Wealth Transfer

A Split-Interest Trust Gaining Momentum

Charitable lead trusts have grown in appeal as a way to give to charities now and family members later.

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Call it a paradox — or perhaps a silver lining. The recent economic downturn led to an 11% decline in charitable donations by individuals in the three-year period from January 2008 to December 2010.1 At the same time, several gauges of the downturn, including low interest rates and depressed property values, appear to have helped make one vehicle for philanthropic giving — the charitable lead trust (CLT) — attractive to more people.

A CLT is a type of trust known as a split-interest trust because it divides its financial interests between charitable and noncharitable beneficiaries. The trust must make at least annual “lead” distributions to one or more public charities (for example, a donor-advised fund) or private foundations. Then, at the end of the trust’s term, its remaining assets go to noncharitable beneficiaries — frequently the children of the trust’s creator.

CLTs: Two Broad Categories

A charitable lead annuity trust, or CLAT, makes payments to charity of a specified dollar amount determined when the trust is established, while a charitable lead unitrust, or CLUT, pays a stated percentage of each year’s trust value. But both types of CLTs can be funded with a wide range of assets, including cash and securities.

Though CLTs are often lifetime trusts, they can also be created under the terms of your will.

Though CLTs are often lifetime trusts, they can also be created under the terms of your will. There are many potential benefits to establishing a CLT in a will, including the possibility of generating a significant charitable estate tax deduction. But there are challenges as well. A key economic factor in structuring a CLT is the prevailing IRS interest factor — also known as a “discount rate” or “hurdle rate.” Because a CLT created when you die will rely on the interest rate then in effect (month of death or prior two months), it can’t be known whether that rate will be favorable. But current rates provide one of the most favorable environments ever for creating and funding CLATs. So if you would like to satisfy your charitable objectives and estate planning objectives, a lifetime CLAT may well be the answer.

Because a CLT combines both charitable and noncharitable components, the value of the noncharitable portion (which ultimately goes to family members or other noncharitable beneficiaries) is considered a taxable gift. Of course, with the current estate/gift tax exemption at $5.12 million, this may not be a concern. However, most donors who fund a CLT during their lifetime want to maximize the initial charitable gift and minimize the “taxable” gift. The taxable gift component for a CLAT is determined by simple subtraction: the value of the assets transferred to the trust less the value of the charitable interest. In the current environment of record-low interest rates, the initial value of the charitable component is “inflated” — and that, in turn, diminishes the amount of the taxable gift.

CLTs (Particularly CLATs) on the Rise2

According to IRS statistics, from 2001 to 2010, the number of lead trusts increased by nearly 45% — an increase larger than for any other split-interest trust category. (Perhaps more telling, the assets held in these trusts increased by almost 92% during that time period.) Today’s economic environment and recent IRS guidance have contributed to the upsurge.

Current discount rates provide one of the most favorable environments ever for CLATs.

Low discount rate. The IRS discount rate is used to determine the assumed rate of return for assets contributed to a CLAT and affects the calculation of the lead payments (that is, how much must be paid to charities in order to “zero out” or eliminate the taxable gift component). When the discount rate is low, the annual payout to charity can be reduced. For instance, a trust funded with $1 million when the discount rate is 6% would need to pay the charitable recipient almost $136,000 per year for 10 years in order to have that stream of payments have a present value of $1 million. If, however, the discount rate is 1.4% (as it was in March 2012), the charitable recipient would need to be paid only $108,000 per year for the same result. That means that in today’s environment, if this trust had an annualized return in excess of only 1.4%, it would not only be able to satisfy the annuity payment to charity but also would have funds remaining at the end of 10 years for the noncharitable beneficiaries.

Depressed market values. There is also an expectation that the values of assets used to fund a CLT may be only temporarily depressed and that over an extended investment cycle, values will normalize and perhaps appreciate. If indeed that is the case, it can add leverage to this estate planning strategy. Low initial asset values, advantageous for tax planning purposes, might grow at a higher than expected rate, delivering more to your beneficiaries without increasing potential tax liability.

