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Thursday April 28, 2016

Article of the Month

The Benefits of Charitable Lead Trusts: Part III

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 final in a series of three on charitable lead trusts. Part I covered the basics of charitable lead trusts and grantor charitable lead trusts while Part II discussed the non-grantor lead trust (family lead trust). This third part will discuss two distinct lead trust topics. First, an overview of the intentionally defective non-grantor lead trust will be provided. For the sake of convenience, this article will use the term “super lead trust” instead of intentionally defective non-grantor lead trust. Second, this article will discuss some advanced lead trust strategies that will illustrate the lead trust’s flexibility as a charitable and estate planning tool.

Super Lead Trust


Attorneys and professional advisors may have clients who like the appeal of a family or non-grantor lead trust, but who also need an income tax deduction. Fortunately, there is a way to design a lead trust that passes on assets to family, avoids estate inclusion and generates an income tax deduction. For this design to work, the trust must qualify as a grantor trust, generating an income tax deduction, and also qualify as a complete gift. The combination of an income and gift tax deduction provides the client with even greater leverage of the lead trust.

Super Lead Trust Design


The goal of the super lead trust is to combine the benefits of a grantor and a family lead trust: an income tax deduction and leveraging of the gift tax exemption with a gift tax deduction. With a typical family lead trust, preventing estate inclusion is essential. Thus, it will be necessary to create a trust that is not included in the taxable estate. For this reason, the grantor may not retain a reversion or control over the distribution of income. Sec. 2036(a).

However, the grantor must retain a power that does not cause estate inclusion, but does cause the trust to be a grantor trust. The preferred retained power is usually held by a non-adverse party to reacquire trust assets. Sec. 675(4).

The power to reacquire assets under Sec. 675(4), when held by a non-adverse party and exercised in a non-fiduciary role, causes the trust to become a grantor trust. In some circumstances, the trust grantor has retained that power. While it would seem unlikely that the trust grantor would exercise that power, since that could be construed to be a violation of the self-dealing rules under Sec. 4941, it is still a potential power that does create grantor trust status. If the grantor does retain this power, he or she could argue that exercising this power would be permitted under the "incidental exception" to the self-dealing rules. Reg. 53.4941(b)-3.

For more cautious counsel, a safer option would be to give a brother or sister of the client the Sec. 675(4) power to reacquire assets. Since the Sec. 4941 disqualified persons category includes spouses, children, grandchildren and their spouses, but not brothers or sisters, this provision does not violate the self-dealing rules. Sec. 4946(d). The brother or sister would also need to be able to exercise this power in a non-fiduciary capacity to cause the lead trust to be a grantor trust. See PLR 200010036.

Successfully designed, the super lead trust intentionally has grantor lead trust status. This allows the client to receive both an income and gift tax deduction while also avoiding estate inclusion. Of course, because the trust is considered a grantor lead trust, the grantor will be required to report all of the trust’s income on his or her personal tax return. For this reason, as discussed in Part I, investments designed to minimize taxable income, such as municipal bonds or long-term capital gain stock, should be selected.

Example 1

For many years, Willie owned and operated a successful school janitorial business. Consequently, he has a taxable estate and has talked with his attorney about establishing a family lead trust. However, while Willie likes the gift exemption leveraging benefits of the family lead trust, he also needs an income tax deduction. To solve his problem, Willie’s attorney, Lionel, has suggested he establish a super lead trust.

Willie plans to fund the trust with $3 million of appreciated, long-term capital gain stock. Because the trust will have grantor trust status, Willie will report all of the trust’s income on his personal tax return. Fortunately, most of the trust’s income will be taxed at preferential long-term capital gain rates, since it is composed of qualified dividend income and realized long-term capital gain from sales of the stock.

The trust will last for seven years, paying an annual annuity amount to charity of $180,000 each year for a total payout of $1,260,000. Willie receives a gift and income tax deduction of $1,164,960. At the end of the seven years, the trust assets plus any growth will be distributed to Willie’s family.

