Cummings & Lockwood Estate Planning FAQs

A charitable lead trust is a trust that makes annual or more frequent payments to one or more charities for the charitable term.  The charitable term can be a fixed number of years or it can be based on the lifetime of the donor or certain related individuals.  At the end of the charitable term, any property remaining in the lead trust is distributed to or held in further trust for individual beneficiaries (typically the donor’s children or grandchildren).  The amount paid to charity each year may be an annuity (a stated dollar amount) or a unitrust interest (a stated percentage of the value of the trust assets, as calculated annually).  There is no minimum or maximum percentage that must be paid to charity.  The percentage or amount to be paid to charity can remain the same each year or can be designed to increase over the charitable term.

A charitable lead trust can be used to make a future gift to individuals while satisfying the donor’s charitable goals.

When the donor funds a lead trust, he or she makes one gift to charity that is deductible for gift or estate tax purposes and a second, taxable, gift to the individuals who will receive the trust property when the charitable term ends.  The value of the charitable gift is the present value of the stream of payments to be made to charity over the charitable term, determined by using the lowest applicable federal discount rate in effect at the time the trust is funded.  The value of the taxable gift to the individual beneficiaries of the lead trust is the difference between the value of the property used to fund the trust and the value of the charitable gift.

The applicable federal discount rate used to value the donor’s taxable gift to the lead trust is the government’s assumption as to the expected rate of return for the trust’s investments at the time of funding.  The potential for the trust’s actual investment performance to exceed the government’s assumption presents an opportunity for the donor to make a tax-advantaged gift to individuals by using a charitable lead trust to make the donor’s charitable gifts.  If the annual rate of return on a charitable lead annuity trust’s investments exceeds the federal discount rate used to value the charitable gift to the trust, all of the excess investment return will accrue for the benefit of the individual beneficiaries at no further gift or estate tax cost.  With a charitable lead unitrust, the charity and the individual beneficiaries share the benefit of the excess investment return based on their relative interests in the trust.

The benefits of using an annuity trust to transfer property to individuals must be weighed against the generation-skipping transfer tax advantages of using a unitrust when grandchildren or more remote descendants are the beneficiaries.

A charitable lead annuity trust can be structured to “zero out” the taxable gift so that no portion of the donor’s lifetime exemption from gift tax is used and no gift or estate tax liability is incurred in connection with the lead trust.  To zero out the taxable gift, the donor selects a charitable term and payment amount that, using the applicable federal discount rate, creates a charitable gift that is equal in value to the value of the entire property used to fund the lead trust.  If the trust’s investments earn an annual rate of return that exceeds the federal discount rate, assets will be distributed to the individual beneficiaries at the end of the charitable term at no gift or estate tax cost.  A charitable lead unitrust can also be structured to reduce, but not to “zero out,” the taxable gift.

Administration of a Charitable Lead Annuity Trust (the “CLAT” or “trust”) involves investing the trust’s assets, making timely annuity payments to the Charitable Beneficiary, preparing and filing returns in a timely manner, and accounting for the trust’s administration.

Generally, when a charitable lead trust is created for gift or estate tax planning purposes, it is not structured to qualify for a federal income tax charitable deduction.

A lead trust gift that does not qualify for an income tax charitable deduction can still be useful to the donor for income tax purposes.  Although the donor receives no income tax charitable deduction for funding the trust, the trust’s income will not be includible on the donor’s tax return.  For a donor whose charitable deductions already exceed the amount he or she can use to offset taxable income, this type of lead trust can generate an indirect tax deduction for the donor because the trust’s income will be taxed to the trust, instead of the donor.  Although the lead trust will report and pay tax on its own income, it is allowed an unlimited deduction for income it distributes to charity.  Generally, if the lead trust’s taxable income each year does not exceed the amount it pays to charity for the year, the trust will not pay any income tax.

If the donor wishes to receive an income tax deduction for funding a charitable lead trust, the donor must create a special kind of trust that is treated as if it were owned by the donor for income tax purposes.  This means that in order to claim an income tax deduction for funding a lead trust, the donor must be willing to report all of the trust’s annual income and gains on his or her individual tax return.  The donor’s only income tax deduction will be for funding the trust.  The donor will not be able to claim any additional deductions when the trust makes its payments to charity each year.  If the donor dies during the charitable term, a portion of the tax deduction benefit the donor received from funding the lead trust will be included as income on the donor’s final income tax return.

This type of lead trust can be useful when the donor is in an exceptionally high income tax bracket in the year the donor funds the trust and expects to be in a lower income tax bracket in subsequent years when the trust’s income will be taxed to the donor.  The donor’s deduction for funding the trust is equal to the value of the charitable gift, subject to certain limitations that are based on the type of property used to fund the trust, the status of the charity as a public charity or a private foundation, and the rules limiting how much income the donor can offset with a charitable deduction in any year (the maximum amount is 30% of adjusted gross income).

In appropriate planning situations, a “super charitable lead trust” can be created to combine the income, gift and estate tax advantages of the two types of charitable lead trusts.  The structure of a super lead trust is more complicated because the donor must create a trust that will be treated as if it were owned by the donor for income tax purposes, but do so in a manner that does not cause the trust to fail to achieve its intended gift and estate-tax advantages.  The donor must also be in such a financial position that the donor’s obligation to pay tax on the lead trust’s income and gains for a number of years (e.g., 10 to 25 years) would be viewed as a tax-planning opportunity rather than a burden.

