13. Charitable Lead Trusts, Part 2 of 3

13. Charitable Lead Trusts, Part 2 of 3

Article posted in General on 23 June 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 6 July 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

13. CHARITABLE LEAD TRUSTS, Part 2 of 3

Links to previous sections of book are found at the end of each section.

What is the process for estimating the present value of the projected payments to charity?  It is identical to the process for estimating the present value of the projected payments to the non-charitable beneficiaries in a Charitable Remainder Trust.  This makes sense because the charitable and non-charitable beneficiaries switch places in a Charitable Lead Trust as compared with a Charitable Remainder Trust.  The value of an annuity (or unitrust payment) in a Charitable Remainder Trust is the same as the value of the same annuity (or unitrust payment) in a Charitable Lead Trust, only the recipient changes.
Determining the value of the annuity payments in a Charitable Lead Annuity Trust (i.e., the part not subject to gift or estate taxes) requires (1) finding the §7520 interest rate and (2)  multiplying the annuity payment by the annuity factor in IRS Publication 1457 for that §7520 interest rate.
Consider the example of a non-grantor Charitable Lead Annuity Trust created on January 31, 2015 paying $1 million per year to charity for 11 years.  What is the present value of these charitable annuity payments (i.e., the part not subject to gift taxes)?  Calculating this first requires finding the §7520 interest rate.  These rates are issued monthly and can be found on the IRS website at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Section-7..., or on other planned giving websites.  The donor may use the §7520 interest rate for the month of the transaction or either of the two previous months.  Thus, the donor in this case may use the interest rates for January, December, or November of 2015.  (Of course, by late in January the future rates for February would also have been posted so the donor could have delayed the transaction into February in order to take advantage of the February rates if desired.)  For a transaction completed on January 31, 2015, the donor would need to choose between a 2.2% and a 2.0% §7520 interest rate.  Which one is better for the donor?

As interest rates rise, the value of a fixed dollar annuity decreases.  Consider the value of an annuity that paid $1,000 per year when interest rates were 1%.  An investor would have to invest $100,000 to generate that same income stream at 1%.  However, if interest rates were 10% an investor would have to invest only $10,000 to generate the same income stream.  Thus, the value of the income stream (the annuity) is higher when interest rates are low and lower when interest rates are high.

Is the donor better off having the annuity valued higher or lower?  In a Charitable Lead Annuity Trust, the annuity is the part that goes to charity.  The value of the portion that goes to charity is not subject to gift or estate taxes in a non-grantor Charitable Lead Trust.  So, the donor is better off having a higher valuation for this charitable portion (meaning a higher valuation for the annuity).

Returning to the two options for the §7520 interest rate of 2.0% or 2.2%, the donor is better off choosing the lowest rate.  Thus, for this calculation the donor should choose the 2.0% rate in order to get the highest annuity valuation, and therefore the lowest gift tax.  This 2.0% interest rate will be used for all calculations for this transaction even though during the life of the trust the interest rates may fluctuate greatly.  Only the initial §7520 interest rate is relevant to the tax calculation.
Once the appropriate §7520 interest rate is identified, the value of the annuity can be determined from the table associated with IRS Publication 1457 which can be found on the web at http://www.irs.gov/Retirement-Plans/Actuarial-Tables.  In this case, the annuity will be paid for a fixed number of years, so we select Table B “Term Certain Factors.”  If instead the annuity was to be paid for life, we would select Table S for a single life or Table R(2) for two lives.  These tables are also found on the same webpage.  Examining Table B under the 2.0 percent interest rate heading shows that the annuity factor for an 11-year fixed term at that interest rate is 9.7868. 
Assuming that the annuity pays annually, the value of the annuity is simply this annuity factor (9.7868) multiplied by the annual annuity payment ($1 million).  Thus, the value of this annuity is $9,786,800.  If the annuity paid more frequently than at the end of each year, then it would be slightly more valuable.  (It is more valuable because the recipient gets the money slightly earlier.)  For example, if the annuity were paid monthly (still with an initial §7520 interest rate of 2.0%) the value of the annuity would be $9,786,800 X 1.0091, or $9,875,859.88.  This adjustment factor of 1.0091 comes from Table K on the previous website and varies with payment frequency and the §7520 rate.
Suppose that the donor transferred $10 million to this non-grantor Charitable Lead Annuity Trust on January 31, 2015.  The projected value of the charitable share, based upon 11 years of $1 million payments would be $9,786,800 as described above.  This leaves a projected gift to the donor’s heirs (or whomever the donor names to receive the remaining amount) with a present value of $10,000,000 less $9,786,800.  Thus, the present value of the projected taxable gift to the heirs would be $213,200.  If, during the life of the trust, the assets in the trust grow at a rate of 2.0% (equal to the initial §7520 interest rate) this projection will be accurate.  However, if the assets in the trust grow at a rate faster than 2.0% this extra growth will go to the heirs without additional gift or estate taxation.  For example, if the assets in the trust grew at a rate of 8%, the actual amount transferred to the heirs would be $6,670,902.51.  This demonstrates the power of the non-grantor Charitable Lead Trust.  The donor would transfer over $6.6 million in value to heirs, but pay gift taxes on only $213,200.
In the previous example, the present value of the amount projected to go to heirs based on the §7520 interest rate was only $213,200.  However, the donor could easily set the payments to charity such that the projected amount going to the heirs would be $0.  This zeroed-out non-grantor Charitable Lead Trust results in no gift or estate taxation, regardless of the size of the actual transfer going to the heirs.  Using a zeroed-out Charitable Lead Trust also eliminates the risk of paying unnecessary taxes if the trust assets underperform the initial §7520 interest rate.  If the trust assets ultimately grew at a rate lower than the initial §7520 interest rate, then the trust would simply exhaust earlier than its intended term with no payments to non-charitable beneficiaries.  But, since no gift taxes were paid, the donor does not risk overpaying gift taxes due to the underperformance.

