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Benefitting the Kids and Charity with One Powerful Strategy – The Charitable Lead Annuity Trust

This article addresses only the use of a qualified charitable lead annuity trust as a wealth transfer device.  There are a number of other possible uses of charitable lead trusts of various types, the discussion of which is beyond the scope of this article. 

The IDEA
For an individual searching for a powerful wealth transfer device and a charity searching for current cash flow, now is the perfect time to utilize a Charitable Lead Annuity Trust (CLAT).  

What’s so special about “now?”  Two things: 

  1. the “7520 rate,” the interest rate identified by the federal government as the rate to use in determining the value of the annuity interest, is extremely low and;
  2. many donors are holding assets that have lost value. (A smaller gift results in less gift tax.)

Because of the way in which the value of the transferred wealth is calculated, as the rate decreases, the benefit of the strategy increases.   

The BASICS
The purpose of a non-grantor qualified CLAT is to transfer wealth to a non-charitable beneficiary in a tax-efficient manner. By using the CLAT, the donor incurs a reduced gift tax liability and, at the same time, provides cash flow to a charity. 

The MECHANICS
A charitable lead trust is an irrevocable trust that creates two distinct interests, an income interest and a remainder interest. After the trust is created, the donor transfers cash or assets (assets that are likely to appreciate are generally the best choice) to the trust, creating an interest in the property in favor of a charitable organization for a period of years or for the life or lives of an individual or individuals. While the trust exists, the charity receives the income interest (periodic cash payments) and an individual of the donor’s choosing receives the remainder interest when the trust terminates. The value of the taxable gift (the initial transfer) is determined by subtracting the present value of the charity’s guaranteed annuity interest from the value of the property transferred. As the present value of the annuity interest increases, the value of the gift decreases. Similarly, the lower “7520 rate,” the higher the present value of the annuity interest.

Lower interest rate >>>> higher PV annuity interest >>>> lower value of the gift >>>lower gift tax liability

Note: A CLAT does not generally produce an income tax deduction. If a charitable income tax deduction is claimed, the CLAT’s income is taxable to the settlor of the CLAT throughout the term of the trust.  If the settlor does not claim an income tax deduction, the CLAT’s income is not taxable to the settlor.

Illustration:
Assume that the donor contributes $1,000,000 to a CLAT with a 15 year term that pays 5% (or $50,000) annually to a charity chosen by the donor. Using a 7520 Rate of 2% and assuming 7% growth of the assets, the result would be as follows:

  • Charity receives $750,000 >>> $50,000 per year for 15 years
  • Current year gift tax charitable deduction of $642,463 >>> Present value of $50K over 15 years
  • Taxable gift in the current year = $1,000,000-$642,000 = $357,537
  • Amount transferring to non-charitable beneficiary at the end of the 15 year term = $1,502,580

What this illustration shows is that the remainder beneficiary received over $1.5 million and the donor paid gift tax on only $358,000. Admittedly, much of the growth was over the 15 year period and during that time, the donor was not receiving the income from the asset but neither was he paying the tax on that income. There are a number of variables in an analysis of whether this strategy yields enough benefit to warrant the creation and administration of a new entity (the trust).  In short, however, trusts holding assets that yield returns in excess of the “7520 rate” will pass those “excess returns” to the remainder beneficiaries tax free. Given this month’s “7520 rate” (less than 2%), this is at least worth a second look.

The GENERATION SKIPPING TRANSFER TAX
The generation skipping transfer (GST) tax applies to transfers of income or corpus to a “skip person.”  A “skip person,” in the case of relatives, is any person who is at least two generations below the transferor (e.g.  a grandchild).  For non-relatives,  a  ”skip person”  is any individual who was born more than 37.5 years after the transferor.   The idea is that there should be a tax on the  transfer of wealth from one person to another. Without the GST, transferors would “skip” certain persons (their children) and transfer assets directly to the following generation (their grandchildren) thereby eliminating the tax on the transfer to an entire generation.   

When using a charitable lead annuity trust in a situation to which the GST applies, the determination of whether the use of the CLAT will be beneficial cannot be known until the trust term ends. Although the GST exemption is allocated when the trust is created, the inclusion ratio is not determined until the end of the trust term. A fictional GST exemption is created by applying a growth factor to the amount of the GST exemption based on the “7520 rate.”  The value of the trust assets at the end of the lead period is compared to the fictional GST exemption, and the resulting fraction is the inclusion ratio for the continuing trust. Generally, if the trust estate grows faster than the assumed federal rate, the CLAT will not be fully exempt at the end of the lead interest, and if the trust estate does not grow as fast as the federal rates predict, some of the GST exemption will have been wasted.

A lead unitrust may be a better choice where GST is applicable (the inclusion ratio is established when the trust is created) but some of the reduction in the gift tax may be lost by using a unitrust. It will be necessary to compare and contrast the two options. 

The ACTION
Call your accountant, do some research or contact a planned giving officer at your favorite charity but don’t miss this opportunity. The “7520 rate” is incredibly low and asset values are down; there may not ever be a better time to use a CLAT.

If you need additional information regarding this article, contact Tax Partner Lynn Henley at 415.568.3294 or email This e-mail address is being protected from spambots. You need JavaScript enabled to view it .