A CREDO TAX PLANNING STRATEGY SOLUTION

CHARITABLE LEAD TRUST: An Efficient Way to Transfer Assets,  Reduce Tax Liability, and Leverage Your Philanthrophy

This whitepaper discusses how Charitable Lead Trust serves as a giving vehicle that offers wealthy individuals the golden opportunity to transfer assets to their heirs at substantial tax incentives while leveraging their philanthropic acts.

Charitable Lead Trust (CLT) has gained popularity over the years because it allows generation-skipping planning, exceptionally low monthly IRS discount rates (under IRC Section 7520), 10% remainder requisite for charitable remainder trusts, and an encouraging tax treatment when the private foundation of the settler is the CLT’s charitable beneficiary.

CLT makes payments to charity for a determined life or a term of years, or an authorized combination of both and then either goes back to the settler or passes to or in trust for other individual recipients. The use of CLT allows you to:

– Be eligible for an income tax deduction for the charitable interest

– Leverage your gift to heirs and exclude from your estate the CLT property

– Or achieve all abovementioned goals via the use of a “Super CLT” wherein a grantor trust is not included in your estate

WHAT IS A CHARITABLE LEAD TRUST?

A charitable lead trust (CLT) is a combination of charitable planning and tax planning that has become a popular gifting technique for donors who are worried about the inheritance taxes that their heirs would pay. The beneficial interests in CLTs are divided between charitable and non-charitable beneficiaries (also called as split-interest trusts). The trusts commences by paying a fixed annuity (unitrust) amount to a charitable institution for the “lead” stage (which can either be a term of years or someone’s life). The rest of such amount would be distributed to the non-charitable beneficiary at the end of the lead period.

HOW DOES CHARITABLE LEAD TRUST WORK?

Step 1: You transfer an asset to a trust (CLT) which can either be a real property, cash, securities, or even an atypical collectible item (which should be sold first to produce income).

Step 2: You select a non-charitable beneficiary who can be anyone (you, your spouse, a relative, a friend).

Step 3: You identify a charity.

Step 4: You decide on the amount of money that you will pay to the charity every year from the trust assets. Payment can either be am annuity amount (fixed amount of the initial fair market value of the trust assets), or a unitrust amount (which is a specific value percentage of the trust assets according to the annual revaluation of the assets).

Step 5: You decide on the term of the trust (which can either be for years of the life of a living individual).

Step 6: At the end of the indicated period, the remainder of the trust assets would then be passed to the non-charitable beneficiary.

SAMPLE SCENARIO OF HOW CHARITABLE LEAD TRUST WORKS

You decide to donate to your chosen charity and you transfer $1 million to a 10-year charitable lead trust with your sister as the non-charitable beneficiary. You then specify that the payout rate to the charity would be a fixed 5% annuity amount. This charity would then receive $50,000 every year for 10 years (5% of the $1 million). All the remaining property in the trust will then be passed to your sister after 10 years.

TAX CONSIDERATIONS OF CHARITABLE LEAD TRUST

INCOME TAX

DONOR OF LIVING CLT WOULD HAVE POSSIBLE INCOME TAX DEDUCTION

Based on IRS rules, the owner of the trust is eligible to receive an income tax deduction for the current value of the CLT’s interest. That is a one-time income tax deduction (based on the year of the trust’s creation) for the present value of the payments that will be received by the chosen charity over the term of the trust. A strategy that is commonly used to be considered as the owner of the trust is to name yourself as the non-charitable beneficiary. But take note that if you are the trust’s owner, you will be taxed on the income that is earned by the trust every year until the end of its term.

Qualifying for a deduction means you are limited to either 30% or 50% of your adjusted gross income deduction based on the type of property that you are donating to charity (via CLT) and the categorization of the charity as a public charity or a private foundation. In case the deduction cannot be taken in full in a given year, it can still be carried over and the remaining amount can be deducted in the following year (for up to five years given that deductions are itemized).

