Deciding if You Should Use a Charitable Lead Trust

What is a Charitable Lead Trust?

A charitable lead trust (CLT) is a trust that provides one or more charitable organizations with a stream of payments for a specific term. At the end of the designated term, whatever amounts remain in the CLT are distributed to one or more non-charitable beneficiaries.

The stream of payments can be in the form of an annuity or a “unitrust” amount. A unitrust amount is, generally, a fixed percentage of the trust assets measured at a particular time each year.

CLTs have different tax attributes depending upon whether they were created during life or at death and whether a gift made to the CLT will qualify for a federal income tax deduction. The actuarial present value of the stream of payments from the CLT to charitable organizations is the portion of the gift that would qualify for a charitable deduction under either the federal gift or estate tax.

How Does It Work?

To create a CLT, your attorney will draft an appropriate trust agreement. The Internal Revenue Service (IRS) has published forms that, if used, will automatically qualify a trust as a CLT. Within the stated guidelines of tax law, you will need to determine how the trust will be administered:

• Select a trustee or trustees to administer the CLT.
• Select the type of CLT you would like to create (charitable lead annuity trust, charitable lead unitrust; grantor trust or non-grantor trust, see below);
• Select the charitable organizations to receive the stream of payments.
• Select the term for the stream of payments.
• Select the amount to be paid to the charitable organizations.
• Select the non-charitable beneficiaries to receive whatever amount remains in the trust when the payment term ends.

After the trust is executed, you would make a gift of cash or other property to the trust. If you decide to have the trust become effective upon your death, you can bequeath property to the CLT under the terms of your will. You should consult with your attorney and accountant to determine if the property you wish to give to a CLT is appropriate for the plan. Note, that only certain types of trusts can hold shares of S corporations.

A CLT that is not a grantor trust is not a tax-exempt entity; however, it may receive a charitable deduction for amounts paid to charitable organizations during the trust term. If the CLT is established as a grantor trust (discussed below) you, as grantor of the trust, will be subject to income tax on the CLT’s income as if you owned the property in the CLT.

According to federal tax law, at least annually, the CLT is required to make a distribution to its charitable beneficiaries based on the formula provided in the trust document (an annuity payment or a unitrust payment). At the end of the trust term, whatever remains in the CLT will be distributed to the non-charitable beneficiaries. These beneficiaries could be members of your family.

A grantor trust is a trust over which you, or someone else, are deemed to own the assets in the trust for federal income tax purposes. Accordingly, the deemed owner is subject to income tax on the income from the trust’s assets. For state income tax purposes, some states, like Pennsylvania, do not recognize grantor trusts that are not revocable. You should consult your attorney or accountant as to the state income tax consequences of creating any trust.

If you create a CLT that is a grantor trust (over which you are the deemed owner), subject to the usual rules and limitations pertaining to charitable income tax deductions, you could be entitled to a federal income tax deduction for the actuarial present value of the stream of payments that will be made to charitable organizations over the term of the CLT. However, if you are the deemed owner of the CLT, you will pay income tax on the trust’s income for all future years of the trust. Further, should you die during the term of the trust, a portion of the deduction that you received in the year that you created the CLT would be recaptured and income attributable to that recapture would be included on your final income tax return. Accordingly, you should weigh the benefit of an “up front” income tax deduction with the requirement that you pay income tax on the CLT’s income for all future years and the possibility that your death before the end of the CLT would cause some of the income tax benefit you received when the CLT was created to be recaptured. If the CLT is not a grantor trust under federal income tax law, you will not be entitled to a federal income tax deduction for your gift to the trust. You should consult your tax advisors to determine which type of CLT would best fit your circumstances.

For federal gift and estate tax purposes, the actuarial present value of the stream of payments made to charitable organizations will qualify for a federal gift or estate tax charitable deduction.

It is possible to allocate your exemption from the generation-skipping transfer tax (GSTT) to a CLT so that the assets passing to the non-charitable beneficiaries when the trust ends can be held in further trust that is exempt from federal transfer taxation. However, the rules for allocating a GSTT exemption to a CLT are complicated and it might not be possible to fully exempt the CLT from the GSTT with an allocation of GSTT exemption to your gift. If you wish to use a CLT to skip generations, you should consult your tax advisors with respect to application of the GSTT.

