Fundamentals - Charitable Lead Trust (Part 3)

Charity Advisor Resource Newsletter - Volume 2.1 (2010)

BY JONATHAN D. ACKERMAN, ESQUIRE

Considering the fact that interest rates have again reached an historic low, presenting a few more fundamental CLT concepts may prove beneficial.

More CLT Fundamental Concepts:

Estate and Gift and Income Tax Regimes

The estate and gift tax regime is separate and apart from the income tax regime. The estate and gift tax regime taxes the transfer of wealth, whereas the income tax regime taxes the earning of income. Although the two regimes may overlap in the charitable gift planning arena, they remain separate and must be independently considered in structuring a CLT. For instance, a non-grantor CLT is, from a tax perspective, created to minimize the estate and gift taxes on a transfer of a remainder interest to heirs; whereas a grantor CLT is generally created to maximize the income tax planning for the donor.

Income Taxation of Trusts and CLTs

The administration of a CLT can be tricky, because the CLT is not a tax-exempt entity, like a CRT. The concept that applies to the income taxation of a CLT is somebody's paying the taxes.

Here is an oversimplified example. In a trust that is treated for income tax purposes as a non-grantor trust, if the trust earns One Hundred Dollars of taxable income and distributes One Hundred Dollars to the income beneficiary, the trust pays no tax and the beneficiary pays tax on the One Hundred Dollars. If in the same scenario, the trust earns Two Hundred Dollars and distributes One Hundred Dollars, the beneficiary again pays tax on its receipt of the One Hundred Dollars and the trust pays tax on the One Hundred Dollars not distributed.

However, a grantor trust will be taxed in accordance with certain special rules. For conceptual purposes only (as the application and interpretation of these rules are highly technical), a trust will be deemed a grantor trust when the donor/grantor or his or her spouse retain a certain level of control over the income or principal of the trust. Sometimes terminology can get in the way of understanding - a grantor is generally the person who creates and funds a trust, for instance, a donor to a CRT or CLT. In the case of a grantor trust for income tax purposes, no matter what the trust earns in taxable income and how much is distributed to the income beneficiary, the grantor will pay the taxes on the taxable income of the trust - you will note in all of these scenarios - someone is paying the taxes.

Another distinction between a non-grantor CLT and a grantor CLT for income tax purposes is the fact that a non-grantor CLT is entitled to a charitable income tax deduction. Thus, a non-grantor CLT which incurs One Hundred Dollars of income and makes a charitable distribution of One Hundred Dollars will have a tax wash (One Hundred Dollars of income and a One Hundred Dollar charitable deduction), so long as the CLT does not incur unrelated business income. However, if a non-grantor CLT incurs more income than the distribution to charity, the trust itself will be required to pay tax on the excess income - so, beware of putting an appreciated asset into a CLT that would be required to be sold and incurs a taxable gain during the term of the trust.

Present Value

The concept of present value is critical in understanding the benefits associated with a CLT. For instance, the present value of the income interest in a grantor CLT on the date of creation of the CLT is the amount of the charitable income tax deduction, and the present value of the remainder interest in a non-grantor CLT on the date of creation of the CLT is the amount of the gift to the heirs.

Conceptually, present value reflects the fact that receiving one dollar today is worth more than receiving one dollar ten years from today, because the negative impact of inflation reduces the value of the dollar over time.

Present value in the planned giving world is calculated using special charitable gift planning software, and the three basic elements of that computation are an amount (one dollar), timing (10 years from today) and an interest factor. The relevant interest factor being referred to in this Article has been coined the charitable mid-term federal rate (CMFR). The CMFR is defined as one hundred twenty percent of the applicable mid-term federal rate, rounded to the nearest two-tenths of a percent and is mandated under Code Section 7520 for purposes of determining the present value of gifts to a CLT (and other planned giving vehicles which are dependent upon the concept of present value, such as a CRT). The CMFR is published monthly.

However, a donor to a CLT may elect the CMFR in the month the CLT is created or the CMFR for either of the two months preceding its creation. Thus, a donor creating a CLT in the month of December, 2010, may affirmatively elect the CMFR for the month of October or November. Since October's CMFR is two percent, matching an historic low, creating a CLT before or during December, 2010 (and electing to use CMFR for October) is the most favorable economic calculation of present value to date.

CLT and Historically Low Interest Rates - The Perfect Storm Again? - As stated above, the CMFR has once again hit two percent. Much has been addressed about the use and application of CLTs in prior CAR Newsletters and especially the impact of low interest rates on the effectiveness of these interesting, but complex, vehicles. See CAR Newsletter Volume 1.1 and Volume 1.2 for in-depth discussions of this vehicle, and especially CAR Newsletter 1.1 Featured Article - What's Hot Now - Charitable Lead Trusts in a Low Interest Rate Environment for a chart with a detailed explanation of the impact of a two percent CMFR on present value calculations. Considering these concepts, today may be the best day to broach to your donors and clients the subject of creating an inter vivos CLT before the end of 2010.

Sample CLT Forms - The IRS has published sample forms for grantor and non-grantor inter vivos and testamentary charitable lead trusts. See Revenue Procedure 2007-45 and Revenue Procedure 2007-46 (for a testamentary CLAT). Each Revenue Procedure contains significant annotations and alternate provisions for a CLT.

As you will note, the CLT is a sophisticated gift planning vehicle, and as with all such vehicles, professional counsel should be retained to fully analyze the effectiveness of a particular vehicle given a particular set of circumstances.