the BERINGER group Newsletter

Barry Levin

 

Doing Good for Charity and Family in a Low Interest Rate Environment

by Barry Levin

In our last article "Wealth Transfer Planning in a Low Interest Rate Environment" we mentioned a technique that can be used to benefit both charity and family, the Charitable Lead Annuity Trust ("CLAT"). We mentioned there that the current historically low interest rates impact Applicable Federal Rates ("AFR") which are used to determine the value of both present and future interests for gifting and other purposes where an outright, immediate gift is not made. The current low AFR's offer an interesting opportunity to "do good" both for charity and for family, through the use of a CLAT.

Let's first look at what a CLAT is and look at some examples of how it can benefit both charity and family (or non-family) members.

A CLAT, like other qualifying charitable trusts, is a "split-interest" trust. That is, it generally has two interests, a present interest that goes to one beneficiary and ends at a point in time, and a remainder interest that begins when the present interest ends (many people are familiar with a Charitable Remainder Trust, which is also a split-interest trust but is the reverse of a Charitable Lead Trust).  In the CLAT the first interest, the present interest, is that of the charitable beneficiary, and the remainder interest is that of the person or person who receive the trust benefits when the charity's present interest ends. So when a CLAT is created, two separate gifts are made (i) a present interest gift to the charity; and (ii) a gift of the remainder interest to the non-charitable beneficiary[ies].

A CLAT can be created during lifetime or at death. The examples we will use later are for lifetime CLAT's since that allows us to focus on the current low interest rates; whereas the tax economics of a testamentary CLAT depend on the AFR at the time of death or the effective date of its creation after death.  

A CLAT is one form of a Charitable Lead Trust ("CLT"), the other being a Charitable Lead Unitrust (which we will not specifically address here).  For any CLT there are certain requirements in order to take advantage of the tax benefits offered through the Internal Revenue Code (the "Code"):

*   The charity beneficiary should qualify as such under the Code.

*   The remainder beneficiary can be one or more individuals, partnerships, corporations, estates or trusts.

*   The donor must designate (or provide a non donor-controlled method for such designation) when the trust is created.

*   There must be a measuring term for the interest of the charity e.g. a number of years, the life of an individual, a "measuring life" plus a number of year, etc.

With respect to a CLAT specifically, there are other requirements that apply in addition to those generally applicable to all CLT's:

*   A sum certain ("annuity") must be distributed to one or more charitable beneficiaries. So long as the annuity payments can be determined when the the CLAT is created, the payments can vary from time to time as to amount.

*   The distribution must be made at least annually for the measuring term.

*  The measuring term for the charitable interest must be either a term of years (generally without limit)  or the lives of one or more individuals who are living when the CLAT is created.

*   The principal of the CLAT must be used to satisfy the annuity if its income is not sufficient.

In most circumstances, the CLAT is treated as a separate taxpayer when it is created, so its income is not taxed to the donor nor does the donor get an income tax deduction for the CLAT's payments to the charitable beneficiary. The CLAT itself receives income, deductions (including charitable deductions without the limits applicable to individuals)  and is responsible for paying tax on its own taxable income. From an economic standpoint, this makes sense e.g. if a donor puts assets in a CLAT, [s]he will not receive receive that income nor be taxed on it, so [s]he shouldn't receive an income tax deduction for what is paid to the charity. (Note: it is possible to create a so-called "grantor" CLAT where the income and deductions flow through to the donor, but a discussion of such trusts are beyond the scope of this article.)

So, the CLAT is a separate taxpayer for income tax purposes. What are the gift/estate tax consequences of creating a CLAT. If one creates a CLAT during lifetime, the donor is making two gifts: the first is to the charitable beneficiary and it qualifies for a charitable gift tax deduction; and the second is to the remainder beneficiary[ies], and it is "taxable" for gift tax purposes. The same principle applies for estate tax purposes.

It is in this gift scenario that low interest rates are so beneficial. The lower the rates are that are used to determine the present value of gifts, the greater is the value of  the present interest going to the charity and the lesser is the value the subsequent interest going to the remainder beneficiary[ies].

