Philanthropy is a worthy end alone, but what if you could increase your charitable giving while at the same time reducing your income, gift and estate taxes and earning a reasonable rate of return to boot?
It may sound too good to be true, but it isn’t. A Charitable Lead Annuity Trust (CLAT) brings this dream to reality. In this sort of trust, the donor first contributes assets to the trust. The trust then pays a fixed annual amount to a charity, based on a rate prescribed by the IRS. (The current required annuity rate for CLATs is 1.2 percent.) Any assets that remain at the end of the CLAT’s term pass to a non-charitable beneficiary – for example, your children.
A CLAT allows you to pass assets to your heirs at reduced tax cost and to maintain a program of regular charitable giving. When you create the trust, you can set the annual donation to the charity at either a fixed amount or a certain percentage of the fair market value of the trust assets. There can also be multiple charitable beneficiaries; you can designate them in advance, or the trustee can select them.
Establishing a CLAT may result in a taxable gift when you create the trust. The gift amount would equal the value, at the time, of the remainder interest that is expected to pass to your heirs when the trust ends. However, you can avoid this scenario by establishing a CLAT with a remainder interest valued at zero. In such cases, there is no taxable gift - even though it is still possible, even likely, that some assets will eventually pass to your family members, as long as the assets outperform the hurdle rate set by the IRS.
The table below summarizes a $2,000,000 contribution to a CLAT with a 10-year term. The assumed annual trust appreciation is 8 percent, and the required fixed annuity rate is set at 1.2 percent. The charity (or charities) in this situation would receive distributions of $213,436 each year for 10 years. In this example, $1,225,894 will pass to the noncharitable beneficiary at the end of the 10-year term without incurring any gift tax, given the trust’s appreciation relative to the IRS’ fixed hurdle rate.
| Year | Beginning Trust Value | Trust Appreciation | Annual Distribution to Charity | Ending Trust Value |
|---|---|---|---|---|
| 2012 | $2,000,000 | $160,000 | $(213,436) | $1,946,564 |
| 2013 | $1,946,564 | $155,725 | $(213,436) | $1,888,853 |
| 2014 | $1,888,853 | $151,108 | $(213,436) | $1,826,525 |
| 2015 | $1,826,525 | $146,122 | $(213,436) | $1,759,211 |
| 2016 | $1,759,211 | $140,737 | $(213,436) | $1,686,512 |
| 2017 | $1,686,512 | $134,921 | $(213,436) | $1,607,996 |
| 2018 | $1,607,996 | $128,640 | $(213,436) | $1,523,200 |
| 2019 | $1,523,200 | $121,856 | $(213,436) | $1,431,620 |
| 2020 | $1,431,620 | $114,530 | $(213,436) | $1,332,713 |
| 2021 | $1,332,713 | $106,617 | $(213,436) | $1,225,894 |
Depending on the CLAT’s structure, you may or may not also receive an immediate income tax deduction upon its creation. If you, the grantor, choose to be taxed on the trust’s income as it is received, then you may receive a current income tax deduction for the net present value of the charitable annuity. That is equivalent to $2 million in the example above.
To see another example of a hypothetical CLAT in action, see my April 2012 Sentinel article, “The Romney Trust: A Masterpiece.” The article also shows how a CLAT can work as part of a larger wealth transfer strategy.
Due to certain income tax benefits related to contributing appreciated securities to charity, low-cost-basis securities are perfect assets to fulfill any substantial charitable gifts or bequests, including the creation of a CLAT. Whatever sort of assets you choose to donate, however, CLATs can be useful tools that allow you to increase your charitable giving, benefit your heirs, and reduce your own gift and estate tax obligations.
Almost too good to be true - but not quite.
