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Tuesday February 9, 2016

Article of the Month

The Benefits of Charitable Lead Trusts: Part I

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 or lower payout lead trusts can produce a benefit far greater today than in the past. Therefore, high net worth individuals will find the lead trust to be an attractive component of their estate, income and charitable tax planning.

This article is the first in a series of three on charitable lead trusts. Part I will cover the basics of charitable lead trusts and grantor charitable lead trusts. A discussion of non-grantor or family lead trusts, defective non-grantor lead trusts and creative applications of lead trusts will follow in Parts II and III.

Lead Trust Basics


In many respects lead trusts are the inverse of charitable remainder trusts (CRTs), though like CRTs they are split-interest trusts. Sec. 4947(a)(2). The typical lead trust will be funded with cash or stock and will pay either an annuity or unitrust amount each year to selected charities for a certain period of time (usually for a term of years). At the end of the selected trust duration, the remaining assets of the trust will either revert to the trust grantor or be transferred to family members or other non-charitable beneficiaries.

The basic requirement for a qualified lead trust is that it must make either an annuity or unitrust payment at least annually to one or more qualified charities. Reg. 20.2055-2(e)(2)(vi). If the lead trust is qualified and makes an annuity or unitrust payment to charity, the donor will qualify for a gift, estate or income tax charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).

In contrast to CRTs, which must pay out a minimum of 5% and a maximum of 50%, a lead annuity trust or lead unitrust does not have payout restrictions. For example, the payout may be as low as 1% or as high as 100%. The percentage used and the duration of the trust will merely produce a smaller or larger charitable tax deduction.

Similarly, an individual has wide latitude in selecting the duration of a lead trust. A lead trust may pay to charity for the life of the grantor, for a term of years or even for the lesser of a life or a term of years. Reg. §1.170A-6(c)(2)(i)(A) and (ii)(A). While CRTs are limited under Sec. 664 to a maximum of 20 years, a lead trust is not limited to a defined term of years. In some circumstances, individuals have created 30 year lead trusts with the remainder to grandchildren.

Unlike a CRT, a lead trust is not tax-exempt. In the case of a grantor lead trust, the trust’s income is taxable to the grantor and reported on his or her personal tax return. With non-grantor and defective non-grantor lead trusts, the trust is taxable as a complex trust and must report each year’s income on its Form 1041. Reg. 1.651(a)-4; Sec. 642(c)(1).

Finally, it should be mentioned that lead trusts are not subject to the 10% minimum deduction rule applicable to CRTs. Consequently, a lead trust will be considered qualified so long as it meets all applicable requirements.

Lead Trust Types


Individuals may create three different types of qualified lead trusts. The two most common types are the grantor lead trust and the non-grantor lead trust. A grantor lead trust is created for the primary benefit of an income tax deduction. With a grantor lead trust, the individual creating the trust (or grantor) will transfer cash, stock or other income-producing property to the trust. At the end of the trust term, the trust assets revert to the grantor.

Unlike a grantor lead trust, a non-grantor lead trust is created for transfer tax purposes with the prime 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 third type of lead trust is the defective non-grantor lead trust, so named because it is a non-grantor lead trust intentionally designed to be classified as a grantor lead trust. Consequently, the defective non-grantor lead trust produces both an income tax deduction and a gift tax deduction. Like the non-grantor lead trust, the trust assets will pass on to family or other non-charitable beneficiaries. Because there is both an income and gift tax benefit, this trust may be called a “Lead Supertrust.”

Grantor Lead Trust


Overview

If a lead trust is created with a reversion to the grantor of trust assets that exceed 5% of value, the lead trust will be a grantor trust. Sec. 673(a). The grantor trust is subject to the grantor trust rules of Sec. 671-678. Consequently, all income and gains flow through and are taxable to the grantor on his or her personal tax return. At the end of the lead trust term, the trust assets revert to the grantor or the grantor’s estate.

The grantor lead trust qualifies for an income tax deduction. Sec. 170(f)(2). The income tax deduction will be equal to the present value of the annuity or unitrust payouts to charity for the selected term of years. However, in order to benefit from the income tax deduction, the trust must be a grantor trust. This grantor trust status includes one important rule—while the trust annuity payments or unitrust amounts are transferred to charity, the grantor must report the trust’s income as taxable income on his or her personal tax return. Sec. 170(f)(2)(B). In addition, if the trust recognizes capital gain, the grantor is taxed on the gain, even though those gains may not be distributed during the trust’s duration.

