Editor: Theodore J. Sarenski, CPA/PFS
Many high-net-worth individual taxpayers are charitably inclined and endeavor to tax-optimize their philanthropic goals. The opportunity for charitable planning in today's environment is immense and ranges from donating simple cash gifts to deploying sophisticated trust structures. Furthermore, the convergence of historically low interest rates and volatile financial markets creates unique opportunities for those with charitable goals. Tax advisers guiding high-net-worth taxpayers will be well served by sharpening their planning knowledge of current charitable giving tools and techniques. This column focuses on an often-underused planning technique, the charitable lead trust (CLT).General overview
CLTs are a powerful planning tool that can prove to be a tax-efficient way for a taxpayer to fulfill goals of both charitable giving and family wealth transfer. A CLT is a charitable split-interest trust that can be created during life or at death, under a revocable trust or will. The lead income interest is paid to the charitable organization, and the remainder interest is transferred to a noncharitable beneficiary (e.g., the donor, the donor's family). The income interest can be in the form of a "guaranteed annuity" interest (a charitable lead annuity trust (CLAT)) or it is a "unitrust interest" (a charitable lead unitrust (CLUT)).
For income tax purposes, CLTs can be drafted either as a grantor trust or as a nongrantor trust. If it is structured as a grantor trust, the donor receives an upfront charitable income tax deduction on formation of the trust and is then responsible for income taxes on future trust income. If it is structured as a nongrantor trust, a separate taxpaying trust is created and allowed an unlimited charitable income tax deduction under Sec. 642(c) for the income paid to charity. It is important to note that donors to a nongrantor CLT do not receive a charitable itemized income tax deduction.
The CLT is composed of the charitable interest, which is wholly deductible for gift and estate tax purposes, and the noncharitable remainder interest, which is wholly taxable for gift or estate tax purposes. The value of the charitable interest is calculated as the present value of the stream of payments to the charity over the charitable term (the computation of this present value is discussed next). The value of the taxable remainder interest is the difference between the trust's initial value and the value of the charitable interest.Comprehensive CLAT example
A is charitably inclined, faces a large estate tax, and wants to support her favorite charity during her lifetime. She creates a 10-year-term CLAT that is funded with $10 million, which will make yearly payments of a $1 million annuity to her chosen charity and pay the remainder to a trust for the benefit of her son, S. The value of the charity's annuity can be figured using the appropriate Sec. 7520 rate and Table B, "Term Certain Factors," of IRS Publication 1457, Actuarial Valuations.
Assume that the valuation date occurs during September 2021, when the Sec. 7520 rate is 1% (per Rev. Rul. 2021-16, Table 5). The Table B factor for a 10-year annuity at a 1% interest rate is 9.4713, which means that the present value of the charity's $1 million annuity is $1,000,000 × 9.4713, or $9,471,300. As the initial value of the CLAT is $10 million, the remainder interest, payable to S's trust, is valued at $528,700. Under the flush language at the end of Sec. 7520(a)(2), A may also elect to use the Sec. 7520 rate for either of the two months preceding the month in which the valuation date falls.
If the trust is established as a grantor trust, A will be entitled to an individual charitable income tax deduction of $9,471,300, subject to a limit of 30% of adjusted gross income (AGI), or the 20% limit if it was funded with long-term capital gain property (if the charity the trust is making donations to is not a public charity) (see Regs. Secs. 1.170A-8(a)(2) and 8(c)). A will also have made a taxable gift to S's trust in the amount of $528,700. Because A is the income tax owner of the trust during the 10-year term and the charity's interest is a fixed annuity, all of the investment growth of the CLAT will accrue to the remainder beneficiary, S's trust.
