A Deeper Dive into the Many Varieties of Charitable Lead Trusts
In our previous article we introduced Charitable Lead Trusts (CLT). This type of trust creates an income interest which the trustee pays to a charitable beneficiary for a number of years, and then the trustee transfers the remaining assets to a non-charitable beneficiary. This category of trusts, like the related Charitable Remainder Trust (CRT), is useful to those people who have charitable intentions and also want a way to reduce taxes. Typically, with Charitable Lead Trusts the client is trying to avoid estate taxes. Clients more commonly reduce income taxes by using Charitable Remainder Trusts, although in certain circumstances, a client can use a charitable lead trust to reduce income tax as well. Charitable Lead Trusts reduce taxes because of the way that the IRS values the assets that you put into the trust and the income payments that the trustee pays to the charitable beneficiary. The remainder interest is a gift to the remainder beneficiary. Because you are pushing the gift into the future, and because you are paying either a fixed amount or a fixed percentage of the asset value each year, the IRS discounts the current value of the gift. If you put $1,000,000 into a Charitable Lead Annuity Trust (CLAT) that pays $50,000 to a charitable beneficiary each year for 20 years, and the IRS uses a 2% midterm rate (the current rate as of April 2016 is 1.74%), then the IRS places a value on the gift to the remainder beneficiary at $182,430. Under this scenario, if the trust assets made enough income so that there is still $1,000,000 in the trust after your trustee has made all of the payments to the charitable beneficiary, then, by using a trust, you are able to transfer $817,570 to a beneficiary of your choice- usually your children- without those funds being subject to gift or estate tax. This example uses a variety of Charitable Lead Trust called a Charitable Lead Annuity Trust, or CLAT. There are a number of other types of Charitable Lead Trust, and choosing between them can change how much benefit your charitable and non-charitable beneficiaries receive. In this article we will review the different types of Charitable Lead Trusts, and provide some insight onto how they are best used.
Charitable Lead Annuity Trusts (CLATs)
Generally, we distinguish between Charitable Lead Trusts by the way the trust determines how much the trustee will distribute to the charitable beneficiary each year. The first type we will discuss is a trust we mentioned earlier in this article, the Charitable Lead Annuity Trust, or CLAT. CLATs pay a fixed amount to their charitable beneficiary. Your trustee needs to make these payments at least annually, and they need to be fixed at the time you create the trust. This means that the yearly payments don’t have to be equal, but at the time you create the trust, you have to decide what the trustee is going to pay the charitable beneficiary in every year of the income period. In most standard CLATs, the annual payment is a constant amount given every year of the income period. Usually the trust document lists this amount as a percentage of the initial value of the assets in the trust when the grantor funds the trust.
When a grantor chooses a CLAT, they are choosing predictability. They know that their chosen charity will receive a fixed amount each year until the income period ends or until the trust runs out of assets. The tradeoff for the stable payments to the charitable beneficiary is more volatility in the eventual gift to the non-charitable beneficiary. With fixed payments, if the assets in the trust increase slower than annuity percentage, it’s possible the trust will run out of assets and the remainder beneficiary will receive nothing. With CLATs, the IRS does not allow the grantor to add assets into the trust after the grantor forms the trust. If the assets increase in value faster than the annuity payment, the actual percentage of trust assets paid out each year will decrease as the trust assets grow. This means that a larger amount of trust assets will pass to your chosen remainder beneficiary thus escaping estate tax.
A grantor generally should not use a CLAT when the remainder beneficiary is a grandchild or further generations removed. This is because the IRS waits until the trust terminates to determine an inclusion ratio for Generation Skipping Tax (GST) purposes. This leads a CLAT to have an uncertain result in terms of GST tax. With a Charitable Lead UniTrust, which we will discuss in the next section, the IRS allows the grantor to allocate the GST Exemption upon the creation of the trust. This allows you to plan around the GST tax, making it possibly a better choice for grantors looking to give to those beneficiaries.
Charitable Lead UniTrusts (CLUTs)
The other main category of CLT is the Charitable Lead UniTrust (CLUT). With CLUTs, rather than the charitable recipient receiving a fixed dollar amount each year, the charity will receive a fixed percentage of the trust assets. Therefore, the trust cannot run out of assets before the income period ends. If the assets in the trust fail to grow faster than the percentage of the trust assets that the trustee pays to the charitable beneficiary, then payments will decrease, if the trust assets grow faster, then payments will increase. Since the amount of payments can change every year, the amount that the trustee will actually pay to the charity is variable, but the probability that the trust will last for the entire income period is almost guaranteed. Choosing a CLUT allows a grantor to give the charitable beneficiary access to the upside of the assets the grantor places into the trust. If the asset does well, the charity receives more, while still ensuring that the estate tax value of the trust will be greater than zero.
