Overview: Part I covered the four types of charitable lead trusts (CLTs) and suggested some of the reasons when a CLT might be used. Part 2 covers some of the detailed requirements of a CLT and  distinguishes the features of a charitable lead annuity trust (CLAT)  versus a charitable lead unitrust. (CLUT.) Common elements and distinctions will be summarized.

Structuring a CLT: The IRS has provided sample CLT forms, sort of ‘safe harbors,’ when creating a CLT.[Revenue Procedure 2007-45, 2007-46, and 2008-45 and 2008-46.] Some of the decisions that go into creating and funding a CLT and its charitable term include:

CLT Term: Most CLTs are structured as term trusts, e.g. a number of years, due to the predictiability of a fixed term. The term of a CLT can be measured by a term of years, but there is no minimum or maximum duration. [Revenue Ruling 85-49.] The Regulations do, however, limit an eligible ‘measuring life’ that may be used to identify a CLT’s duration, to lives of:  (i) the donor; (ii) the donor’s spouse; (iii) the donor’s descendants; and (iv) spouses of the donor’s descendants. [Regulation 1.170A-6(c)(2).]

CLT Payments: There is no minimum or maximum payout from a CLT, unlike a charitable remainder trust (CRT.) The annual payments to the charity must be made from the CLT regardless of whether the income or cash in the CLT is sufficient to make those required payments. In those rare situations where there is not enough cash, property must be distributed by the trustee to the charity. [IRC 170(1)(2); IRC 2055(e)(2)(B); IRC 2522(c)(2)(B).]

CLT Defined Amount: A unitrust payment is the fixed percentage of the FMV of the trust assets determined annually. [Regulation 1.170A-6(c)(3)(i).] Because that amount will fluctuate from year to year, a CLUT cannot be zeroed-out. With a CLAT, the annuity payment is a fixed dollar amount that is expressed as a dollar amount or as a fraction or percentage of the trust’s initial value. Unlike a CLUT, a CLAT can be zeroed-out so there is no gift tax imposed on the transfer of the CLAT’s remainder interest.  With the CLAT, the annuity should be expressed as a percentage of the initial FMV “as finally determined for tax purposes.”

Increasing Annuity Payment:  CLATs can be structured to provide for escalating payments to the charity, which allows the assets to be invested for longer periods of time to potentially provide that the growth of assets in the early years of the CLAT will ultimately benefit the CLT’s remainder beneficiaries; a backloaded CLAT may be in a better position to recover from early poor years’ investment performance than one that pays a level annuity to the charity. Unclear is what is an acceptable increase in the annual annuity amount that can be paid to the charity over the CLAT’s duration. Most commentators think that an annual 20% increase in the annuity amount paid to the charity will pass muster with the IRS. [Revenue Procedure 2007-45, and 46.]

Shark-Fin CLAT: [Nope, this in not an episode of the annual Sharknado Movie Fest each summer.] This type of CLAT has not been blessed by the IRS, yet the Service is aware that they are used. This is an extreme version of the zeroed-out, backloaded, CLAT for the longest possible duration. It is designed to provide minimal annuity payments to the charity for the trust’s term for as long as possible, with a balloon payment to the charity at the end of that term. The risk with a shark-fin CLAT is that the IRS might find that there is no guaranteed payment, which could cause the full value of the CLAT’s assets included in the donor’s taxable estate.

Excess CLT Income:  The CLT instrument can authorize the CLT trustee to distribute to a charity any annual trust income in excess of the required annuity or unitrust amount, or that excess income can be retained by the trust. However, additional distributions to the charity will not increase the donor’s original federal income tax charitable deduction. The CLT is entitled to unlimited income tax charitable deductions for distributions made pursuant to the terms of the CLT. Caution: this discretionary power should not be attributed to the donor or a non-adverse trustee, otherwise estate inclusion of the CLT’s assets may result. [IRC 674(a).]

Additional CLT Contributions: There is no prohibition against additional contributions being made to a CLT. However, additional contributions to a CLAT will not generate any additional income, estate or gift tax charitable deductions. Because of the absence of any IRS authority on the tax consequences of an additional contribution to a CLT, it would be better to make that additional contribution to another CLT established by the donor.

CLT Trustee: Any individual can serve as the CLT trustee. Nevertheless, the donor should not retain power to designate the income or remainder beneficiary’s of the CLT, otherwise the trust’s corpus will be included in the donor’s taxable estate. [IRC 2036 and 2038.] In light of this risk, normally the donor should not serve as the CLT’s trustee. Nor should the donor’s spouse. [IRC 672(e).]

Donor as CLT Trustee: If the donor intends to serve as the CLT trustee, then other prescautions need to be embedded in the CLT instrument. If the donor serves as CLT trustee , the retained power to select the charitable beneficiary will cause the gift of the annuity interest  to be incomplete for federal gift tax purposes. While other family members might serve as CLT trustee, the safest course of action is to name an independent trustee.

Substitute Charities: Along these same lines, if the donor reserves the right to substitute another charitable beneficiary for the charity named in the CLT, that retained power will eliminate the transfer tax benefits of the CLT. It is better to give an independent trust director the power to substitute charities.

