Charitable Lead Trusts
For a single individual or a married couple of very high net worth, the creation of a non-grantor Testamentary Charitable Lead Unitrust (CLUT) is one of the most desirable and powerful ways to minimize estate taxes without complicating your life in any way. The way the testamentary CLUT works is that upon your death, or upon the death of the surviving spouse, assets are irrevocably transferred to a trustee of a CLUT established upon your death. A CLUT can also be created during your lifetime.
The trustee of the CLUT pays a fixed percentage (called the Unitrust Percentage) of the trust assets (re-determined annually) to a qualified charity (which could be a Private Family Foundation that you establish while you’re alive or that is established upon your death pursuant to instructions in your trust) for either a set number of years or the lifetime of individuals. When the term of the trust has ended, the remaining trust assets are distributed to your children, grandchildren, or other individuals (called the remainder beneficiaries). A long-term lead trust with a sufficiently high payout rate can significantly reduce or possibly even eliminate a gift or estate tax on the assets transferred.
Most of our testamentary CLUTs have 3 “tiers,” meaning 3 sub-trusts within one trust. For example, the first tier typically lasts for only 5 or 10 years after your death (paying income to the charity during that time) and then pays the remainder amount to your children; this saves only a small amount of estate taxes but allows a tax-free gift to your children relatively soon after your death. The second tier typically lasts 20 to 30 years after your death (paying income to the charity during that time), and then pays the remainder interest to your children; this saves a much greater amount of estate taxes and allows a tax-free gift to your grandchildren. The third tier typically lasts 50 – 90 years after your death (paying income to the charity during that time), and then pays the remainder interest to your great grandchildren or other remote descendants; this saves the greatest amount of estate taxes and allows a tax-free gift to your remote descendants.
As stated above, each year the value of the trust’s assets must be redetermined. Accordingly, payments to charity will vary from year to year, depending upon the investment performance and expenses of the trust. Although the charity will continue to receive the same percentage of the trust’s assets each year, if the total value of the trust assets increases, the charities will receive more, and if the value of the trust’s assets decline, the charity will receive less.
For example, if the trust is worth $5,000,000 when created upon your death, and you’ve given the charity a 9% annuity, the charity will receive $450,000 in the first year. If the trust doubles in value in the second year, the charity will still receive 9% – but of $10,000,000, i.e., $900,000. Of course, if the value of the trust in the third year falls to only $3,000,000, the charity receives 9% of $3,000,000, $270,000.
The federal estate tax (if any) upon your death or the death of the surviving spouse is based on the present value of the remainder interest — i.e., the beneficiaries’ right to receive the trust remainder at some future time. This calculation is based upon the term of the trust, the amount payable each year to the charity (the present value of which amount results in a charitable deduction to the estate), and the AFR (applicable federal rate) at the time of the transfer. Stated another way, the present value of the charity’s future stream of income is an immediate charitable deduction for estate tax purposes. Stated yet another way, the donor’s estate is entitled to an estate tax deduction equal to the actuarial value of the income interest payable to the charitable organization.
Because your estate doesn’t pay estate taxes on this charitable portion, the money that otherwise would have been paid in estate taxes can instead be held in the charitable lead trust and invested. During the term of the trust, increased investment income can help pay for the fixed annuity promised to the charity — and if there is any surplus, that extra income (plus any appreciation on the value of the assets) will be compounded for your children and grandchildren (or other remainder beneficiaries) and pass to them — free of gift and estate tax — when the trust ends, or when each tier ends.
Part of the significant advantage of the testamentary CLUT is that it allows discounted gifts to family members – i.e., gifts with substantial valuation discounts. Under present tax law, the value of a gift is determined at the time the gift is made (i.e., at your death or the death of the surviving spouse).
Because the family members who are the remainder beneficiaries must wait for the charity’s income term to expire, the present value of that remainder interest is discounted for the time cost of waiting. In other words, the tax value of the gift is reduced because the value of the gift is decreased by the value of the annual income interest donated to charity. If the term of the trust (or at least the 3rd tier of the trust) is long enough, the value of the remainder interest can sometimes be reduced to zero or close to zero.
