Assignment 4: Charitable Lead Trusts

Question 1

How CLTs work

Answer 1

1. Donor contributes cash or asset to CLT
2. CLT makes payments to charity for a number of years
3. Remaining assets pass to donor or another when the trust terms ends

Question 2

Who are CLTS for?

Answer 2

• Highly affluent individuals/families who are concerned with gift and estate taxes (not cost effective for smaller amounts–also termed “Jackie Onassis Trust”)
• Part with asset for a number of years; gives up income stream in return for estate and gift tax savings (deferred inheritance trusts)
• Used by families to reduce or zero-out an estate for transfer tax purposes

Question 3

CLT Terminology

Answer 3

Qualified vs. Non-qualified CLT

CLAT–Grantor and Nongrantor

CLUT–Grantor and Nongrantor

Question 4

Qualified or Nonqualified CLT

Answer 4

Qualified
- Meets IRS requirements for deductibility of the lead interest for income, gift and estate tax purposes (CLAT/CLUT)

Nonqualified

• Does not meet IRS requirements.
• Taxed as a complex trust for income tax purposes

Question 5

CLT: Annuity or Unitrust

Answer 5

CLTs: No minimum or maximum distribution amount; No 5% probability test or 10% minimum charitable interest test; MUST PAY OUT AT LEAST ANNUALLY

Annuity

• Fixed dollar amount each year, expressed as a dollor amount or a fraction or percentage of the trust’s initial value
• Amount can increase over years; unequal payments; so long as the value of the lead interest is ascertainable at the inception of the CLT (e.g., 2% for the first five years, then increasing to 5%)

Unitrust
- Fixed percentage of the FMV of the trust determined annually

Question 6

CLT valuation date

Answer 6

CLAT
–Date the assets are transferred by the donor to establish the trust

CLUT
–Trust document specifies the day of the year or the value can be calculated as the average of multiple dates but the same days must be used each year.

Question 7

Inter Vivos or Testamentary

Answer 7

Inter Vivos

• Set up while living
• Good tool for a person who makes significant annual charitable donations and who has difficulty staying within the AGI limitations for their charitable contributions

Testamentary

• Set up to take effect at death (via a will)
• Used for reducing federal estate tax that will occur upon death
• Testator’s estate may claim a federal estate tax deduction for value of the charitable interest; only the remainder will be subject to tax

Question 8

CLT Reversionary or Non-Reversionary

Answer 8

Reversionary–trust assets come back to the grantor at the end of the trust term

Non-reversionary–Trust assets go to some other noncharitable beneficiary at the end of trust term

Question 9

Grantor or Nongrantor CLTS

Answer 9

Grantor

• is the owner for tax purposes
• remainder beneficiary is donor or donor’s spouse
• There is an income tax deduction

Nongrantor

• not the owner for tax purposes
• remainder beneficiary is someone other than donor/donor’s spouse
• estate/gift tax advantage–not income tax deduction

Question 10

CLT Trust Term

Answer 10

Payment to charity can be specified by a term of years or based on a life or lives in being at the inception of the CLT

Term of years–no term of years limitation; longer term yields a larger charitable deduction; balance tax avoidance goals and growth of principal

Payment for Life or Lives*–Measuring lives that can be used:

• settlor
• his/her spouse
• descendants of the settlor
• spouses of such decendants
• State’s rule against perpetuity will apply even though no maximum number of years

Question 11

CLT Remainderman

Answer 11

• No limitation as to which individuals are eligible to receive the remainder interest
• Usually for children or grandchildren

Question 12

CLT Charitable beneficiaries

Answer 12

Qualifies for a deduction

• charity or charities
• Supporting orgs
• DAFs
• Private Foundations (but be aware of self-dealing rules)

If the settlor retains the power to change the charitable beneficiary, then the lead interest gift is income for gift tax purposes; power must be given to an independent trustee

Trustee may sprinkle the payment amount qualifying charities

Question 13

CLTs not a Tax Exempt Entity

Answer 13

• Four-tier accounting in CRTs does not apply to CLTs
• Taxed like any other taxable trust (Nongrantor–files its own tax return/Grantor–all tax implications flow back to the grantor-reflected on grantor’s personal tax return)
• Undistributed income–taxed at trust income rates

Question 14

CLT: Present value of income stream

Answer 14

Value of income interest transferred to charity depends on:

• Payout rate: CLAT–Annual payment amount/CLUT–percentage of FMV
• Frequency of payments: Annual, semi-annual, quarterly, monthly
• Trust term: Number of years the payments will be made
• 7520 rates*: IRS provides tables to determine interest rate used for discounting the payments (published monthly)/use the month the property is transferred or elect to use the 7520 rate for either the two months before the transfer
• IRS tables cannot be used if the principal will be exhausted before all annuity payments can be made, or if using a life expectancy and the person is terminally ill

