DATELINE: February 11, 2009, Chicago
Yesterday’s Wall Street Journal has an article extolling the benefits of charitable lead trusts, an estate planning device that balances charitable motivations, family wealth transfers, and reductions in estate and gift taxes. Mike Spector, Giving Smarter While Helping Your Estate: Bear Market Provides Boost to Little-Known Strategy (Feb. 10, 2009). It is a great planning device when fully understood and used properly. Structurally, the donor makes a gift to a trust. The charitable beneficiary receives payments during the term of the trust. On termination of the trust, whatever remains is paid to the donor, her chidlren, or other named beneficiaries. It derives its name based on the charity’s relative position to the beneficiaries who receive the trust's assets upon termination. The charity is in the lead--it receives the first payments. A charitable remainder trust is just the opposite. The charity receives what is left following termination of the trust, with the children or other named beneficiaries receiving the annual payments. Charitable lead trusts can be created during an individual's lifetime (inter vivos) time or following an individual's death as part of the estate plan (testamentary).
There are two basic types of charitable lead trusts. The first pays the charity a fixed annual amount (a charitable annuity trust). The second pays the charity an annual amount based on a percentage of asset value (a charitable unitrust). It is worth noting that the payments to the charity can be made at shorter intervals (e.g., semi-annually or quarterly), with the calculations adjusted to reflect that fact. The more popular form is the annuity trust, in part because it avoids the need to value the assets annually.
Lead trusts can be further divided between grantor or non-grantor trusts. If the trust is structured as a grantor trust, the grantor receives an immediate income tax deduction, but must include the income from the trust assets in her annual income. Because the grantor will be paying tax on income that is paid to the charity, the trust is often funded with assets that produce income that is tax-advantaged such as tax-exempt bonds. The grantor is typically the recipient of the assets when the trust terminates, but it is possible to have someone other than the grantor receive the remainder interest--referred to as a nonreversionary grantor charitable lead trust. See Private Letter Rulings 9224029 and 9247024. These trusts look a lot like nonreversionary non-grantor lead trusts, but achieve grantor trust status through a drafting trick that takes advantage of the grantor trust rules. The grantor retains the right to require the trust's property by substituting property with an equivalent value.
The trust also can be structured as a non-grantor trust, in which case the person funding the trust does not receive an income tax deduction at the time of funding, but she does not have to pay include the trust's annual income in her income for tax purposes. Instead, the trust files its own tax return, pays the tax on the income, and receives a charitable contribution deduction. The decision whether the trust is structured as a grantor or non-grantor trust often turns on the funder’s income tax rates at the time the trust is funded. If the funder is in a high marginal tax rate in the year of funding, but expects to be in a lower bracket in later years, the funder may opt for a charitable lead grantor trust. The overall goal with the more popular non-grantor trusts is to...
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shift appreciation in the value of the assets during the life of the trust out of the person’s estate so that it escapes estate and gift tax liability. With stock market assets at relatively low values (at least compared to year-ago values), a person who expects the market to snap back might view a charitable lead trust as particularly advantageous if they believe we are at the bottom and asset values will appreciate substantially in coming years. On the other hand, if asset values continue their decline after the trust is established, there may be nothing left to distribute to the children or other named beneficiaries upon the termination of the trust because despite the decline, the charity is entitled to paid the specified amount or percentage.
The critical calculation is valuing the charities interest and the remaindermen's interests. This is accomplished through complex formulas, but many large charities have calculators online that provide ballpark numbers--the calculators are accurate, but to examine a number of different scenarios, more sophisticated software is required. The current discount rates (reported by the Journal as being currently 2%--check the number) used to value the charitable component are very low, which produces maximum tax advantages. To see why, assume someone sets up a lead trust when the required discount rate used to value the charitable interest is 5%. Assume the trust will be funded with $1 million in assets and its term is 15 years. Further assume that the charity receives a $70,000 annual payment (charitable lead annuity trust). The donor would have made a $154,179 taxable gift to the non-charitable beneficiaries because the gift to the charity is valued at $845,821. If the rate used to value the charitable gift were 8%, the funder would have made a $295,040 taxable gift to the non-charitable beneficiaries and a $704,960 gift to the charity. The appreciation in assets would pass to the non-charitable beneficiaries estate and gift tax free upon termination of the trust. The numerical example is taken from the Jewish Community Foundation Website. It is possible to eliminate a current gift taxable transfer by setting the payout rate high enough, but that also reduces the amount the non-charitable beneficiaries receive when the trust terminates.
Despite the tax advantages, this is a relatively little used estate planning device. For the 2007 tax year, the IRS reported receiving 6,377 tax returns for charitable lead trusts—it is not clear whether this number includes charitable lead grantor trusts (I suspect it does). At year-end, just 280 returns accounted for 60% of the reported book value of assets. Each of those returns reported at least $10 million in assets, measured by book value. Another 644 returns accounted for an additional 19% of the total assets reported on lead trust returns. Those returns reported at least $3 million in assets (but less than $10 million). For detailed statistics and explanations, see Split-Interest Trusts, Filing Year 2006 by Lisa Schreiber of the IRS. This is an SOI publication.
