The Gift That Gives Back – Charitable Lead Trusts Can Help You Shelter Assets

Estate Planner Jan-Feb 1999
In the right situation, a charitable lead trust enables you to transfer significant wealth to later generations at reduced transfer tax costs, while helping you meet your charitable objectives.

The charitable lead trust (CLT) is the reverse of a charitable remainder trust. The CLT is an irrevocable trust established during life or at death that gives one or more charities the “annuity” or “lead” interest. The remainder interest passes to children or other noncharitable remainder beneficiaries, either outright or in trust. The remainder interest could also revert to the donor.

Generally, a CLT is appropriate if you are interested in supporting a charity and transferring assets to the next generation at substantially reduced transfer tax costs. The CLT is also suitable if you make substantial charitable contributions each year or your charitable gifts exceed the percentage of gross income ceiling on income tax deductibility.

How To Create a CLT

You establish a CLT by placing assets into a trust in which one or more charitable organizations receive an annuity interest for a period of time. (CLTs are not subject to the 20-year term limit that applies to charitable remainder trusts.) You can either stipulate the charities to receive the annual distributions in the trust agreement or leave the choice to the discretion of the trustee or a distribution committee. You should not serve as trustee.

To increase flexibility, you can designate a philanthropic or donor-directed fund or a private foundation as the charitable recipient. But take care that this increased flexibility and control do not cause the trust to be included in your estate for estate tax purposes if you die during the trust’s term. All assets remaining in the CLT at the end of the term (the remainder interest) are distributed to your children or to other designated beneficiaries.

Gift Tax Considerations

When you establish a CLT during your lifetime, the present value of the remainder interest is a current taxable gift. To calculate this value, you first determine the present value of the lead or annuity interest to the charity by using the applicable federal interest rate prescribed by U.S. Treasury regulations.

You then subtract this value from the total value of the assets placed into the CLT. The lower the applicable federal interest rate, the lower the taxable gift and the greater the potential benefit to the remainder beneficiaries if the trust can grow in value at a rate greater than the required payout.

For example, let’s say you transfer $3 million of appreciated securities to a CLT that distributes an 8% annuity each year for 20 years to your favorite charity. Table 1, below, shows how the results change depending on the applicable federal rate.
Increasing the term of the trust or the amount of the annual distribution may reduce or possibly eliminate the amount of the taxable gift.

Since the remainder interest in a CLT is a future interest, the taxable gift portion does not qualify for the gift tax annual exclusion. If the remainder interest passes to your spouse who is a US citizen, it should qualify for the gift tax marital deduction.

Estate Tax Considerations

You may establish a CLT at death through a will or revocable trust. Your estate is entitled to an estate tax charitable deduction for the present value of the charitable interest. This value is calculated in the same way as the charitable gift tax deduction.

If you transfer highly appreciated assets to a CLT, a testamentary lead trust may be preferable to a trust established during your lifetime. This is because assets transferred to a CLT created at the time of your death receive a step-up in basis. This will reduce the capital gains tax owed by the trust or by the remainder beneficiaries when the assets are sold. Unlike a charitable remainder trust, a CLT is a fully taxable trust. Income will be taxed either to the grantor or the trust (and the trust will be entitled to receive an offsetting charitable income tax deduction).

A CLT must be either an annuity trust or a unitrust. In the case of an annuity trust, the annuity is expressed as a percentage of the initial fair market value of the assets contributed to the trust. With a unitrust the annual distribution is redetermined each year based on the current value of the trust’s corpus. If the remainder interest in the CLT passes to your grandchildren or other “skip persons,” the generation-skipping transfer (GST) tax rules will apply differently depending on whether the trust is an annuity trust or a unitrust. How you can allocate your GST tax exemption depends on the type of trust established.

You may use a CLT to shelter future growth in the value of assets transferred to or acquired by the trust or as part of a business succession plan. You may be able to fund a CLT with discounted interests, such as in a family limited partnership, thus increasing the potential benefit to the remaindermen. A CLT may produce better results than a direct gift to grandchildren, depending on your assumptions of growth. Just be sure to run the numbers using different examples.

Timing Is Everything

Estate planning is often a matter of timing. The current low applicable federal discount rates provide a significant opportunity to use a CLT to leverage the transfer of wealth to the next generation. If you think a CLT may help you achieve your objectives, please call us. We would be glad to answer questions you may have about CLTs and show you how to use them to your best advantage.

Table 1: Calculation of Current Taxable Gift

Value of transferred securities $3,000,000 $3,000,000
Annual distribution to charity (8%) $240,000 $240,000
Applicable federal rate (120%) 5.4% 7%
Present value of charitable gift $2,892,000 $2,543,000
Taxable gift $108,000 $457,000