For example, if you zeroed out a trust, i.e. set the payout percentage and term of the trust in such a way that the IRS sets the value of the future interest at 0, with a payment of 6%, and initial assets in the trust were $1,000,000 and the trust value in the final year of the trust was $50,000, with a CLAT, the final payment is $50,000 and $0 goes to the remainder beneficiary, with a CLUT, the final payment to charity is $3,000, and the remainder beneficiary receives $47,000.
Unlike CLATs, a grantor can add assets to a CLUT during the life of the trust and, depending on how they structured the trust, they may be eligible to receive income tax deductions for the present value of the percentage of these contributions that the IRS calculates as going to the charitable beneficiary.
Increasing Payment Charitable Lead Annuity Trusts (IPCLATs)
With both CLATs and CLUTs, there is no way to give the trustee an option to pay net income or generally to choose between several payment options. This limits planning options, but there is a newer type of Charitable Lead Trust that does provide a planning opportunity. This type of trust, the Increasing Payment CLAT (IPCLAT) stem from a gap in IRS rules that do not require that annuity payments be an equal percentage every year. Also, unlike with a Charitable Remainder Trust, there is no requirement that the annual annuity payment be between 5% and 50% of the trust assets. How these trusts work is that when the grantor creates the trust, they specify how much the trustee will pay to the charitable beneficiary in each year of the trust’s existence. The grantor will have the trustee pay small amounts to the charity in the early years of the trust, and then make a large payment at the end of the trust. By controlling the payments in this way, the grantor can maximize the amount they transfer to the remainder beneficiary free of gift and estate tax.
The reason for this is, in the early years of the trust, the payments are low, allowing the trust assets to grow faster. Ideally, you would have your trustee invest in a high growth asset that doesn’t generate any taxable income.
For example, your trustee can invest in a portfolio of growth stocks and if the portfolio pays no dividends, and the stocks go up but the trustee does not sell the position, there will be unrealized capital gains, but no taxable income.
If you had a $1,000,000 dollar asset that you expected to grow at 12% a year, and you wanted to make a 10-year, zeroed out, CLAT, if the IRS discounts at 2%, you would have your trustee pay about $111,500 a year. At the end of this trust, you would be able to transfer about $1,150,150 to your remainder beneficiary free of gift and estate tax. If you made an IPCLAT, and pushed it to the extreme, so that the trustee only paid $1 in each of years one to nine, and then paid the charity about $1,220,000 in year ten, you would be able to transfer about $1,884,000 to your remainder beneficiary free of gift and estate tax. By using an IPCLAT over a CLAT, you have increased the amount transferred tax free by over $730,000.
In both scenarios, your trustee will try to invest and manage the trust assets so the realized trust income was equal to the amount given to the charitable beneficiary. The gift to the charitable beneficiary would generate a charitable deduction that offsets the trust income. When the trustee eventually transfers the trust assets to the remainder beneficiary, the remainder beneficiary will take the same basis in the remaining assets as the trust had in the assets, and will be responsible for paying capital gains tax if they eventually sell the assets.
Grantor CLTs vs. Non-Grantor CLTs
A question you may have at this point is how the IRS treats these types of trusts from an income tax perspective. It is important to remember that a CLT, unlike a charitable remainder trust, is not tax exempt. While the appropriate asset to put into a CRT is a highly appreciated asset that you may want to sell to diversify your portfolio, this type of asset would not work well in a CLT. A grantor should fund a CLT with a high basis asset which you anticipate will have a high growth rate.
In most of our discussion so far, we have been talking about non-grantor versions of these CLT trusts. In a non-grantor CLT, the grantor does not receive an income tax deduction, and the trust pays tax on the income made by the trust. The trust will be able to take a deduction each year equal to the amount paid to the charitable beneficiary. At the end of a non-grantor trust, the IRS does not include the trust assets in the grantor’s estate. With a grantor CLT, the grantor gets an upfront deduction for the present value of the interest given to the charity, rather than getting deductions when the trust actually gives the assets to charity, and the grantor is responsible for paying tax on the trust’s income. The assets in the grantor CLT are still included in the grantor’s taxable estate. In short, a grantor CLT is useful for clients in a year when they expect to have an income high enough to take the income tax deduction in the year they fund the trust, and a non-grantor CLT is useful for someone who wants to reduce estate taxes.
