Overview

I have to admit that I was a pretty good high school Latin student. In fact it may have been my best subject. When I got to West Point, I was in for very rude awakening. Not only did I realize too late that the School was the oldest engineering institution of higher learning in the country, but that I would not be studying the “Dead Language.” I sadly realized that I had eighth grade math skills. My Latin skills led me to Spanish and Portuguese in order to save myself from the Dean.

The biblical mandate asks us to give Caesar (aka the Government), its fair share, but not more than that amount. Of course, the discussion by necessity focuses around the definition of “fair share” in the tax discussion. In my view, taxpayers only have three choices–(1) Pay Yourself (2) Pay Caesar (not Sid Caesar), or (3) Give the money to Charity. My personal bias and value system favors Options #1 and #3. Regardless of political party affiliation, most of us can agree that the Government spends money as if it grew on trees.

The Charitable Lead Annuity Trust (CLAT) seems to be less well known than its cousin the charitable remainder trust (CRT). Part of the reason is the technical and marketing focus of the planned giving community and trust companies. For a public charity, “cash” is the low hanging fruit on the money tree. The specialized nature of charitable split interest trusts makes the charitable lead and remainder trusts somewhat of an “oddball” to many trust companies. Elton Brooks, a former life insurance general agent with Manulife, started the Renaissance Trust Company in the late 1980’s focusing exclusively on charitable remainder trusts. Renaissance marketed the CRT primarily to financial advisors and life insurance agents and their clients, and built a very successful trust business.

The moral of the story here is that when you focus on a specific solution and market it through strong salesmen with high net worth clients, the likely result is “success with a capital S”. The planning benefits of the CLAT are well known by tax and estate planning attorneys, but unfortunately, have primarily been utilized by only the wealthiest of taxpayers.

The CLAT is a planning solution that is equally worthy of taxpayer attention across the board for many of the same reasons that made CRTs a mainline solution. Once financial advisors and life insurance agents see the product solution and opportunity relative to the planning benefits, the CLAT will also become a household solution just like the CRT.

Charitable Lead Trusts – A Primer

There are two basic types of living charitable lead trusts -the grantor lead trust and the non-grantor, or family lead trust. In the case of a non-grantor type lead trust created during lifetime, no income tax deduction is available. In the case of a grantor lead trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed an income tax deduction in the year the trust is established for the actuarial value of the annuity or unitrust income stream to be paid to the charity.

A negative consequence of grantor trust status allowing for the income tax deduction downside is the taxation of CLAT income to the grantor during the lifetime of the trust. Nevertheless, a CLT is  a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT can be designed to produce a deduction equal to the contribution. The deduction (including cash contributions) is limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.

Unlike a charitable remainder annuity which needs pay out a minimum of five percent on the CRT’s value per year, up to a maximum of fifty percent per year, a charitable lead trust, does not face these payout restrictions. The CLT may pay as little as one percent or as high as 100 percent. The percentage used and the duration of the trust will merely produce a smaller or larger charitable deduction for gift or estate tax purposes.

Similarly, the CLT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. In contrast the charitable remainder trust is limited under IRC Sec 664 to a maximum of 20 years. The CLT does not have a limit for a term of years. A CLT may be created lead trusts for thirty or thirty five years, with the CLT remainder to grandchildren at the expiration of that term.

A lead trust is an excellent means for leveraging the gift tax exemption. The charitable deduction is calculated using the Applicable Federal Rate (IRC Sec 7520 rate) from the current month, or one of the two prior months. Since the payout is fixed with an annuity lead trust, the lower the IRC Sec 7520 rate, the less assumed earnings will accrue to the remainder recipient, and the smaller the taxable gift. Since all split interest calculations use an assumed interest or earnings rate to determine the value of the income interest, and the value of the remainder interest, the most favorable result for a lead trust is to use a low IRC Sec 7520 rate. As a result, the low interest rate environment has favored the use of CLATs for the last several years.

The charity receiving payouts must be a qualified exempt charity and thus be able to receive charitable transfers under IRC Sec 2055 for estate tax or IRC Sec 2522 for gift tax purposes. For a family lead trust, since it is permissible to make a gift or estate charitable transfer to a foreign charity. 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. IRC Sec 2036(a). However, it is permissible for the children of the trust grantor to select each year the qualified exempt charities.

In contrast to a charitable remainder trust, which is normally exempt from trust income taxation, the lead trust remainder will pass to family and is therefore a non-grantor trust taxable under Subchapter J of the Code. As such, it must file Form 1041 and pay taxes on its ordinary income and capital gain.

A charitable lead annuity trust must pay a guaranteed annuity amount to one or more qualified charities at least annually. The annuity must be paid in all events. It is not permissible to create a lead trust in which the payment to charity is determined by the income earned by the trust. This aspect of the CLAT has spawned the use of the so-called Shark Fin CLAT. The Shark Fin CLAT provides for a minimal fixed and guaranteed CLAT payment to a charity with a large balloon payment in the final year of the CLAT’s term of years.

