Anyone looking outside their window (or watching TV) recently knows that we are in a volatile time. Among other things, current volatility results from the ongoing COVID-19 pandemic, an uncertain economy,[1] and upcoming elections. The effects of this include large amounts of government spending,[2] low interest rates,[3] and a reduction of the value of a number of assets (including many small businesses).[4] In many ways, these items are not seen as positive factors. However, these factors produce planning opportunities.
Given the variables described above, many planners expect the taxes to increase in the future. This may be necessary to cover the costs of the current pandemic. Of course, the outcome of elections will most likely have a large effect on how those future tax changes look. Regardless of who wins the election, it appears likely future tax liabilities could increase (at least for higher income taxpayers). If Mr. Biden wins the election, there are a number of areas where higher income taxpayers may see increased exposure.[5]
The purpose of this writing is to discuss one planning opportunity which can benefit from the current planning landscape. That opportunity is the use of a charitable lead annuity trust (“CLAT”). A CLAT provides more benefits when interest rates are low and where assets contributed to the CLAT are low relative to anticipated future value. The CLAT also is a good leveraged use of gift tax exemption allowing wealth the pass to beneficiaries with minimal use of exemption. Preserving gift and estate tax exemption can be important to allow more assets to pass free of wealth transfer tax, especially sensitive now given that gift and estate tax exemptions may be reduced and tax rates may rise.
What is a lifetime CLAT?
A CLAT is a trust someone establishes during his or her lifetime that makes annuity payments to a charity for a stated term of years after which whatever assets remain in trust pass to the non-charitable beneficiaries.[6] Because the non-charitable beneficiaries do not receive their interests for a number of years, and the interest received is net of the charitable annuity, the value of the transfer to the beneficiaries is discounted. This reduces the gift tax value of the transfer of wealth. Also, an income tax deduction is generated by the charitable gift component (more discussed below).
As a simple example, consider someone who intends to donate $25,000 per year to charity and is concerned about estate tax liability. That person transfers $1 million to a CLAT that will distribute $25,000 per year to charity for 20 years, after which all assets will pass to his or her children. The results include:
- Depending on the structure of the CLAT, an immediate $480,000 charitable income deduction.
- Valuation of the gift to children of $520,000 for gift tax purposes.
- If the CLAT grows at 6% annually, at the end of 20 years, $2.3 million will pass to children. $500,000 will have been paid to charity.
- By retaining the same $1 million, even without continuing $25,000, the donor would pass only $2.2 million to children versus $2.3 million using the CLAT (assuming the same $520,000 of gift or estate tax exemption used)[7].
- If the donor continued making annual $25,000 charitable donations out of the same $1 million, the donor would pass only $1.6 million versus $2.3 million using the CLAT (again assuming the same $520,000 of gift or estate tax exemption used).[8]
Ultimately, the donor has the ability to structure the CLAT to strategically time a large up-front charitable deduction (such as in the year of a large bonus, exercise of stock options, sale of a business, etc.), continue to make gifts to charity as intended, and ultimately pass more wealth to children than what could have passed to children even without the charitable gifts after estate tax. This is a great result.
There are a number of drafting options for CLATs. While there must be both a charitable annuity beneficiary and non-charitable remainder beneficiary, sufficient planning flexibility can be retained. Examples of the flexibility that can be drafted into a CLAT as described above include:
- Granting a third party chosen by the donor the power to change charitable beneficiaries. The donor also can retain a certain level of control here by naming a donor advised fund as the charitable beneficiary.[9]
- Granting a third party, such as a spouse, the right to alter the non-charitable remainder beneficiaries by granting a limited power of appointment over the remainder trust assets. The class of beneficiaries subject to the exercise of this power may include the donor.
- Granting a third party the right to substitute assets of equivalent value with assets held in the CLAT.[10]
- The ability to back-end-load the CLAT such that payments are low in the early years and higher in the later years. The primary benefit of this is that CLAT assets benefit from additional compounding in the early years resulting in more assets passing to non-charitable beneficiaries.[11]
- The ability to “zero-out” the CLAT meaning that the actuarial value of the non-charitable gift is $0. The result is the ability to pass wealth to family without any use of gift or estate tax exemption. In the $1 million CLAT donation described above, making the charitable annuity an annual payment of $52,000 would result in a $0 transfer to children for gift tax purposes. However, at the end of 20 years $1.3 million would pass to children (gift/estate tax free). Alternatively, the initial CLAT donation could have been reduced to $475,000 while keeping the annual annuity payment at $25,000.
