The Rich Get Richer by “Giving It Away”

Today’s unnerving volatility in global stock and bond markets, combined with low prevailing interest rates and the prospect of higher income taxes ironically creates an unusually good opportunity to effectively transfer wealth to family members and benefit charity in the bargain. Some of the most effective family wealth planning tools involve the companion act of giving to charity. One such vehicle is the Charitable Lead Trust (“CLT”), a lesser-known relative of the “charitable remainder trust” often used by the rich, famous, and well-advised. In fact, Jacqueline Kennedy Onassis is sometimes credited with making the CLT fashionable when, upon her death in 1994, it was revealed that a large portion of her estate was designated to fund “The C & J Foundation”, a CLT named for her two children.

Mechanically, a CLT is an irrevocable trust that makes annual distributions to charitable beneficiaries for the life of a related individual or some fixed period of time, and distributes its residue on termination to non-charitable beneficiaries, such as children, grandchildren, or even the creator of the trust (the “grantor”). Because of the interim charitable annuity, the grantor is only subject to gift tax on the present value of the remainder interest and the remainder interest, including any future appreciation, passes to the non-charitable beneficiaries free of any gift tax.

Depending on how the grantor structures the trust, the CLT provides either an immediate income tax deduction to the grantor (subject to applicable income tax restrictions on that deduction) equal to the value of the charitable annuity, where the original donor is to receive the assets back after the charitable term. Or, in the case where the ultimate remainder beneficiaries are other family members, the trust receives an income tax deduction for the annuity payments to charity when made and the gift taxable value of the gift is reduced by the present value of the interim charitable payments. The CLT is not a tax-exempt entity and either the grantor recognizes any income tax attributable to the trust, such as when the grantor received the income tax deduction, or the trust recognizes income tax to the extent its earnings exceed its annual distribution to charity. To minimize such income tax, a CLT is often funded with property that has little current appreciation or is funded at death after the contributed assets received a step-up in basis to fair market value.

A CLT comes in two basic varieties, annuity trusts and unitrusts. An annuity trust pays a fixed dollar amount to charity each year during the period of the CLT. A unitrust pays a fixed percentage of the trust assets determined annually to charity each year during the period of the CLT.

The decision to use an annuity trust or a unitrust hinges upon how the grantor chooses to allocate the investment risk among the charitable and non-charitable beneficiaries and whether the grantor expects returns above the low IRS mandated rate (currently 3.8% for October 2008). Because an annuity trust will distribute the same dollar amount to charity each year, all of the benefits of appreciation and risk of loss in trust asset value will benefit the non-charitable remainder beneficiaries. In contrast, because the charitable distributions paid by a unitrust will vary, up or down, based on the fluctuating annual values of the trust assets, both the investment risk and reward is shared by both the charitable and non-charitable heirs. As a result, to the extent the grantor believes the assets will appreciate at a greater rate then the IRS mandated rate and wishes to maximize the wealth transfer benefit, the annuity trust will provide a greater benefit to the remainder beneficiaries. An additional benefit of the annuity trust is that grantor can effectively reduce or eliminate the taxable gift upon creation by selecting a charitable annuity stream whose present value equals the current value of the asset. The one drawback to the annuity trust is that it is more difficult to name grandchildren as remainder beneficiaries due to complicated generation-skipping transfer tax rules.

As discussed, the grantor can structure the CLT to provide the grantor with an immediate income tax charitable contribution deduction equal to the present value of the charitable distributions. This type of CLT can be particularly useful when the grantor’s taxable income (and/or marginal tax bracket) in a given year is higher than it will be in future years, say, because of a large asset sale or the exercise of a stock option and the grantor is committed to making significant future charitable contributions. By establishing the CLT in this manner, the grantor is able to take an income tax deduction in the year of creation despite the fact that the majority of the charitable distributions will not be made for several years. Plus, the value of the remainder will not be reduced by future income tax payments since those taxes are imposed on the grantor, which may be important for taxpayers facing the prospect of higher future tax rates.

A CLT also provides a great opportunity to the grantor who already has a strong charitable intent and is making significant annual charitable contributions. In this scenario, the grantor can structure a CLT to reduce gift or estate tax that would otherwise be imposed on transfers to children and other heirs and at the same time fund the family’s future charitable bequests through a donor advised fund that serves as the family’s permanent endowment.

The CLT provides the most benefit when funded with business, real estate, or other investment assets that have the potential to generate earnings and appreciation at a rate greater than the IRS mandated rate. At today’s low interest rates and reduced market values, that “excess” appreciation is likely easier to achieve. If you have assets that exceed your own needs and are looking for ways to pass more on to your heirs, now may be an especially opportune time to consider adding a CLT to your existing charitable giving and wealth transfer plan.

Ray Edwards
and Mike Angell

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