Presented by:
Warner Center Estate and Tax Planning Counsel
on
November 7, 2001

Speaker:

Philip S. Magaram, Esq.
Valensi, Rose, Magaram, Morris & Murphy, PLC
2029 Century Park East, Suite 2050
Los Angeles, CA 90067
(310) 277-8011

The information contained herein is for purposes of discussion only. It should not be relied upon as the basis for decision- making. Counsel should be consulted before taking any action or inaction in reliance on this information.

CHARITABLE LEAD TRUSTS (CLTs)

1. CLT Overview
   1. Defined

      A CLT is an irrevocable trust that provides for annual payments (the lead interest) to a qualified charity for a specified period of time, after which the remainder reverts to the grantor or passes to named beneficiaries (can be a trust).

   2. Two Types of CLTs
      1. Charitable lead annuity trust (CLAT) - pays a guaranteed annuity to a qualified charity (i.e., $100,000 per year).
      2. Charitable lead unitrust (CLUT) - pays a fixed percentage of the fair market value (FMV) of the trust, determined annually, to a qualified charity (i.e., 7% of the then value of the trust).
   3. Either type of CLT (a CLAT or a CLUT) can be set up intervivos or at death.
   4. Either type of CLT (a CLAT or a CLUT) can be a "grantor" lead trust or a non?grantor lead trust.
   5. Term
      1. May be for a Term of years or for the life or lives of designated individuals in being or a combination of the two. However, only the lives of the grantor, the grantor's spouse, and lineal ancestors of remainder beneficiaries may be used. Regs 20.2055-2(e) and 25.2522(c)-3
      2. There is no limit on the length of the Term.
   6. Payout Rate
      1. No minimum or maximum Payout Rate for either a CLAT or a CLUT.
      2. Payments are periodic, i.e. a monthly, quarterly, etc., but must be at least annually.
   7. Additions - May not make additions to a CLAT but can add to a CLUT.
   8. Private Foundation Rules Apply to CLTs
      1. Charitable lead trusts are subject to the private foundation rules set forth in Internal Revenue Code 4941 (relating to taxes on self?dealing), 4943 (relating to taxes on excess business holdings), 4944 (relating to investments which jeopardize charitable purpose) and 4945 (relating to taxes on taxable expenditures). Anyone drafting a charitable lead trust instrument or administering its provisions must have some familiarity with these rules.
      2. IRC 508(e) requires the CLAT to instrument to include provisions prohibiting the CLAT from:
         1. Engaging in any act of self?dealing (as defined in 4941(d));
         2. retaining any excess business holdings (as defined in 4943(c);
         3. making any investment which subjects the organization to taxation under 4944 (relating to investments which jeopardize charitable purpose); and
         4. iv) making any taxable expenditure (as defined in Section 4945(d)).
            
            Failure to include these provisions will result in disallowance of the charitable deduction otherwise allowed under income, gift or estate tax laws. I.R.C. 508(d)(2).
      3. IRC 4943 (relating to taxes on excess business holdings), and 4944 (relating to investments which jeopardize charitable purpose) will not apply to a CLT if the value of the lead interest does not exceed 60% of the trust's value. See PLR 8241098.
         1. For this exception to apply, (a) all income must be paid to charity during the lead term and (b) the trust must have only non-charity remaindermen.
         2. By way of example, assume A owns 100% of C, A's wholly-owned corporation. At the time of the gift, the C stock has a FMV of $5 million. A establishes a CLT by transferring his entire interest in C. The CLT terms are establish such that the lead interest is worth $3 million. Because the lead interest does not exceed 60% of the trust's value, neither of Section 4943 nor 4944 will apply to the CLT. As a result, the CLT need only be concerned with the prohibitions on self?dealing and taxable expenditures.
   9. Grantor Lead Trusts - An income tax charitable deduction is allowed for the interest passing to charity if the CLT is a grantor trust (GT) for income tax purposes. I.R.C. 170(f)(2)(B).
      1. If the CLT is a GT, the grantor is taxed on all items of income, gain, loss, deduction, and credit attributable to trust assets. See I.R.C. 671?679.
      2. The grantor of a CLT that is a GT is accelerating an income tax charitable deduction into the current taxable year and deferring taxable income to later years.
      3. The grantor's final income tax return may have to recapture part of the income tax charitable deduction if the trust loses its GT status because of the grantor's death or the termination of the powers that caused the trust to be a GT. Reg. 1.170A?6(c)(4).
      4. Only an intervivos CLT can be a GT.
      5. This outline will deal primarily with non-grantor lead trusts as they are much more common.
   10. Intervivos Non-Grantor CLTs
       1. Income Tax - No income tax charitable deduction but the CLT can still qualify for the gift tax charitable deduction.
       2. Benefits to Grantor -
          1. Reduction of grantor's taxable estate.
          2. Removal of the income earned by the CLT from the grantor's taxable income. This is similar to a 100% charitable deduction.
          3. Grantor makes a taxable gift equal to the value of the remainder interest. Since the remainder interest is deferred for the Term of the CLT, it is discounted.
             
