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.
In effect, life insurance acts as a hedge against both client mortality and portfolio fluctuations. Although the insurance here used a level pay design for the life of the client, other insurance design elements or riders can be employed to enhance what death benefit might go to the beneficiaries.
Important technical considerations
CLTs can be structured to provide an annuity-like (fixed) income stream, as was the case in the Bill and June example, or as a fluctuating income stream based on each year’s ending trust value. These are respectively called charitable lead annuity trusts and charitable lead unitrusts (CLATs and CLUTs).
Unitrusts are advantageous when a client is concerned that income may vary widely from year to year, while an annuity trust is better with an income-generating asset that produces relatively steady income. The Bill and June example used a CLAT (annuity) trust because life insurance was purchased on a life-pay scenario and because the couple wanted to be certain funds were available for premium payments.
There is another trade-off for unitrusts and annuity trusts: Because of the mechanics of the generation-skipping transfer tax exemption, unitrusts are more appropriate than annuity trusts in cases where a client wishes to skip a generation in planning, although unitrusts yield less predictable premium payments.
Clients also need to decide whether to use a grantor or non-grantor trust. With grantor trusts, the trust stands as the grantor’s (typically the client’s) alter-ego for income tax purposes. In non-grantor trusts, the trustee (not the client) pays the taxes and receives deductions.
Using a grantor trust might yield the client an immediate income tax deduction for the present value of the projected charitable gift. Any unused amounts can be carried forward for up to 5 years. In future years, income might be generated as it is paid out to the charity; the income will be taxed to the client but he or she won’t receive a subsequent income tax benefit.
By contrast, the non-grantor structure won’t provide the client with an up-front income tax deduction. Instead, each year the trust recognizes income and a charitable deduction at the trust level, not the individual’s level.
So, clients need to determine how much they value the charitable income tax deduction and their tolerance for future years’ income being charged to their 1040 income tax return. Once they can decide on this, they can determine if they should go the grantor or non-grantor route.
Some people comment that life insurance purchased in a trust for the benefit of a charity might trigger the charitable split-dollar rules under Internal Revenue Code ?170(f). This remains debatable, but unlikely. Code Section 170(f) (10) requires that such a transaction falls under its control if:
(1)(a) The charity directly or indirectly pays the premium OR
(1)(b) There is an understanding or expectation that any person will directly or indirectly pay the premium AND
(2) The grantor or a member of his or her family is a direct or indirect beneficiary of the policy.
Although a CLT purchasing life insurance would meet condition (2), it would not meet either (1)(a) or (1)(b). In these situations the charitable beneficiary is not involved with the purchase of life insurance and it is not anticipated that the charity will receive any benefit.
Clients and their advisors need to weigh all of the implications of establishing one of these arrangements. These considerations include:
? The trust is irrevocable and, once established, clients cannot change their mind.
? Some clients may find that the structure of their estate, their deductions or their income tax isn’t suitable for a CLT. If so, this may lead toward other planning that might be more appropriate for the client.
? If the trust cannot generate sufficient income to cover the charitable income, principal might need to be tapped, and there may not be funds to pay the life insurance premium.
? Clients with adverse medical underwriting might find the insurance too costly to buy insurance within a CLT, given the priority need to pay income to the charity.
? Depending on the property gifted, clients might find the charitable deduction is available for only a limited percentage of their adjusted gross income.
? CLTs risk triggering gift taxes. Clients need to measure the cost of any transfer taxes against available gift tax exemption equivalents (still fixed at $1,000,000 for 2009). Because these trusts involve gifts of future interests, a client cannot use part of their annual exclusion gift amounts.
Charitable lead trusts offer a wide range of opportunities; however clients need to weight these approaches against their overall planning needs. Where a CLT makes sense, clients should weigh enhancing the wealth transfer with life insurance to help boost what trust beneficiaries receive and help stabilize this wealth transfer against the risk of market fluctuations.
Mark Teitelbaum, JD, LL.M., CLU, ChFC, is vice president of the Life Division at AXA Distributors, Hartford, Conn. You can e-mail him at [email protected]