If you qualify for a deduction, your deduction is limited to either 30% or 50% of your adjusted gross income, depending on the type of property donated to charity (via the trust) and the classification of the charity as a public charity or a private foundation. If you cannot take the full deduction in a given year, you can carry over and deduct the remaining amount the following year, for up to five years (assuming you still itemize deductions). Usually, a public charity is supported publicly by domestic organization while a private foundation does not have the same expansive public support.

INCOME TAX OUTCOME FOR CLT

As compared to the charitable remainder trust (such as CRATs and CRUTs), a CLT’s income tax treatment is far different. A CLT is not exempt from income tax. Instead, it is treated for income tax purposes as an intricate trust and is taxed under the normal rules Subchapter J of the Internal Revenue Code. The said rules state that the CLT is taxable on all of its income but is allowed to all existing deductions (which includes a deduction for any amount paid to charity).

The sources of payment and the sequence on which the sources would be used should be well-documented in the trust. Normally, the trust payments are made in the following order:

Ordinary income (which includes short-term capital gain) –> Capital Gain –> Unrelated Business Income –> Tax-Exempt Income –> Principal

Unless specific provisions for the order are made, state law may determine the source of payments and the order of use. If the payment to charity is not made out of gross income, the trust’s deduction for the payment will be disallowed.

GIFT TAX

YOU AND/OR SPOUSE ARE THE ONLY NON-CHARITABLE BENEFICIARIES

No gift tax will be incurred if you and/or your spouse are the sole non-charitable beneficiaries of a CLT. The payment to your spouse would be categorized under the limited marital deduction. However, you have to take note that community property stipulates that a husband and wife are treated as equal owners. So if a community property is used to pay a trust that benefits merely one spouse or if a separate property of one of the spouses funds a trust that provides lifetime benefits to both parties, then, there is an acknowledged gift to the other spouse. This would then have implications under the specific state’s gift tax law.

SOMEONE OTHER THAN THE SPOUSE IS A NON-CHARITABLE BENEFICIARY (POTENTIAL GIFT TAX CONSEQUENCES)

Federal rules on gift tax apply if the non-charitable beneficiary of a CLT is someone other than (or in addition) to the spouse. Any remainder interest to the non-charitable beneficiary is appreciated at the time of the creation of the CLT. Take note though that the annual gift tax exclusion (see tax laws changes and updates on this blog) cannot be used to offset any of the taxable portion of the gift since the gift is considered as a future interest.

Any gift to a non-charitable beneficiary is included in your estate (for determining your indefinite estate tax). But any gift tax paid against any estate tax owned would be credited. It would also be excluded from your estate (unless the donor dies within three years after the creation of the trust).

Take note also that state gift tax may still be imposed.

ESTATE TAX

GROSS ESTATE SIZE IS REDUCED

Here are some scenarios in which a donor’s gross estate tax is reduced:

  • In the case of a testamentary CLT, IRS permits the executor of the estate to subtract the current value of the lead interest to charity from the gross estate.

  • When a donor who is also the non-charitable beneficiary dies prior to regaining complete control of the trust property (or during the trust term), any value of the remainder interest would be included in the donor’s gross estate.

  • If the grandchildren are the assigned non-charitable beneficiaries of the CLT, generation-skipping transfer tax (GSTT) issues may arise at the end of the trust term.

STRENGTHS OF CHARITABLE LEAD TRUST

TAX HAVEN FOR GIFT AND ESTATE TAX

Upon the establishment of a CLT, the IRS assigns a direct value to the interest of the non-charitable beneficiary (despite the person not getting the trust assets until the end of the trust term). However, over the years of the term, the value of the trust assets might significantly appreciate. Once the assets are then passed on to the non-charitable beneficiary, any appraisal in the value of the property would not be included in the gross estate of the donor (for purposes of determining estate tax liability), nor is the appraisal regarded in identifying the value of the gift to the non-charitable beneficiary.

