The following article was written by L. William Schmidt, Jr. Denver Foundation Trustee and Chair of the Professional Advisors Council.
The Non-Grantor Charitable Lead Annuity Trust
A common obstacle to making a large charitable donation is the concern that it will either impair either the donor’s lifestyle or reduce the inheritance of family members. However, with careful planning, it often possible to create a win-win strategy which benefits both a charity and the donor’s family. I have called the non-grantor charitable lead annuity trust (CLAT) a “Boomerang Trust” because it enables the donor to make a gift to charity which, after a period of years, returns to the donor’s family. This is a strategy sanctioned by the IRS and used for many years by tax planning professionals.
Let’s see how it works:
1. Allows a substantial gift to children with little or no gift tax consequences.
2. Removes the value of gifted assets from the estate for federal estate tax purposes.
3. Removes future appreciation of gifted assets from the estate.
1. No charitable income tax deduction for assets transferred to the CLAT.
2. Children must wait until the CLAT terminates to receive the property.
3. The CLAT is taxable on its income – but receives a charitable income tax deduction for distributions to charity.
The donor creates an irrevocable trust which provides a specific, dollar-amount annuity payable to charity for a designated number of years. At the conclusion of the trust term, the property remaining in the trust is distributed to the donor’s children or grandchildren. This is a split gift, meaning that there are two beneficiaries of the trust: the charity, initially, and the donor’s family later. Therefore, this is referred to as a charitable “lead” trust because the charity’s interest leads the remainder eventually distributed to the family.
VALUING THE LEAD AND REMAINDER: The IRS has a formula for determining the value of the charitable lead interest based on several factors:
1. The value of the asset contributed to the trust
2. The term of the trust,
3. The amount of the annuity payable to charity during the term of the trust,
4. An assumed rate of return on the investment of the trust assets.
The calculated value of the anticipated value of the trust remaining at the end of the trust term (the remainder interest) is treated as a gift to the family beneficiaries. The rate of investment return used by the IRS (called the 7520 Rate) is based on the average yield of marketable debt of the U.S., such as government bonds and T-bills, and is published monthly.
Assume a CLAT having a trust term of 10 years, receiving a donation of $1MM, with an annual annuity of 5% (50,000) to charity. Based on these factors, with a current 7520 Rate of 0.4%, the value of the charitable annuity would be $489,175. The value of the projected remainder interest passing to family members would be $510,825 and would be reported as a gift (any potential gift tax liability would potentially be offset by the donor’s applicable estate and gift tax exclusion).
The Wealth Transfer Bonus
But here is the real kicker: The IRS calculation assumes the trust will only appreciate at the published 7520 Rate of 0.4%. However, if we assume the trust actually appreciates by 5% annually and distributes that same amount each as the charitable annuity, at the end of the trust term, the trust still has the original $1,000,000 which now passes to the family members with no further estate or gift tax consequence. Result? There has been a reported gift of $510,825 with a real value $1,000,000. The only downside is that the family had to wait 10 years for the gift to be received.
CLATs are most commonly used as a strategy to make large discounted gifts to the next generation. Low 7520 Rates favor these trusts because of the government’s poor assumed investment rate of return. This makes today a particularly important time for the use of the Boomerang Trust because the 7520 Rates are historically low.
The Denver Foundation is eager to serve as your charitable partner, and can support you in designing a gift-planning proposal to meet your unique needs. Please contact Ben Perry, Director of Professional Advisor Programs and Philanthropy Advisor, at firstname.lastname@example.org for more details.