             (1) The I.R.C. 7520 valuation tables determine the "IRS Rate" used to determine the discount and may have the effect of overvaluing the lead interest passing to charity. For example, the IRS Rate for November 2001 is 5%. If the CLT actually earns more than 5% per annum, the lead interest is overvalued.
             
             (2) If investment performance (income and gain) exceeds the IRS Rate, the excess will pass to remainder beneficiaries.
   11. Selection of Trustee
       1. While technically, a grantor can act as trustee of his CLT if he only has routine administrative powers, it is not recommended. If the grantor, as trustee, retains the power to designate the beneficiaries (charitable and/or remainder), the trust will be included in the grantor estate under 2036 or 2038.
       2. Family Members as Trustees - Generally all right to name family members, but should not name spouse.
       3. Safest to appoint a disinterested trustee - grantor's good friend, CPA or attorney. Such a trustee can have the power to sprinkle the lead payments among a class of qualifying charitable beneficiaries.
   12. Selection of Beneficiary
       1. A grantor may use his private foundation as the charitable organization to which the charitable lead interest is paid.
       2. Caution should be used when the grantor's private foundation has the lead interest. If the grantor of the CLT is also a member, director, or officer of the private foundation, the entire corpus of the charitable lead trust may be included in the grantor's estate under 2036(a)(2). By acting as a member, director, or officer of the private foundation, the grantor is treated as having retained the ability to select the beneficiary of his charitable gift. To avoid inclusion under 2036(a)(2), amounts paid to the private foundation should be segregated in a manner which precludes the grantor from participating in management or distribution of those funds. See PLR 9532027.
       3. Alternatively, a Donor Advised Fund at a Community Foundation can receive the lead interest and the Grantor can recommend the charitable beneficiaries.
   13. Income Taxation of Grantor
       1. No income tax charitable deduction for a non-grantor CLT.
       2. If CLT is a GT, then grantor gets an income tax charitable deduction for the present value of all future payments to charity.
       3. Deductible Limit - Contributions to a CLT are considered made "for the use of" rather than "to" a charitable organization. Regs 1.170A?8(a)(2). Therefore, they are subject to a limitation of 30% of the grantor's contribution base or 20% in the case of long term capital gain property where the charity is a non?operating foundation. IRC 170(b)(1)(D)
       4. Carryover of Excess Contributions - Generally five year carryover but see PLR 8824039 setting forth the view that there is no carryover for contributions "for the use of" charity as exists in a CLT. The IRS position has been widely criticized.
   14. Income Taxation of Non?Grantor CLT
       1. A non-grantor CLT is not considered a tax exempt organization. Instead, a non-grantor charitable lead trust is treated as a complex trust and taxed under the rules found in IRC 661 et seq.
       2. Subject to limitations found in IRC Section 681, a non-grantor CLT may deduct from gross income the amount paid to charitable organizations during the year. IRC 642(c). A CLT is not subject to the AGI or taxable income limitations applicable to individuals or corporations, respectively. As a result, a charitable lead trust can deduct 100% of the charitable contributions made from gross income, but such deductions can not be used to create a loss.
       3. IRC 681 limits the deductibility of charitable contributions made by a CLT from UBTI.
          1. Contributions made from UBTI are limited to 50% or 30%, depending upon the character of the charitable recipient.
          2. To maximize the deduction allowed under IRC 642(c), some have recommended inclusion of a tier system within the governing instrument. Under this tiering approach, charitable payments would be deemed made from the following types of income, in the order presented:
             (1) first from ordinary income that is not UBTI;
             
             (2) then from 50% or 30% of the CLT's UBTI;
             
             (3) then from capital gain;
             
             (4) then from the remainder of the CLT's UBTI;
             
