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Charitable Lead Trusts
(A presentation to the Museum of Modern Art, by Michael I.
Frankel of Carter, Ledyard & Milburn and Anthony Marshall of Bankers Trust
Company on March 13, 2000)
1.What is a charitable lead trust (CLT)?
1.1 Involves a transfer of property to a trust, creating an "income
interest" in favor of a charitable organization for a term of years or the
life of an individual, with the remainder payable to non-charitable
beneficiaries.
1.2 For the charitable "income interest" to be deductible, it must
be in the form of a guaranteed annuity (CLAT) or unitrust (CLUT) amount. No
minimum fixed rate.
1.2.1 A guaranteed annuity amount is a fixed dollar amount, expressed as
either a fixed sum or as a percentage of the initial value of the trust's
assets. The fixed amount does not change annually.
1.2.2 A guaranteed unitrust amount is a fixed percentage of the value of the
principal of the CLUT determined each year. Because the value of the trust's
assets will vary, the unitrust amount will vary from year to year.
2. Why is a CLT used?
2.1 To pass assets to the grantor's heirs at a reduced transfer tax (estate
tax, gift tax and generation-skipping transfer tax (GST)) cost. This is because
the tax is imposed only on the present value of the remainder. In general, the
charitable interest is not subject to transfer tax.
2.2 To transfer a current stream of income to a charitable organization. This
may be a private foundation, subject to caveats concerning the grantor's
control.
3. What are the income tax
consequences of CLTs: Grantor and Non-Grantor Trusts?
3.1 Grantor trust.
3.1.1 Inter vivos trust. Used to obtain an income tax deduction for the
present value of the charitable interest. But
the grantor is taxable on all trust income, even though that income is used to
make payments to charity. (Possible use of municipal bonds as a trust
investment, which has other drawbacks).
3.1.2 If the trust ceases to be a grantor trust during the trust term (for
example, if the grantor dies), there is a recapture of part of the charitable
deduction: the grantor or the grantor's estate must report as ordinary income
the difference between the charitable deduction claimed and what would have been
allowed for a trust with a term ending on the date the trust ceased to be a
grantor trust.
3.1.3 Care must be taken in what makes the trust a grantor trust. The grantor
may be given a reversionary interest to qualify the trust as a grantor trust,
but this may not be useful for estate or gift tax planning. In order to transfer
wealth to other family members, consider use of a foreign trust or a power to
substitute assets of equivalent value held by a non-adverse party.
3.1.4 Non-grantor CLT is generally considered more advantageous. Balance of
remarks focus on that type of CLT.
3.2 Non-grantor trust.
3.2.1 May be inter vivos or testamentary. No income tax deduction is
available to the grantor, but
the income earned by the trust is not included in the grantor's income. The
trust will get an income tax charitable deduction for amounts paid to charity;
there are no percentage limitations on this deduction.
EXAMPLE 1: Donor is a charitably inclined individual, who gives $40,000
each year to MOMA. He has assets with a value of $500,000 earning about 8
percent annually which generate the income to make this gift. He takes $40,000
into income each year and receives an offsetting income tax charitable
deduction. Instead, Donor places the $500,000 into a CLAT which pays $40,000
to MOMA each year for 21 years. The annual income is not included in Donor's
income each year, leaving him in the same position he was in when he made the
gift directly. The trust takes the $40,000 into income annually and receives
an offsetting income tax charitable deduction. In addition, the $500,000 is
now out of Donor's estate, and will pass tax free to his heirs at the end of
the 21 year CLAT term. The cost for this benefit is a gift of about $80,000,
the present value of the remainder interest.
3.2.2 With a CLAT, the annual payments are fixed, whereas with a CLUT, the
payments vary depending on changes in the value of the trust. Thus, with a CLAT
appreciation inures to the benefit of the family, while with a CLUT, charity
shares the benefit of appreciation in value.
4. What are the estate and gift tax
consequences of CLT's?
