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George F. Bearup, J.D. Senior Legal Trust Advisor

21-Oct-20

CLATs, Shark Fins, and Income Tax Planning

Take-Away: Charitable Lead Annuity Trusts (CLATs) are an underutilized estate planning tool that can provide a large current income tax charitable deduction, in addition to the prospect of shifting considerable wealth to the remainder beneficiaries of the CLAT gift tax-free. The historically low IRC 7520 rate that currently prevails makes the CLAT even more beneficial to shift wealth gift tax-free.

Background: According to the IRS, only about 5% of charitable split-interest trusts are CLATs. A CLAT functions like a grantor retained annuity trust (GRAT). However, the annuity is paid to a charity rather than the grantor of the trust.

  • Income Tax Deduction: The actuarial present value of the annuity stream dedicated to the charity is claimed for an immediate income tax charitable deduction (subject to the settlor’s adjusted gross income limitations for the year of the gift.) Like the GRAT, if the trust’s investments grow faster than the IRC 7520 rate used to value the present value of the annuity stream (120% of the federal mid-term applicable federal rate, or AFR).
  • Gift Tax Charitable Deduction: Like a GRAT, a CLAT can be ‘zeroed out’ so that there is little or no gift tax associated with the transfer of the remainder interest in the CLAT. At the end of the CLAT’s annuity payment term, the remaining assets pass to the CLAT’s remainder beneficiaries (or a trust for their benefit) gift tax-free.
  • Estate Tax Exposure: Unlike a GRAT where if the settlor dies during the term of the annuity payment period the GRAT’s assets are included in the grantor’s taxable estate, the value of the CLAT’s assets are not included in the settlor’s taxable estate. However, there will be a recapture of some of the previously taken charitable income tax deduction, which will be reported on the settlor’s final income tax return.

CLATs are not simple to administer, though, and there are a fair number of tax traps since it is subject to the private foundation rules, which may explain why CLATs are underutilized. For an individual about to face a large liquidity event, and who is also charitably inclined, creating a large income tax charitable deduction with a CLAT in the year the capital gains tax will be recognized will help to reduce the income tax liability that he or she will face.

CLAT Overview: The basic structure of a CLAT, along with some options, is described below.

  • Trustee: The settlor of the CLAT can serve either as the trustee of the CLAT, but with some limitations on the settlor’s decision-making on picking charities to receive the annuity payment, or the CLAT’s settlor can serve as the trust director of the CLAT with regard to its investments. If the settlor wishes to serve as trustee of the CLAT, the charitable beneficiary needs to be ‘locked in’ from the start so there is no discretion held by the settlor-trustee which beneficiary receives distributions from the CLAT.
  • Charitable Annuitant: The CLAT is an irrevocable trust with a charity, or charities, entitled to receive  annual annuity payments for the annuity payment period. Unlike its ‘cousin’ the charitable remainder trust, a CLAT is not a tax exempt entity.  If the settlor wishes to act as the trustee of the CLAT, then the settlor’s donor advised fund can be named as the CLAT’s sole charitable beneficiary to receive all annuity payment for the CLAT’s annuity-payment period.
  • Duration: There is no minimum or maximum limit on the length of the CLAT’s annuity payment period. With the low IRC 7520 rate used to calculate the present value of the charity’s right to the annuity payment stream, and thus the income tax charitable deduction, the longer the CLAT’s duration, the more wealth that can be shifted gift-tax free to the CLAT’s remainder beneficiaries.
  • Charitable Income Tax Deduction: The settlor’s charitable contribution is tax deductible up to 30% of the settlor’s adjusted gross income (AGI) if the CLAT is established as a grantor trust for income tax reporting purposes. Any excess income tax charitable deductions can be carried forward by the settlor for the next 5 calendar years. If the CLAT is structured as a non-grantor trust, the settlor is not eligible to claim an income tax deduction for the charitable interest, but then the CLAT is responsible for its own income tax liability.
  • Gift Tax Exposure: The gift of the annuity interest to the charity qualifies for the federal gift tax charitable deduction. Like a GRAT, the CLAT can be ‘zeroed out’ so that the value of the remainder interest in the CLAT is reduced to zero, so there is no federal gift tax of the transferred remainder interest.
  • No Estate Tax Exposure: Unlike a GRAT, there is no concern over the settlor dying during the annuity payment period, so a much longer CLAT annuity payment period can be used to permit the growth in the CLAT’s investments.
  • Income Tax Exposure: As noted earlier, if the settlor took an immediate charitable income tax deduction and the settlor dies during the charity’s annuity payment period, some of that charitable deduction will be recaptured and reported as ordinary income on the settlor’s last income tax return.
  • Creditor Protection: The assets held in the CLAT are protected from creditor claims of both the settlor and the CLAT’s residuary beneficiaries.
  • Annuity Payment: The amount of the annual annuity paid to the charity is calculated when the CLAT is initially funded, using the current (or two months prior) IRC 7520 rate. That rate in September, 2020 was 0.40. [More on the importance of low interest rate is described below.]
  • Back-loading the Annuity- the ‘Shark Fin’ CLAT: The CLAT can be structured with increasing annuity payments during the CLAT’s annuity payment period. This is informally called a shark fin CLAT. Each year during the annuity payment period that year’s annuity amount increases over the prior year’s annuity amount. If those annual annuity amounts are graphed, the graph looks like a shark fin, with very large payments made to the charity during the last few years of the annuity payment period. An example of this permissible increase would be to require the annual annuity payment to be 120% of the prior year’s annuity payment amount. This back-loading of the annuity payment to the charity in the last few years of the annuity payment period is advantageous in a low interest rate environment for a couple of reasons. (i) Back-loading permits the CLAT’s assets to grow and accumulate to a much larger amount before large amounts are then paid out to the charity. This is akin to deferring the payment of a low-interest loan, i.e. the longer the assets can be retained and invested in excess of the IRC 7520 rate paid on the loan balance, the greater the value of the assets at the end of the charity’s annuity payment period, which is how a GRAT is intended to function. (ii) Back-loading the annuity payments allows for the CLAT asset performance to make up for underperformance of assets in early years due to an unexpected drop in the markets. The more time that more assets held in the CLAT have the opportunity to ‘beat’ the low interest-rate-hurdle used to determine the annual annuity payments, the more likely there will be CLAT assets at the end of the annuity payment period to be transferred gift tax-free.