Since there is a charitable deduction, the lowest applicable federal rate in the current month or prior two months period should be used. Sec. 7520(a). It is important to note that the charitable income tax deduction received for a lead trust is subject to a 30% of AGI deduction limit. This is because the charitable distributions from the trust each year are deemed “for the use of the charity” rather than “to charity,” which lowers the deduction limit for a cash gift to 30% of AGI. Sec. 170(b)(1)(B). If the donor passes away before the trust matures, there is a partial recapture of the charitable deduction. See Reg. 1.170A-6(c)(4).

Investments

For high net worth individuals looking for income tax relief, the grantor lead trust has great appeal. It enables them to receive an income tax deduction and reclaim the transferred assets at the end of the trust term. The downside to this benefit is that the grantor must report all of the trust’s income on his or her personal tax return, even if that income was part of the annual distribution to charity. For this reason, professional advisors should work with clients to develop an investment strategy that minimizes recognition of income during the term of the trust.

Generally, two main strategies are used to minimize a grantor’s recognition of income in a lead trust. First, grantors have commonly funded their lead trusts with cash, which is then used to acquire municipal bonds, preferably exempt from both state and federal tax. Each year the tax-free municipal bond income is distributed to qualified charities. Because the municipal bond income is not subject to federal or state tax, there is no additional tax consequence to the trust grantor. This strategy permits the grantor to fully use the tax savings produced by the income tax deduction.

Example 1: CLAT Invested in Municipal Bonds

Lionel is a successful litigator. This year he won a large civil suit that gave him a much higher-than-expected income. As such, he has been talking with his professional advisor about the need for a larger deduction than he usually takes for his annual gift to charity of $25,000. Lionel’s advisor suggested that he consider establishing a grantor charitable lead annuity trust (CLAT). With this trust Lionel could make his annual gift of $25,000 to charity, but he would be able to compress the next few years’ deductions into the current year. Because the trust’s income would be taxable to Lionel, his advisor suggested that the trust be invested in municipal bonds producing tax-free income. This would allow Lionel to fully take advantage of the income tax deduction.

Lionel decided to establish a seven-year CLAT funded with $500,000 cash that the trust would use to acquire municipal bonds. The trust pays an annuity amount of $25,000 per year to charity. By establishing the trust, Lionel receives an income tax deduction of $160,563. Because this deduction is “for the use of charity,” it will be subject to the 30% deduction limit. Over the seven years the trust will pay $175,000 to charity. Because the trust is funded with municipal bonds, Lionel will not have to pay tax on any of the trust’s income. Finally, at the end of the trust term, the trust assets will revert to Lionel.

The second investment strategy for grantor lead trusts is to fund the trust with appreciated stock. The tax deduction will reduce the donor's ordinary taxable income. In effect, charitable deductions save at the top marginal ordinary income tax rate. Each year the dividend income from the stock plus any realized gain from the sale of stock will be used to make the distribution to charity. If stock needs to be sold each year to make the distribution to charity, the basis in the portion sold will cause no gain recognition. The balance will be recognized at long-term capital gain rates. Even though there will be taxation on the capital gain, in many circumstances the charitable deduction will save at least twice the tax that is later paid during the term of the trust.

Example 2: CLAT Invested in Appreciated Stock

Moe is in a similar situation to Lionel in Example 1. However, he has a stock portfolio valued at $1 million. He plans to establish a grantor lead trust that would pay $60,000 a year to charity for seven years. At the end of that time he would like the stock back.

The stock has a basis of $500,000. When Moe transfers the stock to the lead trust, he initially receives an income tax deduction of $385,350. The lead trust pays out $60,000 per year to charity for seven years with the trust assets reverting to Moe at the end of that time. Each year the trust will receive some dividend income, which will be used to pay the $60,000 annuity amount. If the dividend income is not sufficient to pay the full $60,000, then some of the long-term capital gain stock will need to be sold to make up the difference. Both the dividend income and the realized capital gain from the sale of the stock will be taxable to Moe.