4.1 A principal benefit of a CLT is that in computing the amount of the
transfer subject to estate tax (for a testamentary CLT) or gift tax (for an
inter vivos CLT) you subtract the value of the charitable interest. This value
is based on three factors: (i) the IRC Sec. 7520 interest rate which applies to
the transfer, (ii) the amount to be paid to charity each year during the trust
term, and (iii) the length of the trust term.
4.1.1 The IRC Sec. 7520 rate varies monthly and is currently 8.2 percent. In
valuing a transfer for estate or gift tax purposes, the taxpayer may use the
Sec. 7520 rate for the month of the transfer or either of the two preceding
months. The Sec. 7520 rate for February was 8.0 percent and for January was 7.4
percent. With a CLAT, a lower gift tax or estate tax value for the remainder
interest will result with a lower Sec. 7520 rate. The examples herein,
therefore, use the January rate of 7.4 percent.
4.1.2 The IRS calculations assume the trust will earn the Sec. 7520 rate each
year. If the annual payout rate exceeds the Sec. 7520 rate, the IRS assumes
trust principal must be used to make the charitable payments. If the annual
payout rate exceeds the Sec. 7520 rate by enough, and the term is sufficiently
long, the calculation assumes all the trust principal will be paid to charity.
In other words, with an annuity trust for a fixed term, it is possible that the
value of the calculated charitable interest will be equal to the value of the
assets transferred to the CLT. In that event, there is no estate or gift tax
due. The trust is said to be "zeroed out" and is referred to as a
zeroed-out CLAT. If the term of the trust exceeds 21 years, the rule against
perpetuities must be taken into account.
EXAMPLE 2: Donor places $1,000,000 of assets in a CLAT which provides that
9.73 percent of the initial value ($97,300) is to be paid to MOMA each year
for 21 years. Using a Sec. 7520 rate of 7.4 percent, the value of the
charitable interest equals the value of the property transferred to the trust;
the remainder interest has no gift tax value. At the end of the trust term,
all assets remaining in the trust will be transferred to Donor's children,
free of tax. If the trust earns $97,300 annually, the full $1,000,000 will
pass to the children. If it earns a greater amount, then more will pass to the
children free of transfer tax. If the trust earns less than $97,300 but more
than $74,000 (based on the Sec. 7520 rate), then the children will receive
some amount less than $1,000,000 when the trust terminates. If the trust earns
$74,000 or less, then all the trust assets will pass to MOMA and nothing will
be left for the children.
4.1.3 A unitrust cannot zero out. This is because the payments to charity
increase or decrease as the trust increases or decreases in value. It is often
the case that at the same payout levels, an annuity trust will result in a
smaller taxable gift than a unitrust. Charts 1 through 8 (chart1,
chart 2, chart
3, chart 4, chart
5, chart 6, chart
7, chart 8) compare the amount of the
taxable transfer for CLATs and CLUTs at payout rates ranging from 8 to 15
percent.
EXAMPLE 3: Assume the same facts as Example 2, except Donor creates a CLUT
(instead of a CLAT), with 9.73 percent of the value of the trust determined
annually to be paid to MOMA. This results in a gift of $136,127 (13.6127
percent of the amount transferred), which may be sheltered from gift tax by
use of Donor's unified credit.
4.2. It is advantageous to use assets with a discounted value to fund a CLT.
This is because the cash flow from the asset represents a greater percentage of
its discounted value than its undiscounted value. Care must be taken not to
violate the excess business holdings rules, which may apply to a CLT.
EXAMPLE 4: Assume the same facts as Example 2, except the $1,000,000 of
assets consist of a limited partnership interest which may be discounted 30
percent for estate or gift tax purposes. The limited partnership earns 9.73
percent of its undiscounted value annually. If the payout rate is kept the
same, the trust will still zero out in 21 years. However, more will be left in
the trust when it terminates, because the annual payments to MOMA will be
reduced to 9.73 percent of the discounted value, or $68,110 (9.73 percent of
$700,000). The excess earnings of $25,590 per year ($97,300 less $68,110) will
remain in the trust. At 7.4 percent, those excess earnings will grow to
$1,202,750 (without considering income tax). Alternatively, the payout rate
could be increased to 13.9 percent ($97,300 divided by $700,000). This will
allow the CLAT to zero out after a term of about 11 years, so the children
will receive the principal about 10 years earlier.
