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What is a Charitable Lead Trust?
I will cut right to the chase – Charitable Lead Trusts are not designed for most people. In fact, by “most people” what I mean is individuals with less than $11 million in net worth or couples with less than $22 million in net worth, with a few exceptions. Why is that the case? Charitable Lead Trust’s primary benefit is reducing the cost of wealth transfer to a future generation and as of the time of this writing every individual can transfer $11.58 million dollars without any estate or gift tax consequences.
So why am I writing this article? Three reasons. I wanted to do a complete series on different charitable planning strategies. The series started with gifting appreciated property and donor advised funds. My favorite charitable strategy involves combining these two by bunching appreciate stock gifts to donor advised funds. The next blog discussed Qualified Charitable Distributions (QCDs) and the latest blog discussed Charitable Remainder Trusts, the reverse twin of the Charitable Lead Trust. The last blog of this charitable planning series is this one, covering Charitable Lead Trusts.
The second reason to write this blog is because I (like many) do not believe the estate tax exemption will remain at roughly $11 million per person forever. In fact, the exemptions are scheduled to be cut roughly in half beginning in 2026. In a low estate tax exemption environment, a Charitable Lead Trust will become a much more common and necessary planning consideration for those who are charitably minded and looking to mitigate estate and gift taxes.
Finally, I simply wanted to deepen my own knowledge on the ins and outs of Charitable Remainder Trusts and Charitable Lead Trusts. Is there a better forcing mechanism to learn something than having to publicly write about it? However, while the applicability might not be far and wide, it is hard to overstate the power of Charitable Lead Trusts as shown below.
How It Works
A Charitable Lead Trust is a split interest trust, meaning the beneficiary interest of the trust is split. With a Charitable Lead Trust, a charity receives regular payments (usually annually) for a certain number of years and at the end of that term the remainder noncharitable beneficiaries receive what is left. Generally, and for our discussion today, the remainder beneficiaries are the children or other descendants of the person who placed the property into the Charitable Lead Trust.
There are multiple reasons why an individual would set up a Charitable Lead Trust, but the primary reason is to reduce the costs (taxes) of transferring wealth to the next generations. The current estate and gift tax rate is 40%. This 40% rate is applied to the portion of a individual’s wealth transferred during life or at death that exceeds the exemption, which is $11.58M in 2020. Given this rate, most people prefer to leave some of their assets to charity to reduce the amount left to the government. Charitable Lead Trusts attempt to do that using appreciating property and discounts rates.
Chip has built a net worth in excess of $11 million and is beginning to look at his estate planning. In particular, Chip is looking to transfer a $2 million piece of commercial real estate that produces $200,000 in annual cash flow, to his children. In January of 2020 Chip contributes the building to a Charitable Lead Trust which states that an annual donation of $100,000 will be made to the charity for 15 years at which time the remaining assets in the trust will pass to the beneficiaries, Chip’s children. The present value of the annuity payments to charity is $1,284,930. The balance of $715,070 is a gift to Chip’s children that must be reported as a taxable gift in 2020. Chip’s use of a Charitable Lead Trust successfully reduces his estate and gift tax by $513,972 ($1,284,930 x 40%) up front. In addition, any appreciation of the building or growth inside the trust by investing the excess cash flow will ultimate pass to his children in 15 years without being subject to estate or gift tax because he locked in the $715,070 gift up front.
Two Main Types (CLATs vs. CLUTs)
There are two primary types of Charitable Lead Trusts. Charitable Lead Annuity Trusts (CLATs) and Charitable Lead Unitrusts (CLUTs). The primary difference between a CLAT and a CLUT is that a CLAT establishes regular charitable payments upfront. The regular charitable payments out of a CLUT however, are redetermined annually based on the FMV of the trust property each year.
If Chip were to establish a CLUT instead of a CLAT the payout percentage might be 5% of the annually determined FMV of the trust property. This causes the charitable payment to increase as the value of the building increases. CLUTs spread the investment risk and reward between the charity and the remainder beneficiary. Given that most people expect investments to appreciate over an extended period, CLUTs are far less common as the charity participates in that appreciation leaving less assets for the remainder beneficiaries at the end of the term.
A second important difference is the way the IRS handles CLATs vs CLUTs when the remainder beneficiary is someone two generations removed from the donor, such as a grandchild. The IRS does not allocate Generation Skipping Tax exemption until the assets are distributed to the remainder beneficiary. This fact makes CLATs inappropriate when the ultimate beneficiary is a grandchild or other skip person.
