Spotlight on Charitable Lead Trusts

In light of current market conditions, a charitable lead trust (CLT) may be an ideal philanthropic opportunity for high-net-worth individuals. A lead trust allows the donor to “lend” the benefit of specific assets to charity for the term of the trust and ultimately regain control of the assets in the trust. Depending on factors such as the amount of the payments and the term of the trust, the lead trust can significantly reduce or even eliminate gift and estate tax on unlimited amounts passing to heirs.

The basic structure of a CLT is the inverse of a charitable remainder trust. However, there are considerable differences with respect to the rules controlling the operation and taxation of a CLT. With a CLT, the donor makes an irrevocable agreement to transfer assets to a trust that makes payments to charity for a term measured either by a person’s life or a specified number of years.

A charitable lead annuity trust (CLAT) makes fixed annuity payments to charity. With a charitable lead unitrust (CLUT), the payments to charity are variable, based on a percentage of the trust. At the end of the trust term, the trust’s remainder interest either reverts to the donor (grantor CLT) or passes to another non-charitable beneficiary, such as the donor’s children (non-grantor CLT).

Grantor Charitable Lead Trust

With a grantor CLT, the donor receives an immediate income tax charitable deduction for the present value of the future payments to charity. Since the donor must be treated as the owner of the trust’s income in order to qualify for the income tax deduction, the trust income (including capital gains and amounts paid to charity) is taxable to the donor. When the trust terminates, the assets revert to the donor or the donor’s estate.

For example, if the Smiths establish a Grantor CLAT with $3 million in cash paying 6% annually to charity over a term of 20 years, the Smiths will receive an immediate income tax deduction of $3 million, and the charity will receive $3.6 million over the course of 20 years. At the end of the trust term, the Smiths are projected to receive over $5.7 million (ending principal less net taxes), assuming an 8% annual investment return.

This type of trust will appeal to donors who wish to provide annual support to charity and receive the income tax deduction up front, which could not be accomplished with a standard multi-year pledge.

Non-Grantor Charitable Lead Trust

With a non-grantor CLT, the assets are owned by the trust. Therefore, the donor does not receive an income tax deduction up front as with a grantor CLT. On the other hand, none of the trust’s income is taxable to the donor. Because the remainder beneficiary is usually someone other than the donor, a transfer tax deduction is allowed for the charitable interest. Furthermore, the appreciation of the trust principal and income not used to pay the charitable lead interest is excluded from the donor’s estate.

If the Smiths contributed $3 million of closely held stock to a non-grantor CLAT also paying 6% annually to charity over 20 years, the charity will still receive $3.6 million, and while the Smiths will not receive an income tax deduction, assuming an 8% annual investment return, their children are projected to receive over $5 million from the trust free of gift and estate tax.

For tax purposes, the portion of a CLT attributable to the charitable gift is based on the present value of the annuity or unitrust income interest. The annuity or unitrust interest is discounted based on the IRS discount rate, which is updated monthly. When calculating a deduction, the current month’s rate or the rate from one of the two previous months may be used. A lower discount rate produces a higher charitable deduction, and if the trust total annual return exceeds the discount rate assumed, the extra amount can ultimately pass to the remainder beneficiaries free of gift and estate tax. Rates have been trending downward, and the discount rate for the month of June 2020 is at an historical low of .6%, making the CLT a very attractive charitable planning vehicle for donors who want to transfer assets to children or other heirs and reduce or even eliminate the estate tax.