Charitable Lead Trusts: Not The Ugly Duckling Of Charitable Planning

Last year, I had the privilege of co-authoring Tools & Techniques of Charitable Planninga book published by the National Underwriter Company–with Stephan Leimberg as the principal author.

Not surprisingly, since publication of this book, I have received numerous calls regarding the use of life insurance in charitable planning. As a result of these calls, I have found that life insurance professionals are generally very knowledgeable with regard to charitable remainder trusts (CRTs) and the use of life insurance for wealth replacement purposes.

However, I have been surprised at how few professionals seem to understand the workings of a charitable lead trust (CLT) and the role of life insurance in such trusts. This article will discuss the various types of CLTs and demonstrate how life insurance may be used as an effective investment by a CLT.

In many ways, the charitable lead trust is a mirror image of its more popular cousinthe charitable remainder trust. Like the CRT, a CLT can take a variety of forms. However, in essence, a CLT is nothing more than a trust to which a donor transfers property–creating an income interest in the property in favor of one or more charitable organizations for a period of years or for the life of the donor.

Upon the termination of the charitable (lead) interest, the remainder interest ordinarily passes to non-charitable remainder beneficiaries. In most instances, these beneficiaries are the donors children. A CLT can be created during life (inter-vivos) or at death (testamentary).

The lead interest often takes the form of a fixed “annuity”–making the CLT a charitable lead annuity trust (CLAT). In times of low interest rates, like today, a CLAT can be a very effective planning tool for passing more wealth on to heirs.

Why are falling interest rates good for CLAT planning? It is because, for tax valuation purposes, it is assumed that the property originally contributed to the CLAT will grow at a rate equal to the IRS 7520 rate. With the 7520 rate at 4.8% (December 2001), it is highly likely that the value of the property contributed to the CLAT will grow at an average rate in excess of this projected rate–leaving more for the heirs than assumed by the IRS valuation tables.

For example, in a CLAT created by a husband and wife, both age 60, and paying 5% a year to a charity until the death of the surviving spouse, the value of the remainder interest subject to federal gift tax would be less than 28% of the total value of the property contributed to the CLAT when the Section 7520 rate is 4.8%. If the AFR were 7%, as in December 2000, the remainder interest for this same CLAT would be over 42%. For a CLAT funded with a $1 million contribution, this results in a gift to the remainder beneficiaries that is approximately $143,000 less today than it would have been if the gift had been made a year ago when the Section 7520 rate was 7%.

In other instances, the charitable lead interest is determined by a fixed percentage of the trust balancemaking the CLT a charitable lead unitrust (CLUT). Unlike CLATs, falling interest rates have little impact on the valuation of the remainder benefit of a CLUT. This insensitivity to decreases in the Section 7520 rate is because the annual payout with a CLUT is a fixed percentage of the trust balance and not a fixed dollar amount as with a CLAT.

A gift tax charitable deduction is allowed for gifts to CLATs and CLUTs, which is one of the primary advantages of CLT planning. Because the charity will enjoy the lead interest before the remainder of the trust passes to the ultimate remainder beneficiaries (i.e., the family), the gift tax value of the property contributed to the CLT is reduced by the value of the charitable lead interest. In effect, the donor is giving his or her heirs the remainder interest–allowing the time value of money to create a substantial discount for gift tax purposes.

For example, the transfer of $1 million to a charitable lead unitrust (CLUT) that pays 7% of the trust value annually to charity and lasts for the lifetime of a 70-year old is a gift to the remainder beneficiaries (probably the children) of $423,210. For a 50-year old, the value of the remainder gift in a 7% CLUT is only $177,590.

Whether the donor receives an income tax charitable deduction depends upon the structure of the CLT. If all income is taxable to the grantor (i.e., it is a “grantor” trust), the grantor is entitled to a charitable income tax deduction for the value of the charitable lead interest at the time the CLT is created.

However, if the CLT is not a grantor trust (i.e., trust income is not attributed to the grantor), the donor does not get an income tax charitable deduction for creating the CLT. Instead, all income earned by a non-grantor CLT is tax-exempt.

Whether a CLT should be created as a grantor trust or not will depend upon the grantors tax situation and the nature of the assets being contributed to the trust.

To summarize, CLTs can be categorized in several ways. First, you can create them during life (inter-vivos) or at death (testamentary). A CLT can be structured as an annuity trust (CLAT) that pays a fixed dollar amount to the charities annually or as a unitrust (CLUT) that pays a fixed percentage of the fluctuating trust balance annually.

Furthermore, inter-vivos charitable lead trusts can be further divided into grantor and non-grantor trusts. A grantor trust provides the grantor with a current income tax charitable deduction for the actuarial present value of the income stream that is projected to be paid to the charitable lead beneficiary. However, any income earned by a grantor-type CLT is reportable on the grantors individual income tax return. For income tax purposes, the trust is ignored.

A non-grantor charitable lead trust does not allow the grantor to take a current income tax deduction for the value of the charitable lead gift. However, income earned by the CLT is not taxable on the grantors tax return.