Grantor Trust: Where things get complicated with a CLAT is that the CLAT can either be set up as a grantor trust for income tax reporting purposes, or it can be established as a non-grantor trust for income tax reporting purposes.

  • Grantor Trust: To enjoy an income tax charitable deduction when the CLAT is funded, the CLAT is required to be a grantor [IRC 671-677.] Accordingly, during the annuity payment period the settlor must pay the taxes on the CLAT’s income using funds outside the CLAT. While this creates a financial hardship on the grantor, the payment of the trust’s income tax liability also reduces the size of the grantor’s taxable estate, called an estate burn. It also permits the assets held in the CLAT to grow in essentially a tax-free environment, thus shifting more wealth to the CLAT’s remainder beneficiaries.
  • Non-grantor Trust: If the CLAT is a non-grantor trust during the charitable annuity payment period, it will be taxed as a complex trust subject to tax under Subchapter J of the Tax Code. Distributions to the charity will be deductible by the CLAT, but the trust will pay its income tax on income earned by the trust that is not used to pay the annuity to the charity.
  • Conversion to a Non-grantor Trust: The CLAT can start out as a grantor trust and then later during the annuity payment period convert to a non-grantor trust, usually by the settlor releasing one of the retained rights in the trust instrument, e.g. the release of the right to substitute assets of equivalent value. However, that conversion will then cause the settlor to recapture some income.

Impact of Low Interest Rates: If a CLAT is set up as a grantor trust using a very low IRC 7520 rate of interest, several benefits can be achieved.

