In this article, we will continue to review charitable trusts. In our last two articles we looked at Charitable Remainder Trusts (you can find our article on CRT basics here; and our article on CRT varieties here). Charitable Remainder Trusts are split-interest trusts where a beneficiary or beneficiaries receive an income stream either for a specified number of years, or for the life of the beneficiary(s). Once the income interest ends, the trustee transfers the remaining trust assets to a charitable beneficiary. These types of trust are irrevocable, and come in multiple varieties. Generally, these varieties are distinguishable by how the payment to the income beneficiary is determined. A Charitable Remainder Annuity Trust pays the income beneficiary(s), at least annually, a fixed dollar amount that the settlor of the trust lists in the trust document. The income beneficiary(s) receives this fixed amount until the income portion of the trust ends, or until the trust runs out of money. The IRS requires that the amount of these payments be between 5% and 50% of the initial value of the trust assets. Alternatively, in Charitable Remainder Unitrusts, instead of paying the income beneficiary(s) a fixed dollar amount, the trustee pays the income beneficiary(s) a fixed percentage of the fair market value of the trust assets, in the year of the distribution.
There is another major category of split-interest charitable trusts. The Charitable Lead Trust (CLT) operates exactly like the charitable remainder trust with one important difference: the income beneficiary is a charity, and the remainder interest can go to a non-charity. Reversing the interest of the trust beneficiaries greatly changes how the IRS treats these trusts and, in turn, changes the reasons why clients use them. In this article we will briefly look at the different types of CLTs, examine their tax ramifications, and look into who they may be useful for.
While CRT 's tax benefits tend to be in the area of income tax, CLT's tend to be for estate tax savings. When you create the CLT, the goal is to create a situation where the IRS values the remainder interest at $0. By doing this, there is no taxable gift given to the remainder beneficiary.
In a low income rate environment, you can zero out a CLT with a lower payout rate to your chosen charity. The IRS determines the value of the remainder interest by using the §7520 rate, also known as the Federal Midterm Rate. The IRS assumes that the trust assets will earn at least 120% of the lowest midterm rate of the last three months, including the current month. The May 2017 midterm rate is 2.4%. This rate is quite low; over the last 20 years, this rate has been as low as 1% and as high as 8.2%. If you have a 20 year CLT, and the midterm rate is 2%, then you have to make the payout rate to the charitable beneficiary 6.12% in order to have the IRS value the remainder interest at $0. For the same 20 year CLT, if the midterm rate is 4%, you need to make the payment to the charitable beneficiary 7.36% in order to zero out the remainder interest.
Whether or not you zero out the value of the remainder interest, the goal of the CLT is to fund the trust with assets that you think will rapidly appreciate or otherwise generate a large amount of income. If these assets grow more than the payout rate, the value of the additional assets goes to the remainder beneficiary, free from any gift or estate taxes. For example, if lets look at a CLT where the IRS values the remainder interest at $100,000, and after the income period is over, the assets in the trust have grown so there is now actually $500,000 remaining in the trust. You would pay gift tax on $100,000 when you create the trust, and the remainder beneficiary will receive the additional $400,000 free from any additional tax.
Unlike Charitable Remainder Trusts, Charitable Lead Trusts do have to pay income and capital gains taxes. Because of this, we recommend that you do not fund a CLT with highly appreciated property. While the ideal assets to use in a CLT could depend on the exact type of CLT you create, most of the time you want high growth or high income assets.
There are a huge number of variants of CLTs. Some of these variants come from whether you create the trust in life or through your will. There are different types of CLT based on how you want to calculate the payment amount during the income portion. We generally categorize CLT, on how the trustee calculates the income interest, as this is often where a large part of the tax planning occurs. There are also CLT classifications based on whether the grantor pays taxes on the trust assets, or if the trust itself pays the taxes. These are very customizable documents, and for the right client, a specialized attorney can tailor a CLT to fit your specific needs. In future articles, we will examine these different varieties of CLT, go into the types of clients they are ideal for, look into how they can be used for more than estate tax planning, and give tips on how to maximize their usefulness.