Advanced Lead Trust Strategies


This series on lead trusts has focused on the primary benefits of the three different types of lead trusts. However, all clients have unique situations with differing goals and objectives. Fortunately, a lead trust can be a very flexible estate, income tax and charitable planning tool. The remainder of this article will discuss some of these more advanced lead trust strategies and how they enhance the core benefits of charitable lead trusts.

Layered Lead Trust


A family lead trust or a super lead trust can be a great tool for clients to pass on assets to family at reduced gift or estate tax cost. Some clients may be wary of the long duration necessary for a lead trust to generate a sufficient gift or estate tax deduction. For these clients, they are concerned that a 12 or 15 year lead trust will result in a “long delay” of their family members’ inheritance.

A solution to this “long delay” dilemma is to establish multiple lead trusts with increasing term durations. For example, a client could establish one lead trust that terminates in four years, another in eight and so on. These different “layers” provide family with an inheritance over time as opposed to all at once. Establishing multiple lead trusts may also be recommended if grandchildren are beneficiaries. As discussed in Part II, a lead unitrust provides more certain generation-skipping transfer tax (GSTT) planning than is possible with a lead annuity trust. The layered lead trust approach can be a great component of an estate plan where the goal of the parent is not only to provide children with an inheritance, but also to ensure that they are well-rounded and financially responsible individuals.

Example 2

Bob and Selma have a $20 million estate that they desire to leave to their three children and six grandchildren. Their attorney, Herschel, has proposed a family lead trust as a solution. However, Bob and Selma want an inheritance plan for their children that will help them develop responsible investment habits. They also want to avoid the “long delay” problem of a lead trust. In addition, Herschel has made them aware of the potential GSTT that could be levied on the transfer to grandchildren.

Because of Bob and Selma’s goals, Herschel has recommended they establish four lead trusts. The first three trusts will be for the benefit of Bob and Selma’s children and will be annuity trusts. The fourth trust will benefit the grandchildren and will be a lead unitrust for GSTT planning purposes.

In devising the plan, Herschel assumes that Bob and Selma will be able to take advantage of the deceased spouse unused exclusion amount (DSUEA), increasing their combined exemption to $10.9 million. Finally, Bob and Selma want to transfer only $18 million of their estate to family with the lead trusts, using the balance as an immediate inheritance when they pass away.

With this layered lead trust plan, the trusts will distribute assets to the family members over a period of 20 years. The trusts will distribute to family in four, eight, 12 and 16 years.


Bob and Selma were very pleased with the plan. They are able to transfer $18 million of their estate to family with no estate tax or GSTT. In addition, after estate costs, they will be able to leave an immediate inheritance of $1.6 million to their family.

Double Discount Lead Trust


For a client creating a family lead trust, the primary goal is a zero-tax transfer of assets to family. However, to accomplish a zero-tax transfer, the trust payout must be high, the duration long or a combination of both. If a lead trust plan is structured properly, a client may be able to move assets through to children in a few short years with zero gift or estate taxation and a reasonable payout.

The way to do this is with a “double discount” lead trust. The double discount lead trust combines a family limited partnership (FLP) with a charitable lead annuity trust.

Double Discount Steps

The first step in this plan is for the client to transfer assets into a FLP, which is created with 99% limited partnership interests and 1% or less general partnership interests. Under IRS guidelines, there must be a business purpose for the limited partnership.

A limited partnership interest is typically not easily sold and the family member with the general partnership interest controls the operation and liquidation of the partnership. Thus, under the willing buyer/willing seller test, the appraiser will provide a significant discount from fair market value. The discount levels for FLPs with liquid securities are typically 15% to 20% and for those that hold real estate 30% to 40%. These discounts reflect both the lack of marketability and the lack of liquidity of the FLP interests.

Once the FLP is created, the client then transfers the limited partnership interests with their discounted value into a lead trust. This is the first discount. The second discount comes from the gift or estate tax deduction, which further reduces the value of the taxable transfer. Combined with the exemption amount, the client can then use the double discount lead trust to make a zero-tax transfer to family in a short period of time.