Let's look at two examples of how a CLAT could, therefore, be used by a donor to "do good" for charity and family.

Example 1:

Suppose donor has $1,000,000 of assets from which [s]he doesn't need the income nor to have it available in the future for lifestyle, support, etc. The donor is on the Board of Directors of a local charity ("Charity") and annually has been making a leadership gift to it and plans (but has not previously committed to doing so) to continue such gifts for the foreseeable future. The donor also knows that her/his child may well need some funds in 15 years to pay for college for the donor's grandchild. In May, 2012, [s]he contributes those $1,000,000 of assets to a CLAT. The CLAT is designed to pay an annuity to charity for 15 years at the end of which, whatever remains will be paid to her/his child.

If this CLAT is designed to pay a 6% annuity at the end of each year to Charity, the present value of the Charity's right to receive $60,000 per year for 15 years under current AFR tables is $806,718; and the present value of the remainder interest (what her/his child will receive at the end of the 15 years is $193,282, which represents a "taxable" gift to the donor's child. That gift may not require the current payment of gift tax if the donor has gift tax exemption that [s]he can apply to it (the aggregate exemption applicable in 2012 is $5,000,000 per taxpayer). Over 15 years, the charity receives an aggregate of $900,000 in payments. If the trust earns 6% per year after tax, the amount remaining at the end of 15 years that is payable to the donor's child is $1,000,000 (perhaps enough for 4 years of college 15 years from now!)

One may view this is the same result if one did this her/himself over 15 years, i.e. gave $193,282 now and grow it at 6% per year for 15 years ($463,209), and take the balance as a "sinking fund" of $806,718, grow it at 6% per year and take out $60,000 per year for charity (end with $536,778) (the two total ~$1,000,000). But, the CLAT guarantees the payments to the charity whether the donor lives or dies, and in 15 years with the sinking fund, there is the $536,778 in the donor's taxable estate, subject to whatever tax regime is then in place; whereas, with the CLAT there is $0 in this sinking fund subject to tax .

Example 2:

Suppose donor has $1,000,000 of assets from which [s]he doesn't need the income nor to have it available in the future for lifestyle, support, etc. The donor is on the Board of Directors of a local charity ("Charity") and annually has been making a leadership gift to it and plans (but has not previously committed to doing so) to continue such gifts for the foreseeable future. The donor also knows that her/his child may well need some funds in 15 years to pay for college for the donor's grandchild. In May, 2012, [s]he contributes those $1,000,000 of assets to a CLAT. The CLAT is designed to pay an annuity to charity for 15 years at the end of which, whatever remains will be paid to her/his child.

If this CLAT is designed to pay a 7.438% annuity at the end of each year to Charity, the present value of the Charity's right to receive $60,000 per year for 15 years under current AFR tables is $100,000; and the present value of the remainder interest (what her/his child will receive at the end of the 15 years is $O, which represents a no "taxable" gift to the donor's child. Over 15 years, the charity receives an aggregate of $1,115,700 in payments. If the trust earns 6% per year after tax, the amount remaining at the end of 15 years that is payable to the donor's child is $665,292 (perhaps enough for 4 years of a state college 15 years from now!)

One may view this is the same result if one did this her/himself over 15 years, i.e. gave $0 now and taking the balance as a "sinking fund" of $1,000,000, growing it at 6% per year and taking out $74,380 per year for charity (ending with $665,291).But, the CLAT guarantees the payments to the charity whether the donor lives or dies, and in 15 years with the sinking fund, there is the $665,292 in the donor's taxable estate, subject to whatever tax regime is then in place; whereas, with the CLAT there is $0 in this sinking fund subject to tax.

Of course, these are just illustrations, and results could differ. There are more elaborate uses of a CLAT that could provide even better results.  But these simple examples  illustrate that in today's low interest rate environment, one can do good for charity and family. What could be better than that? .

 

 

 

 

 
 
 
 
 

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