Although the nongrantor CLAT does not benefit A with an income tax charitable deduction, it may provide her with significant transfer tax savings. The trust assets will be removed from her taxable estate, and if the CLAT were to grow at a rate of 5% over the term, the remainder interest would be $3,711,054, all of which would pass to S's trust at a gift tax value of only $528,700. A CLT may also be designed to "zero out" the value of the noncharitable remainder interest to avoid making a taxable gift upon formation.Grantor trust vs. nongrantor trust
For income tax purposes, a grantor CLT may be advantageous to A in a year when her taxable income is particularly high. The benefit then compounds if A finds herself in a lower income tax bracket in subsequent years as she reports the CLT's income. However, it is probably best to use a grantor CLT only for donors who have a greater likelihood of surviving the trust's term, because the often-overlooked recapture of the charitable deduction applies under Sec. 170(f)(2)(B) when the grantor ceases to be the taxable owner of the CLT. Thus, if the donor dies before the end of the trust's expected term, he or she will have to include the following amounts as recapture income on his or her final return: (1) the value of the deduction allowed under Sec. 170, reduced by (2) the discounted value of all amounts that were required to be, and actually were, paid with respect to the income interest under the terms of the trust to the charitable organization prior to the donor's death (see Regs. Sec. 1.170A-6(c)(4)).
If A expects to remain in a high income tax bracket, a nongrantor CLT may prove more attractive. Because the CLAT will be entitled to take an income tax charitable deduction equal to its gross income included in the $1 million annuity paid to the charity, most (if not all) of the trust's income will not be taxed, effectively shifting that income from A (as compared with scenarios in which she either kept the $10 million or gave it to a grantor CLAT) to the charity. Of course, A will not receive a charitable income tax deduction for her very large gift to charity, but by her forgoing this benefit, the CLAT will likely get a 100% charitable deduction for its income. However, taxpayers should note that in any year trust income exceeds the charitable distribution, the trust will pay income tax on the "excess" taxable income.Low-interest-rate environment
An advantage of funding a CLT during the donor's lifetime is the ability to lock in a low interest rate, which (all else being equal) results in larger net wealth transfers. If assets in the CLAT outperform the Sec. 7520 rate, the excess earnings will pass to the remainder beneficiaries free of any transfer tax. To illustrate a CLT's interest rate sensitivity, consider the effect of increasing the presumed interest rate in the earlier example. If the Sec. 7520 rate were increased from 1% to 3%, the value of the charity's lead annuity interest would be reduced to $8,530,200, with an offsetting increase to the value of the taxable gift to S's trust, from $528,700 to $1,469,800.
As the Sec. 7520 interest rate rises, the value of the lead annuity interest decreases. Higher interest rates reflect (in part) the market's expectation of greater inflation, which also means that future payments of a fixed amount become less valuable. Thus, a hypothetical buyer would pay less for the same annuity, which means that the value of the charitable lead interest in the CLT correspondingly drops. As shown in the previous example, there is a dollar-for-dollar increase in the value of the taxable remainder interest for every decrease in the presumed value of the annuity, making CLTs much more attractive in a low-interest-rate environment.Maximizing charitable deductions for donors
Some individual taxpayers face significant limitations on their tax-deductible charitable contributions. The restriction may arise from limitations based on the taxpayer's AGI or on any carryover deductions not absorbed in each of the five succeeding tax years of the gift. A donor facing deduction limitations may transfer some income-producing assets to a nongrantor CLT as a potential solution. The CLT can offset 100% of its income because the trust has an unlimited charitable deduction under Sec. 642(c).