Fortunately for Moe, he will pay tax on the dividends and capital gain at preferential tax rates. If Moe is in the highest tax-bracket, then he will pay tax on the dividend and capital gain income at a 23.8% rate. However, any basis Moe has in the stock is tax-free.

Moe’s CPA projects half of the value of the stock is going to be basis and the other half is going to be taxable. If half of the $60,000 annuity amount comes from dividend income and the other half comes from selling some of the stock, then $45,000 would be taxable to Moe each year. At a 23.8% tax rate, Moe would be paying $10,710 in tax each year. The following table illustrates Moe’s net tax benefit from establishing the lead trust.


As can be seen, Moe’s net tax savings are greater than the amount of tax he will have to pay over the seven-year period. Though Moe would prefer not to pay any tax, he can be confident that even a grantor lead trust that produces taxable income provides him with significant tax savings.

Best Grantor Lead Trust Candidates


While grantor lead trusts can be great tax planning tools, they are not for everyone, especially because the trust income is taxable to the grantor. Grantor lead trusts best fit certain client profiles. Typically, a grantor lead trust is funded by an individual in a high income tax bracket. This is because the initial deduction, usable up to 30% of AGI, saves taxes at the grantor’s ordinary income tax rate. The subsequent payments to charity over the selected term of years are either tax-free municipal bond income or low-tax payouts of capital gain from sales of stock.

There are two common client profiles that could benefit from a lead trust. First, an individual who has had a significant cash-out event will find a lead trust appealing. This could be a person who sold highly appreciated real estate or stock, received a large bonus or lottery winnings, exercised stock options or sold a business. Second, an individual with a high annual income may be interested in establishing a grantor lead trust. For both these profiles a grantor lead trust enables these individuals to offset taxes they would be required to pay as a result of their high income. At the end of the trust term, they could receive return of the trust corpus (plus any potential growth).

Example 3: CEO Donor

Montgomery runs a number of successful businesses. One of his businesses is a recycling facility. He recently sold the business for $5 million. Montgomery’s basis in the business was $1 million, leaving him with a taxable gain of $4 million. Because he is in the highest ordinary-income tax bracket, Montgomery knows he will pay tax on the $4 million taxable gain at the highest long-term capital gain rate of 23.8%. In order to reduce his tax liability, Montgomery has been talking with his tax attorney, Waylon. Knowing that Montgomery does not like the idea of parting with his money, Waylon has suggested that Montgomery place the $5 million into a grantor lead annuity trust.

Under this plan, Montgomery will transfer $5 million to a 10-year term grantor CLAT paying out 5% or $150,000 per year to charity. When Montgomery establishes the CLAT, he receives an income tax deduction of $2,222,325, which equates to the present value of the annuity payments. If he cannot use all of this deduction in the first year, he may carry it forward up to five years. The total gift to charity over the 10 years will be $2,500,000. In order to minimize Montgomery’s tax liability over the 10-year period, the trust will be invested in either municipal bonds producing tax-free income or a diversified portfolio of stocks.

The income tax deduction of $2,222,325 will give Montgomery $880,041 in tax savings. The tax bill Montgomery will have on the sale of the business is $952,000. Consequently, the lead trust will allow Montgomery to reduce his net tax bill to $71,959 (the charitable deduction savings may be over one to six years). In addition, the trust assets will revert to Montgomery at the end of the ten years along with any potential growth. When Waylon asked Montgomery what he thought of the plan, he said, “Excellent!”

Conclusion


With the AFR hovering at historical lows, now is a good time for high net worth clients to think about establishing charitable lead trusts. For those individuals interested in receiving a charitable income tax deduction while still receiving return of the gifted property, a grantor charitable lead trust may be a great fit. The grantor lead trust is beneficial for a client with a high annual income or for an individual who has received a higher-than-expected cash-out during the year. In essence, with a grantor lead trust an individual loans the trust property and its income to charity for a term of years. After that time, the trust assets revert back to the grantor. Therefore, many high net worth individuals may find grantor lead trusts to be an excellent way for them to achieve their financial and charitable objectives.

Published February 1, 2016

Previous Articles

Early Termination of a Charitable Remainder Trust: Part II

Early Termination of a Charitable Remainder Trust: Part I

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Portability Part II - Deceased Spouse and Surviving Spouse

Portability Part I - Deceased Spouse and Surviving Spouse

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