             (5) then from tax exempt income, and
             
             (6) then from trust corpus.
          3. Reg. 1.681(a)-2(b) provides a scheme for allocating the 642(c) deduction between UBTI and other types of trust taxable income. It is therefore questionable whether a tiering system will work. IRS has announced it will not respect tiering systems unless they offer "substantive economic affect" independent of tax consequences. See PLR 8727072.
       4. The governing instrument should include provisions which allocate all depreciation, amortization, and depletion deductions to the trust. In the absence of such provisions, depreciation, amortization, and depletion deductions will be allocated between principal and income. See Reg. 1.642(e)-1.
   15. Testamentary CLTs
       1. Works similarly to intervivos CLTs.
       2. Often there is a formula in the decedent's will or trust that sets up a zeroed out CLAT. This can be done by setting the Term at, for example, 20 years and having the formula determine the Payout Rate necessary to zero out. Alternatively, the Payout Rate can be set at, for example, 8% and having the formula determine the Term necessary to zero out.
       3. If there is to be generation skipping, then a CLUT is usually used with a formula providing that the remainder value will equal the decedent's remaining GSTT exemption. For example, the decedent can provide for a Payout Rate of 7% and a Term of 20 years. Sine the decedent will not know what the IRS Rate will be, the formula can fund the CLUT with the amount of assets so that the value of the remainder interest equals the decedent's remaining GSTT exemption.
       4. Decedent's estate entitled to an estate tax charitable deduction. IRC 2055.
       5. Estate taxes cannot be paid from a CLT after the funding of the trust since such payment would be for a non-charitable purpose.
       6. Since a testamentary CLT will rarely be funded at the date of death, there are issues with valuation, the timing and amount of payments to charity, etc., but they are beyond the scope of this outline.
   16. Intervivos vs. Testamentary CLTs.
       1. The intervivos CLT reduces the time the remaindermen must wait to enjoy the remainder, assuming an identical CLT is set up at death. Likewise, the charity benefits sooner.
       2. If a CLT is not zeroed out, the gift tax on the remainder interest may be less than the estate tax. Furthermore, if the gift is made more than three years before death, any gift tax paid is not part of the decedent's estate.
       3. An intervivos CLT is done with known actuarial tables and IRS Rates whereas the IRS Rates and the law can change.
   17. CLAT vs. CLUT
       1. Use a CLAT in inflationary times to benefit remainderman.
       2. Use a CLAT to avoid annual appraisals of difficult to value assets.
       3. Use a CLUT if grantor wants to add assets to the CLT in lieu of setting up another CLT.
       4. Use a CLUT if generation skipping is involved.
       5. Use a CLUT if more interested in benefitting charity.
       6. Compare rate sensitivity. See Exhibits A, C and D.
2. Observations - The intervivos non-grantor CLAT
   1. Who would use it and why?
      1. A grantor who wants to zero out the value of the remainder interest because he has no remaining exemption amount or because he does not want to use his exemption amount, preferring instead to save it for other gifts or to use it at death - see Chart of Sensitivity attached as Exhibit A that shows the Term and Payout Rate to zero out a CLAT.
      2. A grantor who wants to benefit charity.
      3. A grantor who anticipates that the CLAT investment performance will exceed the IRS Rate. See Chart of Applicable Federal Mid?Term 120% Annual Rates attached as Exhibit B that shows the IRS Rate over time.
      4. A grantor who wants to maximize the benefit to the remainder beneficiary in inflationary times (because the payments to charity do not change).
      5. A grantor whose charitable giving exceeds the percentage limitations on deductions.
      6. Example: G has child C, age 25. G wants C to get $1,000,000 at age 40. G sets up a CLAT in November 2001 for a Term of 15 years and funds it with $1,000,000 of low basis publicly traded stock that he thinks will appreciate at 10% per year. The CLAT will pay $96,340 ($1,000,000 x 9.364%) to charity at the end of each year for 15 years, at which time C will get whatever remains in the CLAT. Per the Chart of Sensitivity attached as Exhibit A, the gift to C is valued at zero and the charity will get a total of $1,445,100 ($96,340 x 15). The IRS Rate for November 2001 presumes that CLAT investments will earn only 5% regardless of how much is actually earned and therefore if only 5% is earned there will be nothing left to distribute to C. If the trust earns 9.634% per year or more, C will receive at least $1,000,000.
   2. Funding the CLAT
      1. The Grantor should fund the CLAT with low basis assets and the CLAT should sell off only enough assets to pay the guaranteed annuity to charity. This presumes that the Grantor has low basis assets that should be held for the Term of the CLT.
      2. Example: Using discounting techniques:
         G owns Blackacre free and clear, but subject to a 20 year triple net lease. The lease produces income of $60,000 per year. Blackacre has a FMV of $1,000,000. If G establishes a CLAT by contributing Blackacre, the gift will be valued at $1,000,000. What if G establishes two CLAT's, one for each of C1 and C2, and contributes 50% of Blackacre to each. If an appraiser determines that a 20% discount applies to each fractional interest, the amount of the gift is reduced to $800,000, $400,000 for each one-half interest. What if G instead, contributes Blackacre to a limited partnership (LP) in exchange for a 1% general partnership interest, and a 99% limited partnership interest which he uses to fund two CLATs each receiving a 49.5% limited partnership interest? If a 40% discount is applied to each 49.5% limited partnership interest, the value of each gift falls to only $300,000. The use of discounting will permit the CLAT to be zeroed out in a shorter Term but with the same guaranteed annuity payment to charity as follows:
         