Design Considerations

For a double discount lead trust to work, it must be appropriately designed. First, the partnership should not produce any unrelated business taxable income (UBTI). While lead trusts normally are able to earn and deduct 100% of income under Sec. 642(c) when the income is transferred to charity, lead trusts with UBTI are subject to the 30% appreciated and 50% cash limits of Sec. 170. See Sec. 681. A partnership will produce UBTI if there is any debt-financed income or if the partnership is engaged in an active trade or business. Therefore, there should not be debt in the partnership and the partnership should not contain an active business.

Second, the combination FLP and lead trust does require a fairly knowledgeable attorney and an experienced appraiser. The valuation of the discount on the FLP must be very well supported, or it may be subject to challenge by the IRS.

Another design decision includes considering the possibility of a sale of assets during the term of the lead trust. Since a lead trust is a taxable trust, potential negative tax consequences exist with a sale of trust assets and payment of capital gains tax out of the lead trust. It is possible that a major portion of the lead trust principal could then be required to make the distributions to charity, thus reducing the inheritance for family.

In some circumstances, the limited partnership will make distributions to the lead trust and those distributions may then be transferred to the charity. However, it may in other circumstances be necessary or appropriate to transfer limited partnership interests to the charity. At a future time, a plan would necessarily contemplate repurchase of those interests by the family from the charity. Fortunately, a public charity is not subject to the Sec. 4941 self-dealing rules. Therefore, the children or an entity owned by the children would be permitted to repurchase limited partnership shares at fair market value.

The FLP/lead trust plan provides a very effective means for wealth transfer. Assets may be transferred to family members in a relatively short period of time with little or no gift taxation.

Example 3

Lisa has a substantial estate and desires to move significant assets to family members. She would like to leverage her exemption so that for each dollar of exemption used she is able to move at least five million dollars through to family members.

Working with her attorney, Lisa came up with a plan to transfer $5 million to a family limited partnership. She selected a mix of liquid property and real estate with a fixed payment lease. The appraiser determined a 40% discount for the limited partnership interests because of a lack of marketability and lack of control. Lisa then transferred the limited partnership interests with their $3 million discounted value into a lead trust. The trust paid out $300,000 per year to charity for seven years, which produced a gift tax deduction of $1,941,600. This in turn reduced her taxable gift to $1,058,400.

Lisa is pleased with this plan because she is able to pass on $5 million of assets plus any growth to family members in only seven years and at a cost of only about $1 million of her exemption amount. For Lisa, the double discount lead trust was the perfect plan to significantly leverage her exemption amount and make a significant gift to family.

Increasing Payment Lead Trust


With increased volatility in stock markets, clients seeking to establish lead annuity trusts (CLATs) may be concerned about the trust’s ability to transfer significant assets to family. The favorable benefit for family with a fixed annuity is that growth can compound and significantly increase the distribution to family. However, what if there is a market downturn? With a fixed annuity amount during an economic downturn, most, if not all, of the trust principal may need to be used to make the annuity payment.

Fortunately, a CLAT may have increasing payments.1 There are persuasive economic reasons for a CLAT with increasing annuity payouts. By reducing the payouts in the early years and then significantly increasing the payouts to charity in the latter years of the trust, there is added protection against an early economic downturn. While the economy and markets could produce below-average returns in the early years, the low payouts will not require significant sales of trust equities during the down markets. The trust is then able to recover and benefit from potential higher returns during the latter years when the payouts to charity are greater.

Example 4

Troy, an actor who is remembered for appearing in a variety of movies, decided to establish a 10-year term super lead trust. However, he knows the economy and stock market have been in a boom cycle for several years now and he is concerned about the possibility of a market downturn in the early years of the trust. In order to hedge against any potential market risk during the early years of the trust, Troy worked with his attorney and financial advisor to establish an increasing payment annuity for the trust.

The trust will be funded with $3 million of growth stocks. The trust will have an increasing annuity schedule, paying 1% for the first three years, 3% for the next three, then 5% for one year, 10% for two, and finally 33% in the final year. The average annuity payment for deduction purposes will be 7% or $210,000.

