Charitable Lead Trusts

Charitable Lead Trusts – A Brief Primer

A charitable lead trust (CLT) is a split-interest trust in which the income interest is to be paid over to one or more charitable organizations and the remainder interest is to be paid over to one or more noncharitable beneficiaries.  The CLT is often used as a vehicle for the donor to have a deduction to offset the gift tax otherwise owed for transferring property from the donor to the noncharitable beneficiary. The income interest (lead interest) may be contributed for a term of years or for the life of one individual or the lives of multiple individuals (alive and ascertainable as of the funding of the trust). A term of a period of lives in being plus a term of years also qualifies. Unlike with a CRT, there is no maximum payment period and no minimum or maximum payout requirement.

The donor may get a deduction in the year the CLT is funded for the value of the income interest if certain conditions are met. For federal income, gift and estate tax purposes, the income interest must be in the form of a guaranteed annuity interest (guaranteed amount) or a unitrust interest (fixed percentage of the FMV of the trust property, valued annually). IRC §§170(f)(2)(B), 2055(e)(2)(B), 2522(c)(2)(B). The income interest must be received at least annually, and the recipients must be charitable organizations. Income in excess of the annuity or unitrust amount may be distributed to charity (unlike with a CRT).

The income interest of a CLT is irrevocable. However, back-up charitable recipients may be named (e.g., in the case that the original recipients do not qualify under IRC §170(c) during the charitable term), and the trustee may be given discretion to pick what charity gets the income interest. If the grantor reserves the power to change the annuitant, the grantor will have retained control and enjoyment of the property, and the gift will not be complete. See IRC §2036(a). Accordingly, the grantor will be subject to gift tax liability.

A CLT is treated as a private foundation for certain purposes, and the private foundation rules for self-dealing, excess business holdings, jeopardizing investments and taxable expenditures may apply. The governing instrument must include the provisions described in IRC §508(e). No in terrorem clause is allowed.

There are two types of CLTs:

  1. A non-grantor CLT, which is the more common type, is not tax exempt (i.e., donor does not get “front end” charitable deduction for the income interest). The income of the CLT is taxable to the CLT (and not to the donor), but the CLT is allowed an unlimited charitable deduction for its charitable distributions, whether to a U.S. or foreign charity. Unlike with a CRT, there is no statutory ordering of income distributions (i.e., it goes out pro rata). The non-grantor CLT may be used by a donor who cannot fully deduct his or her charitable contributions because of the percentage limitations.
  2. In a grantor trust CLT, the donor is treated as the owner of the income interest. The donor receives a “front end” charitable deduction for the value of the income interest, but the income received by the CLT is taxed to the donor and not to the trust. The deduction is subject to the AGI limitations for a gift for the use of a charity. In general, a 30% limitation applies to such gifts for income tax purposes if the donee is a public charity, and a 20% limitation applies if the donee is not a public charity and the gift is capital gain property. The grantor trust CLT may be appealing to a donor in a year in which he or she has abnormally high income to offset.

The donor with respect to a CLT is entitled to a gift tax charitable deduction for the value of the income interest (the higher the % to charity, the bigger the gift tax deduction and the lower the gift tax). If the donor would like to transfer an asset (e.g., closely held stock) to his kids at some later date and would like to minimize his gift tax liability, he might put the asset into a CLT for a term (during which it would benefit the charity), after which it would go to the kids without gift tax. The donor gets a real benefit (from a gift tax perspective) if the asset appreciates while in the CLT (because it was valued on the date it was transferred to the CLT) and his gift tax exemption ($1M) has already been used up. If, however, the donor/grantor retains the power to change the charitable beneficiary, the gift is incomplete, and gift tax must be paid on the FMV of the asset as of the end of the term during which income is paid. If the donor/grantor dies while the asset is still in the CLT, the asset is includable in his estate for estate tax purposes.

The donor with respect to a CLT is entitled to an estate tax charitable deduction for the value of the income interest.  IRC §2055(e)(2)(B).

If the remainder beneficiaries of a CLT are the donor’s grandkids, the donor may also be liable for generation skipping transfer tax (GST). The donor may offset part of this liability with the $1.5M GST exemption. The donor allocates the amount of the GST exemption based on the calculated remainder interest. If the trust grows at a higher rate, the amount passing to the grandkids would be higher and the exemption in effect would be leveraged. However, under IRC §2642(e), for transfers made to a CLAT, the applicable amount for the adjusted GST exemption is based on the value of the assets remaining at the end of the annuity term, but the adjusted GST exemption is still calculated using the IRC §7520 rate at the time of the initial transfer of the assets into the CLAT. Thus, any appreciation above the calculated amount will trigger a GST.

A CLT may be formed inter vivos or testamentary. In the latter, the charitable deduction is available to the estate. A creative use of a testamentary CLT is to have it provide that the income rate should be fixed at the time of grantor’s death at a % that reduces the estate tax value to the exemption amount in effect at that time. For example, a $3M estate contributed to a CLT for a term of 10 years may provide for an income rate that leaves the remainder beneficiaries with $1.5 million at the end of the term, which is equivalent to the estate tax exemption amount (so no estate taxes owed).

A CLT is often used to pay the income interest to the grantor’s private foundation or donor advised fund. If the annuitant if the grantor’s private foundation, of which grantor is the sole director, there may be an issue with whether donor relinquished control and enjoyment of the property to complete the gift. The solution is to wall off the grantor as a director with respect to his contribution (i.e., put it in a separate fund which grantor does not control). This problem is avoided with a proper DAF as the grantor can only advise on how the funds are distributed.

A CLT is subject to an anti-abuse rule to shut down the use of “vulture trusts,” trusts that use a seriously ill individual as the measuring life in order to increase the remainder interest. The rule limits the individuals whose lives may be used as measuring lives to the donor, his or her spouse, and an individual who, with respect to all remainder beneficiaries, is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. Treas. Reg. §1.170A-6(c)(2)(i)(A).