Tax Planning Tool: Charitable Lead Trusts

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This article was co-authored by Richard Lee.

Many donors make multi-year commitments to a charity of their choosing. For example, an agreement to contribute $50,000 per year for 5 years to a new building campaign. Some donors are happy to make the pledge payment each year from their annual income, which makes them eligible to take an income tax charitable deduction annually. However, what about the donor that wants to fund their pledge payment out of existing wealth and garner a large upfront income tax deduction? There may be a way to accommodate this type of donor with a Charitable Lead Trust (CLT).

Conventional wisdom is that CLTs are actually estate-planning tools for the very wealthy. While this is true, there are estate and gift planners, such as Lani Starkey of Fifty Rock Consulting, who believe there are income tax planning uses for CLTs as well, particularly to generate an upfront income tax charitable deduction, in a year in which the donor has unusually high income.

A CLT involves making a charitable gift to an irrevocable trust. A CLT in some respects is the mirror-image of its trust cousin Charitable Remainder Trust (CRT). A CRT is tax-exempt and provides a regular income stream to the donor or named beneficiary for the donor’s lifetime(s) or term of years, with the remainder thereafter going to the charity. Conversely, a CLT is not tax-exempt, with periodic payments going to charity for a specified term, and the remainder either reverting to the donor or passing to some other person chosen by the donor.

Please note there are two different types of lead trusts: grantor trusts and non-grantor trusts. The income tax benefits discussed here stem from using a grantor charitable lead trust.

With a grantor trust, the trust will annually file a fiduciary income tax return for income tax purposes, the trust’s income, gain or loss, will flow through the trust and be reportable on the donor’s personal income tax return (Form 1040).

The upfront income tax charitable deduction is equal to the present value of the charitable income stream, which is determined by using an IRS-prescribed interest rate known as the “Section 7520” rate. The lower the Section 7520 rate, the higher the discounted present value of the charitable income stream, and the higher the upfront income tax charitable deduction. Currently the Section 7520 rate is very low, thus producing higher income tax charitable deductions for gifts to CLTs.

As an example, assume a donor makes a pledge to a charity for $25,000 per year for 10 years and has accumulated assets of $500,000. The donor could donate to a charitable lead annuity trust and they could use a large charitable deduction in the current year to offset a large bonus they received. If you assume a 5% payout rate and a 6% investment rate of return on trust assets over the 10 years, the transaction would yield the following:

  1. An immediate charitable deduction of approximately $229,000, which could offset other income by up to 20% of the donor’s adjusted gross income, or 30% if the contribution were made in cash (compared to a $25,000 deduction per year over 10 years). The deduction is so close to the $250,000 to be paid to the charity because of the low Section 7520 rate. This rate will presumably go up given other rate increases making the deduction less.
  2. $25,000 per year to go to the charity for 10 years, same as the pledge.
  3. Approximately $566,000 to revert back to the donor or their assignee at the end of the 10-year period.
  4. An amount greater than the $500,000 contributed as the rate of return on trust assets at 6% exceeded the 5% payout.

This might be a very attractive result for a prospective donor. The catch is that they would have to have sufficient wealth to completely fund the trust in the first year. A donor that pays their yearly contribution out of their annual income could not do that.

Additional benefits:

  1. The charity has more security that the pledge will be fulfilled as the trust is funded.
  2. If the trust is funded with securities, the donor gets an immediate income tax charitable deduction applied against ordinary income whereas subsequent sales of stock to fund the payments could trigger more favorable long-term capital gains.
  3. If the pledge is paid immediately, the donor gets the full $250,000 deduction but the money is gone. With this arrangement, unspent corpus is returned to the donor.

A CLT can be structured to fit a donor’s objectives and financial situation. The donor can select the trust’s start date, the trustee (e.g., a bank, individual, or the charity), the trust term, the lead interest charitable recipient, the payout percentage and formula (annuity or unitrust), the payout frequency (e.g., quarterly or annually), the contributed assets, and the remainder beneficiaries (e.g., the donor themself, or their children).

As mentioned before, a CLT is taxable, unlike its tax-exempt CRT cousin. Therefore, contributing low basis assets and selling them once inside the trust would result in the grantor having to recognize capital gain on the sale, thus offsetting the income tax benefit of the upfront charitable deduction. Thus, higher basis assets would generally be better assets to contribute to a CLT.

Note: Although the initial contribution of assets to the trust will generate an immediate income tax charitable deduction, over the trust’s term the initial income tax benefit is at least partially offset by the donor’s reporting of the trust’s income. And, if the donor dies during the trust term, the donor is required to report as income a portion of the up-front charitable deduction.

Keep in mind too that any income tax charitable deduction allowed is limited to 20% of a donor’s adjusted gross income, or 30% of adjusted gross income in the case of contributions of cash rather than capital gain assets, even if the lead interest goes to an otherwise 50% public charity.

These arrangements might work very well in the right situation for the right donor. If you would like additional information, please contact our office at 301.231.6200. .


About Craig Stevens

Craig Stevens has written 81 post in this blog.

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