Nongrantor CLTs offer planning opportunities.

• Author: Vella, Nancy J.
• Position: Charitable lead trusts

EXECUTIVE SUMMARY

* To generate an estate or gift tax charitable deduction, a charitable lead must be in the form of a guaranteed annuity or a unitrust.

* The longer the charitable lead, the larger the charitable deduction and the lower the transfer tax.

* The tax-avoidance aspects of CLATs are primarily a function of the interplay between the Sec. 7520 rate and the return that can be obtained on trust assets.

A charitable lead trust (CLT) is generally a grantor trust that allows the grantor a one-time, sizable income tax charitable deduction. However, use of a nongrantor CLT allows the trust to take charitable deductions over the trust term. Not only does the grantor not report the trust income, he takes a transfer tax charitable deduction for the transfer into the trust. This article and its extensive examples explain how nongrantor CLTs, particularly charitable lead annuity trusts, can be used to meet both charitable and wealth preservation goals.

Charitable lead trusts(1) (CLTs) are used by tax advisers to save clients transfer taxes and/or to reduce the cost of charitable contributions. The deduction generated by the charitable lead is used to shield the taxable remainder from some (or all) of the taxes otherwise imposed on a direct transfer. CLTs can also be used to bypass the limits on income tax charitable deductions. As illustrated below, these trusts generally make economic sense when an individual has significant charitable and wealth preservation motives; however, in the proper circumstances, they can also increase the wealth passed to family members (or others) above the amounts that would be possible without a charitable contribution.

Although CLTs have a long history in tax planning, there has not been much activity in recent years. Renewed interest in these vehicles should arise as individuals generate more and more wealth in this robust economy.

The tax adviser's role is to evaluate the usefulness of CLTs in given situations and perhaps, "sell" the concept to appropriate clients. Once it has been determined that a CLT is appropriate for a client, CPAs are particularly well prepared to help determine the appropriate characteristics to build into the trust. Because a client's attorney will actually draft the trust, drafting issues are discussed only generally in this article.

Definitions

CLTs can be structured in various ways. A "nongrantor trust" is any trust not subject to Secs. 671-679 and is a separate taxable entity. "Qualified" indicates a trust that generates a transfer tax charitable deduction for the contribution of property to it. To be qualified, a charitable lead interest must be in the form of (1) a guaranteed annuity (a charitable lead annuity trust (CLAT)) or (2) a unitrust (a charitable lead unitrust (CLUT)).(2) An inter vivos trust is created during life; a testamentary trust is established at death.

How Does a CLAT Work?

Qualified nongrantor CLATs offer a low-cost method of making charitable contributions. Benefits are achieved via the transfer tax charitable deduction generated by the charitable lead; the deduction shields some (or all) of the transfer into the trust from gift or estate tax. The trust's income is partly or wholly shielded from income tax by the trust's essentially unlimited income tax deduction for the amounts it transfers to charity each year. Finally, the transfer to the noncharitable remainder beneficiaries (NRBs) at trust termination is not subject to income or transfer taxes; thus, for the price of a charitable contribution, property is transferred by the grantor currently to be received by his NRBs at a specified future date at a lower effective transfer tax rate. At best, the transfer tax is eliminated.

A qualified nongrantor CLAT can also be used to avoid the individual contribution limits; both the income and the deduction are removed from the donor's income tax return and the trust's deductions are limited to income by Sec. 642(c)(1). This can be a significant benefit to those who exceed the Sec. 170(b)(l) individual charitable deduction limits.

Valuation Factors

The amount transferred to a CLAT ultimately benefits both a charity and the NRBs. The transfer of property into the trust is subject to transfer tax, but the value of the charitable lead annuity is deductible in determining the amount of the transfer subject to transfer tax. For gift tax purposes (i.e., inter vivos trusts), Temp. Regs. Sec. 25.2512-5T(d)(3) provides that the fair market value (FMV) of a charitable lead annuity created after April 30, 1999 is determined under Sec. 7520. For estate tax purposes (i.e., testamentary trusts), Temp. Regs. Sec. 20.2031-7T(4) provides that the FMV of a charitable lead annuity created after April 30, 1999 is determined under Sec. 7520. Sec. 7520(a) provides that an annuity is valued using 120% of the Federal midterm rate (rounded to the nearest 2/10 of 1%) under Sec. 1274(d) for the month in which the valuation date falls (or for either of the two preceding months). For example, the annuity factor is 7.50161 for a 10-year annuity interest, paid at the end of each year, when the Sec. 7520 rate is 5.6%.(5)

The following four examples illustrate the results using a 10-year CLAT and a 5.6% Sec. 7520 rate. The examples assume that the FMV of the property transferred and the transfer tax thereon total $1 million. For each example, the results achieved by using a CLAT are compared to the results that would be achieved by having the transferor (1) hold the property for 10 years, then pass it at death to NRBs net of tax; and (2) give the property (net: of tax) to individual donees who invest it for 10 years. It is assumed that the property will be invested the same way by the transferor, the trust and the taxable transferee.

Further, all individuals and trusts in the examples are U.S. citizens or residents subject to a 40% ordinary income tax rate and a 20% long-term capital gains (LTCG) rate; all taxable transfers are subject to a 55% gift or estate tax rate. Trust formation and administrative expenses have been ignored; donors are assumed to have both charitable and wealth preservation motives. Examples 1 and 2 assume the investment return is ordinary income; Examples 3 and 4 assume it is LTCG.

Example 1--conservative, ordinary income:

...