Whether the trust is "qualified" under federal tax law or "nonqualified"The charitable lead trust is split interest trust under which an annual income is paid to a qualified charitable organization for a specified period of years, with the principal of the trust reverting to the grantor or passing to noncharitable remaindermen (often, descendants of the grantor) upon termination of the trust term.
Thus, the charitable lead trust is a technique for making a temporary gift of an income interest to a charitable institution. Because the value of the charitable interest is gift or estate tax-deductible under certain circumstances, the lead trust often is used to minimize transfer taxes while ultimately passing ownership to family members. This is often called the non-grantor (or non-reversionary) lead trust.
The charitable lead trust can also be set up inter vivos with the property reverting back to the donor—or passing to the donor's spouse—when the required annual payments to the charity terminates. This is known as a grantor (or reversionary) lead trust. It is designed to produce an immediate income tax deduction (for those who itemize) for the present value of the income stream that will be paid to charity during the trust term.
Understanding Charitable Lead Trusts
Using a CLT makes good sense in times of low applicable federal rates (AFRs). The AFR is published by the Treasury department every month to value annuities, life interests or interests for terms of years, and remainder or reversionary interests. The AFR is important because a low AFR increases the present value of the charity's income interest. Conversely, this reduces the valuation of trust assets expected to go to non-charitable beneficiaries. So, if the trust corpus appreciates during the trust term, a greater amount of the appreciation escapes transfer taxation as it ultimately passes to family members.
Charitable lead trusts can be categorized according to the following criteria:
Whether the trust is "qualified" under federal tax law or "nonqualified"
Whether the income payout to the charity is an annuity interest, unitrust interest, or some other type of (nonqualified) interest
Whether the grantor is considered the owner of the trust for federal income tax purposes
Whether the trust is set up by inter vivos or testamentary transfer
Qualified vs. Nonqualified CLTs
A qualified CLT is one that meets the tax law requirements to qualify for a gift tax or estate tax charitable deduction. As we shall see, a CLT may also qualify for an income tax charitable deduction if the trust is deemed a "grantor trust" for federal income tax purposes. Nonqualified CLTs are those that fail to qualify for any of the three charitable deductions.
It's important to note that even a qualified CLT is not income tax-exempt (as is a qualified charitable remainder trust). Trust income will be taxed either to the grantor or to the trust. If the trust is the taxpayer, it is taxed as an accumulation trust. To be "qualified," a CLT must meet several requirements:
The trust must be irrevocable.
The term of the trust generally must be measured by a fixed term of years or, alternatively, by the life or lives of one or more persons living when it is created. Most CLTs are created for a fixed term of years.
Income payments must be made to charity either in the form of a guaranteed annuity interest or a unitrust interest (defined below).
Generally, payments to noncharitable beneficiaries are not allowed during the term of the trust.
The trust agreement must contain language that forbids certain kinds of prohibited dealings and activities.
Under IRS regulations, permissible measuring lives for CLTs are limited to the donor, the donor's spouse, and individuals who are either a lineal ancestor or the spouse of a lineal ancestor of all of the non-charitable remainder beneficiaries. To satisfy the last of these categories, there must be less than a 15% probability that persons who are not lineal descendants of the measuring individual will receive any portion of the trust corpus.
A guaranteed annuity interest is a fixed percentage of the initial value of the trust principal. This establishes at the outset a fixed dollar amount that must be paid to charity each year regardless of trust performance.
A unitrust interest is a fixed percentage of the annually revalued trust principal, and results in an annual payout that fluctuates in dollar amount with trust performance.
There is no 5% minimum payout for CLTs as there is for charitable remainder trusts. This applies to both types of qualified payouts. Nor is there a minimum charitable interest as there is with charitable remainder trusts (10%). Further, there is no "net-income CLT," under which the trustee would distribute only the trust's net income if that were less than the regular percentage payout. Nor is there a "flip CLT," under which the trustee would switch from one type of payout to another upon the occurrence of some contingency. To be qualified, a CLT must select one of the two authorized payout methods and stick with it for the entire term of the trust. Any other payout method makes the trust "nonqualified."
The grantor only qualifies for an income tax charitable deduction upon the creation of an inter vivos, qualified CLT if the trust is considered a "grantor trust" for federal income tax purposes [IRC Sec. 170(f) (2)(B)]. While the net income of the trust is included in the grantor's gross income each year, the grantor who itemizes can deduct the present value of the charity's income interest in the year of the gift (subject to the percentage limitations).
