Charitable Lead Trust Basics
Charitable Lead Trusts (CLTs) are sophisticated financial instruments that serve dual purposes: supporting philanthropic endeavors and managing estate or gift taxes. As an estate planning tool, CLTs are particularly appealing to financially affluent individuals who are also committed to making significant charitable contributions.
This article reviews the common uses, considerations, and pros and cons of implementing Charitable Lead Trust strategies. CLT strategies are complex and should involve a trusted attorney, accountant, and financial advisor.
What is a Charitable Lead Trust?
A Charitable Lead Trust is an irrevocable trust where the grantor (the person or persons who created the trust) donates assets to a trust. The trust then uses those assets to fund donations to a selected charity or charities for a set time period (10 year, 20 years, etc.) up to the grantor’s life. After the time period is over, the remaining assets in the trust (if any) are passed to non-charitable beneficiaries that the grantor named.
CLAT’s are Irrevocable: This means that once the trust is established and funded, it cannot be reversed later if you change your mind before the trust is complete.
What a Charitable Lead Trust Can Accomplish
A Charitable Lead Trust can be set up a number of different ways depending on the goals of the grantor. Here are a few common strategies of how to use a CLT:
- Reduce Income Tax Liability After Income Has Occurred: If you have a large income tax liability that cannot be mitigated or deferred, a CLT can give you a deduction to offset that income tax liability.
- High Net Worth Wealth Transfer: A CLT can be structured with the intent to pass along assets to heirs outside of their estate which can be beneficial depending on the expected estate size. If high growth assets are used (and realized), the CLT can effectively freeze the value of the estate at today’s value rather than passing to heirs in the future at a much higher value.
Charitable Beneficiary
The Charitable Beneficiary (Lead) that can be named through a CLT is quite flexibility. It can be a charity, donor advised fund, or a foundation. Multiple organizations can be named if you would like as well.
The Charitable Beneficiary cannot generally be changed but you can add provisions for an alternate charitable beneficiary if the primary is no longer around.
Annual Payments to Charity
Once the assets are in the trust, donations must be made annually to the selected charitable beneficiary. How much depends on whether you establish a Charitable Lead Annuity Trust (CLAT) or a Charitable Lead UniTrust (CLUT).
Charitable Lead Annuity Trust (CLAT)
The income distributed to the charity is a fixed amount annually.
For example, if a 10-year CLAT establishes a $50,000 per year distribution to charity, it will distribute $50,000 for every year regardless of the trust value.
If the trust assets are performing poorly, the trust will continue to distribute even to the point of depletion.
If the trust assets are performing well, the amount distributed will never increase.
Charitable Lead UniTrust (CLUT)
In a CLUT, the amount distributed to the charity is a percentage of the asset of the trust in that year.
For example, assume a 10-year CLUT is funded with $1 million and sets a distribution rate of 5%. The first year, the CLUT will donate $50,000 ($1M x 5%).
If in year 3 the CLUT is worth $1.3M, the donation will be $65,000.
If in year 8 the CLUT is worth $600,000, the donation will be $30,000.
The advantage of a CLUT is that it cannot be depleted as donations will decrease if the trust assets do not perform as intended.
Regardless of the structure, the grantor is the one who determines the rate of donation which can be higher or lower depending on their goals.
- A higher rate of donation provides greater tax deduction benefits but less to the ultimate heirs.
- A lower rate of donation reduces the tax deduction benefits but adds more to the ultimate heirs.
Charitable Lead Trust Tax Considerations
Income Tax Considerations
A CLT can be set up to receive an up-front charitable deduction, or to avoid ongoing income taxes on the assets but not both.
Up-Front Charitable Deduction
To receive an up-front, immediate tax deduction, the trust must be set up as a Grantor Trust. The value of the deduction is based on the estimated value of the charitable donation reviewed below. While the up-front income deduction can offset income, the grantor is taxed on annual income generated from the assets and is not granted a charitable deduction for the donations made by the trust to the charity.
Avoid Ongoing Income Taxes on Assets
To avoid annual income taxes on the trust assets, the grantor would have to give up the up-front, immediate tax deduction on the donation. Instead, the trust is taxed on the income of the assets but is allowed a charitable deduction for donations made. So long as the donation amount is greater than the income tax liability, no taxes will be owed.
Valuing the Charitable Deduction
The value of the charitable deduction is the present value of the estimated charitable donations. Since these donations happen in the future, the IRS provides a rate to use when computing the present value calculation called the Section 7520 rate which mirror short term interest rates for the most part. The computation of the charitable deduction should be completed by a professional.
While the computation is beyond what any non-professional should know, here are a few implications to be aware of:
- The lower the 7520 rate, the higher the up-front charitable deduction if all else is equal in the trust.
- The lower the 7520 rate, the lower the gift tax burden.
Gift and Estate Tax Considerations
Gift taxes are paid based on the value of the remainder interest in the trust. Effectively, the remainder interest is what is left over after the charitable deduction is calculated and determines the taxable gift.
The taxable gift is used to calculate gift taxes if you exceed the lifetime gift tax exclusion limits. While the annual gift exclusion is not available to use for this type of gift, the lifetime gift tax exclusion is. See here for the current limits: 2024 Tax Resources – Gilbert Wealth
It is possible to structure the trust provisions to where there is no taxable gift. These are called “Zeroed-Out CLAT’s” as they zero out any value of the gift.
Final Beneficiary or Remainderman
The final beneficiary of the remaining proceeds of the trust are not charitable beneficiaries. They can be any of the following:
- The Grantor Themselves: The grantor receives the remaining assets back to use themselves after funding years of gifting.
- Descendents: The grantor’s descendant’s receive the remaining assets outside of the estate.
- Trusts: A final trust can be created to managed the distribution of the remaining assets.
Charitable Lead Trusts are just one tool in a charitable gift planners toolbelt to help you maximize your giving. Check out my comprehensive article on charitable giving strategies for other ideas: The Comprehensive Guide to Charitable Strategies – Gilbert Wealth