Everyone has heard the proverb, “It is better to give than to receive.” Implicit in this age-old axiom is the notion that true charity is made without an expectation of reciprocation. One should give for the sake of giving and expect nothing in return. But what if you can give to charity and create the possibility of getting something in return? Then consider a Charitable Lead Annuity Trust (“CLAT”) as an option in your charitable planning.
A donation to a CLAT is a better way to give to charity because it leaves open the possibility of passing some portion of the donated assets to your children. Here is how it works:
A CLAT is a trust to which one makes a charitable gift. The donor predetermines the duration of the trust, usually based on a number of years (or even someone’s lifetime). During the term of the trust, the Trustee pays the assets gifted to the trust to one or more charities, including a private foundation established by the donor. At the end of the term, the assets that remain in the trust (if any) are distributed to the donor’s children. Essentially, the charity receives the gifted assets over time, while the donor’s children receive the upside growth on the gifted assets. So if the assets gifted to the CLAT are invested and produce income and growth at a rate greater than the fixed annuity passing to charity, then the additional investment performance will be leftover for distribution to the donor’s children. This possibility does not exist with an outright gift to charity because the appreciation on the gifted asset remains with the charity instead of being segregated for later distribution.
The following example illustrates the concept. Assume that a donor wants to gift $1,000,000 to the American Red Cross. Instead of writing a check for $1,000,000 to the American Red Cross, he gifts $1,000,000 to a CLAT and sets the term for 20 years. Under the terms of the trust the American Red Cross will receive an annuity equal to 5% (or $50,000 a year) at the end of every year during the 20-year term (totaling $1,000,000). Whatever assets remain in the CLAT after 20 years will pass to the donor’s children. Finally, assume that the assets of the CLAT are invested and earn a rate of return equal to 5% a year. In each year, the CLAT will earn $50,000 and will pay $50,000 to the American Red Cross. Since the CLAT earns sufficient income every year to satisfy the annuity payment to the American Red Cross, the Trustee never has to invade the original $1,000,000 gift to the trust, and the $1,000,000 principal remains intact to be distributed to the donor’s children after 20 years.
Now consider the relevant estate, gift, and income tax consequences of the foregoing gift. For estate tax purposes, the assets gifted to the CLAT are immediately removed from the donor’s gross estate. For gift tax purposes, the donor’s gift is bifurcated into a gift to charity and a gift to the donor’s children. The portion determined for charity will be offset by a gift tax charitable deduction and result in zero gift tax. The portion determined for the donor’s children will be subject to gift tax. Each portion of the gift is determined by an actuarial calculation based on a time value of money concept. Although the charity and the donor’s children will receive their respective gifts in the future, the value of those gifts is determined on the date of the gift to the CLAT, not when the beneficiaries receive the gift. Most critical in this calculation is the interest rate assumption used to compute the present value of each portion of the gift. A lower interest rate increases the value of the charitable portion and decreases the value of the taxable gift to the donor’s children.
Here is how the tax results are translated from the example above. Based on an interest rate of 1.4% (the February 2012 rate), the value of the gift to the American Red Cross is $867,000 and the value of the gift to the donor’s children is $133,000. Notwithstanding this determination, the charity will actually receive $1,000,000 over 20 years. It is less clear what the donor’s children will actually receive because that simply depends on the investment performance of the assets of the CLAT. What is clear, however, is that if the assets of the CLAT earn a rate of return greater than the assumed interest rate of 1.4%, then the donor’s children could receive significantly more than the $133,000 for which the donor was charged a gift tax. But here is the real gift tax benefit: to the extent that the donor’s children do receive more than $133,000 as a result of good investment performance, any excess is not deemed a gift from the donor but rather a tax free transfer of wealth!
For income tax purposes the donor may also receive an income tax charitable deduction similar to the gift tax charitable deduction. This would be the result if the donor chose to create the trust as a grantor trust for income tax purposes. Although the income tax deduction may seem appealing, consideration should be given to the fact that the donor will also be taxed on all of the trust’s income during the remaining term — even though he will not actually receive the income.
While the intricacies of the calculations are beyond the scope of this article, it is important to note that the current low interest rate environment presents a unique opportunity to consider income, estate and gift tax planning with a CLAT. Please call us at SGR if you would like further information on this area of charitable and estate tax planning.