Please note that the federal discount rate is recalculated each month.  The lower the rate, the easier it is to structure a charitable lead annuity trust that will “zero out” the taxable gift.  Donors have some planning flexibility because they can use the discount rate in effect in the month they fund a lead trust or the rate that was in effect in either of the two preceding months.

If a donor wishes to transfer assets other than cash, cash equivalents and unrestricted publicly traded securities to a CLAT, the donor should review the funding plan with his or her accountant and legal counsel to confirm the income tax consequences of the proposed gift to the donor, as well as the tax and administration consequences to the trust and the trustees of accepting and holding the proposed gift.

Funding the CLAT with appreciated assets will not cause the donor to recognize capital gain, and the unrealized appreciation will not be a preference item for AMT purposes on the donor’s income tax return.  However, if the CLAT must pay a large capital gains tax in order to reinvest low basis assets contributed to the trust, it will be harder for the CLAT to make all the required annuity payments and build up property to be distributed to the remainder beneficiaries when the charitable term ends.

Care should be taken to ensure that the funding of the CLAT is not deemed to be an “assignment of income” by the donor.  If a CLAT is funded with appreciated property that is subject to a binding sales contract or any agreement or understanding under which the trustees are obligated to sell the property to a third party, the donor will recognize gain on his or her personal income tax return when the trust sells the property.  Caution should also be exercised if the donor transfers stock in a closely held corporation during an ongoing tender offer and pending merger that the donor has participated in negotiating and planning.  In such a case, the donor could be deemed to have already converted the stock into a fixed right to receive cash at the time the stock is contributed to the CLAT.

The CLAT does not qualify as a shareholder of S corporation stock.

If the CLAT will hold more than 2% of the ownership interests in any business enterprise (corporation, partnership, other entity), the trustees should consult legal counsel with respect to the application of the excess business holdings rules.

Holding or making investments in entities that are disqualified persons, as well as co-investing with or holding investments in common with disqualified persons, can create a variety of self-dealing problems.  The trustees should review the private foundation self-dealing rules to confirm that the CLAT’s investment plan will not give rise to any potential self-dealing issues.

Care should be taken before funding a CLAT with or investing CLAT assets in stock of a donor-controlled corporation, stock subject to a voting trust, or insurance policies on the life of the donor and/or the donor’s spouse, and before funding a CLAT with property encumbered by a mortgage or other similar lien.  While there are certain exceptions that may be applicable in a given situation, generally a donor risks that a gift of mortgaged property to a CLAT will generate relief of indebtedness income and be taxed as a bargain sale, be a prohibited act of self-dealing at the time the gift is made and when the CLAT makes payments on the debt, and give rise to debt-financed income as to which only a portion (not more than 50%) can be sheltered from income tax by the annuity amounts paid to charity.

To minimize the income taxes that a CLAT must pay, trustees should consider avoiding borrowing and debt-financed investments (mortgaged property, margined securities accounts, partnerships with debt-financed investments) as well as interests in a partnership or other pass-through entity that operates an active trade or business or holds debt-financed property.  Such investments produce unrelated business taxable income or debt-financed income, and annuity payments made to charity will shelter only a portion (up to 50%) of such income from tax.

The CLAT is a taxable trust.  It will be subject to income tax to the extent that its gross income exceeds its deductions.  The trustees must file a federal fiduciary income tax return (Form 1041) and split-interest trust information return (Form 5227) with the Internal Revenue Service each year.  The trust’s Form 5227 (other than Schedule A) will be open to public inspection.  The trustees may also need to file a state fiduciary income tax return depending on the situs of the trust.

The CLAT will be entitled to a charitable deduction each year for the gross income of the trust that is distributed to the Charitable Beneficiary when the annuity payment is made.

The trustees may need to register the trust and file annual reports depending on the situs of the trust.  For example, the trustees of a New York CLAT are required to register the trust within six months of its funding and to file annual reports (Form CHAR004) within six months following the end of each taxable year of the trust with the Charities Bureau of the New York Attorney General's Office.

Annuity payments must be made each year in a timely manner and in accordance with the provisions in the trust document regarding frequency of payments.  Failure to make the payments in a timely manner can give rise to private foundation excise (penalty) taxes.

CLATs are subject to the private foundation excise tax rules under Code section 4945 that prohibit the trustees from making taxable expenditures.  If the charities are named in the trust and their shares are fixed by the terms of the trust, the trustees may simply distribute the annuity amount to the named charities in the shares stated in the trust.

If, however, the trustees have discretion to select the charities to receive the annuity amount or to determine their respective shares of the annuity amount, then the trustees must follow special procedures when making annuity payments in order to avoid incurring a penalty tax and having to try to recover the payments made.  If the trustees document that the charities are 501(c)(3) tax-exempt organizations that have been classified by the IRS as “other than” private foundations because they are described in Internal Revenue Code section 509(a)(1) or (2) (“501(c)(3) publicly supported charities”), the trustees may simply pay the annuity amount to those charities.  If, however, the trustees determine that a charity is not a 501(c)(3) publicly supported charity (for example, a 501(c)(3) charity that is classified as a private foundation, a private operating foundation, or a 509(a)(3) supporting organization), then the trustees must obtain certain additional documentation required by the IRS and/or use a grant agreement and require annual grant reports from the charity in connection with any annuity payments made to that charity.

The trustees may wish to prepare informal accountings and request that the beneficiaries release them from personal liability in connection with the trust’s administration.  The trust document describes the information to be provided in an informal account.  The trustees may opt to instead file periodic court accountings, with notice to the appropriate state’s Attorney General’s office (which would represent all charitable beneficiaries), in order to ensure that the trustees are effectively released from personal liability in connection with their administration of the trust.