  • Immediate Income Tax Deduction: If the CLAT is set up as a grantor trust, the settlor is entitled to an immediate income tax charitable deduction. The deduction is equal to the present value of all charitable payments ‘pledged’ from the CLAT during the annuity payment period. For a settlor who is facing a large income tax liability in the year, creating a large income tax charitable deduction will help to mitigate that income tax burden. With the very low IRC 7520 rate used to determine the annuity stream paid to the charity, most of the amount contributed to the CLAT by the settlor will be available as an immediate income tax charitable deduction, almost as if the full amount was contributed directly to a donor advised fund.
  • Estate Burn: As a grantor trust, the settlor of the CLAT will be required to pay the CLAT’s income tax liability. Admittedly that sounds like a negative, not a positive. The perceived benefit of any grantor trust is the estate burn, which effectively reduces the settlor’s retained taxable estate in order to reduce his or her future estate tax exposure. With the CLAT’s settlor paying its income tax liability each year, that permits the assets held in the CLAT to grow in a tax-free environment. For context, recall that the amount to be paid the charity is ‘locked in’ when the CLAT was first formed, even though the assets held in the CLAT grow in a tax-free environment. The growth in the CLAT’s investments arguably does not benefit the charity; the charity receives the annuity amount, regardless of how well the CLAT’s investments perform. In short, the tax-free environment the CLAT’s assets accumulate in benefits the CLAT’s remainder beneficiaries, who will receive those accumulated assets gift tax-free.
  • Wealth Accumulation: The annuity amount paid to the charity is determined using the IRC 7520 rate, i.e. 0.40% in October. That is the presumed rate-of-return the Tax Code requires the charity to receive from the CLAT. The CLAT’s trustee will set aside just enough funds to pay that amount, but will invest the rest of the CLAT’s assets to generate long term growth. While the CLAT settlor will be faced with having to pay the CLAT’s income tax liability as a trade-off for taking the immediate charitable income tax deduction, CLAT assets can be invested in a way to reduce the amount of current income it produces, e.g. REITs, long-term growth with few dividends. By back-loading the amount of the  CLAT annuity payment obligation, even smaller amounts will have to be paid out of the CLAT in its early years as annuity payments to the charity, thus leaving more assets ‘inside’ the CLAT to grow and accumulate in a tax-free environment.
  • Lowers the Annuity Amount: As noted, the currently all-time low IRC 7520 rate makes CLAT planning attractive because it reduces the aggregate amount of charitable annuity payments that must be paid from the CLAT to the charitable beneficiary. The annuity amount is fixed at the outset and is not subject to future interest rate changes. The historically low IRC 7520 rate is thus locked-in for the entire duration of the CLAT’s annuity payment period.

Example: A 30-year CLAT is funded with $1.0 million in December 2018, when the 7520 rate was 3.6%. The charity would receive (as annuity payments) over that 30 year period $2,400,000. If the same CLAT had been funded in May, 2020, when the 7520 rate was 0.8%, the charity would have received in annuity payments over the same 30-year period $1,230,000. The lower the 7520 rate, e.g. September 2020 it is 0.40%, the less the charity will actually receive from the CLAT over the annuity payment period. Thus, a ’zeroed-out’  CLAT created in October of 2020 will be assured of having assets at the end of the annuity payment period if, over that 30 years, the GRAT’s investments grow at more than 0.4% each year. With a grantor trust classification that permits even more assets to grow inside the CLAT for the ultimate benefit of the remainder beneficiaries with the settlor paying the CLAT’s income tax liability.

  • Create Large Charitable Deduction: With a near-zero IRC 7520 rate, the CLAT’s settlor can receive close to a dollar-for-dollar charitable income tax deduction with regard to the amount contributed to the CLAT, based on the promised annuity payments from the CLAT. If the CLAT’s grantor is contemplating a large Roth IRA conversion this year, to address fears of substantially higher income taxes in future years, creating the large charitable income tax deduction this year will go a long way to deal with the additional income that is reported on the conversion of a traditional IRA to a Roth IRA in late 2020.

Conclusion: Admittedly, a CLAT is an estate planning tool of limited utility. An individual must face a large income tax liability which can be effectively reduced by the large income tax charitable deduction  that is generated with a funded grantor CLAT. That individual must also be charitable inclined, but the use of a donor advised fund as the CLAT’s charitable beneficiary makes this less of an impediment. The individual must have ‘outside’ resources available to pay the CLAT’s income tax liability  if it is structured as a grantor CLAT. If the individual has already fully used their available federal estate and gift tax exemptions and still needs (or wants) to transfer more wealth out of their taxable estate, a zeroed-out CLAT would appeal to them. These circumstances all suggest that a CLAT is not for everyone, and establishing and administering a CLAT is not for the faint-of-heart. However, the low IRC 7520 rate that is used to determine the annuity payment over a long period of time may make a grantor CLAT, with back-loaded annuity payments to the charity, makes the CLAT a highly attractive wealth shifting device to children or trusts for more remote descendants.