KEEPING ASSETS WITHIN THE FAMILY

Upon the establishment of a CLT, the IRS assigns a direct value to the interest of the non-charitable beneficiary (despite the person not getting the trust assets until the end of the trust term). However, over the years of the term, the value of the trust assets might significantly appreciate. Once the assets are then passed on to the non-charitable beneficiary, any appraisal in the value of the property would not be included in the gross estate of the donor (for purposes of determining estate tax liability), nor is the appraisal regarded in identifying the value of the gift to the non-charitable beneficiary.

POSTPONE NON-CHARITABLE BENEFICIARY'S RECEIPT OF TRUST ASSETS

Using CLT helps you set the duration of the trust to concur with the age at which you think your non-charitable beneficiary will best be able to manage the trust assets (in the case of a beneficiary who is too young to handle finances responsibly).

ANNUAL CHARITABLE GIVING

CLT provides for an organized way to donate to charity on an annual basis for a set period of time (that instead of the money going largely for taxes, you can use it instead to donate to charity).

PAYMENT METHOD OPTIONS

There are two ways by which you can pay the charity in a CLT:

Annuity Method – This is a payment of a fixed sum or a fixed percentage of the initial fair market value of the trust assets (with the trust asset being valued only once). Such payment remains the same every year (until the end of the trust term).

Unitrust Method – This is a payment of a specified percentage of the trust assets which is being revaluated each year. So depending on the value of the trust assets, the amount being paid to the charity fluctuates every year. IRS only allows additional contributions to the trust using only this payment method.

NO MINIMUM % PAYOUT TO CHARITY

There is no rule that specifies a particular percentage amount that you can pay to a charity (unlike in a charitable remainder trust which has a minimum of 5% of the original or annual value of the true assets).

POSITIVE IMPACT OF CHARITABLE ACTS

Despite the awesome tax benefits, we cannot deny the fact that donating to charity provides you with a positive social, psychological, and even religious benefits.

REDUCED FEDERAL ESTATE TAX LIABILITY

In the case of a testamentary CLT, the executor of the estate is allowed by the IRS to deduct the whole current value of the lead interest to charity. This is computed using special IRS tax tables that factor in the duration of the trust and the payout amount to charity.

THE TRADEOFFS

NO INCOME TAX DEDUCTION (except if you are also the CLT's owner)

In a usual CLT, the donor (or the one who creates the trust) is not the non-charitable beneficiary. In this scenario, the donor is not given the privilege to deduct the current value of the charity’s interest on his income tax form. But, in the instance that you are the donor and at the time the owner of the trust, IRS entitles you to a one-time income tax deduction for the present value of the interest to charity on the same year that the trust is created.

ENTAILS AN IRREVOCABLE COMMITMENT

In a usual CLT, the donor (or the one who creates the trust) is not the non-charitable beneficiary. In this scenario, the donor is not given the privilege to deduct the current value of the charity’s interest on his income tax form. But, in the instance that you are the donor and at the time the owner of the trust, IRS entitles you to a one-time income tax deduction for the present value of the interest to charity on the same year that the trust is created.

CHARITABLE LEAD TRUST FAQs

When will a charitable lead trust take effect?

In a usual CLT, the donor (or the one who creates the trust) is not the non-charitable beneficiary. In this scenario, the donor is not given the privilege to deduct the current value of the charity’s interest on his income tax form. But, in the instance that you are the donor and at the time the owner of the trust, IRS entitles you to a one-time income tax deduction for the present value of the interest to charity on the same year that the trust is created.

Can the non-charitable beneficiary also act as the trustee?

YES. Your non-charitable beneficiary can also be the trustee and he can have control over the property that he will own in the future. All non-charitable beneficiaries (in an instance that there is more than one) can all be appointed as trustees.

Can a CLT pay both the charity and the non-charitable beneficiary at the same time?