4.2.1 No gift will occur on revaluation by the IRS of assets transferred to a
zeroed-out CLAT (which may occur if difficult to value assets are transferred),
if the annuity amount is expressed as a percentage of the value of the trust.
Rather, the annuity amount will be retroactively adjusted.
4.3 It is desirable to use a CLAT when the spread between the sec. 7520 rate
and the real potential earnings rate of a trust is great. Compare the period of
"stagflation" with the current economic climate. Chart 9 shows an
historic overview of the Sec. 7520 rate.
4.4 A CLT may be created for a term measured by the life of an individual,
who may be the grantor or another person. If the life expectancy of the
measuring life is less than average, but the normal valuation tables of Sec.
7520 may be used to value the charitable interest, then the value of the
charitable interest will be overstated and the value of the remainder interest
understated. For example, assume a 50 year old individual established a CLAT for
his or her lifetime with an annuity of about 9 percent of the trust's assets,
based on a Sec. 7520 rate of 7.4 percent. If the trust earned 7 percent and the
individual died 3 years later, over 93.5 percent of the trust's assets would
remain for distribution to the non-charitable beneficiaries.
4.4.1 May a zeroed-out CLAT be used for the life of an individual? The
regulations under IRC Sec. 7520 now prohibit this result, so there will be some
taxable gift for a trust for the life of an individual (rather than a fixed
term). Although a Tax Court case has rejected the IRS position, it must be taken
into account in structuring the CLAT.
4.4.2 The IRS will allow use of the tables for an individual with an
incurable illness or other deteriorating physical condition, if there is a
greater than 50 percent probability that the individual will not die within one
year. If the donor's health is uncertain at the time of the transfer, it may be
advisable to obtain a medical opinion stating the likelihood that the donor will
survive for one year. This may be necessary to defend use of the valuation
tables, particularly if the donor dies within a year of the transfer.
4.5 An individual considering an outright charitable gift or bequest might
consider a zeroed-out CLAT instead. If the CLAT earns more than the Sec. 7520
rate, assets will pass free of gift or estate tax to the non-charitable
beneficiaries. If the CLAT earns the Sec. 7520 rate or less, all the assets will
pass to charity, the same result that would have occurred with an outright gift
or bequest.
5. What are the GST consequences of
a CLT?
At the end of the charitable term of a CLT, the property remaining in the
trust will pass free of estate or gift tax to the non-charitable beneficiaries.
However, if these beneficiaries are grandchildren or more remote descendants of
the grantor, then the assets passing to them will be subject to the GST. To the
extent the donor's GST exemption (currently $1,030,000) is allocated to the
trust, the GST is reduced and may be eliminated. The rules for allocating GST
exemption to a CLAT or a CLUT are different and are critical to planning in this
area.
5.1 With a CLUT, allocation of the GST exemption is allowed when the trust is
created, giving full effect to the charitable deduction. The portion of the
trust subject to the GST is determined by subtracting from 1 a fraction, of
which the numerator is the amount of GST exemption allocated to the trust, and
the denominator is the value of the property transferred to the trust, less any
federal estate tax or state death tax paid from the property and less any gift
or estate tax charitable deduction allowed for the unitrust interest.
EXAMPLE 5: Assume the same facts as Example 3, except at the end of the
charitable term the trust property passes to grandchildren or more remote
descendants. Donor may shelter the trust from the GST by allocating $136,127
of GST exemption to the trust when the trust is created. If the trust earns
9.73 percent, the $1,000,000 corpus will pass to the grandchildren at the end
of the charitable term, free of any estate tax, gift tax or GST. If Donor
wished, he or she could increase the initial corpus of the trust to
$7,566,000, and shelter the remainder interest from GST by allocating to the
trust the full GST exemption of $1,030,000. This would, however, increase the
initial gift to about $1,030,000. To the extent this exceeds the available
unified credit of Donor (and, possibly, his or her spouse) a gift tax would be
incurred.
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