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April 19, 2009 at 08:00 PM
Sophisticated estate planners often use charitable lead trusts for charitably inclined high net worth clients. CLTs provide income to the client’s favorite charity for a period of time, after which the balance goes to the trust’s beneficiaries, usually the client’s children.
The advantages for clients are often enormous. They can both satisfy their charitable objectives and transfer property to heirs at a discounted rate. Why? Because the transfer doesn’t occur until some time in the future and the value of the gift is discounted under a formula established in the tax code and regulations. Clients might also be able to remove appreciation from their estate, moving it into the hands of heirs. Clients may even receive a charitable income tax deduction.
How it works
Clients who meet the profile would take the following steps:
1. Identify a charity to which they wish to provide income.
2. Identify appreciating property that generates income or could be sold by the trust and placed into income-generating property.
3. Establish the CLT and determine the most appropriate structure.
4. Donate property to the trust that can be sold or used for the income it generates.
Each year the charity receives income, the amount of which is based on a pre-determined percentage and will vary if the charity is set up as an annuity trust or unitrust, which are described later in this article.
The client receives potential income tax deductions, but may also pay gift taxes based on the structure of the trust. The gift taxes can be substantially reduced by adjusting the structure. Because of the nature of the gift tax calculation, in today’s low interest rate environment, the trust might be particularly attractive when gifting appreciating property.
At the end of the trust term, the property in the trust ceases sending income to the charity and, instead, transfers the trust assets to a remainder beneficiary such as the children.
Enhancing the trust with life insurance
Where a CLT is established with income-generating property that is sufficient to pay the charity its income commitment, a client might wish to enhance the CLT with life insurance. This won’t necessarily help the charity; however, it will help the remainder beneficiaries (typically the children or other family members).
How will life insurance help? First, the trustee leverages trust income not needed to benefit the charity through a life insurance death benefit. Secondly, the life insurance death benefit provides a hedge, or collar, against fluctuations by the trust’s other assets.
Not all income can be directed to the policy because the charity’s income needs are paramount. But income that exceeds the charitable payout can enhance and stabilize wealth transfer to future generations.
Example of CLT in action
To illustrate, consider a husband and wife, Bill and June, who have substantial assets and are 65 and 64 years old, respectively. They desire to minimize potential estate taxes by boosting charitable contributions to their favorite charity. One asset, a rental property worth $1 million, generates income they no longer need. They would like the charity to receive the income while they live, and then for their children to inherit the property.
Bill and June establish a charitable lead annuity trust funded with the $1 million rental property. The Red Cross receives income of $75,000 per year for the duration of their lives; the children are projected to receive $5,479,957 at their deaths.
More importantly, the discounted value of the remainder gift to the children–$118,820 after income is paid to charity–is substantially lower than the value of $1,000,000 today. Making the gift to charity also reduces the federal estate tax because the $1,000,000 is no longer included in the couple’s taxable estates at death.
Where income generated by the CLAT is sufficient to pay the charity, its income as well as anticipated life insurance premiums, life insurance can boost the benefits to the donor’s heirs. The accompanying chart shows how powerful that benefit can be.
By using a CLAT with life insurance Bill and June accomplish their three major goals. They:
? Generate $1,950,000 in income for their favorite charity with a $1 million gift;
? Reduce estate taxes with a taxable gift of only $118,820 (a more than 88% discount);
? Bequeath a projected $6,586,999 to their heirs with a gift of $118,820, thanks to life insurance. This is an increase of over $1 million from the CLAT alone.
Depending on when the client(s) die, more or less assets might pass to the beneficiaries through life insurance. The longer the clients live, the less critical is the role life insurance plays when paired with other assets. But for clients who die prematurely, life insurance might have a significant role.