The statistics are clear: The über-rich account for the bulk of the assets contributed to charitable lead trusts, but well-off, but less wealthy individuals do utilize charitable lead trusts. Someone with a spare $10 million lying around can obtain significant benefits from these trusts. We prefer simplicity when it comes to financial products and these are not simple devices. Before less well-to-do people run to set up charitable lead trusts, they should keep the following in mind:
A. Charitable Lead Trusts Are Not Magic Boxes. Financial and estate planners often present these as magic boxes, largely because it takes a lot of effort to understand all the options, variations, and implications. Typically, the client will be given a bound presentation pamphlet filled will color pie charts and detailed schedules. There will be a summary page that shows the tax benefits, the amount that goes to charity, and the amount that the kids receive. There may be several summary statistics, sometimes under different sets of assumptions. Although the client rarely understands the mathematics, they do understand the estate tax savings. What clients may not understand is that these are not magic boxes. The client does not somehow get more out of the box then the client puts in. The rules are designed to make sure that the client bears some of the cost of the charitable gift. More generally, this estate planning device only makes sense when someone wants to give money to charity and would have done so anyway. Individuals shouldn’t lose sight of that, as this example from the University of Pennsylvania's Web site makes clear. Yes, the donor's estate taxes drop from $2,583,714 to $226,458, but the donor has given away $1,800,000 to the University of Pennsylvania. Giving money to charity is a good thing, but the donor has to part with his cash.
B. Loss of Control Over Assets. When the trust is established, the client loses control of the assets used to fund the trust. The assets no longer are the client's, although they may revert to the client when the charitable interests expire. If the stock market or the client's other sources of income hit the skids or the client’s financial needs increase, the client can not look to the assets held in trust for help.
C. There are Simpler Ways to Reduce Estate Taxes. We strongly suspect that individuals shouldn’t be fooling around with these devices until their estate is a taxable one. We have no doubt that someone with far more knowledge than us can produce an example contradicting that statement, but we bet it is a good rule of thumb. We further suspect that most individuals should not using these trusts unless they have taken full advantage of the $13,000 annual exclusion for gifts to indivduals. Once again, we know someone will be able to point to a scenario where that is not true, but our point is that individulas should generally take advantage of the simple estate planning tools before they utilize complex ones. Obvioulsy the annual gift exclusion doesn't have a charitable component and it involves a current gift rather than a future one to the non-charitable beneficiary so simple annual gifts don't address some of the objectives addressed by charitable lead trusts. Nevertheless, if a charitable lead trust is being used to reduce estate tax, the $13,000 annual gift exclusion is a much simpler way to achieve that result.
D. Charities Love These Devices. Charities love charitable lead trusts. That is why many colleges and universities have extensive information about these devices on their Web sites. The reason is quite simple: When a donor makes annual gifts, there is always the possiblity that the donor will discontinue giving at some future time. When the donor creates a charitable lead trust naming a particular charity, the charity has locked in those annual contributions. This is not a criticism of charities. They are being perfectly rational. Donors, however, must look through all the hocus pocus, recognizing that while there may tax benefits, donors are giving up flexibility both in terms of annually evaluating the charity and in assuring that they can maintain their current lifestyle should circumstances change.
E. Uncertainty Regarding The Estate Tax. President Obama has telegraphed his views on the estate tax, but the debate over what should happen to the estate tax will be a contentious one. Although one might suspect that Republicans are for repeal and Democrats for ratcheting the rates up through the stratosphere, some Democrats have small business owners and family farmers as influential constituents and campaign contributors. Predicting the final version of the estate tax that is assure to emerge sometime within the next year or two could well turn out to be a fool’s game. Some gift and estate tax regime is likely given our growing deficits, but the exlusion level is more difficult to predict Today’s best laid plans might make no sense in light of the final legislation. This is another reason why in light of the uncertainty, the über-rich--those with tens of millions of dollars and who will most likely be subject to high estate tax rates under any version of the estate tax--are probably the most appropriate candidates for charitable lead trusts.
F. We Have a Strong Preference for Simplicity. We aren’t going to advise anyone not to create a charitable lead trust, but sometimes simplicity should carry the day. For most people, annual charitable contributions, combined with a conservative investment policy, will permit individuals to make annual gifts to charities while leaving a chunk of change to their kids and retaining maximum flexibility. We are sure that we will hear from financial and estate planners who can demonstrate that some people who follow this strategy are leaving some potential tax benefits on the table. We have no doubt that they are right. But people who don’t create charitable lead trusts will not be burdened with what can be an inflexible structure when personal circumstance change. Nor will they face what are often high advisory fees or incur administrative burdens.
Over the years, we have seen too many people invest in tax shelters, exotic derivatives, hedge funds, and annuities, only to see the projected benefits never match the sales pitch. We are currently speaking with two relatives who are asking why they listened to advisors many years ago. Many of the more exotic estate and financial planning tools are the equivalent of lobster traps--they are easy to get into and impossible to get out of. There is a lot to be said for simplicity and knowing that you can use your assets as and when you see fit. In short, charitable lead trusts are for the über-rich--those who after the charitable lead trust is funded, will still continue to hold other assets sufficient to fund their lifestyles and assure that they don't come up short if markets decline or emergencies arise.
G. Rely on Reputable Advisors. Before setting up a charitable lead trust, people should make sure that they fully understand what they are doing. That means having your own legal and tax counsel review the plan rather than relying on the charity to explain and create the trust. Reputable charities will insist on separate counsel. Moreover, individuals should look to longstanding counsel and advisors--people they know and trust and who undestand the client's temperment. Individuals should be very leery of unknown advisors trying to sell them a concept. Individuals need to understand all the details That is another cost of charitable lead trusts. Nobody should rely on this blog post to structure a charitable lead trust.
I. Calculators. Here are a few sample calculators that charities have incorporated into their Web sites.
J. Article. Here is an excellent article from the Planned Giving Design Center for those who want to know more.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
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