Wealth managers across the country are taking advantage of the current gift and estate tax laws to shift significant assets in an effort to avoid transfer taxes. Many see the charitable lead annuity trust (CLAT) as an integral piece of a tax-efficient wealth transfer plan, and given the current economic environment, I couldn’t agree more. Now may be the time for your wealthiest clients to consider using a CLAT to move assets out of their taxable estates and into the hands of their heirs.
What Is a CLAT?
Through a CLAT, clients can leverage their charitable contributions to shift wealth to family members in a tax-efficient manner. As a split-interest trust, a CLAT names two beneficiaries. The first, the charitable lead beneficiary, receives a fixed annual annuity payment throughout the term of the trust. At the end of the trust term, the assets remaining in the CLAT are then distributed to one or more noncharitable remainder beneficiaries—typically the grantor’s children or family members. A CLAT can be funded either during the client’s life or upon his or her death as a testamentary transfer.
Types of CLATs
For income tax purposes, there are two types of CLATs: grantor trusts and separate tax-paying trusts. Grantor CLATs are drafted in such a way that all income and deductions pass through the trust to the donor, who is considered the owner of the trust assets for income tax purposes. Because of this structure, a grantor CLAT can only be created during the donor’s life.
A separate tax-paying trust, on the other hand, must report all income and deductions on a separate trust income tax return. Unlike a grantor CLAT, a separate tax-paying CLAT can be funded either during the donor’s life or at death.
Which CLAT to Choose?
Determining which type of CLAT to establish depends on the client’s objective. If one of the client’s primary goals is to create a significant charitable income tax deduction in the current year, then a grantor CLAT would be most suitable. In the tax year in which the CLAT is funded, the grantor can deduct the present value of the income payments to be made to the charitable lead beneficiary. This can be an effective planning strategy for clients who foresee an uncommonly large income tax year due to circumstances such as the sale of a business, a lump-sum bonus, or the exercise of nonqualified stock options. Clients can use the grantor CLAT to achieve the desired tax deduction and have the trust assets revert to the donor (named as the remainder beneficiary) at the end of their chosen trust term. For example, the trust term could be drafted so that the assets return to the donor at his or her anticipated retirement age.
If the client is primarily focused on reducing gift and estate taxes, a separate tax-paying CLAT may provide the desired results. Funding a non-grantor CLAT does not create a charitable income tax deduction, as all income and deductions are attributable solely to the trust. But as a separate tax-paying entity, the trust can deduct the annual payments made to the charitable lead beneficiary. Because the CLAT 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 will receive the assets, effectively removing them from the donor’s estate.
But why should clients consider a CLAT to reduce transfer tax liability? Let’s look at an example of a CLAT in action.
How CLATs Work
Assume that your client, Mr. James, has a gross estate of approximately $15 million. Mr. James is philanthropic and would like to help his alma mater fund the development and ongoing operation of a new facility. He has two children, whom he would like to inherit the bulk of his assets, but he understands that estate taxes could significantly reduce the amount that ultimately passes to them. Because his income comes primarily from a portfolio of municipal bonds, Mr. James has a relatively small income tax liability. The remainder of his estate consists primarily of large-cap growth and value stocks. You advise him to fund a 20-year non-grantor CLAT with $5 million of growth stock. The annuity payout to the school as the lead beneficiary is $250,000 per year (5%). At the end of the 20-year term, the assets remaining in the CLAT will pass to his children as remainder beneficiaries.
The $250,000 annual payment will certainly help Mr. James’s alma mater, but how will the CLAT help reduce the cost of transferring the trust assets to his children? Because of the 20-year annuity payments to the school, the IRS discounts the value of the initial transfer to the trust. At the time the trust is funded, the present value of the lead and remainder interests are calculated using factors such as the fair market value of the assets used to fund the trust, the amount of the payout, the trust term, and the applicable federal rate (AFR/Section 7520), which is 2% for September 2011. The value of the remainder interest is a taxable gift to the CLAT remaindermen, Mr. James’s children. 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 school’s annuity interest is $4,087,850. The remainder interest, which is subject to gift tax, is valued at $912,150. That figure doesn’t accurately represent what may pass to Mr. James’s children, however. Assuming that the CLAT assets grow at 8% over the 20-year term, the remainder interest to pass to the children would be $11,864,294. Because the trust assets appreciate at a rate higher than the AFR of 2%, Mr. James would effectively transfer close to $12 million from his gross estate, with gift tax paid only on the initial transfer of $912,150. He could use his lifetime gift tax exclusion amount of $5 million, if available, to make the initial transfer to the CLAT free of gift taxes.
With the AFR at historic lows, CLATs have become a particularly advantageous wealth transfer tool. In fact, for wealthy clients seeking to reduce their taxable estates, efficiently transfer wealth to heirs, and fulfill charitable goals, the CLAT tops the list of wealth transfer strategies.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax preparer, professional tax advisor, and/or a lawyer.
Gavin Morrissey, JD, LLM is the director of advanced planning at Commonwealth Financial Network, member FINRA/SIPC, a registered investment advisor, in San Diego, Calif. He can be reached at firstname.lastname@example.org.