Part 1 of our Article addressed why a charitably-inclined client should make a gift to charity in the year of business sale. 

Having completed the analysis of when it is best to make a gift, some clients may hesitate to make a large charitable gift in the year of the liquidity event because it may not allow them to meet other objectives, such as providing for children or retaining funds for themselves.  These clients can meet these “split” objectives of providing benefits for themselves or family members with a “split-interest” trust.  A charitable lead trust allows a current charitable income tax deduction, while providing a benefit for children.  A charitable remainder trust allows a current income tax deduction, while also permitting the client to retain access to income.

Combining a Charitable Gift with a Gift to Your Children to Minimize Estate Taxes

The charitable lead annuity trust (“CLAT”) allows the client to benefit a charitable organization and the client’s family, while reducing the future impact of the estate tax.  It also provides an immediate income tax deduction if structured properly.  However, as discussed below, there are some caveats as to the real financial benefit of the income tax deduction.

A.  Mechanics of Charitable Lead Annuity Trust (CLAT)

• The client contributes property and/or cash to an irrevocable trust with both a charitable beneficiary and family member beneficiaries.
• The charitable organization will receive an initial stream of payments (i.e. annuity payments) on an annual basis for a certain term of years. Each annuity payment will be for a fixed amount.
• At the end of the designated charitable lead period, the remaining trust assets, if any, will be distributed to the client’s descendants or held in trust for their benefit.

B.  Income Tax Deduction and Timing of Trust Income

There are different ways to structure the income tax status of the CLAT.  However, if the CLAT is structured as a “grantor trust” for income tax purposes, then the client can take an immediate income tax deduction equal to the present value of the annuity payments payable to the charitable organization.  This means the client must report the income of the CLAT each year on his/her own tax return, even though it is actually paid to the charitable organization in the form of an annuity.  This may seem like a wash from an income tax perspective; however, the primary advantage lies in the acceleration of the income tax deduction.  The client can take the deduction in the current tax year when he/she will have a sizeable amount of taxable income from the business sale (and the deduction is worth more).  The client will then recognize and report income in future years.

There are primarily two income tax drawbacks to the CLAT.  Since the charitable lead interest is considered a “for the use of” gift to charity, rather than a direct gift to charity, the client’s deduction will be limited to 30% of adjusted gross income (“AGI”).  For this reason, it may be important to create and fund the CLAT in the year of business sale when AGI will be highest.  The tax code also imposes a special recapture rule if the client dies during the term of the CLAT.  In that event, a portion equal to the original income tax deduction minus the discounted value of all the amounts paid to the CLAT prior to the client’s death will be subject to income tax.

C. Gift-Tax Efficient Transfer of Wealth to Remainder Beneficiaries

The federal gift tax is imposed on gratuitous transfers to individuals during life, and the estate tax is imposed on bequests made upon death.  Donors are permitted to make gifts of up to $15,000 per donee per year free from gift tax (i.e. the annual exclusion amount).  The donor will need to utilize his/her estate and gift tax exemption amount for any gratuitous transfers in excess of the annual exclusion amount.  The current estate and gift tax exemption amount is $11.7 million per person ($23.4 million for a married couple).  Any gratuitous transfers in excess of the estate and gift tax exemption amount will be subject to gift tax (at life) or estate tax (at death) at a maximum rate of 40%.

Gifts or bequests to children are subject to gift tax, requiring the client to utilize his/her estate and gift tax exemption to transfer assets to the next generation.  Once the exemption is exhausted, the parent will pay a gift tax or estate tax equal to 40% of the transfer.

However, a CLAT can minimize or eliminate this tax.  While a transfer to a CLAT for the benefit of a charity and children is subject to gift tax, the value of the gift is determined at the time of the CLAT’s creation (not at the end of the CLAT’s term, when the children actually receive the assets of the CLAT).  The value of the gift is equal to the funding of the trust less the value going to charity.  Without taking into account investment growth or interest rates, if a donor contributed $100 to a CLAT and the CLAT terms required it to make $100 in payments to charities, the taxable gift to the donor’s children on the date the trust is funded is $0. 

The CLAT can be an attractive approach because the trustee can invest the assets during the term of the trust.  While the investments grow, the required payments to charity do not increase, and the investment gains remain in the trust for the children.