TAKE YOUR PICK2

Your U.S. Trust advisor and your attorney can help you decide whether it makes sense to incorporate a CLT into your overall wealth transfer plan, during your lifetime or at death, and help you choose between a CLAT and a CLUT. A CLUT’s distributions will vary with the fair market value of the trust, so both the charity and your family share the risks and rewards of the investments. (The current low discount rates do not affect this strategy.) With a CLAT, any increase in trust assets in excess of the amount needed to pay the charitable beneficiary will go directly to the noncharitable beneficiaries who receive the property at the end of the charitable term. For families that wish to transfer assets to their children as efficiently as possible, CLATs may be preferable. Also, there are distinct differences between CLATs and CLUTs for generation-skipping transfer tax planning.

Distributions. A CLAT provides a fixed distribution, or annuity, to one or more charities in each year of the trust. Distributions can be the same each year or can increase annually at a rate established when the trust is put in place. Starting with a small annual payment but increasing the amount over the course of the trust may result in assets of greater value passing to your children. For instance, a $1 million CLAT providing steady payments of $108,000 to charity for 10 years would result in $369,000 passing to your children if it earned 6% per year. If, however, that $1 million CLAT started with an initial payment of $33,000, increasing by 25% each year for 10 years, $476,000 would pass to your children. In both cases, the taxable value of the gift to the children would be zero.

Risks and benefits. The value of assets in a CLAT will likely fluctuate during the trust term. Regardless of the trust’s value, however, the charity will usually still get the predetermined payments, with the expectation that the trust will increase in value so that even after paying the charity, there will be significant assets left for the noncharitable beneficiaries. In order to achieve that goal, the trust’s investment return must exceed the hurdle rate — the IRS interest rate in effect when the trust is established. Of course, the trust could fail to exceed the hurdle rate, in which case the noncharitable beneficiaries get nothing and the charitable beneficiary may get less than expected. With a CLAT, the charity bears the downside investment risk while the family may enjoy any upside investment benefit.

Types of CLTs

Taxation. CLTs are not exempt from income tax, an important consideration when structuring the trust. Perhaps the biggest decision when creating a lifetime CLT is whether the trust will be a grantor or nongrantor trust (the trend is to make these grantor trusts, but you should discuss the tax implications of CLTs with your tax advisor).

Grantor CLT. With a grantor CLT, you may receive a charitable income tax deduction for the present value of the charity’s interest: typically the full value of the trust. Whether you can fully deduct the charitable gift depends in part on your adjusted gross income for the year. Deductions you can’t use the first year can be carried forward for as many as five years. If you die, during the term of your grantor CLT, the charitable income tax deduction may need to be partially recaptured. It is often advantageous to create a grantor CLT in a year in which you expect significant income so you could benefit fully from the charitable deduction. In return for the tax deduction, you must include all of the CLT’s income each year on your personal tax return. This may not be as nearly as bad as it sounds. First, the charitable deduction can offset ordinary income that is otherwise taxed at a rate as high as 35%. And because the trust’s income is likely to come in the form of capital gains and dividends, it will generally be taxed at the preferential tax rates that apply to investment income.

Nongrantor CLT. With a nongrantor CLT, you do not get a charitable income tax deduction, but instead of you being taxed on trust income, it’s taxable to the trust, which can take an income tax deduction for all or a portion of the distribution it makes to charity each year and is not subject to the percentage limitations applicable to individuals. Also, with a nongrantor CLT, the trust’s deduction could be limited if the trust has “unrelated business income,” such as income from, but not limited to, master limited partnerships and certain hedge funds.

A CLT can be especially effective if you typically give substantial amounts to charity on an annual basis. Additionally, certain temporary conditions, such as low interest rates and depressed asset values, have made these trusts more attractive. For more information on CLTs, please contact your U.S. Trust advisor and estate attorney.

Mitchell A. Drossman is national director of U.S. Trust’s Wealth Planning Strategies group.

Douglas Moore is a managing director of the Family Office of U.S. Trust in New York City.

1Giving USA, December 31, 2010. 2Examples presented in this article are hypothetical and meant for illustrative purposes only. They do not reflect actual investments, nor do they account for the effects of taxes, any investment expenses or withdrawals. Had different rates been used, results would have been different. Returns are not guaranteed, and results will vary. Investment returns cannot be predicted and will fluctuate. Investor results may be more or less.

IMPORTANT INFORMATION

Projections made may not come to pass due to market conditions and fluctuations.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust, Merrill Lynch, and its represen-tatives nor its financial advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.