For those who are charitably inclined, the current low interest rate environment tends to favor charitable lead trusts over their better-known cousins, charitable remainder trusts.
With a charitable remainder trust (CRT), a donor transfers assets into a trust with annual payments to you or your designated noncharitable beneficiary. This payment may be in the form of a fixed annuity – a charitable remainder annuity trust (CRAT).
Alternatively, the trust can be established with a unitrust payment, which is based on a fixed percentage return calculated annually on the fair market value of the trust assets, revalued each year – a charitable remainder unitrust (CRUT). In either case, at the end of the trust’s term – which can be either a period of years or the life of the noncharitable beneficiary – the assets held in the trust pass to your designated charity.
Current low interest rates can limit the tax benefits available from CRTs. With a CRT, the value of the charitable remainder interest is measured using an actuarial calculation that takes into account both the number of years the trust is expected to remain in existence and a tax determination called the “Section 7520 rate.” The Section 7520 rate is published monthly by the government and takes into account the prevailing market rate of interest.
Generally speaking, the longer the term of the trust and/or the lower the Section 7520 rate, the lower the present value of the remainder interest. With CRATs and CRUTs, a lower value of the remainder interest reduces the amount of the charitable deduction available to the donor when the trust is set up. Correspondingly, the taxable gift to your noncharitable beneficiary is higher.
One of the requirements to qualify as a CRAT is that the present value of the charitable remainder interest must not be less than 10 percent of the initial fair market value of the property contributed to the trust. In addition, if there is an actuarial probability of 5 percent or greater that the charity will not receive the required 10 percent interest, the IRS requires the income tax deduction to be denied.
While a detailed explanation of the 5 percent test is beyond the scope of this article, suffice it to say that, because of low Section 7520 rates, this test has become problematic for CRATs. CRUTs are not affected by the 5 percent test because the unitrust feature guarantees a remainder for the charity.
Some of the same factors that have made CRTs less favorable to donors may point to a charitable lead trust (CLT) as an attractive alternative. Compared to a CRT, the roles are reversed with a CLT. The charitable beneficiary receives annual payments from the trust, either in the form of an annuity – a charitable lead annuity trust (CLAT) – or a unitrust payment – a charitable lead unitrust (CLUT). At the end of that trust term, the assets remaining in the trust are paid to your noncharitable beneficiaries (e.g., your children).
With a CLT, so long as the Section 7520 rate remains low (for December 2012 the rate was 1.2 percent), the lower valuation of the remainder interest reduces the taxable portion of your gift to your noncharitable beneficiaries. Moreover, if the assets held in your CLT appreciate during the trust term at a rate in excess of the Section 7520 rate that was in effect at the time the trust was created, the difference between the two measures will be a tax-free gift to your beneficiaries.
In effect, a meaningful portion of your total gift to your beneficiaries avoids transfer taxes, while also providing a valuable interim benefit to your charity. See example.
While the donor does not receive an income tax deduction for a contribution to a CLT, the trust income likewise is not taxed to the donor. It is possible to structure a CLT so that the income from the trust is taxable to the donor. In this case, you may deduct the actuarial value of the charitable portion of the gift for income tax purposes when the trust is created.
As with most trust arrangements, charitable remainder trusts and charitable lead trusts are highly technical in nature. All aspects should be reviewed carefully with your tax advisor before committing to any course of action.
Charitable Lead Annuity Trust Example
In December 2012, Dad contributes $1 million to a CLAT that will make annual payments to Designated Charity for a term of 10 years, after which the trust will be distributed in equal shares to Dad’s three children.
If the annuity payment to Designated Charity is set at $106,718 per year, the present value of the annual charitable payments will be $1 million, meaning there will be no taxable gifts and no gift tax owed.
Under this scenario, the charity will receive aggregate payments of $1,067,180 over 10 years. Assuming an 8 percent rate of return on the trust investments, the three children will share an aggregate sum of approximately $613,000, gift tax-free, at the end of 10 years.