Excellent attorneys speculate on the legal authority for the use of the Shark Fin CLAT. Some attorneys view the language of Rev. Proc. 2007-45 as justification that the Shark Fin CLAT is a viable strategy. The language of the revenue procedure provides for a need to have a “guaranteed” annuity for term of years or life contingency that is paid annually. The CLAT payments must be ascertained at the time of the transfer without any regard to a minimum or maximum amount or percentage of the contribution. The Shark Fin CLAT meets these requirements based upon the requirements of Rev. Proc. 2007-45.

In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the §7520 rate (currently 2.2 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.

Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year), varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies.

CLATs and Life Insurance

Since the CLAT is a grantor trust for income tax purposes, the grantor is taxable on any CLAT income. Advisors have reasoned that life insurance might be a strategic investment within the CLAT due to the inherent tax-advantages of life insurance. The trouble with this planning scenario is the potential application of the so-called charitable split dollar rules of IRC Sec 170(f) (10).

The rules provide that no deduction is allowed if the charitable organization directly or indirectly pays a life insurance premium. Advisors reason that the rules don’t apply because the CLAT is not an organization, i.e. a public charity. Other advisors reason that the rules don’t apply because the CLAT’s ownership and beneficiary status of a life insurance policy is not a split dollar arrangement as defined the treasury regulations.

Of course, no advisor wants to be on the wrong side of the law and make their clients famous. As a result most advisors recognizing the issue recommend the purchase of life insurance outside of the CLAT on a single premium basis with the taxpayer contributing a the policy to the CLAT.The policy funded as a MEC allows the policy to accumulate on a tax-advantaged basis. The CLAT’s trustee may take loans to make the CLAT’s escalating payments.

Some taxpayers may prefer a policy that is a non-MEC (modified endowment contract) which would allow the trustee of the CLAT or the trustee of a family trust in the future, to take tax-free withdrawals from the policy.

The charitable split dollar issues might create a limitation for funding the policy over several years because neither the CLAT nor the charitable lead unitrust (CLUT) provide for ongoing contributions. Overlaying a LLC or limited partnership might create a vehicle to consolidate the policy ownership while introducing a series of cascading CLATs, i.e. forming a new CLAT each year funding the CLAT with cash contributions. The trustee of the CLAT may contribute the cash to the LLC or LP in exchange for an interest in the LLC. The managing membership in his capacity may have the LLC be the applicant, owner and beneficiary of the policy.

Arguably, the CLAT has invested in a security for state and federal law purposes that is not subject to registration. The investment strategy within the LLC is clearly out of the management and control of the LLC’s manager. In my view, this structure is not a violation of IRC Sec 170(f) (10).

Ultimately the efficacy of the CLAT strategy depends upon the ability to out-perform the IRC Sec 7520 rate. One method to ensure the CLAT’s performance is to structure the LLC with two classes of LLC interests – Class A –Common Voting and Class B – Preferred. This structure is the classical Freeze Partnership. The CLAT contributes the cash that it receives to the LLC in exchange for Class B Interests. The Class B interest is similar to preferred stock.

The Class B interests provide a non-voting liquidation preference equal to the capital contribution in this case. The Class B interest in this case also provide a preferred return within the LLC. The preferred return is necessarily set a high level based on upon the speculative nature of the closely held entity. This preferred yield might be in the 7.5-12% range. The preferred return may be cumulative that provide for indexing based upon inflation or compounding at the preferred yield for payments that are not made. 

The Class A members are only entitled to income and growth only after the Class B preferred return has been made. This structure ensures two important items. First, the Class B return is guaranteed to be higher than the IRC Sec 7520 return. Second, the Class B interests will ultimately be distributed to a family trust or the taxpayer as the remainder interest. Lastly, the Class B preferred return is separate and distinct from the investment rate (IRC Sec 7520 rate) used to determine payments to the charity.

The taxpayer may gift the Class A interests to a family trust. In the event the LLC owns a life insurance policy, the excess death benefit, i.e. the amount in excess of the Class B liquation preference, will accrue the benefit of the Class A members, the trustees of a family trust.

CLATs are subject to the prohibited transaction rules under IRC Sec 4947(a)(2) regarding self-dealing with disqualified persons. The taxpayer as well as entities that the taxpayer controls would generally be considered disqualified persons with respect to the prohibited transaction rules dealing with private foundations which include charitable trusts. These rules in theory might come into effect based upon the planning suggestion that the taxpayer use a partnership to provide investment management activities for the CLAT. However, the prohibited transaction rules provide an exemption for services performed by disqualified parties on an arms-length basis.

CLATs without Life Insurance

In lieu of life insurance, the investment advisor of a CLAT might prefer to invest CLAT assets in a diversified growth portfolio with little turnover within the portfolio. This type of “buy and hold” strategy would reduce taxation within the CLAT due to the application of the grantor trust rules. The same Freeze partnership approach described above might also be locked in ensure an investment return that exceeds the IRC Sec 7520 return over the CLAT’s term of years.

