In Part 1 of this two-part series, we described several basic design features of a charitable lead trust (CLT). In Part 2 we will explore three common CLT formats.
The Non-Grantor CLT
The most commonly selected format of CLT is the non-grantor version. A non-grantor CLT can be designed to produce an estate tax or current gift tax charitable deduction that effectively removes the transferred assets from the donor’s federal taxable estate. The power of a non-grantor CLT is derived from the ability to precisely control the amount of the charitable deduction through a combination of the selection of the CLT’s payout rate, duration, and CLUT or CLAT format. To achieve the greatest degree of control, most donors choose a CLAT. How does this work?
Consider a donor that:
- Transfers $1,000,000 to a CLAT;
- The CLAT pays $70,000 per year to her alma mater;
- The applicable federal rate (AFR) is 2.0%; and
- Anything left in the CLAT after it expires is paid to her children.
If the payments last for ten years, the donor will receive a gift tax charitable deduction of $628,780 or 62.878% of the amount transferred. The remaining $371,220 is a taxable gift of a future interest for which the donor must pay gift tax on any amount in excess of her unused lifetime gift tax exclusion.
If the $70,000 annual payments are extended to 16.992 years (16 years and 362 days), then the gift tax charitable deduction factor is 100%, resulting in a gift tax charitable deduction equal to $1,000,000. Because this extended duration produces a 100% charitable deduction factor, any amount transferred to this CLAT, whether $1 or $100,000,000,000 (or more), will escape estate or gift tax!
The benefit of a CLT for the remainder beneficiaries (usually the donor’s children) is especially enhanced if the CLT’s net investment return exceeds the AFR at the time of funding. Where this is the case, not only is the value of the initial transfer excluded from taxation, but also any future appreciation is shielded from gift or estate tax as well.
Note that even though a donor makes a gift to charity when he or she creates a non-grantor CLT, the donor is not entitled to an income tax charitable deduction. However, as the non-grantor CLT makes its annual payments to the charitable beneficiaries, the CLT is allowed an unlimited charitable income tax deduction for any portion of its charitable distributions paid from gross income. There is a catch where the CLT receives unrelated business taxable income (UBTI)—to the extent the charitable distribution is made from UBTI, the 50%/30% limitation on deductibility applies.
Each year a CLT reports its taxable activity on its own tax return. Therefore, by carefully matching income earned within the tax year with the non-grantor CLT’s unlimited charitable income tax deduction, most non-grantor CLTs avoid paying any income tax. To fully realize the unlimited charitable deduction for its annuity or unitrust amount, the amount paid must be made from the CLT’s gross income as defined either under the terms of the governing instrument or in accordance with local law. In the absence of guidance from local law, where the source of funds to pay the annuity or unitrust amount is capital gains, special language must be included in the trust agreement so that the payment is deductible.
To ensure that the assets of an inter vivos non-grantor CLT are excluded from the donor’s estate, the donor should not be empowered to change the identity of either the charitable income beneficiaries or the remainder beneficiaries (charitable or non-charitable). In addition, the donor should not serve as trustee, nor should the donor retain the right to change the trustee to any party that is not independent of the donor.
For donor’s desiring an income tax deduction, the non-grantor CLT format will not work. Such a donor typically chooses the grantor CLT format. However, in exchange for claiming an upfront, one-time income tax deduction, each year the donor must include all of the grantor CLT’s taxable items on his or her personal income tax return. Neither the donor nor the trust is permitted to claim an additional charitable income tax deduction as payments are made to the charitable beneficiaries.
The most common method for causing a CLT to be a grantor trust is for the assets of the CLT to come back to the donor at the end of the CLT’s charitable term.
One potential danger for donors that create a grantor CLT arises if the donor dies before the end of the trust term. In this case, the donor must recapture on his or her final income tax return a portion of the income tax deduction claimed when the trust was created. Where the donor dies before the end of the term of a grantor CLT, some or all of the CLT assets will be includible in the donor’s estate and the CLT ceases to be a grantor trust and becomes a non-grantor CLT from that date forward.
The third (less common) format of CLT, sometimes referred to as the “Super” CLT or “intentionally defective” CLT, combines elements of both the grantor and non-grantor CLT formats. Like the grantor CLT, the “Super” CLT’s items of income, deduction, and credit are included in the donor’s gross income, and therefore the donor is allowed an upfront, one-time income tax deduction for the charitable interest. Like the non-grantor CLT, the “Super” CLT’s remainder beneficiary is typically the donor’s heirs, therefore the donor is allowed a transfer tax deduction for the charitable interest. Great care must be exercised in drafting and administering a “Super” CLT to ensure the donor realizes the expected tax benefits.
A well-designed, managed, and administered CLT can empower donors to realize charitable goals that seem beyond their reach including:
- Making charitable gifts
- Reducing gift, estate, and/or generation skipping transfer taxes
- Creating an income tax deduction
- Transferring money, stock, and/or illiquid assets to heirs
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