A grantor is treated as the owner of a trust if, among other things, the present value of the grantor's reversionary interest in the trust exceeds 5% of the trust's value [IRC Sec. 673(a)]. Unless the grantor creates a CLT with a very high payout percentage and/or a very long trust duration--so that the present value of the charity's interest is 95% or more of the trust's value--the donor's retention of a reversionary interest will make the CLT a grantor trust for income tax purposes.
When the grantor is not treated as the owner for federal income tax purposes, then a nongrantor CLT has been created. This means that the grantor does not have any of the following rights or powers:
A reversionary interest exceeding 5%
A power to revoke the trust
A power to control its beneficial enjoyment
A right to receive trust income or to have trust income applied in certain ways for the grantor's benefit (e. g. , to discharge the grantor's support obligations, or to pay life insurance premiums on a policy on the life of the grantor or the grantor's spouse)
Certain administrative powers over the trust (e. g. , a power to borrow from the trust on "sweetheart" terms)
No income tax charitable deduction is allowable for the creation of a nongrantor CLT, although the trust itself can deduct its annual payouts to charity during the trust term.
If a grantor provides that the principal of a CLT will pass to a third party upon expiration of the trust term rather than reverting to the grantor, no reversionary interest exists in the grantor. The grantor would neither be taxed on trust income, nor allowed an income tax charitable deduction. But the federal gift tax may become a factor because a future-interest gift is made to the noncharitable third party. Only the present value of the charitable portion is sheltered by the gift tax charitable deduction (assuming the trust is qualified).
Inter Vivos vs. Testamentary CLTs
CLTs may be set up during the grantor's life or at the grantor's death. When the primary motive is current income tax savings, the CLT must be set up during life. When the primary motive is transfer tax savings, the grantor may choose to establish a testamentary CLT. This will have the important side benefit of passing a tax basis to beneficiaries (when the CLT ends) that is stepped-up to the estate tax value of the trust property.
An inter vivos CLT can also produce transfer tax savings. The gift tax charitable deduction (for a qualified CLT) reduces the value of the gift to the noncharitable remaindermen in the case of a nongrantor CLT. However, the grantor's basis in the trust property carries over to the remaindermen when an inter vivos CLT ends.
If remaining payments are to be made to charity at the grantor's death, the present value of the these payments is estate-tax deductible if the CLT is included in the grantor's gross estate.
Finally, the appreciation in value of the trust principal after the trust is created would escape transfer tax entirely (unless the generation-skipping tax is triggered upon trust termination).
Qualified Nongrantor Lead Trusts (nonreversionary lead trusts)
Transferring property to a nongrantor (nonreversionary) charitable lead trust does not produce an income tax charitable deduction for the donor. However, the income earned by the trust is not taxable to the donor, and the present value of the charitable interest is deductible for federal gift tax purposes if the requirements of a qualified CLT are met. The transfer does not trigger a capital gains tax for the donor even though the property may have appreciated substantially in value.
Income Tax Charitable Deduction
Because this is not a grantor lead trust, no upfront income tax charitable deduction is available for the present value of charity's annuity interest. During the trust term, the trust as a separate taxpayer can claim income tax charitable deductions for the annual amounts paid out to charity.
Gift and Estate Tax Considerations
Aside from the philanthropic motive, a key purpose of the nongrantor lead trust is to pass property to family members sheltered from gift and estate taxes. The present value of the charitable interest is deductible for both gift tax (if inter vivos) or estate tax (if testamentary) purposes.
The exact amount of the gift tax charitable deduction for a CLT depends on:
The dollar amount payable to charity each year
The number of years payments are to be made
The applicable federal midterm interest rate (AFR) at the time the transfer is made
The frequency of payments to the charity (annual, semiannual, quarterly or monthly)
In determining the deduction, the donor can select among the AFRs for the month in which the trust is established or for either of the two preceding months. Selecting the lowest of the available rates will maximize the charitable deduction, other factors being held constant.
The charitable lead unitrust will produce a larger charitable deduction than the charitable lead annuity trust if the payout rate to the charity is less than the given AFR. If the payout rate is greater than the AFR, the charitable lead annuity trust will produce the larger deduction.
A key advantage of the nongrantor CLT is the opportunity to shift future appreciation out of the donor's estate tax base.