Additional Considerations

Certain acts do not constitute self-dealing such as when the benefits received by the disqualified parties are no more than those that would be received by the general public or persons who are not disqualified parties.

IRC Sec 4941(d)(2)(E) provides that the payment of compensation by a private foundation to a disqualified person for personal services which are reasonable and necessary to carry out the exempt purpose of the foundation is not an act of self-dealing if the compensation is not excessive.

Section 53.4941(b)(3)(c)(2), Example 2, allowed a disqualified person to provide investment counseling to a foundation on the condition that the fees were not excessive. Additionally, a string of related PLRs, 200315031, 20122103, and 200007039, provide similar guidance and rationale in the application of the payment of reasonable compensation to a disqualified person by a private foundation or charitable trust subject to the private foundation rules.

As a result, a taxpayer providing investment management services on an arms-length basis, for assets held in a LLC which the CLAT is a member, should not rise to the level of self-dealing constituting a prohibited transaction.

Strategy Example

Facts

Perry Masonelli is a plaintiff’s lawyer focusing on product liability cases. He is 45 years old and is married with three children. Perry recently received a contingency fee of $500,000 and does not need the income currently to live on. He would like to identify a strategy that allows him to receive a tax deduction while providing some benefit to his donor advised fund administered by his favorite charity. He would also like to provide wife and children with future access to the principal and interest of the contingency fee.

Solution

Perry forms a CLAT and contributes $500,000 in cash. The CLAT provides for a twenty year term. The 7520 rate is 2.2 percent. The CLAT provides for an income pattern that provides for an annuity stream that increases by twenty percent each year. The payment in Year is $3,740; Year 5 is $7,755; Year 10 is $19,297; Year 15 is 48,018. The payment in Year 20 is 119,485. The total payments to charity over the twenty years is $698,210. The amount of charitable deduction is equal to the contribution amount. The deduction is limited to 30 percent of AGI.

The trustee contributes the cash to a new LLC which provides for two different class of LLC interests – Class A Common Equity and Class B Preferred. The Class B interests have a preferred return of ten percent cumulative. The Class interest is entitled to the income and growth over ten percent. The Class B interests have no voting rights and liquidation preference equal to the original contribution plus the ten percent cumulative yield.

The Manager of the LLC decides to purchase second-to-die life insurance private placement life insurance policy on Perry and his wife. The policy will have a single premium of $500,000 and a death benefit of $10 million. The manager will distributions each year from the policy and distribute to the CLAT. The projected value of the Class B interests at the end of Year 20 is $2.39 million. The projected remainder interest is $2.181 million. The projected future value of the tax savings ($500,000 x 40 percent marginal tax bracket=$200,000 in tax savings) invested at a net rate of seven percent over the twenty year term is $774,000.

The combined projected benefit for the family at the end of the twenty term is almost three million dollars not including the almost $700,000 that they provided to charity. At the end of the twenty year term, the policy reverts to the Family Trust.

    CLAT Payment Summary

Assumptions

(1)Trust Type: Term

(2)Transfer Date:8/2014

(3)§7520 Rate:2.20%

(4)FMV of Trust: $500,000.00

(5)Growth of Trust:10.00%

(6) Percentage Payout: 0.748% in Yr. 1

(7) Payment Period: Annual

(8) Payment Timing: End

(9) Term: 20

 (10) Total Number of Payments: 20

(11) Exhaustion Method: IRS

(12) Annual Annuity Payment Growth: 20.00%

(13) Present Value of Annuity: $500,000

(14) Remainder Interest Value: 0

(15) Donor’s Deduction as a % of Contribution: 100%

Summary

In the current low interest rate environment that has prevailed for more than a few years, the CLAT produces excellent tax leverage for taxpayers. It is not just a strategy for the ultra high net worth. When financial products like life insurance are added to the planning equation, the leverage and tax advantages of life insurance add an additional dimension of tax leverage. Even without life insurance, a growth oriented investment portfolio without much portfolio turnover that creates current taxation can provide an excellent result as long as you outperform the IRC Sec 7520 rate of 2.2 percent.

Adding the Freeze Partnership/LLC structure without a high preferred investment return can ensure or guarantee that the CLAT outperforms the IRC Sec 7520 rate which is fixed at the time of contribution. In the final analysis, the combination of transfer and income tax leverage coupled with tax deferred investment growth within the CLAT, is a powerful combination. An escalating annuity structure (Shark Fin or Not) can be very forgiving to the investment return of assets within the CLAT in order to minimize and backload the CLAT’s payment stream.

This planning structure is not only good for millionaires but high income, charitably oriented taxpayers that face high current taxation without the benefit of other planning structures such as qualified plans. Financial service professionals should add this planning technique to their arsenal of solutions in case they have yet to do so.