Normally, the non-charitable beneficiary of a charitable lead trust holds a residue interest only, which means it is second in line to the charity’s interest. Nevertheless, in certain situations, the IRS permits a non-charitable beneficiary to obtain an income interest that runs at the same time as with the charity’s interest. The income interest is allowed only if it is paid from trust assets that are separated from the assets used to pay the charity. The provision for this should be drafted accurately in the trust document and executed according to the regulations of the IRS. Or else, the IRS may rule that the total charitable lead trust is invalid.

Benefits of CLT over CRAT or CRUT

CLT allows donation to the charity for a period of years and ten award the remaining trust assets to non-charitable beneficiaries (who can either be family members or other people). On the other hand, the charitable remainder annuity (CRAT), charitable remainder unitrust (CRUT), and pooled income fund all function in the reverse. All three provide an income flow to the non-charitable beneficiary for a period of time and then pass the residual assets to charity.

CLT’s edge over the others is its potential to transfer property to family with minimal gift and estate tax liability. This applies when you fund the trust with an asset that is expected to considerably appreciate in value. This is because the gift and/or estate tax liability is established by the fair market value of the property at the time of the trust’s transfer (and not by its appreciated value when it is transferred to the non-charitable beneficiary after 10,20, or 30 years after). In CLT, the IRS does not oblige to give any minimum amount to charity. In contrast with a CRAT or CRUT, a CLT is not exempted from income tax. It is being taxed as a complex trust. The donor of a CLT is not entitled to an income tax deduction for the charitable contribution unless he is considered as the trust owner as per the rules of IRS. But as the owner, the donor is then taxed on the trust income that is earned every year.

Is there a term years of limitation for CLT?

There is no term of years limitation for the charitable lead trust as for the charitable remainder trust and, as a result, successful planning for grandchildren can be accomplished using terms in excess of 20 years by vigilant choice of assets that create enough growth for the preservation of the grandchildren’s future interest in the trust assets whilst meeting the payment obligation to the charity during the trust term.

What is the “Super CLT”?

The IRS has permitted a CLT design which provides grantor trust status and exclusion of the CLT assets from the grantor’s gross estate.  The trick is to use a grantor trust taint (such as giving a non-adverse person other than the settlor hold the IRC Section 675(4)(c) ability in a non-fiduciary capability to obtain the corpus by substituting assets of equivalent value) that does not cause inclusion in the gross estate.

Trustees and Trustee Powers

Grantor as Trustee:

(a)   The grantor can act as trustee of a nongrantor CLT without causing inclusion of the corpus in his gross estate as long as the grantor holds only routine administrative powers.  Nevertheless, the corpus will be includible in the gross estate under IRC Section 2036 or 2038 if the grantor maintains the power to assign the income or remainder beneficiaries.

(b)   The grantor can act as trustee with the power to assign the income or remainder beneficiaries if the trust is a grantor CLT and the corpus will be includible in his gross estate in any event, such as due to a retained reversionary interest.

Grantor’s Family Member as Trustee:

(a)   A member of the grantor’s family other than the grantor’s spouse can act as trustee of a nongrantor CLT.  The spouse can act as long as not granted any power that would cause grantor trust status due to IRC Section 672(e).

(b)   Family members may act even where the trustees otherwise have power over the assets which are held in the trust, such as closely held stock.

(c)   Any compensation paid to a family member trustee should not surpass reasonable compensation, or such excess compensation might be deemed a current non-charitable distribution and thus disqualify the CLT.

Trustee’s Sprinkle Power

(a)   An independent trustee of a CLT may safely have the power to sprinkle the annuity or unitrust payment among eligible charitable beneficiaries.  It should also be safe to let an independent trustee to sprinkle the remainder among a class of individual beneficiaries upon termination of the lead interest.

(b)   If the grantor or the grantor’s spouse held the power to sprinkle corpus, the grantor would be treated as the owner for income tax purposes under IRC Section 674(a).  Moreover, a sprinkle power held by the grantor (but not his or her spouse) will cause inclusion of the corpus in the grantor’s gross estate under IRC Sections 2036(a)(2) and 2038(a)(1).