The trust will provide Troy with gift and income tax deductions of $1,780,898. The gift tax deduction reduces his taxable gift from $3 million to $1,219,102. With the final year payment of $990,000 to charity, there is a balance left to family of $3,043,472. Because Troy has used a super lead trust, he will report all of the trust’s income on his own personal tax return. Taking into account his tax savings from the income tax deduction, his net tax savings are $298,752.

Lesser of Life or Term Lead Trust


Most lead trusts are established to last for a set term of years. However, it is possible for a lead trust to last the lesser of a life or term of years. A lesser of life or term lead trust works well for a client who is already making annual gifts to charity. The client may continue his or her annual gifts to charity by establishing a lead trust while at the same time leveraging the exemption amount. A further benefit of this approach is that the inheritance is immediately passed to family if the client does not survive the trust term.

Example 5

Edna, age 76, has a $9 million estate, which she knows would be subject to estate tax if she were to pass away. In addition, she already gives approximately $100,000 each year to her favorite charities. Edna’s attorney has suggested she establish a lead trust with $2 million in selected stocks from her investment portfolio. The trust would last for 12 years and pay an annuity amount of $110,000 per year to selected charities. The trust would produce a $1.16 million gift tax deduction.

However, Edna is concerned that her planned inheritance for her family could be delayed if she were to pass away prior to the expiration of the 12 years. Her attorney has thus indicated that Edna could establish a lead trust that lasts for the lesser of her life or the term of years. That way, if she passes away during the 12-year term, the inheritance would go immediately to family. Of course, the attorney explained that Edna would receive a modestly reduced gift tax deduction because of the chance that she could pass away during the term, reducing the overall benefit to charity. Edna was okay with this possibility. Therefore, Edna’s gift tax deduction for the trust will be $840,000.

Tandem Trust Plan


As part of a comprehensive inheritance plan where cultivation of heirs’ financial responsibility is a priority, some clients may find the combination of a charitable remainder trust with a lead trust to be a wonderful strategy. These “tandem trusts” can be funded through a will or living trust when the individual passes away. The testamentary unitrust may be funded with an IRA, pension plan, stock options, commercial annuity or other IRD assets. Normally, the lead trust will be funded with stocks or real property. In many instances, the terms for the remainder trust and lead trust will be the same.

The unitrust provides income for the selected term of years to family and the lead trust then provides a deferred distribution of principal. The plan is nicely balanced and has the advantage of diversifying the inheritance. In most families, some of the children or nephews and nieces are perhaps not as skilled at financial management as others. By diversifying the inheritance, all beneficiaries have greater opportunity to learn effective investment management skills over a period of time.

Conclusion


Because of low Section 7520 rates, charitable lead trusts can produce greater benefits today than were previously possible. The grantor lead trust is perfect for the high income client who could use a deduction and is interested in making an annual gift to charity. Despite high exemption amounts, the family lead trust is still a great fit for high net worth individuals with a taxable estate who desire to leverage their exemption amount. Then there is the super lead trust, which is well suited to clients looking to combine the benefits of a grantor and family lead trust. Finally, the lead trust is a flexible tool that can be used to achieve a variety of objectives when properly structured, such as a layered lead trust approach, the double discount lead trust, and the increasing payment lead trust, among others. With the right planning, attorneys and professional advisors will find that lead trusts can help their clients achieve their objectives.

Footnotes


1 In Rev. Proc. 2007-45, IRB 2007-29 (16 Jul 2007), the Service approved the concept. Under 02 Annotations for Paragraph 2, Payment of Annuity Amount, the IRS stated in Section 4, “Alternatively, the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded.”

Published April 1, 2016

Previous Articles

The Benefits of Charitable Lead Trusts: Part II

The Benefits of Charitable Lead Trusts: Part I

Early Termination of a Charitable Remainder Trust: Part II

Early Termination of a Charitable Remainder Trust: Part I

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