Charitable lead trusts are a creative estate, income and charitable tax planning strategy for high net worth individuals. Lead trusts often involve significant legal and administrative costs and are more complex in nature than other charitable vehicles. However, with historically low applicable federal rates (AFRs), charitable lead trusts have become more attractive as a planning tool.
A charitable lead trust (CLT) is an irrevocable charitable trust where the annuity or unitrust payouts are made at least annually to a selected charity or charities. Reg. 20.2055-2(e)(2)(vi). Because the charity receives the interest first, it has the “lead” interest. After the lead interest terminates, the trust corpus returns to the grantor of the trust or to beneficiaries selected by the grantor, usually family members. If the lead trust is qualified and makes an annuity or unitrust payment to charity, the donor qualifies for a gift, estate or income tax charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).
While many charitable trusts are tax exempt, lead trusts are not. The taxation of the lead trust and the benefits to the donor depend on the drafting of the lead trust. It is the structure of the trust that creates unique income, estate or gift planning opportunities for the grantor. This article is Part II in a two-part series. This article discusses the unique planning opportunities currently available with CLTs, with a focus on the historically low Applicable Federal Rate (AFR).
Applicable Federal Rate
The Applicable Federal Rate, or AFR, is released each month by the IRS in a revenue ruling. For example, the revenue ruling for August 2020 was released in July 2020 and is titled Rev. Rul. 2020-15. Among other purposes, the AFR from Table 5 in the monthly ruling is used in calculating charitable deductions for certain planned gifts, including charitable lead trusts. The AFR is essentially a projected investment return.
In each monthly revenue ruling, there are tables of the AFR that applies for federal income tax purposes. The tables contain the short-term, mid-term and long-term AFR for the month, the AFR for certain loans, and the AFR for determining the present value for certain charitable gifts as required under Section 7520. Thus, the AFR for charitable gifts is often referred to as the Section 7520 rate.
Historically Low AFR
The AFR for the month of August 2020 is 0.4%. This is historically the lowest AFR that has been seen for charitable gifts. By comparison, in 1990 the AFR for August was 10.4%, in August of 2000 the AFR was 7.6% and in August of 2007 the rate was 6.2%. It was not until May of 2020 that the rate first fell below 1%.
The AFR may drastically affect a donor’s charitable deduction. For charitable gifts where a payout is retained for a noncharitable beneficiary and the charity receives the remainder interest, a higher AFR produces a higher deduction. However, for reversionary gifts like CLTs where the charity receives income payouts but the remainder passes back to the donor or to family members, the lower the AFR, the higher the charitable deduction.
Example: Abigail and Winston contemplated establishing a $1,000,000 CLT in August of 1990 when the AFR of the month was 10.4%. Assuming an annual 3% lead trust payout to charity, 6% trust return and a term of 20 years, the charitable deduction for the couple would have been $248,586.
Abigail and Winston decided against funding the CLT at that time and instead created a different charitable gift plan. However, their assets have grown over the years and their tax advisor recently spoke with the couple about the benefits of funding a CLT in a low interest rate climate. With the current AFR of 0.4% and the same assumptions as before, their tax advisor explained that the couple could generate a charitable deduction of $575,523.
For reversionary gifts, the lower the AFR, the more heavily discounted the assets transferred to the donor’s beneficiaries will be in the eyes of the IRS. This results in a lower taxable gift. In this calculation, the AFR is in essence the equivalent of an assumed earnings rate. The donor’s taxable gift with a lead trust is the initial value of the assets contributed to the trust less the value of the charity’s interest in the trust. If the assets in the trust generate a return higher than the assumed AFR, the donor’s remainder beneficiaries will benefit from the growth. They receive assets which are greater in value than the initial amount reported to the IRS as a taxable gift. Therefore, the best time for funding a lead trust is during a period of low AFRs coupled with a solid expected return on assets in the trust.