Grantor CLT
In a grantor CLT the grantor takes a tax deduction in the year that they fund the trust equal to the present value of the income interest that the trust will pay to the charitable beneficiary. Typically, someone will create a grantor CLT in a year when they have a spike in income that they want to offset. A common example of this is when someone converts a Traditional IRA into a Roth IRA. The IRS treats the grantor as the owner of the trust assets, so the grantor pays the taxes on trust income, but they do not receive deductions for the amount that the trustee pays to the charity each year; because they already received those deductions in in the year they funded the trust. Because the IRS treats the grantor as the owner of the trust assets, the IRS will include any assets in the Grantor CLT at the grantor’s death in the grantor’s taxable estate (usually, although this depends on the reasons they classified the trust as a grantor trust.) Normally, the reason the IRS classifies the trust as a Grantor CLT is that the grantor has kept a reversionary interest, that is to say, they will be the remainder beneficiary. If the remainder beneficiaries are not the grantor or the grantor’s spouse, then the grantor pays gift tax equal to the present value of the remainder interest. A Grantor CLT must be an inter vivos trust, meaning the grantor creates the trust during their lifetime rather than in their will.
A major risk of a Grantor CLT is that, if the grantor dies during the trust term, their final income tax return has to recapture a portion of the upfront charitable deduction that the grantor claimed when they formed the trust. Then, depending on the specific language of the trust, some or all of the assets in the trust will be includable in the grantor’s estate. At that point, the CLT ceases to be a Grantor Trust and becomes a Non-Grantor CLT, taxed as a complex trust, from that date forward.
Non-Grantor CLTs
In a non-grantor trust, the grantor does not receive a charitable deduction upfront, but the trust gets a charitable donation every year equal to the payment made to the charitable income beneficiary. The grantor no longer owns the assets put into the non-grantor CLT a for estate tax purposes, so they won’t be includable in the grantor’s taxable estate. The grantor pays gift taxes on the present value of the remainder interest only, because a charitable estate tax deduction offsets any tax on the present value of the income interest. Non-grantor CLT’s cannot own S-Corporation Stock however, so they may not be the proper vehicle for some grantors.
Intentionally Defective Grantor CLTs
An Intentionally Defective Grantor CLT is a mix between a grantor and a non-grantor trust. The grantor receives an upfront income tax deduction for the value of the income interest, and the grantor is responsible for paying tax on the trust income, but does not receive a charitable deduction in the years the trustee gives the assets to the charitable beneficiary; just like a normal grantor trust. But, the assets in the trust are not includable in the grantor’s taxable estate for estate tax purposes. There are additional benefits a grantor can be gain from intentionally defective grantor trusts that depend on the exact terms of the trust, but they are outside the scope of this article.
Testamentary vs. Inter Vivos
For non-grantor trusts, you have the option of creating these trusts either in your will or during your life. Each option has its pluses and minuses. One of the pluses of an inter vivos trust is fixation. This means that you fix the value of the assets at the time you place the asset in your trust. If you have an asset worth $200,000 that you think is going to go up in value, then if you make the present value of the benefit paid to the charity $100,000, then the amount that asset contributes to your estate is $100,000. If that asset does very well and increases in value so that there is $1,000,000 in assets left in the trust when the income period ends, that will not change the size of your estate. If you transfer an asset in your will, then the IRS will include it in your estate at its current value. You will get a deduction for the charitable component of the CLT, but you can get a similar deduction by simply giving to charity without a trust. The big advantage of testamentary giving is that you get a step up in basis upon death. With the fixation example above, when the remainder beneficiary received the $1,000,000, they would get the grantor’s basis of $200,000. When the beneficiary sells the asset, they will have to pay capital gains tax on $800,000. With a testamentary trust, the asset will get a step up in basis to $1,000,000 when it enters the trust, so the beneficiary avoids capital gains tax on the $800,000.
Qualified vs. Non-Qualified
A final distinction in CLT trusts is whether they qualify for charitable deductions. All of the trusts we have talked about in this article are qualified trusts. Technically, there are a large number of requirements that a grantor needs to follow to create a qualified CLT. A few, but not all, examples of these requirements are:
The trust must be irrevocable,
You need to structure the income payments as an annuity or a fixed percentage,
The trust must prohibit self-dealing,
The charitable beneficiary must be a qualified charity
If you wanted to create a split interest trust that gave money to a charity for a time and then gave money to a non-charitable beneficiary, but you didn’t want to follow all of the requirements, you can make a non-qualified CLT. Non-Qualified CLT are very flexible, but do not have any of the specific advantages of the qualified CLT that we have described throughout this article.