From the December 2008 issue of Wealth Manager Web • Subscribe!

December 1, 2008

RIGHT TIME, RIGHT TRUST

In my day-to-day job, my primary responsibility is to consult with wealth managers about planning issues that come up and to offer planning techniques to address those issues. My role is to react to the situations presented, and it's not often that circumstances lead me to offer solutions proactively. But I'm offering a proactive recommendation now because I believe that this is a time when wealth managers can truly take advantage of market conditions to pursue favorable wealth transfer results.

Next month, I will discuss how grantor retained annuity trusts (GRATs) can be used to leverage transfer-tax costs in an environment of depressed values and low interest rates. This month I'd like to focus on how charitable lead trusts (CLTs) can be implemented in similar conditions--not only to efficiently transfer wealth but also to provide potential income tax benefits while benefitting charitable causes.

What is a CLT?

A CLT is a charitable trust that allows the donor to provide gifts to a charity while leveraging the charitable contributions to produce tax-efficient transfers of assets to family members. Depending on the income tax status of the trust, the CLT can either be funded during the donor's lifetime or as a testamentary transfer at the time of the donor's death. There are various planning considerations in deciding whether to fund the CLT during life or at death as I will discuss in more detail below. But first, a review of the basic characteristics of a CLT is in order.

A CLT is a split-interest trust with two beneficiaries. The first beneficiary is the charitable lead beneficiary which receives an annual income stream throughout the term of the trust. The amount of the income paid to the lead beneficiary can be based on an annuity payout, which is a fixed dollar amount, or a unitrust payout, which is a percentage of the annual fair market value of the trust. At the completion of the trust term, the assets remaining in the CLT are distributed to the second beneficiary--typically either the donor who originally funded the trust or non-charitable remainder beneficiaries such as the grantor's children.

There are two types of CLTs: grantor trusts and separate tax-paying trusts. Grantor CLTs are drafted so that all items on income and deduction pass through the trust to the donor. The donor is considered the owner of the trust assets for income tax purposes. Because of this tax characteristic, a grantor CLT can only be created during the donor's life. A separate tax-paying, non-grantor trust must report all items of income and deductions on a separate trust income tax return. Unlike the grantor CLT, the separate tax-paying CLT can be funded either during the life of the donor or at death.

Making the Decision

The decision about which type of CLT to establish depends on the result desired when the strategy is ultimately implemented. If the donor's primary goal is to create a significant charitable income tax deduction in the current year, then a grantor CLT is is the more suitable option. The grantor can deduct the current value of income payments made to the charitable lead beneficiary in the tax year in which the CLT is funded.

The grantor CLT could also be an effective planning strategy for clients who forecast an uncommonly large income tax year due to circumstances such as the sale of a business, a lump sum bonus, or the exercise of non-qualified stock options. The client could use the grantor CLT to create the needed tax deduction and have the CLT assets revert to the donor (named as the remainder beneficiary) when the trust term ends at a time of the donor's and beneficiary's choosing. The trust term could be drafted so that the assets return to the donor at a desired retirement age.

A separate tax-paying CLT is in order when a client is more concerned with the looming effect of gift and estate taxes than with income tax. Funding a non-grantor CLT does not create a charitable income tax deduction because all items of income and deduction are attributable solely to the trust. The donor does not receive an income tax deduction, but the trust--as a separate tax-paying entity--can deduct the annual payments made to the charitable lead beneficiary. Because the CLT receives a charitable deduction, the income tax to the trust should be minimal or zero--assuming that the charitable distribution is paid from the trust's gross income. Once the trust term ends, the named remainder beneficiaries receive the assets--effectively removing them from the donor's estate.

How the CLT Mitigates Transfer-Tax Liability

Why consider the CLT to mitigate transfer tax liability? The answer is best illustrated through an example.

Assume that the client, Mrs. Smith, has a gross estate of approximately $20 million. Very active in philanthropic causes, she would like to help her church fund a new school and other community initiatives. She wants her three children to inherit the bulk of her estate, but she understands that estate taxes could significantly reduce the amount they inherit.

Because her income is provided through a portfolio of municipal bonds, Mrs. Smith has a relatively small income-tax liability. The remainder of her estate consists primarily of large-cap growth and value stocks. Her wealth manager advises her to fund a 20-year, non-grantor charitable lead annuity trust (CLAT) with $5 million of growth stock. The annuity rate paid to the church as lead beneficiary would be $290,000 per year (at 5.8%). At the end of the 20-year term, the assets remaining in the CLAT would pass to the remainder beneficiaries.

It is obvious that the $290,000 annual payment to the church would go a long way in funding the school and other community initiatives. But how would the CLAT help reduce the costs of transferring the trust assets to her children?

Because of the 20-year annuity payments to the church, the IRS allows the value of the initial transfer to be discounted. At the time the trust is funded, the present value of the lead and remainder interests is calculated using factors such as the fair market value of the assets that fund the trust, the amount of the payout, the trust term, and the applicable federal rate (AFR/Section 7520) which was 3.8% for October 2008. The value of the remainder interest is a taxable gift to the CLAT remaindermen. The lower the AFR at the time the CLAT is created, the lower the taxable remainder interest. In this example, the present value of the church's annuity interest is $4,011,918. The remainder interest, which is subject to gift tax, is valued at $988,082.

Although the remainder interest is calculated to be slightly below $1 million, the figure does not accurately represent what may pass to the remaindermen.

Assuming that the CLAT assets grew at 8% over the 20-year term, the remainder interest that passes on to the children would be $10,033,816--a stunning result! Because trust assets appreciated at a rate higher than the applicable federal rate of 3.8%, the donor effectively removed approximately $10 million from the gross estate, with transfer costs of $988,082 associated with the initial transfer. And if her lifetime gifts exclusion of $1 million is still available, Mrs. Smith could use it to make the initial transfer to the CLAT free of gift taxes.

Gavin Morrissey, JD, is the director of advanced planning at Commonwealth Financial Network in San Diego. He can be reached at gmorrissey@commonwealth.com.

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