A. Charitable Lead Trusts – The Fundamentals.
1. A Working Definition.
a. Conceptually, a CLT is the reverse of a Charitable Remainder Trust (“CRT”). With a CLT, a fixed or variable annuity is paid to charity for a determinable period which may be measured by a term of years or by reference to the life of one or more individuals; the remainder passes outright or in trust to one or more non-charitable beneficiaries. The charity should qualify under the applicable sections of the Code, sections 170, 2055 and 2522, which govern the type of deduction associated with the creation of the charitable lead trust. The remainder beneficiary can be one or more individuals, partnerships, corporations, estates or trusts. CLTs have been one of the more valuable planning structures available for wealthier individuals who wish to give to charity but also want to provide for the continued affluence of designated family members. Two separate gifts are made when the CLT is created: a gift of a current interest to one or more charitable beneficiaries; and a gift of the remainder interest to one or more non-charitable beneficiaries. The donor is liable for gift tax on the present value of the non-charitable remainder interest.
b. The principal tax advantage to a CLT lies in the transfer tax deduction for the present value of the charitable interest. The CLT has been used most appropriately in situations where the donor and his or her family have no immediate need for all of the income that they currently enjoy and are willing to forego some current benefit in exchange for the prospect of long-term capital appreciation.
c. The trust property and any appreciation on that property are removed from the donor’s estate, unless the donor retains any powers that could lead to its inclusion in his or her estate under sections 2036 or 2038 of the Code.
d. The donor must designate the charitable beneficiary when the trust is created (or provide a method for designating the charity that is beyond his or her legal control). Unless great care is taken with the wording and structure of the charitable benefit, a donor should not designate a private foundation of which he or she is a trustee as the charitable beneficiary of a CLT created by that donor.
e. The term of the lead interest can be measured: in a variety of ways: (i) in years; (ii) by the life or lives of individuals living when the CLT is created; (iii) a measuring life plus a term of years; or even (iv) by the shorter of a term of years or a measuring life plus a term of years. Treas. Regs. §§ 1.170A-6(c)(2); 20.2055-2(e)(2); 25.2522(c)-3(c)(2) and Rev. Rul. 85-49, 1985-1 C.B. 330. See Ltr. Rul. 1997-21006. The core requirement is that the term is ascertainable when the CLT is created.
2. Cautionary Note. There are two basic varieties of qualified CLTs: those created inter-vivos or at death that are treated as separate taxpayers, (often referred to as Qualified Non-Grantor CLTs) and those created inter vivos where the grantor is treated as the owner of the CLT’s income for income tax purposes (often referred to as Qualified Grantor CLTs). Another variation is a Non-Qualified Non-Grantor CLT created during life. These materials first address only Qualified Non-Grantor CLTs. Qualified Grantor CLTs and Non-Qualified Non-Grantor CLTs are discussed in Section F of this outline.
3. Qualified CLTs. A Qualified CLT is a trust that meets the various statutory definitions that qualify a donor's transfer to the CLT for one or more tax deductions. I.R.C. §§ 170(f)(2), 2055(e)(2)(B), 2522(c)(2)(B). To be Qualified, the CLT must pay the charitable lead interest in the form of a fixed annuity or unitrust amount. The CLT need not specify a particular charitable recipient; this designation can be left to the trustees and can be changed by the trustees from year to year. Ltr. Ruls. 2000-43029; 1997-48009; 1993-31015; 1980-51159.
4. Charitable Lead Annuity Trust. A charitable lead annuity trust is an irrevocable trust under which a sum certain is to be distributed periodically to one or more charitable beneficiaries not less often than annually for a term of years or during the life or lives of one or more individuals who are living when the trust is created. The principal of the trust must be used to satisfy the annuity if trust income is insufficient. So long as the annuity payments are determinable when the CLT is created, provision can be made to vary them. Treas. Regs. §§ 1.70A-6(c)(2)(i); 20.2055-2(e)(2)(vi) and 25.2522(c)-3(c)(2)(vi).
Unlike the rules governing charitable remainder annuity trusts there is no explicit prohibition against making additional contributions to a charitable lead annuity trust. But see Ltr. Rul. 1993-04020. However, such contributions do not generate additional estate or gift tax deductions because the amount of the annual guaranteed annuity payment must be determinable at the inception of the trust. Treas. Regs. §§ 1.170A-6(c)(2)(i)(A), 20.2055-2(e)(2)(vi)(a) and 25.2522(c)-3(c)(2)(vi)(a). Furthermore, it is unclear how the annuity amount would be adjusted to take such additions into account. Accordingly, most planners have assumed that such additions must be prohibited and that separate trusts must be created to hold such assets. See Ltr. Ruls. 1980-34093 and 1980-21095.
