Charitable trusts are a common planning technique in the advanced markets arena due to their ability to help clients transfer wealth while benefiting their favorite charity. Charitable lead trusts offer a great opportunity to help clients transfer wealth at a reduced gift tax cost and, when used with life insurance, increase the amount left for heirs.
To understand the benefits of a CLT, a brief refresher course is in order. The vehicle is a split-interest gift wherein a charity receives an income stream from assets in the trust for a set period; at the end of that time, the remaining assets pass to designated heirs.
The charity will receive income from the trust for as long as the trust document specifies, either for the life of the donor or for a set number of years. At the end of the trust term, the remaining assets in the trust will pass to the designated remainder beneficiary, usually the donor’s heirs or a trust set up for the donor’s heirs’ benefit.
A CLT can be either a charitable lead annuity trust or a charitable lead unitrust. With a CLAT, the amount of income paid each year is based on a fixed dollar amount, and does not change based on the value of the underlying trust assets. With a CLUT, the income paid each year is based on a stated percentage of the annual value of the trust assets. So if the value of the trust increases, the payment will increase and if the value of the trust decreases, the payment will decrease.
While each approach has its pros and cons, a CLAT works particularly well in a low interest rate environment. That’s because the lower the ?7520 rate, the greater the likelihood the value of the property contributed to the CLAT will grow at an average rate in excess of this projected rate and leave more for heirs than assumed by the IRS valuation tables.
Tax-wise, there are also two forms that a CLT can take: The donor must decide if the income taxes will be paid by the trust (a “non-grantor” trust) or by the donor (a “grantor trust”). If the donor wants a current income tax deduction, then a grantor CLT should be established. The donor will receive the desired deduction, but must also pay income taxes generated by the trust assets. The taxes may be offset by a deduction for the income payments made from the trust to the charity.
In some cases, the trust balance at the end of the term reverts to the donor and is includible in the taxable estate. In other instances, it may also be possible to transfer the CLT balance to the heirs and receive a gift tax deduction. While a full discussion of this technique is beyond the scope of this article, favorable private letter rulings (PLRs) allow the income, estate and gift tax benefits of using a properly structured grantor CLT. Bear in mind that a PLR is not authority and this technique remains relatively untested.
A CLT can increase money left to heirs by reducing the client’s estate and the size of the gift. By purchasing life insurance on the client, the CLT can further leverage the amount left for the heirs. As long as the trust income payable to the charity is not compromised, a portion of the trust assets in the CLT can be used to fund a life insurance policy on the client’s life. Generally, when life insurance is included in CLT planning, the CLT should be established as a CLAT in which the income provided to the charity is an annual fixed dollar amount.
An example may help demonstrate. Consider a widowed female client, Catherine, age 63, non-smoker-preferred. She has an estate of about $10 million and is concerned about her estate tax liability. She also is charitably inclined.
Catherine could create a CLAT and fund it with $1 million. Half of this money will be in the form of cash (which grows at 5% a year), and the other half will be securities (which have a total return of 8% a year). The charity will receive 6% of the original trust assets every year, or $60,000. The trust can support a premium stream of about $26,000 a year without having to touch the trust income, which can purchase roughly $1,800,000 of a guaranteed universal life product. Catherine’s children will receive the remainder of the trust assets when the trust terminates at Catherine’s death.
Based on the current ?7520 rate of 5.8%, Catherine will receive a gift tax deduction of $620,718, and the ultimate taxable gift to the CLAT will be $379,282, instead of the full $1,000,000 value of the assets given to the trust. Catherine will use her applicable exclusion amount to cover this cost and avoid paying gift taxes. By the time Catherine dies in year 19 (her life expectancy), both the charity and her heirs will benefit more than if she had not created the CLAT.
As the chart demonstrates, the CLAT benefits both Catherine’s heirs and her favorite charity, increasing the amount available for the charity by more than $1 million and the amount left for her heirs by over $1.5 million.
The charitable lead trust is a flexible and powerful planning tool that can help protect and preserve wealth for future generations. By reducing transfer tax costs, the CLT can create a gift-tax savings and potentially even current income-tax deductions. Finally, when used in conjunction with life insurance, the benefits of a CLT can be leveraged and further increase the amount transferred to future generations.
Cynthia A. Crino, CLU, is assistant vice president, operations, advanced markets unit, John Hancock Life Insurance, Boston, Mass. She can be reached via email at .