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IL Estate Planning Blog

Thursday, July 28, 2016

The Benefits of Charitable Lead Trusts

By American Heart Association:

The Benefits of Charitable Lead Trusts: Part II

Introduction


Charitable lead trusts have become more attractive as an estate and income tax planning tool. The reason for this is the historically low Section 7520 rates (Applicable Federal Rates or AFRs). In recent years, the AFR has hovered between 1.0% and 2.4% and hasn’t been above 3.0% since June 2010. With lead trusts, the lower the AFR, the higher the deduction. As a result, shorter term and lower payout lead trusts can produce far greater benefits today than were possible in the past. Therefore, high net worth individuals will find the lead trust to be an attractive component of their estate, income and charitable planning.

This article is the second in a series of three on charitable lead trusts. Part I covered the basics of charitable lead trusts and grantor charitable lead trusts. Part II will discuss the non-grantor lead trust. The purpose of a non-grantor lead trust is to leverage the gift or estate tax exemption so that individuals can transfer assets to family at a reduced gift or estate tax cost.

Family Lead Trust


As mentioned in Part I, there are two common types of charitable lead trusts: the grantor lead trust and the non-grantor lead trust. A non-grantor lead trust is created for transfer tax purposes with the primary benefit being a gift or estate tax deduction. This allows an individual better leverage of the gift or estate tax exemption amount. With the non-grantor lead trust, the trust assets will eventually pass on to family or other non-charitable beneficiaries. For convenience this trust may be called a “Family Lead Trust.”

The Family Lead Trust must satisfy all the basic requirements to be a qualified lead trust. Specifically, it must be an irrevocable trust that makes an annuity or a unitrust payment at least annually to one or more qualified charities. Reg. 20.2055-2(e)(2)(vi). If the lead trust is qualified, the donor will qualify for a gift or estate charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).

Zero Gift/Estate Tax Lead Trust


The primary benefit of a Family Lead Trust is leveraging the gift or estate tax exemption amount. If the exemption for illustration purposes is $5 million and a lead trust funded with $9 million produces a charitable gift deduction of $4 million, the remaining $5 million may be covered by the gift exemption. The $9 million in the lead trust will earn income for the selected term of years and pay the stated annuity or unitrust amounts to charity. At the end of that time, the $9 million plus growth may be transferred to family. Through use of the lead trust, the exemption has effectively been doubled for the benefit of family.

Individuals who want to use a Family Lead Trust to make a zero-tax transfer of assets to family will need to generate a gift or estate tax deduction equal to the taxable transfer being made. There are three ways to increase the deduction. First, the charitable deduction is calculated using the AFR from the current month or one of the two prior months. Sec. 7520(a). The most favorable result for a lead trust is to use a low AFR. A low AFR produces a higher income interest and thus a higher deduction. The two other ways to increase the value of the charitable deduction include increasing the trust term or the payout amount. Individuals who desire a “zero tax” lead trust should work with their advisor to find the optimum AFR, trust term and payout amount that will allow them to zero-out the taxable transfer to the trust.

Family Lead Trust Income Taxation


In contrast with a charitable remainder trust, which is normally exempt from trust income taxation, the lead trust remainder will pass to family and the trust is therefore subject to taxation. As such, it must file Form 1041 and pay taxes on its ordinary income and capital gain. For this reason, a lead trust does not offer the opportunity of a tax-free sale like the remainder trust.

While it is a taxable trust, a carefully designed lead trust should pay little or no income tax. This is because a lead trust receives an unlimited income tax deduction for distributions to qualified charities. Sec. 642(c). Therefore, if the distribution to charity each year is equal to or greater than trust income, the lead trust will pay no tax on its income.

However, unrelated business taxable income (UBTI) poses a problem for a lead trust’s ability to receive an unlimited deduction for distributions to qualified charities. Consequently, it is important to ensure that a lead trust does not have UBTI under Sec. 512. Otherwise, the deduction for distributions of UBTI to charity will be limited to a 50% charitable income tax deduction under Sec. 170. See Sec. 681. This could result in the trust paying tax on some of its income.

Example 1

Abe plans to create a $2 million non-grantor charitable lead annuity trust (CLAT). The CLAT will have a fixed payout of $100,000 per year, a 10-year term and Abe’s children as the remainder beneficiaries. Abe has a choice between two assets he could contribute. First, he has $2 million worth of stock. Second, he has a commercial building that he leases. Abe’s accountant has indicated that the lease payments include a net profits interest and therefore are UBTI.

If Abe funds the lead trust with the stock, the annual annuity payment will consist of dividend income and realized capital gain, totaling $70,000. Because the trust will pay out $100,000 to charity each year, it will be able to deduct the entire $70,000 from its taxable income. If the trust is funded with the commercial building, the lease income of $100,000 will be UBTI. Under Sec. 681, the trust’s deduction for amounts paid to charity will be reduced to 50% of AGI. Consequently, the trust will pay tax on $50,000 of its annual $100,000 lease income. Therefore, the best result is for Abe to fund the lead trust with the stock.