Click here for an example of the transfer tax savings possible with a nongrantor (nonreversionary) charitable lead trust.
Bartholomew transferred property valued at $500,000 to an inter vivos, nongrantor lead trust. Because he itemized, Bartholomew was able to take a gift tax charitable deduction of $290,000 and there was a taxable gift of $210,000 to the remaindermen. When the trust ended, the trust property had appreciated to a value of $1,200,000. The CLT permitted Bartholomew to transfer almost $1,000,000 free of federal gift and estate taxes.
Does it make sense for the client's family to lose the use of wealth for X years to gain an estate tax savings of Y? The answer will be individual and depend on several factors, including not just the raw numbers for X and Y, but the present values of those numbers based on realistic projections and assumptions, and the subjective philanthropic motives of the client.
There is excellent commercial software available to compute the amount of the gift tax or estate tax charitable deduction. Many charities will offer to make these calculations on a complimentary basis upon request by a donor's attorney or other advisor.
Income Taxation of the Nongrantor Lead Trust
A charitable lead trust, unlike a charitable remainder trust, is not income tax-exempt. Rather, the nongrantor lead trust is taxed as a complex trust. All income and capital gains are taxed to the trust and the trust is allowed a charitable deduction for amounts paid to the charitable beneficiary.
The trust agreement should generally direct the following order of payment:
Ordinary income (including net short-term capital gains)
Unrelated business income
Net long-term capital gains
Tax-exempt income; and
Principal
The accumulation trust throwback rules should be considered in planning a charitable lead trust unless the trust provides that all income in excess of the annuity is to be paid to the charity or it appears that income will not be greater than the annuity payments.
The donor's transfer of appreciated property to the trust will not trigger a capital gains tax because the transfer is not considered a sale or exchange of the property. The trust will take the donor's basis in the property and will realize a taxable capital gain if the property is sold for more than the adjusted cost basis.
As previously noted, this capital gain will be taxable at the donor's tax rates if the sale is made within two years of the date of transfer.
It is important to emphasize that appreciation in the value of the property after the transfer to the trust will not be subject to either a gift or estate tax.
If the nongrantor lead trust is created inter vivos, the donor's basis in the trust property (if still held at trust termination) will carry over to the noncharitable remaindermen. In the case of a testamentary nongrantor CLT, the beneficiaries' basis will step up to the estate tax value of the trust property.
Qualified Grantor Lead Trusts (reversionary lead trusts)
A charitable lead trust that is treated as a grantor trust for federal income tax purposes has special tax consequences. The typical grantor lead trust provides that, after a specified number of years, the trust property will revert to the grantor or to the spouse of the grantor.
Because of this reversionary right, the grantor is treated as the owner of the trust (assuming the value of the reversion exceeds 5%, as it usually will). The grantor is taxed on all the trust income, but the present value of the charitable interest is immediately deductible for income tax purposes.
Click here for a graphic on the Qualified Grantor (Reversionary) Charitable Lead Trust.
Income Tax Charitable Deduction
While the grantor can claim an upfront deduction for the present value of the guaranteed annuity or unitrust interest given to the charitable beneficiary, the deduction in the year of the transfer cannot exceed 30% of the donor's adjusted gross income. This is true even if cash is used to fund the trust.
While a cash gift is normally subject to a 60%-of-AGI limitation, the charitable interest in a lead trust is considered a gift for the use of charity, not a gift to charity [Reg. Sec. 1.170A-8(a)(2)]. This triggers the special 30%-of-AGI limitation. Any excess amount not deductible in the year the trust is established can be carried over and deducted (subject, again, to the 30% limitation) for up to five succeeding years.
If the donor dies during the term of the grantor lead trust (or for any reason ceases to be treated as the owner), a portion of the charitable deduction will be recaptured.
Strangely, if a donor relinquishes his or her reversionary interest to charity during the trust term, there is still a recapture of the charitable deduction originally allowed for value of the charitable income interest.
Gift and Estate Tax Considerations
There will be no taxable gift when property is transferred to a grantor lead trust. Because of the grantor's retained interest, the only completed gift is the present value of the charity's income interest, which usually will qualify for a gift tax charitable deduction.
If the donor dies before the termination of the trust, the full value of the trust will be included in his gross estate, but a charitable deduction will be allowed for the present value of the remaining charitable income interest.
