Basic Features of the Charitable Lead Trust 1

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1 W E A L T H C A R E C A P I T A L M A N A G E M E N T : A D V I S O R E M A I L For the latest in Financeware news and Wealthcare resources, please see the last page of this document. A PRIMER ON THE CHARITABLE LEAD TRUST But all mankind s concern is charity. By George Chamberlin Alexander Pope The charitable lead trust is used by many of our clients as a technique to assist in the transfer of wealth, to reduce a client s tax burden and to control the ultimate disposition of wealth in appropriate cases. The trust is particularly useful for clients with charitable intent and is not limited to high net worth clients, though such clients may benefit the most from using such a trust. In this article, we will examine the charitable lead trust in light of what we, as advisors and consumers, should know about the various types of charitable lead trusts and how such trusts may be used in applying the Wealthcare process to our clients financial and tax planning strategies. Basic Features of the Charitable Lead Trust 1 The charitable lead trust, as its name implies, names one or more charities as the holder of the lead or income interest in the trust. The creator of the trust, also referred to as the donor or the grantor, chooses the charitable beneficiaries who, during the trust term, receive the lead interest in the form of a stream of income. When the income received by the charity is paid as an annuity amount the trust is called a Charitable Lead Annuity Trust (CLAT) and where the income is paid as a percentage of the annual value of the trust, the trust is called a Charitable Lead Unitrust (CLUT). The trust may commence currently or may be made to begin at the death of the person creating the trust - what is called a testamentary charitable lead trust. The term of the trust is generally set to run for a term of years or for the duration of one or more lives or a combination of the two 2. The longer the trust term, the greater the value of the income interest is to the charity. When the trust term ends, the remainder is paid to beneficiaries named by the donor - these beneficiaries are typically non-charitable and are usually family members, although the donor may be named the remainder beneficiary of a lifetime charitable lead trust. When created, the charitable lead trust is an irrevocable trust. This means that once 100 West Franklin Street, Richmond, VA p f

2 the trust is established, it cannot be cancelled or materially changed without the consent of the holders of the lead and remainder interests. Often, a change will require court approval to be effective. Care must be taken to remain in compliance with the tax laws if tax benefits are sought. Tax Treatment of Charitable Lead Trusts Though the basics of the charitable lead trust are straightforward enough, when we examine the trusts in light of the tax consequences associated with them, the differences between the trusts and the choices facing the client as donor become more complicated. First, the CLAT or CLUT may be treated as a grantor trust where the donor elects to be treated as the owner of the trust s income each year. This allows the donor to benefit from an income tax deduction for the charitable gift which occurs on the creation and funding of the trust. However, the donor is personally taxed on the income of the trust each year, which may offset the benefit of the current income tax deduction the donor received on establishing the trust. A testamentary charitable lead trust cannot be a grantor trust. If, instead, the donor opts for non-grantor trust treatment, the donor is not entitled to the income tax deduction for creating and funding the charitable lead trust. During the term of the non-grantor trust, the trust itself will be taxed at the higher trust income tax rates while the donor will not be taxed on the trust s income. In fact, a non-grantor charitable lead trust is subject to the alternative minimum tax rules and may be required to pay that tax. This approach does burden the trust with taxes that the donor could otherwise pay (if a grantor trust). Thus, where the donor desires to effectively pass a greater amount to the remainder beneficiaries, the donor might choose grantor trust status and assume the income tax burden. Finally, it is worthy of note that the assets that are transferred to a testamentary charitable lead trust receive a step up in basis to their fair market value. This makes the transfer of low basis assets to the trust appealing for the client creating such a trust in his or her will. Quite apart from the income tax treatment of the charitable lead trust is the handling of transfer taxes where the donor names other persons as the remainder beneficiaries of the trust. When the trust is established during the donor s lifetime, the donor has effectively made a gift of the assets funding the trust. The gift is split between the charitable lead interest and the remainder beneficiaries and the donor is entitled to a charitable gift tax deduction for the present value of the gift to the charity. This gift amount is calculated actuarially and the donor will not be required to pay gift tax on this portion of the transfer. However, as to the present value of the remainder interest, the donor will be required first to apply their lifetime exemption A Primer on the Charitable Lead Trust May 12, 2004 Wealthcare Capital Management All Rights Reserved PAGE 2

3 amount, currently $1,000,000, and then to pay gift taxes on the balance of the gift. The transfer tax situation is somewhat different when the trust is created and funded at the death of its creator - such a trust is called a testamentary charitable lead trust. As is the case during the donor s lifetime, we must determine the present value of the gift to charity - the income interest - and the donor s estate will be entitled to an estate tax charitable deduction for the value of that interest. The estate may shelter up to $1,500,000 of the present value of the remainder interest in the trust, depending on how much of the donor s exemption amount remains at death. Note that although the lifetime exemption for gifts is limited to $1,000,000, the combined exemption for an individual s estate is currently set at $1,500,000, thus allowing additional transfers at death without incurring transfer tax. The application of the charitable gift or estate tax deduction allows the donor some planning flexibility. For example, if the present value of the gift of income to the charity holding the lead interest is sufficiently large, the donor (or the estate) may be able to avoid transfer tax on the remainder interest altogether. This is referred to as zeroing out the estate. Even when transfer tax may be due, using the charitable lead trust allows the donor a powerful tool for transferring wealth to future generations and in reducing transfer taxes. The generation skipping transfer tax (GSTT) may also be a consideration in the context of the CLAT and CLUT. When the remainder beneficiaries are more than one generation below the donor who created the trust, the GSTT will apply to the transfer to the remainder beneficiaries. In the case of the CLAT, which is intended to maximize the amount passing to the remainder beneficiaries, the tax is based on the remainder value when the trust terminates. This may have the undesired effect of increasing the amount subject to the tax. On the other hand, the CLUT allows determination of the taxable amount at the time the unitrust is established. The donor s GST exemption may be fully utilized if the CLUT is the chosen approach. Note that it is possible to create a charitable lead trust that does not qualify for a charitable transfer tax or income tax deduction. Such a trust would typically be used to fund a charitable gift during the trust term with the trust taking a deduction for the charitable donation. The donor would normally hold the reversion - the remainder interest in the trust - and this would be a way to keep the donor from being currently taxed on the income from the assets held in the trust. This would not be a typical usage for most of our clients and is mentioned only to round out the tax discussion. A Primer on the Charitable Lead Trust May 12, 2004 Wealthcare Capital Management All Rights Reserved PAGE 3

