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.