The testamentary charitable lead annuity trust revisited.

• Author: Kern, Jeffrey A.

The testamentary charitable lead annuity trust has been an excellent planning technique for clients with substantial wealth who wish to devise assets for charitable purposes on an estate tax-deductible basis, while at the same time preserving a portion of those assets for generations to come. This article will take a fresh look at the testamentary charitable lead annuity trust; discuss the flexibility in drafting these trusts in a period of uncertainty over the future of the estate tax; and suggest certain alternatives which will make the use of these trusts more responsive to family needs and more efficacious in mitigating the effects of estate, generation-skipping, and income taxes.

Primer on Testamentary Charitable Lead Trust

A testamentary charitable lead trust (CLT) is a trust created under a testamentary instrument, either a revocable or self-declaration trust, or under a will. The CLT pays an amount to qualified charities (either a private foundation or public charity) no less often than annually for a specific term ("the charitable lead interest"), after which the remaining assets generally pass to one or more noncharitable beneficiaries (usually family members) either outright or in further trust ("the family remainder interest"). If the CLT "qualifies" by meeting certain requirements under the Internal Revenue Code, the donor's estate is entitled to an unlimited estate tax deduction for the value of the charitable lead interest. (1) The assets passing to the CLT are fully includable in the donor's estate and accordingly receive a basis equal to their fair market value at date of death or at the alternate valuation date. (2) The CLT is sometimes thought of as a charitable remainder trust (CRT) in reverse because a CRT first provides a stream of payments to noncharitable beneficiaries after which the charitable remainder interest passes to qualified charities.

A CLT can be either 1) a charitable lead annuity trust (CLAT), which pays a specific dollar amount or a percentage of the initial fair market value of the assets used to fund the trust; or 2) a charitable lead unitrust (CLUT), which pays a specific percentage of the fair market of trust assets determined on a periodic basis, usually annually. (3) In a CLAT, the excess of trust yield (4) over the fixed payments made by the trust will eventually be distributed to the family remainder interest. This is in contrast to the CLUT, where (because of the periodic valuation) the payments fluctuate, and accordingly, the charitable lead interest shares the appreciation (or depreciation) in value of the assets with the family remainder interest. Accordingly, CLATs have been favored as an estate planning technique with clients who are looking to provide maximum benefits for the family remainder interest and who are optimistic about the future appreciation of the CLT assets. Additionally, and perhaps more importantly, a CLAT may be "zeroed out," that is, the annual annuity payments may be determined in such a way that their present value is equal to the initial corpus of the trust, thus, resulting in no portion of the trust being taxable for federal estate tax purposes. On the other hand, CLUTs may not be zeroed-out due to the method in which the charitable interest is computed under the applicable treasury regulations. The balance of this article will address the CLAT except where otherwise stated.

CLATs can be for a term of years or the lifetime of certain individuals living at the date of the transfer of assets to the CLAT. (5) Permissible charitable lead beneficiaries include public charities, private foundations, supporting organizations, and donor advised funds. (6) Permissible family remainder beneficiaries include individuals, partnerships, corporations, estates, or trusts. (7) Measuring lives include the settlor and certain related family members. (8) CLATs are subject to certain restrictions applicable to private foundations including self-dealing, excess business holdings, jeopardy investments, and taxable expenditures. (9)

Income Taxation

CLATs are taxed as complex trusts, (10) with the trust receiving an unlimited charitable income tax deduction for gross income paid to the charitable recipients under the terms of the trust (11) instead of a deduction for distribution to beneficiaries applicable to noncharitable trusts. (12) However, in order to maximize the "value" of the charitable income tax deduction, there are two requirements: 1) the trust must have sufficient taxable income so that it may fully use such "unlimited" charitable income tax deduction; and 2) the nature of such income is such that without regard to the charitable deduction it would be taxed at the highest trust tax rate (i.e., 35 percent) as would be the case if all trust income was comprised of taxable interest. Trust income that is comprised of capital gains or dividends would reduce the benefit of the deduction under current law to 15 percent and tax exempt income will result in no benefit to the trust.

In situations in which the trust has income of different categories, in order to avoid wasting the deduction, a trust provision which characterizes distributions as being made from ordinary income, capital gain, unrelated business taxable income, and trust corpus, in that order, is necessary. (13) The IRS, however, has stated that it will ignore such a provision in a trust instrument, and instead will treat distributions as consisting of a proportionate amount of each item of trust income unless such a provision has "substantive economic effect independent of tax consequences." (14) Exactly what type of trust provision would satisfy the requirement of "substantive economic effect" is uncertain. In view of the significant spread between ordinary income and capital gain rates, the stakes could be high enough to consider methods of structuring the CLAT to provide the greatest assurance that the ordering rules will be respected. One such method would be to fund the CLAT with a "series of partnership interests" in a state recognizing series interests (such as Delaware) (15) with the segregation of the assets producing each type of income into separate series of partnership interests. Distributions would then be made from the particular series of the partnership that will achieve the optimum result.

Formula CLAT

The value of the charitable lead interest (and the resulting estate tax deduction), is determined by 1) the term of the charitable lead interest (number of years or life expectancy), and 2) the "7520 rate" (in effect for the month the trust is funded, or for either of the two preceding months). (16) The lower the 7520 rate in effect at the establishment of the CLAT, the less the annual payout rate to the charitable lead interest needs to be in order to achieve the same estate tax deduction, and accordingly, the greater the chance that there will be a benefit to the family remainder beneficiaries at the end of the term. Accordingly, low prevailing interest rates are beneficial for the establishment of CLATs.

As previously discussed, the CLAT can be structured so that the value of the charitable lead interest equals 100 percent of the assets used to fund the CLAT, resulting in...