The Charitable Lead Trust Is a Good Fit for Improving Markets

By Doug White

Of all the charitable planning tools, the charitable lead trust (CLT) is one of the more beneficial types of gifts. But, because of its complexity, it is also one of the least utilized planned gifts.

The current economic environment is uniquely ideal for lead trusts, with equity markets improving while interest rates remain relatively flat.

Taking that into account, donors can make a gift that will immediately generate income to one or more charitable organizations at relatively little cost to the family because of estate and gift tax savings.

At the end of the trust's term, its remaining assets are distributed to family members. Although the trust document must specify the payout amount, the donor does not have outright control over income distributions, but can only make suggestions about which organizations will receive the trust payments each year.

A lead trust established during lifetime can be set up as either a grantor or nongrantor trust for income tax purposes. Most lead trusts are of the nongrantor type.

If estate planning goals are not paramount, a grantor lead trust may be established, and thus the grantor would be subject to income taxes because of the retained reversion.

In other cases, the trust may be a grantor trust because of retained powers that cause the grantor to be taxed for income tax purposes but do not cause the assets to be pulled back into the grantor's estate for estate tax purposes.

The grantor lead trust is useful for someone who has unusually high income in the current year and wishes to accelerate charitable deductions for future charitable gifts into the current year.

Tax Consequences
A charitable lead trust is not exempt from income taxes. Whatever income is not paid to a charitable organization and any realized capital gains in a given year (other than gains realized on satisfaction of the payment obligation with appreciated property) are taxed at trust rates. The remainder value, the amount a donor is permitted to deduct when setting up a remainder trust, is, in a lead trust, the amount considered a taxable gift to the remainder beneficiaries when the lead trust is established.

While, at the outset, a tax may be due on a fraction of the trust's value if the donor has exhausted his or her applicable credit, by the end of its term whatever value the trust has grown to is not taxed.

When the assets are transferred to a noncharitable remainderman, usually children or grandchildren, the transfer takes place tax free (although the generation-skipping tax may apply when a grandchild is a remainder beneficiary). This is because a snapshot of the asset's value is taken at the time the trust is established and the value of the remainder, determined by an IRS calculation, is considered a gift for gift tax purposes.

What This Means
Assume that a person establishes a charitable lead annuity trust for a 20-year term with $1 million worth of stock, and that the trust pays an annuity to one or more charitable organizations totaling 5 percent per year. The equation to calculate the trust's income and remainder values depends on several factors: what goes into the trust, how much is paid out, how frequently payments are made and for how long. Plus, there is an additional important element: the IRS discount rate, which changes monthly. Over the past few years this number has dropped to historic lows, meaning the remainder of a trust established now is valued low. In July 2003, for example, the number was 3 percent, lower than it had ever been in the past.

Reminder: In the case of a charitable lead trust, as with other transfers involving a charitable gift, the donor can value interests using the IRS discount rate for the month of the transfer or for either of the two months preceding the month of transfer.

For this example, let's use a rate of 3.2 percent. Even though that was the rate in mid-summer 2003, it will give us a general idea of how it affects lead trust planning. The annuity value for the $1 million trust equals $730,000, and the remainder value equals $270,000. This means that of the $1 million, $730,000 is subtracted from the amount that is subject to tax.

For illustration purposes, without regard for state estate taxes, assume the donor is in a 40 percent transfer tax bracket, and assume the lifetime credit is completely used up. He or she pays $108,000 in gift taxes.

Contrast that to an IRS discount rate of a more historically typical 6 percent. The remainder value, all other factors being the same, is $426,500; income value is $573,500.v

By using a 40 percent transfer tax assumption, the tax would be $170,600. That is a tax increase of $62,600 for a trust with a 6 percent discount rate, even though nothing has changed other than the discount rate. The two examples cited are for a charitable lead annuity trust.

A lead trust can also be a unitrust, which pays a fluctuating percent each year based on the value of the trust's assets. The calculation to determine the remainder and income values for a unitrust is fundamentally different from that used to determine the same values for the annuity trust, and the results differ markedly. The discount rate has more of an impact on the annuity trust.

Remainder and income values for charitable lead remainder trusts with terms of 20 years and payouts of 5 percent, but with different IRS discount rates. The tax is calculated using a 40 percent transfer tax bracket.

As is clear, the lower the IRS discount rate, the lower the amount of remainder transfer subject to tax. While this is true for the annuity trust and the unitrust, the effect, as noted in the boxed example above, is much more dramatic with the annuity trust. The difference in remainder values for the annuity trust, for discount rates of 3.2 percent and 8 percent, is almost $240,000—nearly double. This shows how important the discount rate is in a charitable lead annuity trust. The difference between two lead unitrusts using 3.2 percent and 8 percent discount rates is far less, only a little more than $17,000.

Frozen at Transfer
Paying any tax at all may seem like a stiff penalty for being charitable, but because the asset's value is frozen at the moment it is transferred to the trust—at which time the tax is calculated—the potential benefit is real, and can be substantial.

Any growth in the trust's value by the time the asset is transferred to the noncharitable remainderman will go untaxed. This can also represent quite a benefit.

