Using a Charitable Trust to Offset Capital Gains

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We are approaching the extended income tax deadline for 2012 and it reminded me (as if anyone could forget) that 2013 carries significantly higher income tax rates for a lot of folks. We have the Medicare surcharge, and most of rates increased as well at a state and federal level. Between now and the end of the year, many people, including cash strapped entrepreneurs, will begin to assess their income tax situation for 2013—WARNING, you won’t like it. One of the things that are (happily) back this year is capital gains.


I wanted to use this post to introduce an interesting way to offset capital gains—a trust for charities and other beneficiaries called a charitable lead annuity trust, “CLAT”—yes, we estate planners have an acronym for just about everything… A CLAT is an irrevocable trust that pays an annual amount to charity for a period, usually a term of years. At the end of this term, all assets remaining in the trust are given to one or more non-charitable beneficiaries. Any appreciation on the trust assets in excess of the specified amount given to charity each year will pass to the remainder beneficiaries free of tax.

There are two types of CLATs, a “Grantor CLAT” and (what else) a “Nongrantor CLAT.” With a Grantor CLAT, the grantor will receive an immediate income tax deduction for the present value of the charity’s interest when the trust is funded, but the trust’s income will be treated as the grantor’s income for income tax purposes. This is where the offset of capital gains comes in, a large charitable deduction.  In contrast, with a Nongrantor CLAT, the grantor will not receive an income tax deduction upon creation, but will also not pay any income tax on the trust’s income. 

When a CLAT is created, the present value of the remainder interest for the noncharitable beneficiaries (e.g., a sibling, child, niece or nephew) will be a taxable gift. This portion is calculated using the term of the trust and the current IRS §7520 rate.  The §7520 rate was at a historic low of 1.2% for June, but was up to 2.0% for August. We have the option to use any of the last three months’ rates.  A low rate means that the present value of the remainder interest will be extremely low—resulting in a low value taxable gift, even though the eventual benefit to your sibling or niece or nephew may be significantly higher. Essentially, any growth of the trust assets in excess of the projected rate of 1.2% will pass to your child, sibling, or niece or nephew tax free.   

Below you will find an illustration of how you could use that spare $1 million you’ve got lying around (from your last successful venture) to create a CLAT that would benefit of one or more charities for a term of years and then benefit your beneficiaries when the trust terminates. In preparing these calculations, I used the IRS rate for June (1.2%); I also assumed that the trust would pay out 5% each year and would be for a term of 15 years.  

Charitable Lead Annuity Trust: 

Initial Contribution:          $1,000,000
Term of the Trust:          15 Years
Initial Annual Payout to Charity (5%):            $50,000
Present Value of Interest for Family:          $317,355
Present Value of Charitable Interest:          $682,645
Immediate Charitable Deduction:  $682,645 (If a Grantor CLAT)
Taxable Gift to Sibling, Niece, or Nephew:  $318,871
Expected Value on Termination (7% Growth):$1,502,580
Benefit to each of Child: $751,290 (assumes 50/50 division between 2 children)

Although you would have an initial taxable gift of $318,871 (which reduces your lifetime exemption of $5,250,000), you would eventually transfer $1,502,580 without any tax.  If you share in this gift with a spouse, it will impact each of your lifetime exemptions by half as much. Using the above example, you would receive an immediate income tax deduction of $682,645! Amazing option to benefit your favorite charities and beneficiaries while offsetting some gains this year. 

I often recommend this to clients with high earning years, or when selling a substantial block of stock or a business. It is just another tool in the estate planning toolbox that not many people know about.