Example: Assume that a $1,000,000 annuity lead trust will pay a 3% annuity, or $30,000, to charity for a term of 25 years. Depending on the AFR, the taxable gift may vary greatly.
|AFR||Principal||Charitable Deduction||Taxable Gift|
A lead trust may be set up as an annuity trust (CLAT) or a unitrust (CLUT). An annuity lead trust will have a pre-determined dollar amount given to charity each year. A lead trust with a unitrust payout will have a variable amount paid to charity each year based on a fixed percentage of the annual valuation. A lead trust may qualify as a CLAT so long as the amount to charity each year may be determined by the trust document with specificity. It is possible to have a CLAT that makes equal distributions each year, a CLAT that makes increasing payouts to charity each year or even a CLAT that makes small distributions to charity for a number of years and then gives one large payout to charity at the end of the CLAT term.
A lead trust structured as a CLAT is generally preferred for passing on assets to family members. A CLAT essentially fixes the charity’s interest at the outset to a certain value and allows all appreciation over that value to pass to family members.
A CLUT more evenly balances the interests of charity and family members. If the value of trust assets appreciates over the term of the trust, part of that appreciation will be included in the income interest paid to charity. Thus, with unitrust payouts appreciation is partially divided between the family and charity. A CLUT structure is preferred if the donor is interested in allowing the charity to share in the upside of the appreciation in the lead trust.
Example: Assume there are two donors, each setting up separate family CLTs. Daniel contributes $1,000,000 in appreciated stock to a 15-year CLAT with equal annuity payouts of 5% to be made each year. At the same time, Wendy establishes a $1,000,000 15-year CLUT providing that the initial payout is 5%, or $50,000 with a new payout based on the trust valuation each year. Assuming an AFR of 0.4%, if the trust assets perform at a rate higher than 0.4% per year, the remainder beneficiaries of Daniel’s trust will receive more than those of Wendy’s trust.
Charitable Annuity Payment Daniel's Trust
Charitable Annuity Payment Wendy's Trust
|Year||Principal||7% Growth||Charitable Payment||Remainder to Family|
|Year||Principal||7% Growth||Charitable Payment||Remainder to Family|
Generation Skipping Transfer Taxes
As illustrated above, a CLAT is often a better fit than a CLUT when transferring assets to children. However, if estate taxes are applicable, a CLUT is typically a better fit when transferring assets to successor generations, such as grandchildren. One unique aspect to CLUTs is that generation skipping transfer taxes (GSTT) can be eliminated if drafted correctly, while CLATs cannot provide the same level of certainty that generation skipping transfer taxes will be averted. When generation skipping transfer taxes are relevant, a calculation is required to determine the applicable fraction and possible inclusion for tax purposes.
With an annuity lead trust, the applicable fraction is not calculated until the termination of the trust. The applicable fraction then equals the exemption with growth for the trust term calculated at the applicable federal rate as of the trust’s inception, divided by the value of the trust at termination. Sec. 2642(e)(2). If the trust corpus grows significantly, payment of a substantial generation-skipping transfer tax would be required. Since this is a taxable termination, the tax would be payable by the trustee at the rate applicable at the time of termination.
In contrast to a lead annuity trust, a lead unitrust is permitted to calculate the applicable fraction as of the testator's date of death. With a lead unitrust, the applicable fraction equals the allocated exemption divided by the fair market value of the property minus the charitable deduction. If the allocated exemption is equal to the present value of the taxable gift, the lead unitrust is exempt from generation-skipping transfer tax.
It is important to note that the charitable income tax deduction received for a lead trust, even one funded with cash, is subject to a limitation of 30% of the donor’s adjusted gross income (AGI). This is because the charitable distributions from the trust each year are deemed “for the use of the charity” rather than “to charity,” which lowers the deduction limit for a cash gift to 30% of AGI. Sec. 170(b)(1)(B).
Due to the current historically low interest rate environment, individuals with high net worth may find a charitable lead trust to be a good solution for estate, gift or income tax planning. Assets may be transferred to non-charitable beneficiaries at an IRS assumed growth rate that is likely much lower than the rate at which the assets inside the trust will perform over time. Similarly, with the low rates, a grantor may be able to generate a much larger income tax deduction than was possible in the past. The grantor may also benefit from substantial tax savings and receive the trust assets back at a later date when the donor’s adjusted gross income is lower. For those with large estates, this may be the best time in history to consider including a CLT in their estate plan.