(c)   A sprinkle power retained by the grantor or his or her spouse with respect to the annuity or unitrust payments will not cause the grantor to be treated as the owner for income tax purposes,[21] but the retention of this power by the grantor (but not his or her spouse) will cause inclusion in the gross estate under IRC Sections 2036(a)(2) and 2038(a)(1).

(d)   Even if the grantor is not the trustee, if the trustee holds sprinkle powers and the grantor can freely discharge the trustee and appoint another, including the grantor or any trustee that is related or subordinate to the grantor, the corpus will be includible in the grantor’s estate under IRC Section 2036.

Is there a limit to the number of non-charitable beneficiaries?

YES.  You may assign more than one non-charitable beneficiary. Just make sure that it is clearly indicated in the trust document how the trust assets would be split among them.

Are there income tax incentives for establishing CLT?

As per the IRS rules, only the owner of the trust is eligible to receive an income tax deduction for the present value of the charity’s lead interest. But it is a one-time event only and is merely allowed in the year of the trust’s creation. And the easiest way to meet the owner criteria is to keep an interest in the trust as a non-charitable beneficiary which is also called as a reversionary interest since it reverts to you (it should be at least 5% of the total trust assets). The computation should be made at the start of the trust using the actuarial tables of the IRS. Under the rule of the 5% reversionary interest, you will be considered as the owner of the trust if your spouse has more than 5% interest in the trust assets, you would be considered as the trust’s owner. But in this case, the deduction on your income tax comes at a price. You will be taxed every year on the income earned by the trust (under the grantor trust provisions of the IRS). This applies even if it is the charity who receives the trust income (and not you).

This means that while you are eligible for an income tax deduction, you should still pay income tax on the trust income yearly. Offsetting any amount of trust income paid to charity is not allowed by the IRS. But one way to avoid paying taxes on trust income is to have the trust hold only the assets that create tax-exempt income like tax-exempt municipal bonds (though the income that can be produced from these may not be enough to make the required payment to charity).

Most of the time, there is a 30% (of your adjusted gross income) limit to your deduction because the IRS regards your gift as “for the use of” and not “to” the charity. But if a long-term capital gain property is used to find the trust, then it is not considered as a public charity and the 20% limit applies. In case that you cannot take the full deduction in the applicable year, the difference can then be carried over to the next years (up to five succeeding years if you will still itemize deductions in those years.

The deduction amount is computer using IRS’ special interest rate tables. At present, the rule requires that the value of a remainder interest be calculated using an interest rate that is 120% of the federal midterm rate then in effect of appraising specific federal government debt instruments of the month that you made the gift. Additionally, the computation uses the most current mortality table obtainable to establish the mortality factor.

When the time comes that you are no longer taxed on the yearly income that is earned by the trust (i.e. due to death), there will be a fractional recapture by the IRS of your prior one-time deduction for the value of the charity’s lead interest. Assuming you set-up a charitable lead trust for a term of five years with you as the non-charitable beneficiary also, your entitlement for an income tax deduction for the present value of the charity’s interest would be on the first year. In case you die on the third year, the recapture rules will take effect. As a result, your income on the third year must include a recaptured portion of the deduction that you took on the first year.

Can the charity be paid any excess amount from the required annuity or unitrust payment?

Normally, the non-charitable beneficiary of a charitable lead trust holds a residue interest only, which means it is second in line to the charity’s interest. Nevertheless, in certain situations, the IRS permits a non-charitable beneficiary to obtain an income interest that runs at the same time as with the charity’s interest. The income interest is allowed only if it is paid from trust assets that are separated from the assets used to pay the charity. The provision for this should be drafted accurately in the trust document and executed according to the regulations of the IRS. Or else, the IRS may rule that the total charitable lead trust is invalid.

When do you consider a CLT?

