Printer-friendly PDF Memorandum: Lead Trusts Thrive In Low Interest Environment.wpd

The Charitable Lead Trust (CLT) is a trust in which the donor gives an income interest to a charity and, upon the donor’s death or after a term certain, a remainder interest passes to noncharitable beneficiaries. In essence, the donor is “lending” the assets to the charity for the term of the trust. Since the gift tax exemption is scheduled to remain at $1 million indefinitely, CLTs may enable charitably-inclined individuals to make substantial lifetime transfers without incurring a current gift or estate tax liability, thus preserving wealth for future generations.

Moreover, the current low interest rate environment is exceptionally hospitable to the CLT. As with a mortgage, the grantor of a CLT may “lock in” the favorable interest rate used to determine the gift and estate tax cost of the arrangement.

To fund a CLT, the donor gifts property into a trust which provides an income interest to a qualifying charity for a determinable period (e.g., a term of years or life of an individual) and a remainder interest to one or more noncharitable beneficiaries. The property may consist of cash, stock, income-producing real estate, or interests in a closely-held family business.

For gift tax purposes, a gift of (i) a present interest is made to the charity and (ii) a future interest is made to the noncharitable beneficiaries. A gift tax deduction is available only for the gift of the present interest to the charity. The larger the nontaxable gift to the charity, the smaller the taxable gift to the remainder beneficiaries.

For income tax purposes, since the CLT is a separate taxpayer, no income tax deduction will be available to the donor for gifts made to the CLT. However, an exception to this rule exists if the CLT is a grantor trust. In that case, an income tax deduction would be allowed since the grantor (donor) will pay income taxes associated with the trust. Grantor trust status may or may not be acceptable to the donor.

Congress requires annual payments to the charity of either (i) a fixed annuity or (ii) a payment consisting of a percentage of the fair market value of the trust assets. This rule prevents donors from investing trust assets in low-income investments which would diminish the present income interest of the charitable beneficiary. Increasing the size of the annuity reduces the size of the taxable gift to noncharitable beneficiaries.

For gift tax purposes, the present value of the annuity or unitrust interest depends on the IRC § 7520 rate (120% of the mid-term AFR) which is 3.6% for June 2003. Ultimately, what is removed from the donor’s estate is the growth of trust assets in excess of the Section 7520 rate. Therefore, like GRATs, CLTs work best in low-interest rate environments. Unlike GRATs, however, CLTs can be zeroed-out at inception with no initial taxable gift by providing for a sufficiently high annuity. Nevertheless, like a GRAT, if trust income is insufficient to pay the annuity, invasion of principal will be required. Selecting a high annuity amount to decrease the size of the taxable gift works if the property generates income sufficient to actually pay the annuity. Invasion of principal, if required to subsidize the annuity payment, would naturally reduce the amount ultimately passing to noncharitable beneficiaries.

To illustrate the mechanics, a CLT is funded with $500,000 in stock, providing for a 6% annuity to a named charity for 20 years, after which the trust will terminate and pay the remaining balance to the donor’s children. Assume (i) the assets will appreciate at a rate of 5%, and (ii) the donor has fully utilized his gift and estate tax exemption, meaning that any further gifts would result in a current tax liability or a future estate tax liability.

If the assets were simply invested, the donor’s taxable estate in the year 2023 would be $3.91 million, of which $1.79 million would be required to pay estate tax, leaving $2.11 million available for distribution. With a CLT, the taxable estate would be $1.43 million, of which $0.53 million would be required to pay estate tax. The lead trust assets, now worth $1.51 million, would pass to the children at no estate tax cost, having been removed from the estate in 2003. The net estate available for distribution would be $2.38 million, $270,000 more than what would have been available for distribution had the assets simply been invested.