Question 15

Non-grantor CLT

Answer 15

Donor contributes cash or asset to CLT –»CLT makes payments to charity –»Remaining assets pass to a non-charitable beneficiary who is neither the donor nor the donor’s spouse when the trust term ends

There are two transfers by a donor in a non-grantor DLT:

1. Income interest in the trust assets to charity
2. Remainder interest to a noncharitable beneficiary other than the donor/donor’s spouse

Question 16

Non-grantor CLAT (seperate entity)

Answer 16

• donor does not retain enough control to be treated as the owner of the income interest
• Income from assets is taxed to the trust, and the trust deducts the payments to charity
• Income and deductions are transferred from the donor to the trust
• Trust is a separate entity

Question 17

CLT Tax Consequences

Answer 17

Tax planning advantage:
Grantor–Donor gets an immediate charitable income tax deduction for the present value of the annuity or unitrust amounts transferred to the charity when the trust is established. This is a one-time deduction–not on charitable contributions the trust makes after the trust is funded. Subject to 30% AGI limits and can be carried over for up to 5 years

Non-grantor–Donor does not get income tax deduction, but can claim a gift or estate tax charitable deduction equal to the value of the income interest given to charity

Question 18

Inter Vivos zero-ing Nongrantor CLT

Answer 18

• Only the remainder interest passing to the noncharitable beneficiaries is subject to gift or estate tax when the trust is funded
• If income inside the trust exceeds payout to the charity, then gift or estate tax may be due, depending on the donor’s net taxable income (investments need to be carefully managed)
• If the remainder interest exceeds the donor’s applicable exclusion amount ($11.58M for 2020) then gift or estate tax may be due

Question 19

“Zero-Out” Nongrantor CLAT

Answer 19

• While zero-ing out CLUTs are difficult because payments are based on a percentage of FMV, it is possible for CLATs.
• With a high-enough payout rate, a low enough 7520 rate, and a long enough trust term, the actuarial value of the charitable interest will shelter the entire value of the asset transferred to the trust
• Trust can zero out for tax purposes while assets may actually grow

Question 20

Zero-Value Nongrantor CLAT illustration

Answer 20

• Donor gives $1 M to CLAT
• Gifts fixed at $70,000, given to charity each yeaer for 20 years
• 7520 rate at 3% for this illustration
• “Zeros out” transfer tax on that asset
• At end of term, balance goes to heir
• If trust earns 8%, then heir gets $1.4M–with non transfer tax

Question 21

Grantor CLT–How they work

Answer 21

Donor contributes tax or asset to CLT–»Donor gets a partial income tax charitable deduction–»CLT makes payments to charity–»Remaining assets pass back to dondor when the trust term ends

There are two transfers by the donor:

1. Income interest in the trust assets to charity–donor gets a charitable deduction for this transfer
2. Remainder interest back to donor–as owner, donor recognizes trust income as it is earned even though it is paid to the charity. It may be included in donor’s estate

Question 22

Triggers for Grantor status

Answer 22

• Grantor or nonadverse party has power to revoke trust, or return corpus to grantor
• Has power to distribute income to grantor or grantor’s spouse
• Grantor retains more than 5% reversionary interest in corpus or income
• Grantor has power over the beneficial interest
• Grantor has admin powers from which the grantor may benefit
• Trustee, beneficiary, or other person can take income or corpus for himself
• A trust can transfer property to a foreign trust for a U.S. beneficiary

Question 23

Income Tax Deferral Tool

Answer 23

Timing—Deduction now, tax later (have use of money)

Income tax rates–deduct against ordinary income now while at higher marginal tax rates; expect to be at a lower marginal income tax rate when income is recognized (i.e. retirement)

Question 24

Managing a Grantor CLT

Answer 24

• Donor must recognize all of the trust income; “phantom income” (i.e. taxable income that does not generate cash)
• “Phantom Income” and remainder value actually received by the beneficiaries are influenced by investment strategy and asset allocation

Question 25

CLT Recapture Risk

Answer 25

If a donor dies before the trust terminates or otherwise ceases to be deemed the owner of the CLT for income tax purposes, then the donor must recognize taxable income equal to…

• The income tax charitable deduction taken when the trust was funded, minus–
• Required payments to charity made before the donor’s death (discounted to the date of the contribution)

Question 26

Grantor CLT Investments

Answer 26

Traditional “diversified” portfolio

• Some ordinary income (rent, dividends, interest) earned each year
• Some gains (long- and short-term) realized from time to time as portfolio is actively managed

