CHARITABLE LEAD TRUSTS: PROVIDING FOR FAMILY AND PHILANTHROPY

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1 CHARITABLE LEAD TRUSTS: PROVIDING FOR FAMILY AND PHILANTHROPY Nadia A. Yassa, JD Director of Estate and Gift Planning Emerson College Nadia A. Yassa All Rights Reserved.

2 OVERVIEW A qualified charitable lead trust ( CLT ) is an irrevocable split interest trust. It pays an income lead interest to one or more qualified charitable organizations and a remainder interest to non-charitable beneficiaries when the trust terminates. CLTs may be inter vivos or testamentary. Taxation of a CLT for income tax purposes will depend on its characterization as either a non-grantor or grantor trust. CLTs created for estate planning purposes are typically structured as non-grantor CLTs, which are treated as complex trusts under Subchapter J. 2

3 NON-GRANTOR CHARITABLE LEAD TRUST Donor Transfer property Income Payments to Charity for one or more lives or a term of years (no limit) Family members Lead Trust Remainder to Family Annuity or Unitrust Charity Benefits Gift Tax Deduction No Income Tax Deduction No Income Tax Paid by Donor for Income Earned by Trust Growth in Trust Passes Tax-Free to Heirs Estate Tax Savings Increased Charitable Giving 3

4 VALUATION OF INTERESTS IN CHARITABLE LEAD TRUSTS Values of the charitable income interest and non-charitable remainder interest are determined upon the creation and funding of the trust. Values are determined based on IRS assumed rate of return known as the Section 7520 rate (CMFR). The donor may select the rate for the month in which the trust is established or the rate for either of the two previous months. The lower the Section 7520 discount rate, the higher the present value of the charitable income interest (and gift or estate tax deduction) and, accordingly, the lower the present value of the remainder interest (taxable transfer). 4

5 IMPACT OF LOW INTEREST RATE Non-Grantor 20-Year CLAT Funding $1,000,000; Payout 6% Feb Feb March 2015 (CFMR = 5.2%) (CFMR = 4.2%) $1,000,000 6% CLT with 20-Year Term (CFMR = 1.8%) Gift Tax Charitable Deduction Taxable Portion* $735,210 $801,170 $1,000,000 $264,790 $198,830 $0 With a 1.8% CFMR, a 20-year term charitable lead annuity trust will zero out at a payout rate of 6.0% * Assumes the donor s lifetime gift tax exemption has been fully exhausted. 5

6 BENEFITS OF NON-GRANTOR CHARITABLE LEAD TRUSTS To Leverage Transfers Subject to Gift and Estate Tax. Donors can use CLTs to freeze gift and estate values upon funding the trust to minimize overall transfer tax liability. Given historically low Section 7520 rates, donors can minimize or reduce to zero the gift to non-charitable beneficiaries. Any assets remaining when the trust terminates pass to heirs free of gift tax. Trust assets are removed from the donor s estate. To Stretch Donor s Income Tax Charitable Deduction. Although no income tax charitable deduction is received by the donor at funding, the donor does not pay tax on income earned by the trust. The trust receives an unlimited offsetting income tax charitable deduction each year for payments made to the charitable beneficiary. To Benefit Charity and Family Members. Donors can benefit charity(ies) immediately, while providing future financial benefits for family members and/or others. Any growth in the trust that exceeds the trust payout rate passes free of transfer tax to heirs. 6

7 REQUIREMENTS OF QUALIFIED CHARITABLE LEAD TRUSTS Payout and Term Distributions to charitable beneficiaries must be made at least annually, either as a fixed annuity amount or a unitrust interest. There is no minimum or maximum payout requirement for payments to charitable organizations. There is no maximum 20 year term (but subject to state rule against perpetuities laws). The lead term may be a term of years or term measured by life/lives of the donor, the donor s spouse and/or lineal ancestor(s) of the non-charitable remainder beneficiaries. CLT may not pay out net income. Therefore, flip, net income and net income with make-up options are not available. 7