Family Lead Trust Investments


The investment strategy for a lead trust depends on whether the trust is created during life (living trust) or at death (testamentary). Generally, the lead trust is funded with securities. Each year, the interest from fixed income securities and the dividends from stocks are used to pay the annuity or unitrust amounts. Most lead trusts have a higher payout than the ordinary income from bond interest and stock dividends can match. As a result, some of the stocks may need to be sold to generate a realized gain to cover the balance of the required payments. It is very helpful for the trustee if the distribution to charity is an annual payment, since he or she must then sell stock only once per year to make the full payout.

For living lead trusts, the trust assets must be selected carefully. Because the trust is taxable, it is undesirable to sell, pay capital gain tax on the sale of the asset and then invest after-tax proceeds. Usually, the most favorable economic result is to hold the assets contributed to the trust and attempt to generate the desired annuity or unitrust payout to charity with the income and appreciation of the contributed assets. If there is no diversification of the assets contributed to the trust, the investment risk is greater. This higher risk with an undiversified portfolio must be understood by the lead trust grantor prior to funding the lead trust.

With a testamentary non-grantor lead trust, the step up in basis normally will allow diversification of trust assets. The trustee of the charitable lead trust may then acquire a portfolio designed to produce maximum return. Most trustees create a portfolio that is approximately 60% or 70% equities, with the balance in fixed return securities.

Charitable Recipients


The charity receiving payouts from a lead trust must be a qualified exempt charity and thus be able to receive charitable transfers under Sec. 2055 for estate tax or Sec. 2522 for gift tax purposes. It is permissible to retain the power to name the charitable recipients after the trust is created. Normally, this power is not retained by the trust grantor to avoid estate inclusion if he or she passes away prior to the expiration of the lead trust. Sec. 2036(a). However, it is permissible for the children of the trust grantor to select the qualified exempt charities each year. PLR 200029033; PLR 9331015.

Some individuals creating non-grantor lead trusts prefer to give the trustee the power to sprinkle the annuity or unitrust amount among qualified charities. If the trust grantor prefers to give the trustee the power to sprinkle income, it is imperative that the grantor not serve as trustee. Otherwise, the grantor runs the risk of estate inclusion. A trust grantor may serve as trustee where he or she only has routine administrative powers with charity selection falling to an independent trustee or the grantor’s children. See PLR 9629009; PLR 9748009.

Case Study: Ned and Maude


To illustrate the powerful exemption leveraging provided by a non-grantor lead trust, it is helpful to review the following case study. Ned and Maude are ages 75 and 70, respectively. Their combined estate value is $15 million. Neither of them has used any of their lifetime gift exemption of $5.45 million ($10.9 million with portability). Consequently, Ned and Maude’s combined estate will pay estate tax on $4.1 million.

In order to reduce the value of their taxable estate, Ned and Maude have worked with their attorney, Gil. Because of the current low AFRs, Gil has recommended that Ned and Maude establish a non-grantor lead trust. Ned and Maude will fund the trust with a current investment portfolio of securities worth $5 million.

To maximize the leveraging benefits of the trust, it will be a CLAT. The CLAT will pay an annuity amount of $325,000 per year to charity for 12 years. The total charitable payments in 12 years will be $3,900,000. By establishing the trust, Ned and Maude will receive a gift tax deduction of $3,395,145, which will reduce their taxable gift from $5,000,000 to $1,604,855.

At the end of the 12-year period, trust assets will pass to Ned and Maude’s two children. The potential value at that time is $5,447,211. There will be no gift or estate tax on the $447,211 of growth.

This arrangement allows Ned and Maude to leverage their gift tax exemption. Instead of having to either pay gift tax on $5 million or use $5 million of their gift exemption, Ned and Maude are able to reduce the taxable gift to $1,604,855. Consequently, they are able to make a $5 million gift to family at a significantly reduced gift tax cost.

Ned and Maude could also increase the payout or trust term in an attempt to “zero-out” the taxable gift. For example, if they increased the lead trust term to 19 years instead of 12, they would receive a gift tax deduction of $5 million, reducing their taxable gift to zero.

Lead Trust Planning Strategies


Annuity or Unitrust Payout?

Individuals seeking to create a non-grantor lead trust will have important design decisions to make. First, it must be decided whether the trust is going to pay an annuity or a unitrust amount. Generally, an annuity payout will be preferred because of its more advantageous exemption leverage benefits. A lead annuity trust with a starting annuity payout of 5% will produce a larger deduction than a 5% lead unitrust. In addition, because a lead annuity trust pays a fixed amount, as the trust grows in value, the payout will remain the same, potentially allowing the trust assets to grow faster than those within a lead unitrust.

