individuals that have already exceeded their charitable deduction limitations.
*A non-grantor CLT is taxable in accordance with the rules applicable to complex trusts. As a result, during the term of the charitable annuity, any income that is earned by the CLT that is not required to be distributed to the designated charitable organization will be taxable income to the CLT.
Non-Grantor CLAT: When you take the information from example 2 and apply a 10% annual growth rate to the trust assets, you can see the impact of both the charitable deduction and the growth outside the estate.
As endowments and foundations lick the wounds inflicted on them by the markets and families across the board have reduced their annual donations, charities are even more dependent on help from their large donors to secure their bottom lines. In a perfect storm of low interest rates, a bottomed out stock market, and impending tax hikes, CLT’s are one of the best deals in town. If you are looking to help your favorite charity in a way that helps you achieve some of your other income or estate planning goals, then a well designed and well executed Charitable Lead Trust could be right for you.