5. Charitable Lead Unitrust. A charitable lead unitrust is an irrevocable trust under which a fixed percentage of the net fair market value of its assets (valued annually) is to be distributed not less often than annually to one or more charitable beneficiaries for a term of years or during the life or lives of one or more individuals who are living when the trust is created. Corpus must be used to satisfy the unitrust amount if income is insufficient. Unlike charitable remainder unitrusts, a net income limitation is not available. Rev. Rul. 77-300, 1977-2 C.B. 352; Ltr. Rul. 1979-18102. Further, the trust instrument may not provide for the percentage to vary over the term of the CLT. Treas. Regs. §§ 1.170A-6(c)(2)(ii)(A), 20.2055-2(e)(2)(vii)(a) and 25.2522(c)-3(c)(2)(vii)(a).
In computing fair market value of the trust, all assets and liabilities are taken into consideration without regard to whether particular items also are taken into account in determining trust income. The same valuation date and method should be used each year. If these details are not specified in the trust, the trustee must select the date and method on the first income tax return that the trust is required to file. Treas. Regs. §§ 1.170A-6(c)(2)(ii); 20.2055-2(e)(2)(vii) and 25.2522(c)-3(c)(2)(vii).
There is no specific prohibition against additional contributions being made to charitable lead unitrusts. The Internal Revenue Service (“IRS”) has ruled that a provision that allows additional contributions to be made would not disqualify the trust: in fact a gift tax deduction may be allowable for such contributions. See Ltr. Rul. 1980-52068 and 1980-43077. However, these are only private letter rulings and should not be relied upon as precedent.
6. Additional Considerations. There is no minimum or maximum payout requirement and no limitation on the number of years that the annuity can be paid to charity. I.R.C. § 170(f)(2)(B); Treas. Regs. § 1.170A-6(c)(2)(i)(A). The trust remainder is distributed to or held for the benefit of the donor’s non-charitable beneficiaries. A clause that “saves” the trust from violating any applicable rule against perpetuities will not disqualify the trust, even if the trust’s term is shortened as a result. Ltr. Ruls. 1981-04213 and 1997-21006. However, a charitable lead interest will not qualify as a guaranteed annuity interest if the trustee has the discretion to commute and prepay the charitable interest prior to the expiration of the specified annuity term. Crown Income Charitable Fund v. Comm’r., 98 T.C. 327 (1992) aff'd, 8 F.3d 571 (7th Cir. 1993) pro; see also Rev. Rul. 88-27, 1988-1 C.B. 331 and Ltr. Rul. 97-34057. In general, no amounts may be paid for private purposes from the charitable lead annuity trust until the expiration of the charitable annuity term. Treas. Regs. §§ 1.170A-6(c)(2)(i)(E) and 1.170-A-6(c)(2)(ii)(D). However, in light of the Tax Court’s decision in Boeshore Est. v. Comm’r., 78 T.C. 523 (1982), the IRS issued final regulations that acknowledge a non-charitable interest in the form of qualifying annuity or unitrust interest can precede a charitable lead interest. T.D. 9068 (7/3/03).
7. Reformation. The transfer of a partial interest to a charity generally will not qualify for a deduction (unless the trust interest is a qualified annuity or unitrust interest) even if the non-charitable trust interests are clearly separable. Rev. Rul. 77-97, 1977-1 C.B. 285. The Tax Reform Act of 1984 included permanent “reformation” rules which permit the amendment of certain charitable trusts which otherwise would not qualify for a charitable contribution deduction. I.R.C. §§ 170(f)(7), 2055(e)(3) and 2522(c)(4). To be eligible for this relief the nonqualifying interest must be “reformable” as defined in the statute. As a matter of practice a provision often is included in CLTs which authorizes the trustee to amend the trust to assure it is and remains a qualified CLT.
