|Brian E. Lacey counsels charities, foundations, families and individuals in nonprofit, philanthropic and planned giving matters. He is a partner at Richardson and Tyler, LLP, where he has practiced since 1991.
Fashions come and go - even with trust and transfer tax planning. Currently, charitable lead trusts (CLTs) are popular, and for good reason. With historically low interest rates, charitably inclined persons can achieve multiple goals such as providing a steady stream of income over a period of time to charity and then offering a significant remainder interest to one's family or even to oneself and one's spouse.
In 1989, Congress enacted discount rates that float at 120 percent of the federal mid-term funds rate. Over the last several years, the federal discount rate has fallen below 4 percent. With such current discount rates, a donor can establish a high payout rate to charity while later transferring more funds to family at little or even no gift tax.
Here are some examples of persons who might consider using a CLT:
• Donor wants to provide money to charity yet also benefit her children and grandchildren when they are older and, presumably, wiser. She funds a CLT, which provides a remainder to her family members following a specified term of years or her life.
• Donor wants to "zero-out" the gift tax value of remainder gifts to his children by creating a CLT with a high payout rate over his lifetime. In a low-interest rate environment, he can pass the remainder interest to his children with little or no gift tax cost.
• For generation-skipping purposes, a donor establishes a CLT that pays out an annuity or unitrust interest to named charities for a term of years and then pays out a remainder interest to her grandchildren calculated to the generation-skipping exemption amount.
Interestingly, CLTs are often considered the converse of charitable remainder trusts (CRTs). While true in some respects, CLTs have important differences. For example, CRTs are tax-exempt entities whereas CLTs are not.
Types of CLTs
Donors can create one of two types of CLTs.
First, a charitable lead annuity trust (CLAT) is one in which a guaranteed annuity of a determinable amount is paid periodically, but not less often than annually, for a specified term of years or for the life or lives of certain individuals, each of whom must be living at the date of transfer for a gift or the date of a decedent's death if a testamentary transfer. A CLAT's annuity rate may fluctuate as long as the annuity payment is determinable from when the trust commences. It is very important that a CRAT's governing instrument contain an explicit prohibition against additional contributions.
Second, a charitable lead unitrust (CLUT) is a qualified CLT in which a payment equal to a fixed percentage of the net fair market value of the trust property, valued annually, is distributed at least annually to a qualified charitable organization or organizations, for a term of years or for the life or lives of identified persons. Further, payments of a unitrust interest may be paid for a specified term of years or for the life or lives of certain individuals, each of whom must be alive at the date of a decedent's death (if a testamentary trust) and can be ascertained at such date for estate tax purposes or at the date of gift for gift tax purposes. If explicitly permitted in the governing instrument, CLUTs can receive additional contributions.
CLTs have multiple parties, including a donor, a trustee, a charitable (or "lead") beneficiary and non-charitable remainder beneficiaries.
First, the CLT has a donor who establishes and funds a CLT during life (inter vivos) or creates and funds it at death by will or trust (testamentary).
The CLT has a trustee who can be the donor, the donor's spouse, a family member or a disinterested person or entity, including the charitable lead person, if state law permits. Also, the donor can be the trustee, subject to certain tax consequences. The drafter must be careful that the donor not retain powers that would cause the trust to be includable in his or her estate for federal estate tax purposes under IRC sec. 2036(a)(2). For example, if the donor serves as trustee and the remainder persons are the donor or the donor's estate, then the principal reverts to the donor and will be included in his or her estate for federal estate tax purposes.
Income tax considerations warrant that the valuation of assets that do not have readily ascertainable market valuations should be made by an independent trustee or by a qualified appraiser. Treas. Reg. 1.664-1(a)(7). This will be of particular benefit where grantor CLTs are involved. An independent trustee is a trustee other than the donor, the donor's spouse, a non-charitable beneficiary or a party related to or subordinate to either of them. Treas. Reg. 1.664-1(a)(7)(iii). A co-trustee who is independent may value assets that do not have readily ascertainable market values.
A party is related or subordinate if the person is a non-adverse party and is also the donor's spouse, parent, issue or sibling. IRC sec. 672(c). Subordinate parties also include an employee of the donor, a corporation in which the donor's interests are significant ones with respect to corporate control or in which the donor is an officer, director or key executive. IRC sec. 672(c)(2).
A non-adverse party is any person not adverse. It includes any person who has a substantial beneficial interest in the trust, such as one with a general power of appointment, since such interest would be adversely affected by the exercise or not of the power.
If a related party to the donor is a trustee of the CLT, the better practice would be to exclude the trustee from having discretion to pay the lead interest to charitable organizations that the related party controls. See Priv. Ltr. Rul. 93-31-015 (May 6, 1993).
The "lead" beneficiaries must be one or more charities, transfers to which are deductible under IRC secs. 2055 and 2522 for estate and gift tax purposes. Lead beneficiaries may be domestic or foreign charitable organizations or private foundations. However, the type of CLT chosen will limit what type of lead beneficiary is permitted. For example, for grantor CLTs, the lead beneficiaries must be domestic charities for favorable income tax deductions to be available. Non-charitable persons cannot receive distributions during the period of the lead interest.
While, the trustees can select the lead beneficiaries, the trust instrument should designate alternate lead beneficiaries or a mechanism by which such lead beneficiaries will be selected in the event that the named beneficiaries fail to qualify as organizations pursuant to IRC secs. 2055 or 2522.