CLAT vs. CLUT Comparison
|Charitable Lead Annuity Trusts||Charitable Lead Unitrusts|
|Annual Charitable Payment||Fixed percentage of initial contribution||Percentage of fair market value re-determined annually|
|Subsequent Contributions||Only one initial contribution to the trust is allowed||Subsequent contributions to the trust are allowed|
|Administrative Costs||Less expensive than CLUT. No annual valuation needed.||More expenses than CLAT. Annual valuation of property needed.|
|Generation Skipping||Not ideal for skip persons such as grandchildren.||More effective than CLATs for skip persons such as grandchildren.|
Zeroed Out Charitable Lead Trusts
The donor who establishes the trust sets the rules of the trust as long as they are within IRS guidelines. This flexibility allows the donor to create a CLAT that when discounted effectively appears to leaves nothing to the remainder noncharity beneficiaries. This type of trust has been called a Zeroed Out Charitable Lead Annuity Trust which is a CLAT where the donor sets the charitable payout rate at an amount that will result in the present value of the charitable donation equally the fair value of the property that is contributed.
Chip’s advisor reviews Chip’s Charitable Lead Trust before it is finalized and recommends that Chip increase the charitable payout rate to 7.78% instead of 5%. This will produce a $155,700 annual charitable payment instead of the original $100,000. The result is that the present value of the charitable payments is $2M and with the fair value of the building at $2M the gift to the remainder beneficiaries is valued at $0. Chip does not have to recognize any gift as having been made to his children. Rent income in excess of the $155,700 charitable payout plus any appreciation in the building will be transferred to the children free of estate or gift tax in 2035.
The IRS 7520 rate has a meaningful impact on the outcome of the CLAT. The chart below compares Chip’s Zeroed Out Charitable Lead Trust in January 2020 with the same scenario but in August of 2007 when the IRS 7520 Rate was 6.2%. Notice the value ultimately received by the remainder beneficiaries after 15 years ($2,520,249) is the same in both scenarios but in August of 2007 a $466,409 taxable gift must be recognized when the trust is funded due to the higher IRS 7520 rate. Charitable Lead Trusts work best with a low 7520 Rate which makes the current environment especially appealling.
Zeroed Out Charitable Lead Trust
|August 2007||January 2020|
|FMV of Trust||$2,000,000||$2,000,000|
|Term of Payout||15 Years||15 Years|
|Discount of Charitable Payments||$1,533,591||$2,000,000|
|Discount of Taxable Gift of Remainder Interest||$466,409||$0|
|Value Received by Remainder Beneficiaries After 15 Years||$2,520,249||$2,520,249|
Increasing Payment Charitable Lead Trust (IPCLAT)
A second planning technique used is the Increasing Payment Charitable Lead Trust. Charitable Lead Trust does not have minimum or maximum annual payout requirements like a Charitable Remainder Trust. What this means for donors is that a Charitable Lead Trust can be set up to provide a substantial portion of the charitable payouts in the later years of the payout period instead of evenly across the period. The effect is the trust assets can grow quicker as they compound in the early years with little to no charitable payments.
Trustees should be aware that if the charitable payout is minimal in the early years any taxable income generated by the trust will be taxable. For this reason, IPCLATs are typically invested in assets that grow tax deferred such as growth stocks. Below is an example of the effect the early compounding of an IPCLAT can have on the outcome of the wealth transfer.
Increasing Payment Charitable Lead Trust
|FMV of Trust||$2,000,000||$2,000,000|
|Term of Payout||15 Years||15 Years|
|Value of Charitable Payments||$2,000,000||$2,000,000|
|Value of Taxable Gift of Remainder Interest||$0||$0|
|Value Received by Remainder Beneficiaries Estate & Gift Tax Free||$2,119,469||$3,653,455|
Drawbacks of Charitable Lead Trusts
Charitable Lead Trusts, like any planning tool, have their pros as well as their cons. The major downsides are the administrative costs and burdens that come with navigating compliance for these special vehicles. Charitable Lead Unitrusts must also require annual valuations to determine the fair market value of the trust property for the charitable payout amount.
Second, the entire premise of the Charitable Lead Trust is that the property contributed should grow at a rate in excess of the 7520 rate. If the asset cannot outperform the 7520 rate then the trust is not leveraged to its potential. For this reason, Charitable Lead Trusts are best suited for assets that are likely to appreciate greatly to overcome the benefit that a step up in basis would have provided shoud the assets have been left to the beneficiaries outside of the Charitable Lead Trust.
Charitable Lead Trusts are a power vehicle for charitably minded individuals looking to transfer assets to the next generation and due so in a tax efficient way. Charitable Lead Trusts are typically leveraged to reduce estate taxes while Charitable Remainder Trusts typically function as an income tax planning vehicle. Unlike Charitable Remainder Trusts, today’s low interest rate environment is the perfect time to consider a Charitable Lead Trust as the rate at which assets must grow to make the arrangement effective is near all time lows. Should the estate and gift tax exemptions be severely reduced as is currently being suggested in Washington D.C., more and more households will want to understand the potential value a Charitable Lead Trust could bring to their family’s estate plan.