Transferring property to an inter vivos charitable lead trust provides the additional advantage of avoiding estate and gift taxes on the appreciation in the value of the property between the date of the gift and the date of death.
Income Taxation of the Grantor Lead Trust
Because the grantor is taxed on all trust income, the trust is not a separate taxpayer during the grantor's life. Like the nongrantor lead trust, the grantor CLT is not income tax exempt.
The donor's transfer of appreciated property to the trust will not trigger a capital gains tax because the transfer is not considered a sale or exchange of the property. The trust will take the donor's basis in the property and will realize a taxable capital gain if the property is sold for more than the adjusted cost basis.
Any capital gain realized by the trust will be taxable to the grantor, even if if the sale occurs more than two years after the date the trust was established. Moreover, any appreciation in the value of the property after the trust was established will add to the amount realized and taxable to the grantor, because of the grantor's retained "string" on the property.
The "Intentionally Defective" Nongrantor CLT
Suppose that the grantor of a CLT, upon the advice of tax counsel, establishes a trust in which his children are the remaindermen. The grantor retains a power over the trust--other than a reversionary interest exceeding 5%—that makes the CLT a grantor trust for federal income tax purposes. Moreover, this retained power is carefully selected so that it is not a "string" for federal estate tax purposes.
For example, the IRS has ruled that the power of a nonadverse third party to substitute other property of equal value for property owned by the CLT made the CLT a grantor trust for federal income tax purposes. However, this power did not require the value of the trust to be included in the grantor's gross estate for federal estate tax purposes [Ltr. Rul. 9224029; see also Ltr. Ruls. 9247024, 9407014, 9810019].
The upshot is that the donor removes the trust property from his gross estate by making the irrevocable transfer to the CLT, while securing an immediate income tax charitable deduction because he created a grantor CLT. The downside is that the donor is taxed each year on the trust income, and gets no offsetting charitable deduction for the annual annuity or unitrust amounts paid to charity.
Private Foundation Prohibitions
Charitable lead trusts are treated as private foundations with respect to certain administrative restrictions under which they must operate. The trust agreement must contain specific prohibitions against the following:
Excess business holdings [IRC Sec. 4943]
Self-dealing [IRC Sec. 4941];
Jeopardy investments [IRC Sec.4944]
Taxable expenditures [IRC Sec. 4945]
The private foundation prohibitions against excess business holdings is applicable to charitable lead trusts if the value of the charitable interest exceeds 60% of the value of the trust assets. For example, when a closely held business interest is transferred to a charitable lead trust, it is generally necessary to limit the charitable income interest to 60% or less of the value of the trust through proper selection of the payout rate and trust term.
The Charitable Lead Trust Agreement
The trust agreement must provide for the annual (or more frequent) payment to a qualified charity of either a fixed dollar amount (an annuity) or a specified percentage of the value of the trust as redetermined each year (a unitrust amount).
Generally, there must be no payments during the trust term other than the prescribed annuity or unitrust payments to the charity. Technically, it is possible to provide an individual annuity as well as a charitable annuity by segregating property transferred to the trust. However, most lead trusts do not provide for private payouts during the time an annuity is payable to the charitable beneficiary.
A charitable lead trust agreement could direct the trustee to pay the sum of $5,000 to a designated charity each year for 10 years. At the end of the 10-year period, the trust agreement would direct the trustee to transfer all the trust assets to designated individual beneficiaries. This is a charitable lead annuity trust.
Or the trust instrument could direct that the trust assets be revalued every year and that, in each of the 10 years of the trust's existence, the trustee is to pay charity an amount equal to 5% of the value of the trust assets as revalued in that year. This is a charitable lead unitrust.
It's important to reiterate that these are the only payout alternatives for a qualified lead trust. The trust cannot direct that trust income, as defined for trust accounting purposes, be paid to charity or that the lesser of a dollar amount or a percentage of value be paid to charity, if the goal is to create a trust that will qualify for income, gift or estate tax charitable deductions.
In July 2007, the IRS issued model Charitable Lead Annuity Trust forms (both inter-vivos and testamentary) with pre-approved language [Rev. Procs. 2007-45 and 2007-46, released in I.R.B. 2007-29].
In July 2008, the IRS issued model Charitable Lead Unitrust forms (both inter-vivos and testamentary) with pre-approved language [Rev. Procs. 2008-45 and 2008-46, released in I.R.B. 2008-30].
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