Increasing Payment Charitable Lead Annuity Trust

A charitable lead annuity trust (CLAT) is an irrevocable split-interest trust in which the income interest is to be paid over to one or more charitable organizations, in the form of an annuity, and the remainder interest is to be paid over to one or more noncharitable beneficiaries.  Typically, CLATs are designed to provide an annual payment that is level throughout the trust term - either a stated amount or percentage of the value of the initial trust corpus.  But according to attorney Jerry McCoy, an expert on charitable tax planning, unlike the case with a charitable remainder annuity trust, "a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period.  The only stipulation is that the value of the annuity amount must be ascertainable at the time the trust is funded."  See Rev. Proc. 2007-45.

A CLAT may then start out at a very small amount and increase during the trust term.  The increase may be gradual or irregular, even with an enormous increase just on the final year of the term.  By adopting such a strategy, it allows the trust corpus to be maintained at a higher level than otherwise would be possible.  And with investments that outperform the IRS actuarial rate on an after-tax basis (always an uncertainty), this may result in a higher distribution to the remainder noncharitable beneficiaries (typically family members) as well as a higher distribution to the charitable beneficiaries.  A true win-win.

One example of such strategy is referred to as the "shark fin" in which the CLAT pays out $1 in annuity payments for all years of the trust term except for the final year, in which it pays one big amount to the charitable beneficiaries.  With a $5 million initial funding value, 15-year trust term, a Section 7520 rate of 2.40%, and a post-tax rate of return of 6.50%, here is a comparison of numbers provided by McCoy, with attribution to DC attorney Daniel J. Dorward:

CLAT with constant annuity payments of $400,867:

• Total payments to charity:     $6,013,005
• Charitable gift tax deduction:  $4,999,994
• Final remainder value:           $3,165, 371

CLAT with de minimus payments until final year:

• Total payments to charity:     $7,136,234
• Charitable gift tax deduction:  $4,999,999
• Final remainder value:           $5,722,962

McCoy notes:  "Don't overlook the fact that ... a CLT is subject to tax on its income and capital gains.  As a general matter, this effect is somewhat offset by the charitable deductions available for the trust's annuity payments to the extent they are paid out of current income.  By deferring some charitable distributions to later in the trust term, the increasing-payment CLAT forfeits some of the benefit of those deductions."

He further cautions:  "Be aware that there is no specific guidance from IRS ... just what the agency's position will be on these trusts.  ...  [I]t is possible that IRS might seek to limit the amount of the CLAT's charitable payments that may be deferred until later in the trust term.  In the case of a grantor retained annuity trust or "GRAT," the regulations limit any increase in trust by out to 20% per year.  Accordingly, a prudent planner may wish to include a similar limitation in an increasing-payment CLAT."  Whether the IRS would view such strategy as abusive may depend in large part on whether the potential advantage to the noncharitable remainder beneficiaries comes at the expense of the charitable beneficiaries.  On first blush, this does not appear to be the case.  But in the shark fin example, it may be concerning that the charitable beneficiaries run a higher risk of not receiving any substantial payouts if the trust busts before the final income distribution is made.

Comments

[Gene Takagi]

Agreed. Lots of pressure on the investment manager to outperform the actuarial rate (the 2.4% discount rate in Jan 09 is currently up to 3.2%). And you need to let your clients know of the risks and uncertainties. But that's how these things work when used as a tax planning strategy. Do make sure your clients have a real charitable intent if recommending a CLAT of any type.

[Mark Hefter]

And where in the world are you going to find a 6.5% after tax return for 15 years these days. Also, the 2.4% discount rate is already history; don't expect it to go anywhere near there again any time soon.