As with any trust there is the need for tax compliance. CLTs are generally required to file an income tax return (Form 1041) and a split interest trust information return (Form 5227). Note that grantor trusts identified for tax purposes by the deemed owner’s social security number do not file a separate Form 1041. Like tax returns pertaining to charitable organizations, the CLT’s Form 5227 is open to public inspection.

Why Should I Do This?

A CLT is a way to make gifts to charitable organizations today while potentially setting aside some of the property for later distribution to your family. If a CLT is created as a grantor trust, it may be possible to receive an income tax deduction for the full value of the gift to the CLT, with property left in the trust at the end of the term passing to your family as an added benefit.

It is possible to use a charitable lead annuity trust (CLAT) to pass assets to your family members without a gift or estate tax. To do this, you would transfer assets to the CLAT and provide an annuity to one or more charitable organizations for a specified term of years. For gift tax purposes (if the CLAT is created during your life) or estate tax purposes (if the CLAT is created under your will at death), the present value of the payments to the charitable organizations would qualify for a gift or estate tax charitable deduction. The present value of the remainder passing to your family would be the fair market value of the assets transferred to the CLAT, less the present value of the annuity stream payable to the charitable organizations.

If the CLAT provides for sufficiently high annuity payments (or a sufficiently long annuity term), then the present value of your annuity interest can approximate the fair market value of the assets transferred to the CLAT. This technique would allow the gift tax (or if created at death, estate tax), or the use of your exclusion from the gift and estate tax, to be minimized or potentially eliminated as the entire value of the property transferred to the CLAT would qualify for a gift or estate tax charitable deduction. This is known as “zeroing out” a CLAT.

The IRS assumes that the assets contributed to the CLAT will produce a total return equal to the interest rate required by section 7520 of the Internal Revenue Code (IRC) over the term of the annuity. As a result, if the actual total return earned by the CLAT’s assets during the annuity term exceeds the interest rate required by IRC section 7520, the IRS will have undervalued the gift. The amount of the undervaluation (that is, the total return realized by the CLAT’s assets in excess of the interest rate required by IRC section 7520) will pass to your beneficiaries at the end of the annuity term free of any gift or estate tax. This technique could be especially useful if you have used your entire lifetime exclusion from the gift and estate tax. A zeroed out CLAT works best in a low interest rate environment. As interest rates remain historically low, now could be an appropriate time to consider creating a CLAT. You should consult your tax advisor to determine the tax impact in your particular circumstances.

If you itemize deductions for federal income tax purposes, the IRC may allow you to take a deduction from adjusted gross income (AGI) when calculating taxable income for gifts made to charitable organizations.

Your ability to deduct the amount you give to charity may be limited depending upon the type of charitable organization that receives your gift, the amount of your AGI and the type of property (including cash) that you give. In general, there are higher limits for gifts made to public charities and lower limits for gifts made to private foundations. If you create a CLT that is a grantor trust for federal income tax purposes (described above), subject to the usual rules and limitations pertaining to charitable income tax deductions, you could be entitled to a federal income tax deduction for the actuarial present value of the stream of payments that will be made to charitable organizations over the term of the CLT.

What are the Downsides?

A CLT is a formal structure that requires the technical skills of an attorney to establish. Additionally, the trustees of the CLT should retain an accountant to ensure that the CLT maintains proper financial records and files the appropriate tax returns. Accordingly, there are professional costs necessary to create and maintain a CLT. Finally, it is important to remember that a CLT’s split interest trust tax return is open to public inspection. There may be information shown on that tax return that you would not want disclosed.

If you created a CLT that is a grantor trust, even though you receive an income tax deduction in the year the CLT was funded, you should be prepared to pay income tax on the trust’s income for the remainder of its term. Also, should you die before the end of the CLT’s term, some of the income tax benefit that you received when the trust was funded will be recaptured, causing an additional income tax on your final income tax return.

Should I Do This?

A CLT is a way to make gifts to charity today, with the possibility of passing assets to your family in the future without a federal transfer tax. Contributing to a CLT may, depending upon how the trust is structured, allow you to receive a charitable income tax deduction as well.

As with any giving and tax strategy, you should consult your attorney, accountant or other tax advisors to determine if a CLT is the right giving strategy for you.

To learn more about CLTs, please contact your PNC Private Bank team; we would be glad to discuss with you and your advisors whether a CLT is appropriate for you.

For more information, please contact your PNC advisor.