Take-Away: A charitable lead trust is an effective estate planning tool to often used in a low-interest environment to shift wealth transfer tax-free.

Background: A charitable lead trust (CLT) is an irrevocable trust which gives to the charity a ‘leading’ interest in the trust, either for a lifetime or a term of years. That ‘leading’ interest is paid in the form of an annuity or a unitrust percentage. [IRC 170(f)(2)(B); Regulation 1.170A-6(c)(2)(i) and (ii).]

Candidates:  A CLT is usually used by an individual who can afford to forego income from one or more income producing assets for a period of years. When a CLT is created the goal is to identify an annuity or unitrust amount that can be paid to the charity without consuming significant amounts of trust principal over a trust duration which is not be unduly prolonged.

The best candidate for a CLT is an individual who: (i) already makes substantial contributions to a charity each year, where that philanthropy is shifted to the CLT; (ii) needs to avoid transfer taxes by removing an appreciating asset from his/her taxable estate; and (iii) faces the percentage limitations on their charitable giving, which is tied to the donor’s adjusted gross income; the income tax effect of using a CLT is equivalent to the donor personally receiving a 100% income tax charitable deduction each year.

Types of CLTs: There are four (4) types of CLTs to choose from.

  1. Nongrantor CLT: This is the most common type of CLT. This CLT can be created either during lifetime or on death. Key to this type of CLT is that the donor is not entitled to an income tax charitable deduction. The primary tax benefit to using a lifetime nongrantor CLT is a gift tax charitable deduction for the value of the charitable lead interest, while potentially removing an appreciating asset from the donor’s taxable estate. If this type of CLT is created on the donor’s death, his/her estate is entitled to a estate tax charitable deduction equal to the value of the charity’s interest in the CLT, but there will also be a stepped-up income tax basis in the assets held in the trust, which might ultimately benefit the remainder beneficiaries of the nongrantor CLT.
  2. GrantorCLT: This type of CLT allows the donor to claim an immediate income tax charitable income tax deduction on funding the CLT equal to the value of the charity’s lead interest in the trust. The trade-off for claiming the immediate income tax charitable deduction is that the donor remains liable for the tax on the income subsequently earned by the CLT; the donor does not receive any additional income tax charitable deductions for distributions made to the charity over the trust’s term. Looking at it a different way, the initial charitable deduction claimed by the donor is recaptured over the term of the grantor CLT, since the trust’s income is taxed to the donor. This CLT is a grantor trust and thus is a lifetime-only type of CLT. Note, too, that this CLT’s corpus will be included in the donor’s taxable estate on the donor’s death.

A grantor CLT can allow a donor to consolidate charitable deductions for future donations into one larger deduction for a single calendar year, which can be helpful for those donor’s who itemize their income taxes in this period of larger standard deductions, limits on SALT deductions, and other limits on income tax deductions imposed by the 2017 Tax Act.

  1. Super CLT, aka Intentionally Defective Grantor CLT: A Super CLT is designed to achieve both income tax and estate tax benefits. It has both grantor and nongrantor trust characteristics. It is designed to transfer property to the donor’s descendants or other designated beneficiaries, but the donor retains just enough rights in the trust for the trust to be classified as a grantor trust for income tax reporting purposes, and a nongrantor trust for gift and estate tax purposes. Consequently, the donor pays tax on the trust’s taxable income, but the trust’s assets are excluded from the donor’s taxable estate.

The donor receives both an income tax deduction and a gift tax charitable deduction in the year the Super CLT is created. While this type of CLT is not specifically mentioned in the Tax Code, the IRS has issued several private letter rulings to taxpayers approving what is essentially a hybrid trust. [Private Letter Rulings 19992207, 200010026, and 199936031.]

  1. Nonqualifying nongrantor CLT: Maybe this should be called a common law charitable lead trust. This trust is designed to keep the income of the trust from being taxed to the donor, while avoiding the private foundation restrictions otherwise imposed on CLTs. [IRC 4947.] This trust intentionally does not provide a guaranteed annuity or unitrust interest to the charity, which is why it is not qualified. Accordingly, this trust will not qualify for an initial income or gift tax charitable deduction claimed by the donor. Rather, the CLT claims an annual charitable income tax deduction when amounts are transferred to the charity while avoiding alternative minimum tax and private foundation restrictions. [IRC 642(c).]

While no income tax deduction is available to the donor, neither is any of the trust’s income taxable to the donor. The next effect to the donor is as if he/she receives a full charitable deduction, even if he/she has previously exceeded his/her adjusted gross income limits. Such a trust might also be beneficial to the donor, if the trust paying its own income tax liability keeps the donor in a lower marginal incoame tax bracket.

Conclusion: This only provides a helpful beginning summary of a charitable lead trust. The general requirements for a CLT will be covered in Part II.