The IRS takes into account the concept that future payments to charity should not be valued the same as current contributions to charity by discounting the future payments.  However, the IRS mandated discount rate is based on historically low interest rates.  The IRS mandated rate for January 2021 is 0.6%.  To the extent the investments in the CLAT beat this rate, the resulting investment appreciation and gains will pass to the children.  If the value of the stream of payments to the charitable organization is large enough, the value of the gift to the remainder beneficiaries will be zero.  This is known as a “zeroed out CLAT.”

The CLAT assets are likely to perform better than the IRS rate during the charitable lead period, which will increase the remainder interest available to the client’s descendants.  While the client will be responsible for any income taxes generated by the CLAT’s earnings during this time, the payment of the income taxes is another transfer of wealth to the trust beneficiaries free of gift tax.

If proper planning is completed, the CLAT assets will not be included in the client’s taxable estate for estate tax purposes when he/she dies.

D.  CLAT Illustration

The below chart illustrates the computations for a CLAT with four different charitable terms.  Each calculation assumes the client will make an initial contribution of $10 million to the CLAT in exchange for a $10 million income tax deduction.  The annuity payments for each term are structured to “zero out” the CLAT for gift tax purposes.  Each calculation also depicts three scenarios of investment returns.  A 0% return on the CLAT assets during the charitable lead period will result in no assets being passed on to the client’s descendants after expiration of the lead period.  Whereas, investment returns of 4% or 8% will leave the trust beneficiaries with significant remainder interests.  The longer the lead term, the larger the remainder interest as the trust has a longer period of time to generate investment return in excess of the required annuity payments.

“Charitable Remainder Trust” Strategy

Instead, a client may want to retain access to the income from the assets for his/her own benefit and donate a remainder interest to a charitable organization by creating a Charitable Remainder Trust (the “CRT”).  This option also nets the client an immediate tax deduction and reduces the future impact of the estate tax. Donors sometimes set up CRTs for their children as a way to provide a consistent, controlled payment, but also to make a charitable contribution.

A.  Mechanics of the CRT

• The client contributes property and/or cash to an irrevocable trust with a split interest—a current interest for the client and a remainder interest to a charitable organization.
• The client and his/her spouse can both receive an initial stream of payments on an annual basis, for life or a certain term of years.
• The client can structure the trust to receive fixed annuity payments (a Charitable Remainder Annuity Trust (“CRAT”)) or to receive unitrust payments based on a fixed percentage of the current trust assets (a Charitable Remainder Unitrust (“CRUT”)).A CRUT allows a donor to participate in the investment returns and growth (or losses) of the trust assets.
• At the end of the payment period, the remaining trust assets are distributed to the beneficiary charitable organization.

B.  Income Tax Deduction for Charitable Remainder Interest

The client will receive an immediate income tax deduction in the year he/she forms and creates the CRT, equal to the present value of the charitable organization’s remainder interest.  Unlike the CLAT, the gift to charity is not considered a “for the use of” gift.  Generally, the charitable income tax deduction will be limited to 60% of AGI, if the client makes the cash gift to a CRT with a remainder to a public charity or a donor advised fund.  Upon creation of the trust, the charitable organization’s interest must be worth at least 10% of the value transferred to the trust.  The annuity amount must also be at least 5%, but less than 50%, of the initial fair market value of the assets contributed to the CRT.  For a CRAT, another requirement is that there cannot be a greater than 5% chance that the trust fund will be exhausted before the trust ends.  The client is not eligible for an income tax deduction if the trust fails any of these requirements.

C.  Estate Tax Impact

The remainder interest that ultimately passes to the charitable organization will not be included in the client’s taxable estate for estate tax purposes.  A portion of the trust can be subject to estate tax when the donor dies if there is a successor individual beneficiary (a child, for example). The payments received by the client could also be included in his/her taxable estate, unless the client expends the funds or takes further action to transfer them outside of his/her taxable estate.

D.  CRAT Illustration

The below chart illustrates the computations for a CRAT with two different charitable terms—10 years and 15 years.  Each calculation assumes the client will make an initial contribution of $10 million to the CRAT in exchange for an annuity of 5% and an income tax deduction for the value of the remainder interest.

Each calculation also depicts three scenarios of investment returns.  A 0% return on the CRAT assets during the annuity period will leave less remainder funds for the charitable organization than investment returns of 4% and 8%.  As illustrated below, the 15 year option will result in a smaller income tax deduction than the 10 year option.  However, the 15 year option has the potential to pass a greater remainder interest to the charitable organization if investment returns meet or exceed the market average over the annuity period.

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