Charitable Lead Annuity Trusts
Our discussion about CLATs last month generated a great deal of reader feedback, so we'll use this space to delve deeper into the topic and answer some of the more frequently asked questions about this tax-advantageous charitable-giving technique.
The bad news first. Given the economic woes America has experienced over the last few years, charitable organizations have been struggling to raise money at a time when demand for these organizations’ services is at its highest. The good news is that with federal interest rates at historical lows, the time has never been better for tax favored philanthropy. This article will explore one such tax favored philanthropic vehicle, namely the Charitable Lead Annuity Trust (CLAT). As this article goes to print, rumors are swirling that Congress may amend the tax laws to limit the effectiveness of utilizing CLATs as a wealth transfer strategy; therefore, readers are strongly encouraged to get in while the getting is good.
A CLAT is structured to provide a charitable organization an income stream (a fixed-dollar annuity payment) during the term of the CLAT with any assets remaining in the CLAT passing gift tax free to a pre-designated beneficiary(ies). The annuity payment is based on the “7520” rate which is announced each month by the IRS. The 7520 rate is effectively the rate that the IRS assumes assets will grow, regardless of how the assets actually perform. As long as the CLAT assets outperform the 7520 rate, then the designated beneficiary will receive some assets when the CLAT terminates. The lower the 7520 rate, the more likely a sizeable amount of wealth will be transferred. With 7520 rates set at 2.4% for September 2010, the likelihood of a very successful CLAT is excellent.
For example, using the September 2010 7520 rate, a contribution of $1,000,000 to a CLAT with a term of 5 years and a 7% assumed growth rate, would result in an annual payment of $209,600 to the charity, and $112,822 passing tax-free to the beneficiary at the end of the 5 years, when the trust terminates.
In our example, the CLAT has been “zeroed-out” so that no gift tax would be payable at the time of the contribution. When interest rates are low, a smaller annuity payment can be utilized to zero out the CLAT because the annuity is worth more. However, if a donor is willing to pay a gift tax at inception, a CLAT can be established with an even smaller annuity payment to ensure a larger remainder passes to the CLAT’s beneficiary at termination.
CLATs can be established as either grantor or non-grantor trusts. If a CLAT is established as a grantor trust, the donor will receive a charitable deduction at the time of the contribution equal to the present value of all of the annuity payments that will be made to the charity over the term of the trust. In our example, the donor would be permitted an income tax deduction of $1,000,000 on his return for the year of the contribution. On the downside, the donor will be taxed on any income the trust earns during the term of the trust. A grantor trust is a good structure for an individual who has a large spike in income during one year (e.g. an individual who sold his business or converted her IRA to take advantage of favorable tax rates). By deducting the contribution up front and reporting income over the term of the trust, the grantor has effectively “smoothed” his income out over the term of the trust. Further, a grantor trust could avoid an annual income tax burden by investing in growth assets or tax-exempt bonds. However, if the bonds do not earn more than the 7520 rate and the trust was zeroed-out at its inception, the CLAT would not be successful in that nothing would pass to the beneficiary at the trust’s termination.
On the other hand, if a CLAT is established as a non-grantor trust, the donor is not entitled to a charitable income tax deduction at the time of the contribution, but avoids being taxed on the trust’s annual income. The non-grantor trust is an excellent structure for donors with low income in the year of the gift, donor’s who have “maxed-out” their charitable contributions for the year, or donors who plan on contributing property with high annual tax obligations (e.g. a stream of royalty payments taxed as ordinary income, at federal rates which may exceed 40% in the coming years). Although a charitable deduction is not allowed, by contributing high-yield assets, the donor is effectively receiving a future income tax deduction by eliminating the annual tax obligation.
Whether one favors the grantor or non-grantor structure, now is the perfect time to employ the CLAT giving technique. Because the 7520 rate is so low, even assuming conservative estimates of rates of return, it is likely that the assets in a CLAT would outperform the statutory rate, thereby transferring a significant amount of wealth tax free to the remainder beneficiary; and because Congress may pass legislation prohibiting the ability to zero out a CLAT, the time has never been better for the charitably inclined to utilize the CLAT giving technique.