If you have stayed with me this far, it is probably only too clear what the problem is with CLTs–they are complicated. So, rather than further complicate this article with an additional technical discussion of the requirements of the various types of charitable lead trusts, Ill attempt to show the power of a charitable lead unitrust (CLUT) as an estate planning tool through an example. This example, I believe, will go a long way toward proving that too few advisors are familiar with the workings and benefits of a CLUT.

Nicholas and Anna are both 60 years old. They have one child, Joseph, who is active in the family business. As part of their comprehensive estate plan, they are considering a grantor inter-vivos charitable lead unitrust (CLUT). A $2 million contribution to this CLUT would result in a taxable gift to the remainder beneficiary (Joseph) of only $557,200 [calculations done on NumberCruncher].

Accordingly, the value of the charitable lead portion of the contribution is $1,442,800. Because this is a grantor-type lead trust, this would be the amount of the income tax charitable deduction–subject to the usual charitable deduction limitations. Assuming a 40% tax bracket, this charitable deduction would be worth $577,120 to Nicholas and Anna–making the net out-of-pocket cost of the CLUT only $1,422,880.

By the 27th year, life expectancy of the surviving spouse, the value of the charitable lead trust would be almost $4 million if a growth rate of 8% is assumed for trust investments. Over 27 years, based on the assumed growth rate of 8% and payout of 5% annually, the charity would have received a total of $3,845,246.

Certainly, this is an effective planning tool for Nicholas and Anna. They believe that use of a CLUT will result in considerable wealth passing to their son as the CLUTs remainder beneficiary. Moreover, they are pleased that they will be making considerable charitable gifts during their lifetime. Most importantly, they are able to do all of this for an out-of-pocket cost of less than $1.5 million.

Creation of the CLUT would use $557,200 of their combined unified credits. Interestingly, this amount is less than the $650,000 combined increase in the unified credit available to them in 2002, as a result of the unified credit increase from $675,000 per person to $1 million per person. So, even if Nicholas and Anna had previously used their $675,000 lifetime exemptions, this transaction would not cause gift tax liability.

However, if Nicholas and Anna are more adventuresome and willing to take on some risk associated with tax-uncertainty, they may consider using life insurance as an investment of the CLUT. Typically, a CLUT funded with life insurance would use less than half of the total contributions to purchase life insurance. Only part of the total trust assets are typically used to purchase insurance because it is important that the CLUT have other liquid assets available from which to pay the annual charitable unitrust amount–in this case 5% of the trust value as determined annually.

For this example, I have assumed that 40% of the initial $2 million contribution is used to purchase life insurance. Specifically, a premium of $200,000 per year for four years (a total of $800,000) is used to purchase $5 million of second-to-die universal life coverage (increasing face option with a 25% term blend).

It has also been assumed that Nicholas and Anna are preferred underwriting risks. The CLUT will be the owner and beneficiary of the life insurance contract. By using 40% of the initial contribution to purchase life insurance, Nicholas and Anna can significantly increase the amount passing to Joseph–especially if they should die prior to life expectancy.

The chart on page 32 summarizes the illustrated (not guaranteed) impact of using life insurance as an investment of the CLUT.

You are probably wondering–if insurance is such an efficient investment for a charitable lead trust–why doesnt everybody do it?

I think there are a few reasons why life insurance isnt purchased by a CLT more often. First, CLTs are complicated and few people understand how they work.

Second, there isnt much legal authority regarding the purchase of life insurance inside of a CLT. Although it isnt an extremely unusual transaction, there isnt much authority to support the concept. In fact, consideration should be given to IRC 170(f)(10) prior to purchasing life insurance as an investment of a CLT.

While the legislative history of section 170(f)(10) (eliminating charitable split dollar transactions) makes it appear unlikely that Congress intended to prohibit the purchase of insurance by a CLT, a broad interpretation of this provision could cover the purchase of insurance by a lead trust.

Third, caution must be taken when determining the type of insurance contract that is purchased and how that contract is funded. If a policy with low cash values is purchased, economic benefits of the arrangement can be shifted from the charity to the remainder beneficiaries. This shifting could cause the IRS to argue that the insurance contract is a jeopardy investment. For this reason, it may be best to use a life insurance contract that provides relatively high cash value accumulation. By using a higher cash value product and only investing part of the total contribution in life insurance, the trustee shouldnt be considered to have made a jeopardy investment.

In summary, with interest rates at their lowest level in memory, charitable lead trusts should be given renewed consideration. Sometimes looked upon as the ugly duckling of charitable planning, this is a tool that can be very efficient in passing wealth to family members.

Moreover, unlike a charitable remainder trust, the grantor of an inter-vivos charitable lead trust can see the benefit of his or her charitable gifts during his or her lifetime. And, although the purchase of life insurance inside of a charitable lead trust might not be for everybody, it may be a very good alternative for a family that is willing to take some tax risk.

As demonstrated by the example, using life insurance in a CLUT can dramatically increase the short-term benefits to the family with little reduction in benefit to the charity.

Randy Zipse, J.D., CPA, is senior counsel, director of advanced markets and small business insurance, Manulife Financial, Boston. He can be reached via e-mail at Randy_Zipse@manulife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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