4 Implementing the Charitable Lead Trust How may a client take advantage of the charitable lead trust as a planning tool? First, as we have seen in the previous discussion, the trust may be used in tax planning for a high net worth client. The client may choose to use the trust as a means to satisfy a charitable intent and subsequently benefit family members while avoiding income taxes. This works well with assets the client as donor does not require to meet personal needs currently or in the future. Thus, an important question for the wouldbe donor of a charitable lead trust is whether the donor can achieve his or her other lifetime goals without the specified assets that will fund the trust. This means that the advisor must be able to assess the client s financial situation to ensure that client objectives may be achieved. What type of assets might a client consider transferring to a charitable lead trust? The CLUT requires an annual valuation of its assets in order to determine the required payout to the charitable beneficiary. This means that liquid assets such as stocks and bonds or other securities, assets that are easily valued, will be the most effective choice for funding the trust. Illiquid assets that may be difficult and expensive to value would not be as desirable. The CLAT provides for a stated annual payout to the charitable beneficiary so there is no similar ongoing valuation issue. However, the remainder beneficiaries are directly impacted by the performance of the assets held in the trust because the lead interest may be satisfied from the income generated by the assets or the assets themselves and where performance is strong, more will remain in the trust to pass to the remainder beneficiaries. Thus it is important to consider transferring assets that are significantly appreciating in value. Who may be considered appropriate beneficiaries for the charitable lead trust? Naturally, the trust must have a charity as the lead beneficiary in order to qualify as a charitable lead trust. There are numerous established public charities from which the donor may choose one or more as the income beneficiaries. It is also possible for the donor to name a family foundation or other private charity as the beneficiary of the lead interest but it will be important to ensure that the donor has little or no control over this beneficiary. This is necessary to avoid potential negative tax consequences to the donor and the trust associated with the retention and exercise of control. The remainder beneficiaries, as noted above, are typically family members of the next or later generations. However, the client may consider using another trust as the remainder beneficiary in lieu of naming individual beneficiaries. This has the advantage of allowing the donor to name individual beneficiaries of the successor trust and to make provision both for continuing the trust and retaining some level of control over the disbursements from the successor trust to its individual beneficiaries. A Primer on the Charitable Lead Trust May 12, 2004 Wealthcare Capital Management All Rights Reserved PAGE 4

5 What level of control does the client have over the use of the trust income and assets? The trust instrument may provide that the charity must use the annual income paid by the trust for specific expenses. Thus, the donor might direct that the payments be used to support a specified program operated by the charity or to cover other specific items. Of course, the payments to the charity may be unrestricted and the donor should be careful to NOT retain the right to direct the use of payments going forward. Where the donor chooses to name a trust as the remainder beneficiary of the charitable lead trust, the donor may establish trust terms that condition the receipt of benefits from the trust on specified needs or events. Summary The charitable lead trust is a powerful planning technique for clients with charitable interests and may be implemented as part of a complex financial and estate advice package. The use of this trust provides advisors with an opportunity to help the client achieve important goals relative to both charities and heirs and to accomplish this as part of the overall financial strategy. It is important for the advisor to work with an attorney and tax expert to build and implement the charitable remainder trust in this context. The planning team may work with the client to assess whether the charitable lead trust will work for the client s particular goals and whether the CLAT or CLUT is the better vehicle for the client. Understanding the charitable lead trust and its potential role in your advice. This is the future of financial advising. 1 The subject of charitable lead trusts is thoroughly covered by a number of sources, most importantly the Internal Revenue Code and the resources available at the Planned Giving Design Center: Please feel free to contact the staff at Wealthcare Capital Management for additional information about the charitable lead trust and other planning techniques. 2 In 2000, the Treasury issued proposed regulations which restricted the individuals whose lives could be used as measuring lives for a charitable lead trust to the donor, the donor s spouse or a lineal ancestor of all of the remainder beneficiaries. This proposal was intended to avoid intentionally choosing a person with a short life expectancy as the measuring life for the trust. A Primer on the Charitable Lead Trust May 12, 2004 Wealthcare Capital Management All Rights Reserved PAGE 5

6 WEALTHCARE RESOURCES Notice: Existing Retirement Quizzards will be converted to regular plans by the end of this month. The Quizzard functionality will be removed, allowing advisors to work with full working plans for all of their clients Updated Disclosures To comply with new SEC disclosure requirements, we have revised investment-related performance disclosures which will be included in each report generated using our system. Click here for the content of these disclosures. A Primer on the Charitable Lead Trust May 12, 2004 Wealthcare Capital Management All Rights Reserved PAGE 6