CLT Charitable Beneficiaries: One or more charities can be specified in the CLT instrument, or the trustee may be given the discretion to select qualified charitable organizations to receive distributions. The charity must be qualified. [[IRC 170(c); IRC 2055(a); IRC 2522(a).] Private foundations and donor advised funds are eligible charitable beneficiaries. However, if a private foundation is the charitable beneficiary and the donor is an officer or director of that foundation foundation, some of all of the CLT may be included in the donor’s taxable estate. [IRC 2036(a)(2).]

CLT Subject to Private Foundation Restrictions: A CLT is subject to the private foundation restrictions including: (i) self-dealing prohibitions; (ii) excess business holding limitations; (iii) jeopardy investments limitations; (iv) expenditure responsibility rules; and (v) the private foundation governing instrument rules that must contain specific prohibitions.

Tax Consequences of a CLT: 

Gift Tax: The value of the noncharitable interest will be subject to gift tax at the time the CLT is created. While a CLAT can be zeroed-out, a CLUT cannot because the amount payable to charity fluctuates over time. The value of the gift to the CLT is determined using the IRC 7520 rate for the month of the gift, or the two prior months; the lower the IRC 7520 rate, the larger the value of the charity’s lead interest, and the lower the value of the taxable CLT remainder interest.

Future Interest: Since the value of the remainder interest in the CLT is a future interest, it will not qualify for the federal gift tax annual exclusion.

Incomplete Gift:  If the donor does not want to incur a federal gift tax on the creation of the CLT, the donor can retain a testamentary right to revoke the other noncharitable interests in order to prevent a completed gift of that future interest when the CLT was created.

Retained Control: If the donor to a CLT retains the right to select charitable beneficiaries, the donor has not parted with control over the trust property and the charitable gift is incomplete. If the donor’s power to designate the charitable beneficiary ends,e.g. it lapses, the gift is completed and becomes subject to gift tax, when the charitable gift tax deduction will then be available. [IRC 2055(e)(2)(B).] Conversely, if the donor leaves the selection of the charity to the trustee, the donor has parted with control and the gift is completed at the time the CLT is funded.

Estate Tax Marital Deduction: If the donor’s spouse is the sole noncharitable beneficiary, the interest that passes to the donor’s spouse will qualify for the unlimited marital deduction. [IRC 2056(b)(8).]

GST Tax: Different rules apply depending upon whether the CLT is either a CLAT or a CLUT. With a CLUT, the fraction for the GST exemption can be calculated with precision. If the intended beneficiaries of the CLT are skip persons, e.g. the donor’s grandchildren, then a charitable lead unitrust is the preferred trust. In the case of a CLAT, the GST calculation is much more complicated and the amount of the GST tax is not ascertainable until the termination of the charity’s lead interest. If the CLT assets outperform the IRC 7520 rate, there will be GST tax owed at the termination of the charity’s lead interest.

ETIP:  With a CLT that will be included in the donor’s gross estate at death, the GST exemption cannot be allocated until the end of the estate tax inclusion period, or ETIP.

Termination vs. Distribution: If a skip person, e.g. a grandchild of the donor, receives the assets outright a the end of the CLT’s charitable term, a taxable termination occurs if the charitable beneficiaries were named in the CLT at the outset of the CLT, because an “interest” as defined in IRC 2652(c)(1)(A) has terminated. When a taxable termination occurs, the trustee of the CLT is liable to pay any GST tax that is owed. In contrast, if the charitable beneficiaries were not named in the CLT at its outset, then a taxable distribution has occurred [IRC 2612(b)], because no “interest” has terminated. With a taxable distribution, the skip person is liable to pay the GST tax, not the CLT trustee.

Income Tax: Unlike a CRT, a CLT is not exempt from income taxation. However, a CLT is entitled to an unlimited income tax deduction for its gross income that is paid to a charity each year pursuant to the terms of the CLT. [IRC 642(c).] As noted in Part 1, the charitable contributions deductions are not limited by the donor’s adjusted gross income  percentage limitations. [IRC 170(b).]

* Ordering of Income: Unlike a CRT, the character of payments made to the charitable beneficiaries from a CLT for income tax purposes is not determined by a statutory tier system of reporting. If the CLT instrument is silent, payments made to the CLT’s charitable beneficiaries will be considered to consist of a pro rate portion of all of the items of trust income. [Regulation 1.643(a)-5(b).] In order to maximize the deductibility of distributions to the charitable beneficiary, the CLT instrument should expressly specify that all income is paid out from the CLT before any principal.

Grantor CLT: If this is the CLT involved, when the donor funds the CLT he/she receives a current income tax deduction for the present value of the charity’s lead interest. If the grantor status later terminates, e.g. the donor releases the power to substitute assets, then the donor will be forced to recognize income in an amount that is equal to the difference between (i) the deduction the donor received upon the trust’s creation, LESS (ii) the present value of the date of the CLT’s creation, of all amounts that wer required to be, and actually were, paid to the charity pursuant to the terms of the CLT.

Conclusion: Admittedly, this is far more than you ever wanted to know about charitable lead annuity and unitrust. That said, there is interest in using them in a low interest environment (used to value the charitable interest and ‘under-value’ the CLT remainder interest) and because if the CLT assets grow at a faster rate than the IRC 7520 rate used to fund the CLT, the remainder assets will pass at the end of the CLT’s charitable term gift tax-free. This is an important benefit when you consider that the federal gift and estate tax applicable exemption amount is schedule to be cut in half (or more) come 2026.