8 REQUIREMENTS OF CHARITABLE LEAD TRUSTS (continued) Non-Charitable Remainder Interest Remainder beneficiaries may be family members, other noncharitable beneficiaries or trusts for their benefit. However, no IRC Section 2503(b) annual exclusion is available because the remainder interest is a gift of a future interest. Donor Control Issues For non-grantor CLT s, the donor may not serve as trustee or retain control of the trust assets. Otherwise, the full value of the trust could be includable in the donor s estate. 8

9 TYPES OF CHARITABLE LEAD TRUSTS Charitable Lead Annuity Trust ( CLAT ) (frequently used) Payouts to charitable organizations must take the form of a guaranteed annuity which may be a fixed dollar amount or a percentage of the initial funding amount. Additional contributions are not permitted. Only with a non-grantor CLAT is it possible to zero out the value of the taxable gift where the value of the guaranteed annuity is equal to the entire value of the property transferred to the CLAT. 9

10 TYPES OF CHARITABLE LEAD TRUSTS (continued) Charitable Lead Unitrust ( CLUT ) (less frequently used) Unitrust payouts to charitable beneficiaries are based on a fixed percentage of trust assets valued each year. Additional contributions are permitted. The CLUT s payout rate has a greater impact on determining the present value of the unitrust interest than the Section 7520 rate. Accordingly, the Section 7520 rate has little effect on computation of gift or estate tax charitable deduction. Because the growth of CLUT assets accrues proportionately to the benefit of both the charitable and non-charitable beneficiaries, it is not possible to zero out a CLUT, and the leveraging benefits of a CLUT are far less than those of a CLAT. 10

11 FUNDING The cost basis of property contributed should be considered carefully to avoid gains in excess of the CLT s offsetting income tax charitable deduction. Note that the remainder beneficiary will be required to assume the donor s cost basis for original funding assets received. 11

12 CASE STUDY: Ellen Owens Donor: Ellen Owens (widow, age 67), four adult children Twenty million dollar estate Long history of consistent annual giving to your organization Goals: Provide income stream to undetermined charitable organizations Realize transfer tax savings Create a permanent legacy Recommendation: Establish a charitable lead trust to establish a named endowed fund at your organization. 12

13 ISSUE 1: CLAT or CLUT? Ellen plans to use up her full gift tax exemption through other gifts so she would like to zero out the taxable gift for the CLAT. She is interested in benefitting her children, not her grandchildren directly through this trust. She would like to remove the full value of the CLAT from her estate. CLAT is the logical choice. 13

14 ISSUE 2: Term of Years or Measuring Life?* Under Table 90CM, Ellen has a life expectancy of 20 years. It is not possible to achieve a 100% deduction when a CLAT is based on life expectancy. Change to fixed term of 20 years. To zero out a CLAT for a term of 20 years assuming a Section7520 rate of 1.8% will require a fixed annual payout to charity of 6% ($60,000 per year). *Limited to donor, spouse, or a lineal ancestor of a non-charitable beneficiary. 14

15 ISSUE 3: Funding Asset If using low basis property, Ellen should consider including cash because this complex trust will realize capital gains (offset by annual charitable deduction for payments to charity). 15

16 NON-GRANTOR CHARITABLE LEAD ANNUITY TRUST Donor Ellen Owens Income Payments to Charity for 20 years Charitable Lead Annuity Trust Gift of $1,000,000 cash and some appreciated stock 6% ($60,000 annual fixed income) Charity Family members $1,915,300 Benefits Immediate gift tax deduction of $1,000,000 Annual payment to charity of $60,000; projected total payments $1.2 million Projected net benefit to heirs free to gift tax Full trust value out of donor s estate 5 16

17 DONOR PROFILE CHARITABLE LEAD TRUSTS Likely to have a taxable estate and be in a high income tax bracket. Might have maxed out income tax charitable deduction through other gifts. Has the capacity to make a substantial gift. Targeted appeal. Make a current gift to charity Transfer assets to heirs Reduce transfer taxes Reduce taxable income Reduce taxable estate 17

18 Thank You 18