B. Tax Consequences To The Donor.
1. Lifetime Transfers.
a. For income tax purposes, generally no immediate deductions are available and the CLT is treated as a taxpayer separate and apart from the donor. I.R.C. § 170(f)(2)(B); Treas. Regs. § 1.170A-6(c). A current income tax deduction is allowable only if the donor is treated as the owner of the property. If the trust is a Qualified Grantor CLT, all items of income, deduction and credit of the CLT are attributed to the grantor. I.R.C. §§ 671-678.
b. For gift tax purposes, a deduction is allowable based on the present value of the charitable interest. I.R.C. § 2522(c)(2)(B). The remainder interest does not qualify for a gift tax per donee exclusion. For the gift tax to apply the gift must be complete. If the donor retains the power, directly or indirectly, to affect the charitable recipient the gift is incomplete. Treas. Regs. § 25.2511-2(b) and (c). It appears the donor may be an officer or director of a charitable recipient. Ltr. Rul. 1981-30033. However, the governing documents of the charity should include provisions that prevent the donor from having control over the property received from the CLT he or she created. See Ltr. Ruls. 2001-38018; 2001-08032 and 2000-30014. Payment to a donor advised fund operated by the charitable recipient may require additional attention. Ltr. Ruls. 2000-10036 and 2000-09048.
2. Testamentary Transfers.
An estate tax charitable contribution is allowable for the value of the charitable interest. I.R.C. § 2055(e)(2)(B). If a grantor retains a reversionary interest in a lifetime CLT which exceeds 5% of the corpus and dies during the term of the trust, a portion of the value of the CLT will be included in the grantor’s estate. I.R.C. § 2037.
3. Valuing the Charitable Interest.
The present value of an annuity is determined by multiplying the amount of the annuity by factors which are dependent on the applicable rate under section 7520. See IRS Pub. 1457. The present value of a unitrust interest is determined by subtracting the present value of the remainder interest from the value of the property contributed to the CLT. Treas. Regs. §§ 1.170A-6(c)(3); 20.2055-2(f)(2) and 25.2522(c)-3(d)(2).
4. Generation-Skipping Transfer Tax. Congress rewrote the GST rules in the Tax Reform Act of 1986. See I.R.C. §§ 2601, et. seq. Subject to a complicated set of exceptions and exemptions, GSTs are taxed at the top marginal estate tax rate in effect at the time of the transfer. See I.R.C. §§ 2601, 2602 and 2641.
a. A GST generally occurs when property is transferred to or for the benefit of a “skip person” or when an intervening interest in property terminates in favor of a skip person. A “skip person” is a person who is more than one generation younger than the transferor of the property (e.g., grandchildren or more remote lineal descendants) or a trust for the benefit of such person(s). I.R.C. §§ 2613(a), 2651. A “non-skip person” is any person who is not a skip person. I.R.C. § 2613(b).
b. A CLT and its charitable beneficiaries are non-skip persons. I.R.C. § 2651(f)(3). Therefore, neither the creation of a CLT nor distributions to its charitable beneficiaries will result in any GST tax consequences.
c. However, upon termination of the charitable interests in a CLT, a GST tax might be imposed if the remainder beneficiaries are “skip persons” in relation to the donor of the CLT. For example, if the donor of a CLT creates a remainder interest in favor of his grandchildren, a GST tax might be imposed upon the termination of the charitable lead interest. Although a GST exemption may be available to shield part or all of the remainder interest from GST tax, every donor must consider the potential impact of the GST tax (for example, a skip person may succeed to the trust remainder if a primary non-skip remainderman dies before the charitable interest expires).
d. In general, GST tax is paid from the remainder interest. I.R.C. § 2603(a)(2).
e. All individuals are granted a GST exemption, which may be allocated to lifetime and/or testamentary transfers to shield all or part of such transfers from GST tax. I.R.C. § 2631. Allocation of the donor’s GST exemption to a charitable lead unitrust that will result in GSTs (where the remainder passes to grandchildren) is relatively simple: to avoid future GST tax, the donor may allocate (on a timely filed gift or estate tax return) that portion of his or her GST exemption which is equal to the value of his or her taxable transfer(s) to skip persons, using the valuation factors provided by the IRS in effect as of the date the unitrust is created. I.R.C. § 2642(b).
f. The effect of allocating a portion of the donor’s GST exemption upon creation of a charitable lead annuity trust cannot be determined until termination of the charitable lead interest using an “adjusted GST exemption” formula. I.R.C. § 2642(e). The formula “adjusts” the donor’s initially allocated GST exemption to a projected future value as of the date the charitable lead interest actually expires, using the discount rate applied under the valuation methods provided by the IRS in effect at the time the trust was created. The amount of GST exemption a donor should allocate to a charitable lead annuity trust is based upon (i) the term and payout rate of the charitable lead interest, (ii) the projected rate of return on trust property (i.e., the donor’s best estimate of the future value of the trust when the charitable lead interest expires), and (iii) the discount rate provided by the IRS in effect when the trust is created.