These are just a few examples of the flexibility that can be drafted into a CLAT.[12] Other planning choices can further enhance the benefits such as stacking CLATs by having a donor with large amounts of recurring ordinary income fund a new CLAT each year up to the applicable AGI percentage limitation. There also may be ways to strategically use generation-skipping transfer tax exemption.[13]
In times where estate tax exemptions may be declining (and rates increasing) leverage of exemption is important. For someone who regularly makes lifetime charitable gifts who also may be facing a taxable estate, whether under current exemptions of $11.58 million per person or under a reduced exemption in the future, a CLAT should be one of the planning tools considered.
Grantor vs. Non-Grantor CLAT
CLATs can generally be broken down into two categories: (a) grantor CLATs, and (b) non-grantor CLATs. The term grantor and non-grantor refer to the income tax treatment of the CLAT under Subchapter J of the Internal Revenue Code.
Grantor CLATs. A grantor CLAT gives the donor an immediate charitable deduction equal to the actuarial present value of the charitable annuity.[14] As a grantor trust, the donor reports and pays income tax on the trust’s income annually without any further charitable deduction. If the donor dies during the terms, there is some amount of charitable deduction that must be recaptured.[15] If appreciated assets are distributed in satisfaction of the charitable payment, the asset is treated as if sold and becomes taxable to the grantor.
Grantor CLATs are very useful for donors with the need for a current large charitable deduction such as a taxable liquidity event. To minimize the ongoing income tax payable by the donor, the CLAT may invest in tax-free investments such as tax-exempt bonds. Alternatively, as with any grantor trust, the donor’s payment of income tax on trust assets allows the trust to grow income tax-free while reducing the donor’s taxable estate. This allows even more wealth to accumulate in the trust to be distributed free of wealth transfer tax to the trust’s beneficiaries while simultaneously reducing the donor’s taxable estate.
Non-grantor CLATs. For a non-grantor CLAT, the donor does not receive a charitable contribution deduction for the initial contribution to the CLAT. Instead, a non-grantor CLAT is subject to taxation as a complex trust except that the trust will not receive a distribution deduction under normal complex trust rules.[16] Rather than a distribution deduction, its charitable deduction is limited by IRC § 642(c) to the current year’s taxable income (without being subject to percentage limitations) even if the amount paid to charity in such year is greater. Any excess income above the payment to charity is subject to income tax payable by the CLAT. For the donor who does not seek a current, large income tax deduction and/or who does not want to be subjected to income tax generated by transferred assets, a non-grantor CLAT may be the preferred planning structure. There may be planning benefits by having the trust in a state without a state income tax, which could eliminate state income tax which otherwise would be taxable to the grantor without the CLAT.
Effect of Interest Rates and Valuations
As stated above, we currently are in a low interest rate environment where assets may be subject to low valuation relative to expected future value. Both of these can present a benefit to the donor of a CLAT.
Continuing from the $1 million donor above, passing $25,000 to charity each year, consider the difference if the IRS interest rates change. Currently, the IRS uses a 0.4% discount rate (the lowest in history) to calculate the non-charitable remainder. That yielded a current gift to children of $520,000 and the potential for an immediate $480,000 charitable income deduction. If the September 2019 rate of 2.2% is used, the taxable the gift to children increases to $599,000 and the charitable deduction decreases to $401,000. To achieve the same results as currently, the annual charitable distribution would need to increase to $30,000 which means children receive $2.1 million in 20 years vs. $2.3 million.
Similarly, low asset value can benefit the donor seeking to maximize what passes to family at minimal wealth transfer cost. If an asset the donor believes to be worth $1 million could currently be valued at $800,000 (or the asset will rapidly appreciate to produce a similar effect), then the same $25,000 gift to charity can be made, the same $480,000 charitable deduction taken, but only generating a taxable gift (i.e. use of exemption) of $320,000. This saves $200,000 of gift and estate tax exemption. However, children end up with the same $2.3 million after 20 years. Alternatively, the trust could reduce its annual charitable distribution to $20,000 which would result in a taxable gift of $416,000 and potential income tax deduction of $384,000. However, this time, children will ultimately receive $2.5 million versus $2.3 million – a reduced taxable gift while resulting in even more assets passing free of wealth transfer tax to children.