A lead annuity trust is generally not the preferred payout method when the main goal of the trust is to pass on assets to grandchildren or other generation-skipping beneficiaries. The reason for this is the generation-skipping transfer tax (GSTT). When grandchildren are the desired remainder beneficiaries, the trust grantor will need to be concerned about the gift and estate tax as well as GSTT. The GSTT exemption is the same value as the gift or estate tax exemption, but it is a separate from the gift or estate tax exemption.

Just like the gift or estate tax exemption, if a grantor wants to avoid GSTT he or she will need to have a taxable transfer less than the exemption amount. It is possible to determine how much of the GSTT exemption needs to be allocated to a lead unitrust at the time the trust is created. With a lead unitrust, the applicable fraction equals the allocated exemption, divided by the fair market value of the property, minus the charitable deduction. If the allocated exemption is equal to the present value of the taxable gift, the applicable fraction equals one. Since the inclusion ratio equals one minus one, or zero, the lead unitrust is exempt from GSTT. This gives grantors certainty in knowing how much of their GSTT exemption to allocate to the trust in order to result in a zero-inclusion ratio and thus a GSTT-free trust.

With an annuity lead trust, the applicable fraction is not calculated until the termination of the trust. The applicable fraction then equals the exemption with growth for the trust term calculated at the applicable federal rate as of trust inception, divided by the value of the trust at termination. Sec. 2642(e)(2). This method subjects the trust to considerable uncertainty. While it is possible to know the value of the exemption with projected growth, the actual trust corpus will not be known with certainty until the date of distribution.

Example 2

Lenny has an estate worth $20 million. Knowing that he will have a taxable estate, he has worked with his attorney to include two lead trusts in his estate plan. One trust will be funded with $8 million and will benefit his children. The other trust will be funded with $7 million and will benefit his grandchildren. Lenny’s attorney has explained to him the potential estate tax and GSTT consequences of establishing the lead trust for his grandchildren.

If the lead trust for Lenny’s grandchildren is a 5% annuity lead trust paying $350,000 per year for 15 years, the adjusted GSTT exemption will be $7,553,704. If the value of the lead trust is $8,629,318 at the end of the lead trust term, Lenny’s grandchildren will pay GSTT of $430,246. However, if the trust is a lead unitrust, then the allocable GSTT exemption at the trust’s creation will be $3,299,163, the value of the taxable transfer. With a lead unitrust, Lenny knows exactly how much of his GSTT exemption should be allocated to the trust. In addition, Lenny will still have $2,150,837 worth of GSTT exemption to use.

Living or Testamentary?

Another important consideration for lead trust grantors is whether the lead trust should be created during life or should instead be a testamentary trust. If the lead trust is created during life, then the grantor in effect “freezes” the value of the gifted assets for transfer tax purposes. Thus, if the transferred assets grow significantly during the trust term, that growth will not be subject to further gift or estate tax when the trust terminates.

However, if a lead trust is created during life, the trust faces greater investment risk. This is because the trust will receive the same basis in the transferred assets as the grantor had. Therefore, if low basis assets are contributed to the lead trust, the family will eventually receive those assets with a low cost basis. Selling those assets could generate a significant capital gain. However, it could be possible for family members at that time who desire to sell the assets to use a sale and unitrust combination to zero the capital gain tax upon sale.

A testamentary lead trust will be funded with assets that receive a step-up in basis. This will allow the trustee to sell the assets and reinvest in a more diversified investment portfolio. In addition, when the trust terminates, family will potentially be facing a lower capital gain tax liability.

Other considerations for grantors deciding between living or testamentary trusts include their preferred level of control. A grantor who establishes a lead trust during life will lose control over the transferred assets. This could pose a problem if the grantor later decides he or she needs the assets or if the grantor would prefer to use the assets for some other purpose. Finally, a living lead trust allows a grantor to know with certainty when his or her family will receive the trust assets. The trust grantor will also be able to witness charity or charities benefit from the charitable distributions during his or her lifetime. Such a consideration may be essential to some clients.

Conclusion


A non-grantor charitable lead trust may perfectly suit an individual with a taxable estate who wants to leverage his or her exemption to make a tax-free or low-tax transfer to family. With the current low AFR rates, individuals establishing non-grantor lead trusts can effectively double the value of their gift or estate tax exemption amount. Potential lead trust grantors should be made aware of the taxable nature of non-grantor lead trusts. In addition, they need to decide whether to establish the trust during life or at death and whether the trust should have an annuity or unitrust payout. With proper design and good planning, non-grantor charitable lead trusts can be a powerful way for individuals to pass significant assets to family at little to no transfer tax cost. 

Published March 1, 2016


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