Planning with Non-Grantor Charitable Lead Annuity Trusts

The government’s intervention to artificially lower interest rates has created important gift and estate tax saving opportunities when using Charitable Lead Annuity Trusts.  The CLAT is an irrevocable trust that pays a specified amount at least annually (called a “lead”) to charity for a term of years (not in excess of 20) or for the life of designated individuals.  The balance in the trust (called the “remainder”) either reverts to the donor (a grantor CLAT) or is paid to one or more non-charitable beneficiaries (non-grantor CLAT) upon termination of the lead interest.  Since gift and estate and gift taxes are scheduled to increase after 2012, a non-grantor CLAT can be a powerful planning vehicle to transfer property to heirs and reduce gift and estate taxes.

The non-grantor CLAT best fits those desiring to make charitable donations and to transfer property to their heirs as part of their estate tax planning.  The value of the charitable interest is subtracted from the fair market value of the property contributed to the CLAT in determining the taxable gift amount for the remainder passing to heirs.  When interest rates are low, the present value of the charitable interest is higher, thus making the taxable gift lower.  The IRS valuation interest rate has never been lower in its history.

Unlike a charitable remainder trust, the CLAT is not exempt from income taxes.  Therefore, it doesn’t make sense to contribute appreciated property to a CLAT, and then have the CLAT sell the property.  The non-grantor CLAT is taxable on income and gains earned, but it also receives a charitable tax deduction for the amount paid to charity.  Unlike an individual, the charitable deduction for a trust is not limited to a percentage of adjusted gross income (AGI).  The payment to charity must be from “gross income” and be authorized in the trust agreement.  Income earned above the lead amount can be contributed to charity and also receive a deduction, but only if the excess contribution is permitted by the trust agreement.

The IRS §7520 valuation rate is 1.2% for October 2012.  The rate is adjusted monthly.  The donor may select the lowest interest rate for the period of the month the CLAT is established or the prior two months.  Since the interest rate was 1.0% in September 2012, that rate can be selected for CLATs established in October or November 2012.  If the property donated to the CLAT earns more than 1.0% a year over the life of the CLAT, there will be significant estate and gift tax benefits.

Example

David pays tithing to his church and is interested in estate tax planning.  He owns $1,000,000 of investments that produce a total return of 6% annually.  Assume that yield and capital gains are recognized only in sufficient amounts to pay 5% annually to charity (zero taxable income) with the balance of the total return constituting unrecognized appreciation.  David would like to give the investments to his heirs as part of his estate tax planning, but not for 20 years during which time his heirs will have had the opportunity to work and gain maturity.  If David establishes a 20-year, non-grantor CLAT in October 2012 with the investments, and the CLAT makes a $50,000 annual payment to his church, then the following results would occur:

·       At the end of 20 years the balance in the trust would grow to $1,367,856 and be transferred to his heirs for a gift tax value of only $97,720 today.  The gift value would be offset by any unused portion of David’s lifetime gift tax exemption.

·       The trust charitable deduction would offset the trust earnings and gains resulting in no income tax to the trust.  Because the trust is making the charitable donations, David cannot take the deduction on his personal tax return.  But in turn, he does not include the investment income and gains on his return either, thereby lowering his AGI.  A lower AGI often results in keeping more tax benefits that are phased-out based upon AGI levels.

·       The amount of the $50,000 charitable deduction would not be at risk of reduction (like it would be if made by David instead of the CLAT) if the Bush tax cuts sunset in 2013, and if certain proposed tax reforms of either presidential candidate are enacted.