With both low interest rates and depressed valuations part of the current planning environment, funding a CLAT can be especially good for anyone attempting to maximize the tax free transfer of wealth. This is especially true for those already making annual charitable donations. With the prospect of reduced estate tax exemptions in the near future, leveraged use of exemption is especially important, even for those who may not have a taxable estate under current exemptions.
Conclusion
CLATs can be extremely valuable planning vehicles. Many people who make annual charitable donations are also looking to minimize the potential for gift and estate tax exposure. Certainly, there is substantial overlap in the Venn diagram representing (a) annual charitable donors, and (b) those with a potential for a taxable estate. Yet, according to IRS data[17] and my anecdotal experience, CLATs are not used nearly as frequently as they should be.
Use of a properly planned CLAT can cost a client almost nothing (i.e. they were making the charitable donation anyway) while providing significant leverage of gift and estate tax exemptions. Also, depending on the structure of the CLAT, clients experiencing a taxable liquidity event may utilize a CLAT to obtain a large current charitable deduction while continuing regular, annual donations and also leveraging gifts to family. There are sufficient flexible options that can be drafted into a CLAT that donors can take comfort that current drafting decisions are not necessarily set in stone. As described above, this can include the donor’s right to appoint a third party to change the charitable beneficiary, add/remove non-charitable beneficiaries, substitute assets held in the CLAT, and more. It would benefit planners and their clients to take a closer look at CLAT planning to determine what benefits may be available.
[1] As an example, the U.S. unemployment rate since April 2020 has been from 14.7% to 8.4% compared with rates of 4% to 3.8% the same months of 2019. https://data.bls.gov/timeseries/LNS14000000
[2] Just a handful of days before the preparation of this writing, the non-partisan Congressional Budget Office projected the 2020 federal budget deficit to hit a record $3.3 trillion, a similar position to the deficits coming out of World War II. https://www.cbo.gov/publication/56517
[3] The effective Federal Funds Rate published on September 4, 2020 is 0.09% versus 2.13% on September 4, 2019. https://www.federalreserve.gov/releases/h15/
[4] Certainly, businesses negatively affected by COVID-19 will see a reduction in value. However, valuation of businesses which have not been negatively affected by the pandemic may be depressed due to increased risks, increase in volatility, and a decrease in market activity (i.e. M&A), all of which typically would reduce valuations.
[5] See https://taxfoundation.org/reviewing-joe-bidens-tax-vision/ and Sage, Joshua, “The Swing of the Tax Pendulum and Planning Considerations,” Sept. 4, 2020, https://esapllc.com/whatif-2021/.
[6] For purposes of this discussion, I am assuming the CLAT is intended to be structured as a completed gift for wealth transfer tax purpose and out of the taxable estate of the donor. Also, I am basing this discussion on CLATs versus a similar structure, the charitable lead unitrust (CLUT) which benefits less from low interest rates.
[7] Future value of $1 million after 20 years at 6% equals $3,319,790. After offsetting with $520,000 of exemption, total estate tax at 40% equals $1,119,916 leaving 2,199,874 for children.
[8] Future value of $1 million after 20 years at 6% reduced by the $25,000 annual charitable donations equals $2,287,496. After offsetting with $520,000 of exemption, total estate tax at 40% equals $706,998 leaving 1,580,498 for children.
[9] This power should not be held by the donor to avoid inclusion in the donor’s estate under IRC §§ 2036(a)(2) and 2038(a)(1).
[10] Retention of this power by the donor, the trustee, or any other disqualified person could potentially be a prohibited transaction between the donor and the CLAT. See Rev. Proc. 2007-45 citing to IRC § 4946(a).
[11] See, e.g., PLR 201216045.
[12] To see a sample form CLAT, see IRS Rev. Proc. 2007-45 which includes a sample form inter-vivos CLAT. https://www.pgdc.com/pdf/rp-07-45.pdf
[13] See PLR 199922007.
[14] IRC § 170(f)(2)(B).
[15] Treas. Reg. § 1.170A-6(d)(2).
[16] Treas. Reg. § 1.663(a)-2.
[17] CLATs only represent 5% of IRS Form 5227 which is filed for charitable split-interest trusts. https://www.irs.gov/statistics/soi-tax-stats-split-interest-trust-statistics