The calculation process for a zeroed-out Charitable Lead Annuity Trust is the same as before.  In this case, the donor transfers $10 million into a non-grantor Charitable Lead Annuity Trust which pays $1,021,785 per year to charity for 11 years.  The present value of this series of annual payments, at a 2.0% §7520 interest rate, is $10,000,005.  This exceeds the value of the trust assets of $10,000,000.  Thus, if the trust assets return exactly 2.0% during the life of the trust, there will be nothing left after the final charitable payment is made.  If, however, the trust assets grow faster than 2.0%, any excess growth is transferred to the heirs (or other non-charitable beneficiaries).  This transfer of extra growth occurs without any gift or estate taxation.

As before, the donor must pay gift taxes on the present value of the amount projected to go to the heirs.  But, because $0 is projected to go to the heirs, there are no gift taxes.  Any amount that actually goes to heirs – due to growth above the initial §7520 rate – also avoids taxation because the gift tax (of $0) has already been paid. 

Conceptually, this might seem to be a lot of effort to go through just to be able to transfer the “extra” growth above the §7520 rate.  But, consider that in the previous example if the $10 million transfer grew at 8% instead of the §7520 rate of 2%, this transaction results in $6,308,281 being transferred to heirs with no gift taxes.  For a donor at top tax rates, gifting that much after-tax money to heirs would otherwise have come at a cost of over $2.5 million in gift taxes or $4.2 million in estate taxes.  (The estate tax cost of transferring this much after-tax money is higher than the gift tax cost because estate taxes also apply to the money used to pay for the estate tax, i.e., estate taxes are tax “inclusive.”  For example, the donor would need to leave $10.5 million in the estate for heirs so that after paying the 40% estate tax of $4.2 million, the heirs would receive $6.3 million)  For those subject to estate and gift taxes, this benefit is well worth the planning, even for smaller transactions.  For example, a $500,000 zeroed-out non-grantor Charitable Lead Annuity Trust earning 8% could transfer $315,414 to heirs after tax, which otherwise would have cost $210,276 in estate taxes.

This tax savings is especially attractive to a donor who was already planning to make these charitable transfers.  In that case the ability to gift the extra growth to heirs with no gift or estate tax is a “free” benefit available simply by using the non-grantor Charitable Lead Trust as the charitable gifting mechanism.  This is one of the reasons why testamentary zeroed-out non-grantor Charitable Lead Trusts are so attractive.  For any taxable estate where the donor has already planned a substantial charitable estate gift, transferring the gift in the form of a testamentary zeroed-out non-grantor Charitable Lead Trust provides the opportunity for tax-free transfers to heirs with no downside risk to the heirs.