NEED FOR LIQUIDITY: A CLT is considered if for instance, you are selling your business and you want to recognize substantial capital gains and you are not willing to part with your sudden riches permanently. Transferring to a CLT that is a grantor trust after any sale of assets like closely-held stock will create a generous deduction while guaranteeing the return of the assets eventually to the donor or your spouse. In cases of unwillingness to part with the principal, this method is very practical. A grantor CLT permits you to offset the gains with an income tax deduction on the year of sale and pay the tax on your gains over a number of years. This efficiently allows income averaging as an alternative to an enormous tax bill in the year of the sale. You will then get the property back once the trust terminates.

INITIAL PUBLIC OFFERING (IPO): Some clients are sometimes advised by their planners to take on an IPO to put some of their shares in a charitable remainder trust. But this is an anathema to the shareholder who only has paper wealth and questions why the need to give it away when he would only be having the income and none of the principal. Some of the closely-held stock amount might be placed in a grantor CLT with a reversion to the donor. This produces a lump sum deduction in the same year that the shareholder had gain on the closely-held stock. Selling a few of the new stock may be essential to meet the payout commitment of the CLT, but eventually receiving back the remainder interested after a period of years would be the selling point of this approach.

BENEFIT TO YOUNGER GENERATIONS IN THE FUTURE: If you have children and you want to provide them with funds when they are all in the age wherein they can responsibly manage finances, a non-grantor charitable lead annuity trust will allow you to pass assets down a generation at minimum or no gift tax cost. A non-grantor lead unitrust will also you to pass assets down to your grandchildren at a minimum generatio-skipping transfer tax cost.

CHARITABLE DEDUCTIONS ARE ALREADY MAXED OUT: If you have contributed some substantial amounts to charity already and you cannot fully deduct your gifts due to the percentage limitations on income tax charitable deductions, CLT can be considered as it pays to your private foundation or to a donor fund that can, in turn, make grants to your chosen charities. The distributions from the CLT are deductible by the CLT and are not subject to the percentage limitation.

Grantor Versus Non-Grantor Trust Status

GRANTOR CLTs:  A grantor CLT offers the settlor with an instant charitable income tax deduction for the current value of the annuity or unitrust amounts to be paid to charity.  The grantor CLT is not allowed to claim a charitable deduction under IRC Section 642(c) for its distributions to charity.

 NON-GRANTOR CLTs.  A non-grantor CLT provides no income tax deduction to the settlor but can present substantial gift or estate tax savings.

The Charitable Beneficiaries

Types of Charities that Can Benefit:  Private foundations, support foundations, community foundations and other charitable receptacles such as donor advised funds can receive the CLT distributions.

Power to Change the Charities:  The charities to receive the lead interest may be named permanently in the trust document or may be modifiable by the settlor, the trustee or another.

Application of Private Foundation Rules

Excise Tax Provisions:  The excise tax provisions suitable to private foundations under IRC Sections 4941 to 4945 also apply to CLTs.  Therefore, the trust document should include specific prohibitions against their violation as required by IRC Sections 4947(a)(c) and 508(e).

Excess Business Holdings:  If the value of the charitable interest goes beyond 60% of the value of the trust at inception, IRC Sections 4943 (excess business holdings) and 4944 (jeopardizing investments) may apply.[22]

CONSULT WITH CREDO

CLT is an attractive gift plan if you are interested in supporting charities, especially with the current conditions (exceptionally low monthly IRS discount rates, a stock market that is at or near record highs, and the likelihood of increased estate taxation), if you are fretful about estate taxes (the odds that tax law changes may raise your estate tax exposure before the year ends), and if you are seeking a tax-efficient strategy to fulfill a multi-year pledge or to offset extraordinarily high taxable income in 2021. Consult with Credo if you are interested and want to understand more about Charitable Lead Trust and if it’s the right strategy for you and one of our CLT tax advisors will educate you on the best giving techniques for your particular situation.

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