They have a large taxable estate with assets they anticipate will increase significantly in value over the next few years, including both securities and real estate.
As part of their estate and philanthropy planning process, Lauren and Jack are seeking a tax-advantaged strategy that allows them to provide certain charities with income streams for a period of time, and then to maximize the after-tax value of the estate they bequeath to their son. They would also like to ensure that a portion of their assets are not transferred to their son until he is much older.
A charitable lead trust, or CLT, which combines an estate planning strategy with a charitable device, may be the answer.
It’s certainly not a new concept―in fact, Jackie Kennedy Onassis’ will included a charitable lead trust, or CLT. What is changing, however, is the increasing popularity of CLTs as philanthropic and estate planning tools.
Perhaps you have assets that are likely to increase in value dramatically, and you’d like to reduce the tax impact of that appreciation on your estate. Maybe you intend that certain of your assets benefit a favorite charity for a period of time, and only later pass to your children or grandchildren. Or you may have a family business that you’d ultimately like to transfer to your children―without requiring them to sell the business in order to pay the taxes. In each of these situations, a CLT may provide significant advantages.
Structure and Types of Charitable Lead Trusts
A CLT is an irrevocable trust that may be set up during your lifetime (intervivos CLT) or at your death (testamentary CLT). The trust distributes an income interest to charity for a specified period of time, referred to as the charitable term. You have much flexibility in choosing the length of the charitable term and the amount of the payout. During the charitable term of an intervivos CLT, you can generally serve as trustee, thereby continuing to manage the trust’s assets.
At the end of the charitable term, the trust’s assets―including any growth in value―are transferred to a noncharitable beneficiary. In the case of a grantor CLT, the noncharitable beneficiary is generally you as the trust’s original grantor. For a nongrantor CLT, the beneficiary is someone other than you―for example, your children or grandchildren.
A CLT, whether grantor or nongrantor, is established as one of the following two types:
Charitable Lead Annuity Trust (CLAT)―a charitable lead trust that distributes a fixed percentage of the initial value of the trust assets, paid out over the charitable term.
Charitable Lead Unitrust (CLUT)―a charitable lead trust that pays a percentage of the value of the trust’s assets, determined annually, during the charitable term.
The choice determines the manner in which the income stream to charity is calculated.
Tax and Financial Benefits of Nongrantor Charitable Lead Trusts
When your assets are transferred to a nongrantor CLT, you receive a gift and estate tax charitable deduction based on the present value of the charitable income stream. The higher the payout and the longer the charitable term selected, the higher the deduction.
A nongrantor CLT is a taxable entity, therefore any income earned or capital gains realized from the assets in the trust are taxed to the trust, and not to you. The trust also receives a charitable deduction when payments are made to the charity. You are not entitled to a charitable deduction for income tax purposes on your individual return.
Because assets transferred to the CLT are not considered part of your estate, any significant appreciation in value is not subject to gift or estate tax. The growth in value is essentially transferred tax-free to your noncharitable beneficiary.
For example, assume you put $1 million dollars in a CLAT today, with a charitable term of 20 years and an annual payout of 6.85 percent. Using the appropriate current §7520 rate of 3.2 percent, the present value of that charitable payment stream (the charitable gift tax deduction) is equal to the full $1 million transferred to the trust. If the assets in the trust grow at 8 percent, $1.37 million will pass to charity and roughly $1.5 million will pass to your heirs free of estate and gift tax at the end of the charitable term.
It is important to note that generation-skipping tax implications should be considered if the noncharitable beneficiary is a grandchild or great grandchild.
Tax and Financial Benefits of Grantor Charitable Lead Trusts
Grantor CLTs are primarily income tax planning tools. The grantor takes charitable income and gift tax deductions for the actuarially determined fair market value of the income interest in the year the trust is created, subject to certain adjusted gross income limitations.
Because of this large front-loaded deduction, a grantor CLT may make sense for a person in a high income tax bracket, or someone with a one-time liquidity event that results in an unusually high income tax liability in the year of formation. Because the grantor retains enough control over the assets to be treated as the owner of the trust, the grantor generally pays income tax on the trust’s income or capital gains.
Using the scenario from the example above, the donor of a grantor CLAT receives an up-front charitable deduction of $1,000,000, subject to adjusted gross income limitations. As a result, this trust is most useful to high-income donors with high marginal income tax brackets.
At the end of the charitable term, the trust’s assets―including appreciation―revert back to the grantor. Consequently, grantor CLTs are of limited value in reducing estate taxes.