Because the non-grantor Charitable Lead Trust provides the opportunity to transfer extra growth, above the §7520 rate, free from estate and gift taxes, the value of this technique depends upon the growth rate of assets in the trust.  If clients have assets that they anticipate will grow more rapidly in future years these are the assets most suited for a non-grantor Charitable Lead Trust. 
A step-CLAT (non-grantor Charitable Lead Annuity Trust) provides for steadily increasing payments to the charity during the fixed term of the trust.  The payments are not flat, but they are known in advance.  The motivation for pushing more of the charitable payments to the later stages of the trust term is that this allows more assets to stay in the trust longer.  For assets that outperform the initial §7520 rate, the longer they stay in the trust the more excess growth they will generate.  For example, the IRS has approved using annual 20% increases in the charitable payment amounts.  Returning to the previous example, a zeroed out Charitable Lead Annuity Trust with a $10 million initial transfer could be generated by 11 annual payments starting at $362,000 and increasing by 20% each year.  Taking this approach instead of paying the flat annuity rate (i.e., $1,021,785 per year) means that the charity receives lower payments at the start of the trust, but larger payments at the end of the trust.  For instance, the first annual payment would be $362,000, but the final annual payment would be $2,241,409.  If trust assets grew at 8% annually (instead of the 2.0% initial §7520 rate) the standard flat payout annuity in a zeroed-out non-grantor Charitable Lead Trust would leave $6,308,281 for the heirs.  But, the 20% annual increasing step annuity in a zeroed-out non-grantor Charitable Lead Trust would leave $7,936,082.  This extra $1.6 million in tax-free transfer results from keeping the faster growing assets in the trust longer.  If, however, the assets underperformed the 2.0% initial §7520 rate both the traditional annuity and the step annuity would exhaust the trust and the heirs would receive nothing.
The more extreme version of keeping assets inside the Charitable Lead Annuity Trust is known as a “shark fin” Charitable Lead Annuity Trust.  The name comes from a visualization of the payment amounts on a graph where the large charitable payments all come in the last year or two of the trust, forming a steep shark-fin like graph.  The benefit to such a payout scheme is the same as with a step-CLAT (Charitable Lead Annuity Trust).  The longer the assets are kept inside the Charitable Lead Trust, the more excess growth they will be able to generate, assuming that they outperform the §7520 rate.  Using these more extreme payouts is a more aggressive approach because it has not been approved (or disapproved) by the IRS (although Rev. Proc 2007-45 seems to allow any payments).  Some argue that 20% annual increases, which have been specifically allowed (PLR 201216045), should be treated as a maximum.  The argument is that 20% increasing annuities is the maximum allowed for Grantor Retained Annuity Trusts, and so perhaps the IRS will dispute Charitable Lead Annuity Trusts that exceed this level.
For Charitable Lead Trusts paying to a charity for a lifetime, the actual amount left for the non-charitable beneficiary depends not only on the rate of growth of the assets, but also on the length of the measuring life.  For example, if a Charitable Lead Trust pays $100,000 per year for the life of a person whose age suggests a life expectancy of 30 years, the present value of that charitable payment would be $100,000 x 22.3965, or $2,239,650 (at a 2.0% §7520 rate).  However, if the person lived for only two years, the actual payments to charity would total only $200,000.  Just as before, gift tax is paid based upon the projected transfer to the non-charitable beneficiaries, not the actual transfer.  Consequently, if a donor transferred $2.2 million to the previous Charitable Lead Trust with projected distributions to charity having a present value over $2.2 million, there would be no gift or estate tax on the transfer.  This remains true even though the shortened life, in reality, would have resulted in $2 million being transferred to the heirs with no gift or estate taxes.  Recognizing this reality led to the practice of creating “viatical” Charitable Lead Trusts (a.k.a. “vulture” Charitable Lead Trusts), where the measuring life for the charity’s payments would be a younger person with a terminal disease.  In response, the law was changed to limit the people who can be named as the measuring life for a Charitable Lead Trust.
To prevent widespread viatical shopping, the measuring life for a Charitable Lead Trust is now limited to the donor, any ancestor of the remainder beneficiaries, or the spouse of either of these.  Thus, taking advantage of a terminal diagnosis for tax planning purposes is still theoretically possible, but only within the much smaller close family group.  Additionally, a person may not be used as the measuring life for a Charitable Lead Trust if there is at least a 50% probability that the individual will die within one year.  Such a probability would be an issue of fact and subject to expert testimony.  However, if the person who is the measuring life actually lives for at least 18 months after being named, then there is no requirement to meet the 50% probability test. 

