Charitable Lead Annuity Trusts

How a charitable lead annuity trust can be used advantageously in one’s estate plan.

July 19, 2007
by Michael Korbholz

A charitable lead trust (CLT) is a type of irrevocable trust that complements a charitable remainder trust (CRT). The CLT provides an income interest (the “lead” interest) to a charitable beneficiary and the remainder interest to a noncharitable beneficiary, which could be either the donor, the donor’s family members or other specified individuals. Here we’ll deal only with a CLT having family members as the remainder beneficiaries of the property used to fund it, not a CLT providing for the property to revert to the donor after the charitable interest expires. In the latter case, the tax benefit is limited to the relatively minor income tax savings that may be available.

Structure of CLTs

The CLT may provide a guaranteed annuity interest (fixed amount — a “CLAT”) or may instead call for a unitrust payout (one depending on the varying year-to-year value of the trust — a “CLUT”). In either case, the payout to the charity must be made no less frequently than annually. There are variants in how the payout formulae may be constructed, even for the CLAT, such as providing either a fixed percentage of the initial value of the trust or a fixed dollar amount, or changing the payout for all or some years, so long as the amount is determinable at the outset. Similarly, CLUTs can vary somewhat in their structure. These variations will not be discussed because the focus of this article will be on CLATs, which, at least at this time, offer greater potential gift and estate tax savings.

The CLAT’s “lead” interest can last for a short or long time, and it can be for a term of years, a measuring life, or a combination of both. The donor may serve as the Trustee, so long as certain quite palatable requirements are met and the donor is content with not being able to change the charitable beneficiary. Otherwise, an independent party can be used.

Tax Effects

Unlike CRTs, CLTs generally result in no income tax deductions for the donor. Creation of a CLT having, say, the donor’s children (or trusts for their benefit) as the remainder beneficiaries results in a gift for gift tax purposes. However, making a charity the intervening beneficiary reduces the value of the gift because the children are required to wait for a period of time before benefiting from the transfer. A CLT can be created also at death, with a comparable estate tax benefit, but this discussion will deal only with lifetime CLTs.

The amount of the charitable deduction, allowing the value of the gift to be determined, depends on the length of the term of the charity’s interest, the amount of the annual payout to the charity and, especially in the case of a CLAT, the interest rates prescribed by the Internal Revenue Code for use in these situations (the “Section 7520 rates”). Because of the enhanced value of CLATs where, as at present, the 7520 rates are historically low, the discussion and example that follow do not address CLUTs.

Discussion and Illustration

If the specified payout for the CLAT is not much greater than the Section 7520 rate, the value of the gift to the children would be reduced significantly, but the concomitant disadvantage is the equivalent reduction of what the children are actually to receive. Thus, this type of CLAT is suitable only where the donor has a significant charitable intent and the delayed gift to the children fits in with some other objective of the donor’s. On the other hand, the charitable intent need not be so pronounced if the assets used to fund the CLAT provide a return, both income and capital appreciation, that is much greater than the prescribed Section 7520 rate. The CLAT can work well in this situation, especially if the donor has used up all or most of her gift tax exemption equivalent.

Let’s assume that the donor owns an interest in a closely held business that she believes will have a 12 percent annual return over the term of the CLAT. The July 2007 applicable Section 7520 rate is 6.0 percent, but, as with CRTs, the rate in effect for either of the preceding two months may be used, making available a 5.6 percent rate for a July 2007 gift. A 15-year CLAT, entered into in that month, paying 10 percent annually to the charity, $50,000 at the end of each six-month period, would “zero out” the gift to the donor’s children: The value of the annuity payments to the charity would slightly exceed $1 million. As a result, if the trust actually earned 10 percent per annum, the children would receive at least $1 million without the transaction being characterized by tax law as a gift to them. Of course, if the investment results exceed those hoped for, so much the better — there would be more left for the remainder beneficiaries. Even if the investment return is less favorable than expected, the tax result does not change (but the children would receive less than the projected amount or nothing).

One can see that this technique has the same beneficial gift tax result as does a “zeroed-out” GRAT (grantor retained annuity trust), where the donor, instead of the charity, receives the payout during the trust’s term, with the difference being that all benefits can stay within the family unit. Thus, the donor should have a charitable intent before creating a CLAT, but if that intent is present, this type of arrangement can be an excellent way to give a handsome income stream to the favored charity while, at the same time, providing the chance for the remainder beneficiaries to receive a significant amount at the trust’s termination, all without the donor’s having been considered as making a gift to them.

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Michael L. Korbholz has almost 40 years of experience in serving numerous individuals and families, as well as individual and professional executors, administrators and trustees. He is certified by the State Bar of California Board of Legal Specialization.