Non-charitable remainder persons
Non-charitable remainder beneficiaries can include one or more of the donor, the donor's estate, spouse, family members or other non-charitable remainder persons. However, a reverter to the donor's estate results in the inclusion of the trust property in the donor's estate for federal estate tax purposes. The trust will be treated as a grantor trust, allowing an income tax charitable deduction on funding and income tax liability for income earned by the trust.
Payout of lead interest
A CLT must make distributions of the lead interests to charitable lead beneficiaries not less frequently than annually. For CLUTs, there is no requirement of a minimum percentage to be paid out as there is with CRUTs. Likewise, CLTs contrast with charitable remainder unitrusts in that CLTs have no maximum payout rules.
If a CLT is created by a donor at death, such as by means of a will or pour-over trust, then the payment of the lead interest may be deferred until the end of the tax year in which the trust is fully funded. Priv.Ltr.Rul. 90-47-053.
While the lead term lasts, CLTs cannot make payments to non-charitable lead beneficiaries. Two caveats exist with this rule. First, if the amount payable for a private purpose is in the form of a unitrust interest and the trust instrument does not provide for any preference or priority in the payment of the private unitrust as opposed to the charitable unitrust interest. Second, if under the trust instrument the amount that may be paid for a private purpose is payable only from a group of assets that are devoted exclusively to private purposes and to which certain private foundation restrictions do not apply.
Finally, the lead interest payout period cannot be commuted.
Term of the lead interest
The terms for lead interests may be for a period of years or for the life or lives of one or more designated individuals alive and in being when the trust is established. Treasury Regulations require that the measuring life or lives be limited to one or more of the donor, the donor's spouse or a lineal ancestor or spouse of a lineal ancestor of all of the remainder beneficiaries. Interestingly, there is no requirement that a term of years be limited to 20 years, as there is with CRTs. Rev. Rul. 85-49, 1985-1 C.B. 330. Priv.Ltr.Rul. 96-31-021. Also, an interest of a specified term of years will also qualify where the trust instrument contains a "savings" clause with reference to the rule against perpetuities.
Grantor versus non-grantor lead trusts
Unlike with CRTs, CLTs have one further important distinction: that between a grantor CLT and a non-grantor CLT. The choice between these types of CLTs will determine the availability and extent of income and transfer tax benefits.
First, a non-grantor lead trust is a fully taxable entity. As a CLT pays out the lead interest to charity, the lead interest amount is deductible. Unless the trust has unrelated business taxable income (UBTI), the deduction is unlimited. If the trust has UBTI, then the charitable deduction for income tax purposes is constrained by the percentage limitations that apply to individuals. IRC sec. 681(a). A CLT will be taxed on undistributed income in excess of the amount necessary to pay the lead interest.
Distributions of appreciated property to satisfy the lead interest results in realization of gain for which the CLT may take a deduction. IRC sec. 642(c); Rev. Rul. 83-75, 1983-1, C.B. 114.
The drafter is advised that the trust instrument should allocate to the trust any deductions permitted for depletion and depreciation.
The donor will not receive an income tax charitable deduction for contributions to the CLT. IRC sec. 170(f). The donor may receive a gift tax charitable deduction when assets are contributed to the CLT with such deduction based on the present value of the lead interest payments to the lead charities. If the donor or a non-adverse party has the power to direct the beneficial enjoyment of trust principal or income because of a power of disposition, then the donor is treated as the owner of the portion of the CLT over which he or she possesses such power. IRC sec. 674(a).
A grantor lead trust differs from a non-grantor lead trust significantly. IRC secs. 671 - 678 apply to grantor lead trusts. With such a CLT, all items of income, deductions and credits are attributable to the grantor and taxed to the grantor and not to the trust. Generally, the trust's principal will be included in the donor's gross estate for federal estate tax purposes. IRC secs. 2036, 2038 and 2035.
A donor can take an income tax deduction for the payment of the CLT's lead interest. IRC sec. 170(f)(2)(B). The donor's deduction is limited to the 30 percent AGI limit for cash gifts. IRC sec. 170(b)(1)(B)(i). Recapture if the donor dies during the trust's term. IRC sec. 170(f)(2)(B); Treas. Reg. 1.170A-6(c)(4). The donor may take a charitable gift tax deduction.
A grantor CLT must be an inter vivos trust.
A CLT drafter faces two other important planning considerations. Alas, the first of these is that the generation skipping transfer tax (GSTT) also applies to CLTs if the remainder persons include "skip" beneficiaries (those who are two or more generations below the donor), yet with mixed results depending upon the type of CLT in question. CLUTs work most easily with the GSTT since the value of the property transferred to the CLUT is determined on the date of transfer or funding. CLATs do not have this benefit.
The drafter must consider also the application of certain laws pertaining to private foundations such as those concerning self-dealing, excess business holdings, jeopardizing investments and taxable expenditures. The CLT's governing instrument must expressly prohibit the foundation from engaging in acts that would violate these prohibitions.
CLTs are remarkable entities that permit donors to achieve multiple goals. CLTs can be effective tools for such donors as those interested in lifetime gifts to charities with gifts over to their families, persons who have otherwise exhausted their ability to deduct charitable gifts because of applicable percentage limitations and/or others who wish to train family members in charitable dispositions before receiving money in their own right.
CLTs have critical distinctions and benefits depending upon whether a CLT is a grantor or non-grantor type, whether a CLT is a CLAT or a CLUT. CLTs also will provide varying levels of benefits to charities and families depending upon whether a charitable lead interest is for a term of years or for a lifetime.
Particularly in a milieu of low interest rates, CLTs can be effective and laudable components of a family's wealth management program and can constitute a win-win arrangement for individuals, families and charities.