All taxable receipts are taxed to donor, whether paid out to charity or retained by CLT

Question 27

Traditional Portfolio

Answer 27

• Does not consider the tax effect of earnings, trades or other components of asset management that might impact the donor in a grantor trust “phantom income”
• Trust holdings not specifically designed to minimize effects of “phantom income”
• May result in tax payments by donor which are not necessary in light of donor’s objectives

Question 28

“Tax Free” Portfolio

Answer 28

• All earnings of CLT are tax-exempt, so donor receives no “phantom income”
• Growth of corpus is minimal at best
• If payout is greater than earnings, then corpus will be distrubuted, reducing remainder value

Question 29

“Tax Sensitive” Management

Answer 29

• Attempt to balance “phantom income” against long-term growth in corpus through strategic asset selection and management
• Combination of tax-free investments (to support payout requirement) and stocks with long-term growth potential (to increase value of remainder interest)

Question 30

But what about the Prudent Investment Standard?

Answer 30

• Generally, a CLT should diversify trust assets in accordance with a prudent portfolio standard
• HOWEVER, it is not uncommon for a nongrantor CLT plan to contemplate that the contributed asset will go to the heirs. Therefore, it is important that the trust’s governing instrument include language that authorizes or directs the CLT trustee not to diversify that asset.

Question 31

Administrative Considerations of CLT

Answer 31

Some cost:

• Set-up costs for drafting document
• Annual tax on taxable income
• Annual tax return preparation fee
• Trustee fee
• Penalty taxes

General filing requirements:

• Form 1041–nongrantor trusts
• Grantor CLTs follow grantor trust requirements
• Form 5227 - nongrantor and grantor trusts file–available for public inspection (except for Sch A)

Question 32

When to consider a CLT

Answer 32

• Liquidity event (selling a business, get a deduction, don’t have to part with the principal)
• A CLT will benefit younger generations in the future, passing assets to the next generation with little or not gift tax
• IPO–generates lump sum deduction in year that the shareholder had gain on the stock

Question 33

When to consider a CLT

Answer 33

• Low 7520 rate is ideal for CLATs
• Depressed asset, if the asset is expected to rebound
• Client who wants to benefit charity
• Client whose noncharitable remainder beneficiaries can afford to wait for property (but consider an irrevocable life insurance trust as a solution for use with testamentary CLT)

Question 34

Nongrantor CLT Client Profiles

Answer 34

• Substantial future estate tax problem
• Assets which the client-donors do not need for current income, do not need for their own benefit
• Most likely married candidates will have $25M or significantly greater net worth

Question 35

Inter Vivos CLT Donor Profile

Answer 35

• Client is making ongoing gifts to charity from an income producing portfolio
• Client is maxing out charitable deductions–he/she cannot fully deduct gifts because of percentage limitations on income tax deductions
• Consider transferring income-producing assets to a CLT (Removes the assets from the estate, provides for the charity for the term of the trust, solves the AGI issue)

Question 36

Generation-Skipping Transfer Tax

Answer 36

• Donor wants to name noncharitable remainder beneficiaries more than one generation down (e.g. grandchildren)
• Subjects generation-skipping transfers to an additional transfer tax
• Rules differ for CLAT as opposed to CLUT (more favorable for CLUT)

Question 37

Super Lead Trusts

Answer 37

• This is a Grantor CLAT
• Typically zeroed out
• Attempts to achieve both a transfer tax and an income tax deduction
• IRS-approved design
• Grantor trust status and exclusion of the CLT assets from grantor’s estate

Question 38

Shark-Fin CLAT

Answer 38

• considered to be an aggressive CLAT
• Gets its name from the graphical representation of a shark fin…small annuity payments over the term of the CLAT which spike at the end of the term with a large balloon payment
• This structure could benefit from a longer term investment strategy, leaving enough income longer term to benefit heirs

Question 39

CLT to DAF and Private Foundations

Answer 39

• Beware of self-dealing practices with private foundations
• If the charity is donor’s private foundation, and donor is director, this may cause inclusion of the CLT property in the donor’s estate.
• To avoid inclusion, provide in foundation’s bylaws that donor will not participate in decisions regarding the disposition of distributions from the foundation attributable to CLT payments
• Alternatively, name a DAF at a community foundation as the charitable recipient

Question 40

CLT and Private Foundation Rules

Answer 40

CLT trust terms must prohibit:

• Self-dealing, i.e. the sale or exchange of property between the trust and any “disqualified person,” including the donor or a trustee
• Excess business holdings (prohibition on holding more than 20% voting interest in a business entity)
• Jeopardizing investments–risky investments that may jeopardize the trust
• Taxable expenditures–transfers for non-charitable purposes