When a client donates assets to a grantor CLAT, he or she is entitled to a charitable deduction equal to the value of the assets transferred (assuming a zeroed-out CLAT) but will not have parted with the taxable income of that asset until the end of the CLAT term. On the other hand, when donating the same asset to a nongrantor CLAT, although the donor is in the same economic position as the donor to a grantor CLAT, his or her tax position is quite different. The donor to the nongrantor CLAT loses the upfront charitable deduction for the gift to the CLAT that the donor to the grantor CLAT gets to take. However, the donor to the nongrantor CLAT is relieved of any future tax on the income from the donated assets, while the donor to the grantor CLAT will have to include that taxable income on his or her own return, without additional charitable deductions for as long as the charitable lead term continues. If the donor cannot make full use of the charitable deduction because of AGI and other limitations, it is more advantageous to forgo the deduction in order to exclude 100% of the CLAT's income from the date of funding.The right assets
The most efficient assets for funding a CLT are those with high appreciation potential that generate cash flows, making the trust most likely to exceed the Sec. 7520 rate while facilitating annual distributions to charity. Given the volatility in the capital markets, many clients are holding depressed assets for which they expect a strong rebound. Funding the CLT with temporarily depressed assets may shift this rebound appreciation from the client's taxable estate to the remainder beneficiary without additional transfer taxes. Again, be sure to consider cash flows, since in-kind distributions to satisfy the trust's annuity trigger gains when using appreciated assets, as provided under Rev. Rul. 83-75.Increasing annuity payments
Given the fixed nature of an annuity trust, there is a concern that the annuity amount may exhaust the trust prematurely if investments underperform. One strategy to help mitigate this concern is to provide for increasing annuity payments, which backload the annuity payments. In the earlier years of the trust, the smaller annuity payments will allow for more trust assets to remain invested. Since more assets remain invested, underperformance may be mitigated, and outperformance may be magnified. This can be a significant advantage for the remainder beneficiary. A more aggressive form of increasing CLAT payments is the "shark fin" CLAT. This type of arrangement provides much larger payments in the latter years of the CLAT. When charted on a graph and outlined, it resembles a shark's dorsal fin. The IRS has not approved such aggressive payment structures, so advisers should proceed with caution.Testamentary charitable bequests
An individual with a substantial illiquid estate may want to eliminate the estate tax at death by leaving amounts above the applicable exclusion amount to a zeroed-out testamentary CLT that will benefit both the charity and the family. In most cases, the highest and best use of one's basic exclusion amount is to fund long-term dynastic trusts having a generation-skipping transfer (GST) tax inclusion ratio of zero. Thus, after expending the decedent's remaining basic exclusion and GST exemption amounts on such a trust, the remainder of the estate can fund a zeroed-out CLT, which is entitled to an estate tax charitable deduction in full and thus requires no additional basic exclusion amount to avoid estate tax. When the CLT terminates, all appreciation (net of tax paid on income for which the trust could not take the Sec. 642(c) deduction) will pass to the decedent's heirs free of estate tax. As this column discusses next, GST taxes require an additional layer of planning.GST tax issues
Unfavorable rules are in place for determining the inclusion ratio for CLATs under Sec. 2642(e). CLUTs and CLATs can allocate GST tax exemption to the noncharitable portion when funded for a skip person as the remainder beneficiary. However, if assets grow faster than the Sec. 7520 rate in a CLAT, then more GST tax exemption needs to be allocated at the trust's termination. This "adjusted exemption" does not allow the donor to leverage the GST tax exemption, nor can the inclusion ratio be truly determined until the trust's termination. It could also result in the GST tax exemption being wasted if the trust grows more slowly than the Sec. 7520 rate. Determining the inclusion ratio for a CLAT is beyond the scope of this column; however, when GST tax is a concern, CLUTs are preferable in order to avoid a taxable distribution or mixed inclusion ratio.Opportunity for trusted tax advisers
Philanthropy remains a top priority for many individual high-net-worth taxpayers. Although charitable giving is decidedly personal, it may also be an opportunity for trusted tax advisers to introduce tax-efficient giving strategies. Tax advisers who understand the tax benefits of CLTs have a timely opportunity to provide thoughtful, consultative advice and guidance to their charitably inclined clients.
|Robert A. Westley, CPA/PFS, CFP, is a senior wealth adviser at Northern Trust in New York City. He specializes in the financial management and wealth planning needs of high-net-worth individuals and their families. Mr. Westley is a member of the National CPA Financial Literacy Commission and a former member of the AICPA Personal Financial Specialist Credential Committee. David M. Barral, CPA/PFS, CFP, is a wealth adviser at Northern Trust Wealth Management in New York City. Theodore J. Sarenski, CPA/PFS, CFP, is a wealth manager at Capital One/United Income in Syracuse, N.Y. Mr. Sarenski is chairman of the AICPA Advanced Personal Financial Planning Conference. He is also a past chairman of the AICPA Personal Financial Planning Executive Committee and a former member of the Tax Literacy Commission. For more information about this column, contact firstname.lastname@example.org.