In Charitable Remainder Trusts it is quite common for the donor to retain the right to change the charitable beneficiary of the trust.  So long as the trust requires that some charity will ultimately receive the funds, this retention of power creates no problems.  In contrast, if the donor retains this power in a non-grantor Charitable Lead Trust the gift and estate tax advantages of the trust will be lost.  Why?  Retaining the power to change charitable beneficiaries causes the assets to remain in the donor’s estate.  Because the assets have not left the donor’s estate, they are still subject to estate taxes at the donor’s death.  This same reality does not create tax problems for the Charitable Remainder Trust.  The Charitable Remainder Trust assets may be included in the donor’s estate, but when those assets are all transferred to charity at death they are not subject to estate taxation because of the unlimited charitable estate tax deduction.  In contrast, the Charitable Lead Trust passes its assets to non-charitable beneficiaries at termination.  Thus, inclusion of the Charitable Lead Trust assets in the donor’s estate at death can result in estate taxation.  Although the donor may not have this power, it is acceptable for the donor’s spouse or some other family member to have the power to change charitable beneficiaries.  Because it is not the donor who holds the power, this will not result in the trust assets being included in the donor’s estate.  (Note, however, that if the Charitable Lead Trust will pay to a “skip person” such as a grandchild with living parents, it is important that no one retains the right to change the charitable beneficiary.  This is discussed briefly below in the section on generation skipping transfer taxes.)

It is also acceptable if the donor has the power to “request but not direct” an independent trustee to change the charitable beneficiary.  Because the donor does not have the legal right to change the charitable beneficiary, keeping this right does not create estate tax problems.  Along the same lines, it is perfectly acceptable for the Charitable Lead Trust to pay to a donor advised fund, even if the donor has the right to advise the charity regarding the timing and recipients of subsequent charitable transfers (see PLR 9633027).  This right is only the right to give “advice.”  It is not a legal right to force a particular charitable transfer.  Because it is not an enforceable legal right, it does not result in inclusion of the assets in the donor’s estate.

The non-grantor Charitable Lead Trust may name the donor’s donor advised fund as the charitable beneficiary because the donor has no legal right to control the distributions out of those funds (only a right to “advise” regarding distributions).  Similarly, if the donor’s private family foundation is named as a charitable beneficiary, it is important to show that the donor has no legal right to control the ultimate charitable grant recipients through his control of the private foundation.  If the donor had this right, then the Charitable Lead Trust assets would still be included in the donor’s estate.  In order to prove that the donor has no ability to direct the ultimate distribution of those assets paid to the donor’s private foundation, the terms of the gift should prohibit the donor from acting with regard to funds coming from Charitable Lead Trust.  Further, such funds should be maintained by the private foundation in a separate account.  There are no problems with inclusion in the donor’s estate if the donor’s spouse, children, or friends can control these separate funds in their role as foundation trustees, but the donor must be excluded.  (Allowing another person to change the charitable beneficiary of the non-grantor Charitable Lead Trust creates negative consequence for purposes of generation skipping transfer taxes, but allowing others to keep the right to control distributions made from the private foundation that is the recipient of Charitable Lead Trust funds does not create any such problems.)
The IRS has allowed early termination of a fixed term Charitable Lead Annuity Trust.  However, it has not allowed the division to be based upon the present value of the relative income and remainder rights (as has sometimes been allowed with a Charitable Remainder Trust).  Instead, the charity must be paid all of the scheduled payments at the time of termination, without discounting for receiving the payments early.  Thus, if 10 years remained in a fixed term Charitable Lead Trust where the charity received $1,000,000 per year, an early termination would require the immediate payment to the charity of $10,000,000, rather than the present value of the right to receive these payments over the next ten years.  Charitable Lead Unitrusts, in contrast, may not be terminated early.