         

         	FMV	Income as a Percent of FMV	Payout Amount	PayoutRate	Approximate Term to Zero Out
         Gift of Blackacre	$1,000,000	6%	$60,000	6%	36?37 years
         Two gifts each of 50% of Blackacre	$800,000	7.5%	$60,000	7.5%	22?23 years
         Two gifts each of 49.5% of limited partnership interests in LP	$600,000	10%	$60,000	10%	14?15 years

   
   
   
3. Type of Property that can be Contributed to or Held by a CLT
   1. Can be income or non-income producing, tangible or intangible, appreciated ordinary income property or capital gain property.
   2. Mortgaged property and real estate
      1. Mortgaged property can be transferred to a CLT - but beware of unrelated business taxable income (UBTI) problems for acquisition indebtedness. IRC 514, See PLR 7808067 which held no UBTI on mortgaged real property transferred to a CLAT where the mortgage was placed on the property more than 10 years prior to the transfer.
      2. If the indebtedness exceeds basis, may be gain on the transfer to the CLT. Regs 1.1001-2
   3. Can hold tax-exempt securities
   4. From the standpoint of the remaindermen, ideal to have property that produces income and appreciation in excess of the Payout Rate.
   5. High basis vs. low basis property
      1. If low basis securities are contributed, can sell off the securities so that the income and gain matches the IRC 642(c) charitable deduction for the year.
      2. Planning Opportunity. When the CLT terminates, distribute the remaining low basis assets to an intentionally defective GT for a term long enough to permit the grantor to purchase the low basis assets from the trust.
4. GSTT Implications
   1. The generation skipping transfer tax (GSTT) is imposed on transfers to persons two or more generations below the grantor, i.e. skip persons, at a flat rate equaling the maximum federal estate tax rate.
      1. GSTT Exemption - IRC 2631 provides for a $1,000,000 lifetime exemption from GSTT, which is applicable to all types of taxable generation-skipping transfers. The exemption is currently indexed for inflation so the amount available in 2001 is $1,060,000.
      2. A transfer to a skip person at the expiration of the Term of a CLT is a "taxable termination" for purposes of imposing GSTT.
      3. There are different rules for allocating GSTT exemption for CLATs and CLUTs.
   2. Inclusion Ratio
      1. As a general rule, the Inclusion ratio for GSTT purposes is 1 less the so-called "applicable fraction". If the applicable fraction equals 1, the transfer will be completely exempt from the GSTT; a fraction equal to 50% will expose one-half of the trust assets to the GSTT.
      2. CLAT Inclusion Ratio - IRC 2642(e) provides a special rule for determining the applicable fraction for a CLAT.
         1. The numerator of the fraction represents the future value of the allocated IRC 2631 exemption based on the IRS Rate used in determining the charitable deduction, and the denominator is the projected actuarial value of the trust at the expiration of the Term.
         2. This concept can be expressed as follows:
            
            1 - Adjusted GST exemption = Inclusion ratio Termination value
         3. The trick is to forecast how much an initial transfer will be worth at the end of the term.
         4. If investment earnings are higher than projected, the end result will be a termination value that exceeds the adjusted GST exemption. That is, the inclusion ratio will be greater than zero when principal distributions are made to skip persons, resulting in the imposition of the GSTT at the end of the Term.
         5. On the other hand, lower investment earnings will not only result in an over-allocation of the GSTT exemption, but also may significantly deplete the trust principal available for distribution to the remainderman. Thus, a small variation in earnings will have a greater impact on the termination values as the length of the Term increases.
         6. Since the CLAT requires the use of various assumptions that cannot be precisely predicted, the grantor should be advised that a fair amount of uncertainty exists in determining the IRC 2631 exemption allocation. For this reason, the grantor may want to consider a CLUT when GSTT is an issue. The exemption analysis and calculation with respect to GSTT are far easier to perform with a unitrust.
      3. CLUT Inclusion Ratio - The general rule of IRC 2642(a) applies when determining the inclusion ratio for a CLUT. That is, 1 minus the applicable fraction equals the inclusion ratio. With a unitrust, the numerator of the applicable fraction is the actual amount of the IRC 2631 exemption allocated and the denominator is the amount of the transfer less the value of the interest transferred to charity. Consequently, a CLUT can be structured so that it will pass GSTT free at the termination to skip persons. However, since a CLUT can never be zeroed out, the remainder interest will be subject to gift or estate tax at the time of the initial trust transfer.