If the annuity trust grows to $2 million over the years, after the annual $50,000 payments to the charitable organization, the donor (should he or she still be alive) or the donor's estate (should he or she be deceased) will not pay any taxes on the transfer.

If applying a 40 percent transfer tax, the tax at that time would be $800,000. This is far more than the $108,000 tax paid at the time the trust is established.

If the $800,000 is discounted 5 percent per year, to take inflation or declining purchasing power into account over the 20-year period, then the resulting number would be about $301,000, still about two and one-half times the tax that would be due today.

There is no question that a lead trust generates the potential to make a sizable gift to a charitable organization at relatively little cost to heirs.

As for the growth outside a lead trust, it is true that assets without a payout obligation will grow faster. The assets in this case, if they were to grow at 7 percent per year for 20 years, would be valued at almost $4 million at the end of that time. This means the transfer tax, at the 40 percent rate, would be approximately $1.6 million, leaving the heirs $2.4 million after taxes The difference in the actual amount transferred to heirs is $500,000, but then we must subtract the tax difference as well, which, even at an inflation-adjusted value, is still more than $200,000.

But, as can be seen, far less tax is paid to the government and far more money is donated to the charitable organization. Over 20 years, the charitable organization receives $1 million.

Planned for Growth
A common goal of donors and practitioners is to get the value of the remainder amount to as low a number as possible while still planning for growth within the trust. While it is possible to generate a low number in other economic environments, a higher discount rate forces the donor to lengthen the number of years or agree to pay more to the charitable organization each year. Both actions have the effect of providing less for the noncharitable remaindermen.

One reason the nongrantor trust is more popular than the grantor trust is that the donor pays the tax on any income or realized gain in the grantor trust. The donor of a grantor trust, however, is able to take an income tax deduction for the income value deemed to pass to the charitable organization over the trust's term, a benefit not permitted to the nongrantor trust donor.

The main reason, however, for the popularity of the nongrantor lead trust is that it has more powerful estate planning potential than the grantor trust.

Unlike remainder trusts, lead trusts can pay less than remainder trusts and go for a longer period, as long as they do not conflict with state laws prohibiting trusts from existing in perpetuity.

Also, charitable distributions from a lead trust are not subject to the normal ceiling limitations. That is, the 30 percent and 50 percent limitations each year on what a donor may deduct for charitable contributions do not apply to distributions from a nongrantor lead trust. Although the donor does not get an income tax deduction for a contribution to a nongrantor lead trust, the donor is also not taxed on the income, resulting in a wash. It is as if the donor received all of the income and was able to give it away to a charitable organization without worrying about percentage limitations. Therefore, this is a good strategy for donors with percentage limitation problems.

Asset Management
The most common asset used to fund a lead trust is closely held stock in a family business that has the potential to grow over the years. Many times, the donor does not want the asset sold. Unlike in a charitable remainder trust, where the assets are almost always immediately sold because there is no capital gains tax, a lead trust typically holds on to the donated assets.

If the lead interest exceeds 60 percent of the value of the trust, the excess business holdings rules apply and require the stock to be disposed of by the trust within five years.

Not selling the asset is quite common. This is because many donors not only want to later transfer value to their heirs, they also want to transfer a specific asset. To do this, the stock must generate a dividend so that income can be distributed to a charitable organization, or the asset must be liquid enough so that a portion of it can be sold to make a payment to the charitable organization. Any gain realized while satisfying the payment requirement is deductible from the trust. Also, it is possible to satisfy the payment obligation with the stock itself. In that case, the charitable organization usually sells the stock back to the company, which then retires it. In any event, the best funding asset for a charitable lead trust is one that is expected to appreciate in value over the years.

Whatever the asset, though, if it is not sold during the term of the trust, the asset maintains its original cost basis when it is distributed to the noncharitable remaindermen. For example, say a lead trust is funded with an asset valued at $1 million; it grows to $2 million by the trust term's end, but it had a zero cost basis. If the heirs wanted to sell the asset, they would pay a capital gains tax on the entire $2 million.

Market conditions favor a new look at charitable lead trusts. Despite interest rates remaining relatively steady at historically low levels, an improving equities market makes it a good time for charitable lead trusts.

About the Author: Doug White
Douglas White consults with nonprofits on various aspects of philanthropy. He has served in leading roles with planned gift investment firms, as the development director at a secondary school and as trustee at several charitable organizations.

Doug is the author of the award-winning book The Art of Planned Giving: Understanding Donors and the Culture of Giving (John Wiley and Sons, 1995). In addition, he has written many articles.

He is a past member of the board of directors of the National Committee on Planned Giving. During his tenure at NCPG he founded the national initiative of "Leave A Legacy."He is a past president of the Planned Giving Group of New England and past president of the New Hampshire/ Vermont chapter of AFP.

For more than a decade he has served as the national capital giving chair for Phillips Exeter Academy in Exeter, N.H. In 2002, the National Capital Gift Planning Council presented Doug with the "Distinguished Service Award."

Doug is located in Washington, D.C.

Please contact Mary Ludwig, Development Director at 712-732-5127, for more information.

The information on this site is not intended as legal, tax or investment advice. For such advice, please consult an attorney, tax professional or investment professional.

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