The primary estate and gift tax advantage to be gained through the use of a non-grantor Charitable Lead Trust comes from the taxation of the projected transfer to heirs rather than the actual transfer to heirs.  This same advantage arises for generation skipping transfer taxes only with a Charitable Lead Unitrust (CLUT), but not with a Charitable Lead Annuity Trust (CLAT).  With a Charitable Lead Annuity Trust, the generation skipping transfer tax is based upon both the projected and the actual transfers to the “skip person” (e.g., a grandchild whose parents are still alive).  For both Charitable Lead Trust types, the donor can initially allocate generation skipping transfer tax exemption equal to the present value of the projected transfer to be made to “skip persons”, just as with the gift tax.  However, if a Charitable Lead Annuity Trust grows faster than the §7520 rate, then additional Generation Skipping Transfer Tax will be due at the termination of the Charitable Lead Annuity Trust.  Worse, if a Charitable Lead Annuity Trust grows slower than the §7520 rate, ultimately leaving less to the “skip person” than projected, there is no refund of the allocated generation skipping transfer tax exemption.  In contrast, the ultimate amount of the transfer is irrelevant to the calculation of generation skipping transfer tax for a Charitable Lead Unitrust.  However, the Charitable Lead Unitrust is not an ideal mechanism for transferring the growth above the §7520, because such growth must be shared with the charity.  A Charitable Lead Unitrust pays a fixed percentage of trust assets to charity each year.  Thus, more rapid growth results in higher payments to charity.

As discussed above, the donor may not retain the right to change the charitable beneficiary of a Charitable Lead Trust.  Otherwise, the assets of the Charitable Lead Trust will still be included, and taxed, in the donor’s estate.  However, allowing another person, such as a family member, to have this right to change charities does not create estate tax problems for the donor.  It does, however, create a potential negative result for generation skipping transfer tax if the trust will be paid to a “skip person.”  In that case, leaving open the option to change the charitable beneficiary means that the transfer to the skip person is a “taxable distribution” rather than a “taxable termination.”  Under the generation skipping transfer tax rules, taxes from a “taxable distribution” are owed by the recipient “skip person” (I.R.C.  §2603(a)(1)), but taxes from a “taxable termination” are owed by the trust itself (I.R.C.  §2603(a)).  For example, if $1,000,000 in generation skipping transfer taxes were due in a “taxable termination” the trust could pay those taxes with no negative consequences to the recipient.  But, if the trust paid the $1,000,000 in generation skipping transfer taxes in a “taxable distribution,” the trust would be paying an obligation of the recipient, meaning that the recipient would have received an additional $1,000,000 gift that would itself be subject to the generation skipping transfer tax.

Although a non-grantor Charitable Lead Trust can create significant potential tax advantages, as with other charitable planning techniques it is important to limit those techniques to clients with charitable interests.  There are other ways to reduce estate taxes that do not involve making gifts to charity.  For the non-charitable client, these techniques will inevitably be more appropriate.  For example, a client may transfer excess growth to the next generation with similar results using a grantor retained annuity trust.  Although this is not a perfect match for a Charitable Lead Trust (e.g., the client must outlive the term of the grantor retained annuity trust in order for the estate to receive the tax benefit), such techniques will typically be more appropriate than charitable strategies for the client who does not desire to make gifts to charity.

The primary role of non-grantor Charitable Lead Trusts is to aid in reducing gift and estate taxation.  However, there is also a less well known role for these trusts in reducing income taxation.  This opportunity arises when a donor’s gifts no longer generate income tax deductions because of the income limitations on charitable deductions.  In this scenario a donor might earn, e.g., $1,000,000 in interest and dividends on certain assets, donate the entire $1,000,000 to charity, but still be required to pay income taxes on the $1,000,000 with no useable charitable income tax deduction.  The non-grantor Charitable Lead Trust can provide a solution to this income tax problem.

By transferring the income earning assets to a non-grantor Charitable Lead Trust, the donor no longer reports future earnings as income.  Instead the trust itself reports these earnings, and pays taxes on them.  Normally, this would not be considered a tax benefit because trusts have a compressed tax schedule (i.e., they pay the highest tax rate at a much lower level of income).  However, a non-grantor Charitable Lead Trust can normally deduct payments to charity with no income limitations.  Returning to the previous example, the donor owns assets generating $1,000,000 in interest and dividends annually.  The donor would still have to pay taxes on that income even if she donated the entire amount to charity because the donor’s other (or previous) gifts have already exceeded the income limitations on charitable deductions.  However, if the donor transferred these assets to a non-grantor Charitable Lead Trust, the trust could deduct all gifts, up to 100% of income.  Additionally, a Charitable Lead Trust may be written to allow distributions of any income in excess of the required annuity or unitrust amount, so that the trust would pay no income taxes regardless of the investment returns.  This plan works well when a donor who is already over the income limitations for deductible gifts wishes to make gifts out of income earned from assets, has no plans to consume the assets personally, but does desire to keep the underlying assets in the family.

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