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Death & Taxes: A Twist on the Testamentary Charitable Lead Annuity Trust

by Randy A. Fox & Dan Rice


A constant theme in dealing with high net worth clients is the desire to fully eliminate estate taxes at the death of the last survivor. While this has become somewhat easier because of the higher exemption amount, it is still a challenge for those with “taxable” estates. This is especially true when clients insist on controlling as much of their wealth as possible while they’re still living.

One strategy that is often discussed and considered is the testamentary charitable lead annuity trust (TCLAT). Generally, the TCLAT receives whatever assets remain in the estate above the exemption amount and, by a formula computation, send an amount to charity for a period of years and bring the remainder back to the children at the end of the period and leaving a “zero” includable amount in the estate. The major issue with this strategy is that because of the way the trust must be computed to achieve a zero estate inclusion, the length of time for children to receive the remainder (if indeed any reminder is left), can be quite long.

One of the purposes of most inheritances is to allow heirs to benefit sooner rather than later. However, it is not unusual to see a TCLAT formula where the period of years is as long as twenty-five or even thirty. This can be a source of disappointment and unanticipated tension between parents and heirs.

The challenge, then, is to find a solution that satisfies the desire to totally eliminate estate taxes and to transfer the wealth to heirs in a more reasonable time frame.

Charitable Lead Trusts in a Nutshell

In a Charitable Lead Trust (CLT), the charity leads off by receiving an income interest for a certain period of time, and then the noncharitable beneficiaries receive the remaining trust principal. A qualified CLT will meet the various IRC requirements for deductibility of the lead interest for federal estate, gift and income tax purposes.

The charity may receive an annuity payment, through the Charitable Lead Annuity Trust, or a unitrust payment through the Charitable Lead Unitrust. An annuity payment is the right to receive a specified amount from the trust each year that does not change. A unitrust payment is the right to receive a specified percentage of the trust assets each year that will vary from year to year.

A CLT is not exempt from federal income tax. A grantor CLT treats the donor as the owner for federal income tax purposes and the donor is taxed on all of the income of a grantor CLT. A non-grantor CLT is taxed as a complex trust for income tax purposes. However, a non-grantor CLT receives an unlimited charitable income tax deduction for the annuity or unitrust payments made to charity each year.

Citations of authority for Charitable Lead Trusts begin on page 6.

Testamentary Non-Grantor Charitable Lead Annuity Trust

Briefly, this philanthropic estate planning strategy is a testamentary method for transferring specific assets to the children tax free, while supporting charitable organizations or funding a family foundation (or Donor Advised Fund), through a testamentary Non-Grantor Charitable Lead Annuity Trust (T-CLAT). Typically, the plan becomes operative upon the death of the surviving spouse.

Not surprisingly, children are often adversaries of the T-CLAT. Imagine children as expectant heirs and think of their disappointment when they discover that their parent’s estate will be placed in a T-CLAT for a decade before the children finally get the trust assets. Is there a way to turn delayed CLATification into instant gratification and to allow the children to become advocates of their parents using the T-CLAT?

Let’s consider the following steps:

  1. Step 1. Create a T-CLAT now. After the donor’s life, the Trust is funded. The Trustee can decide the Trust term and payout rate to the charitable organizations. Depending upon the Trust term and payout rate, estate taxes can be significantly reduced or eliminated. After the Trust term, the trust assets pass to the children. If the Trust income went to a Donor Advised Fund or Family Foundation to be used as Trust principal and additions to principal, the charity may continue to operate, using the T-CLAT annuity income it received.

  2. Step 2. The parents grant an option for $2,500 to each child. Each child now owns an option to purchase an equal share of the selected assets (option assets) from the surviving parent’s estate. The options are usually exercisable for 9 months from the date of the death (the option period). The option can be exercised, during the option period, to purchase an option asset at its fair market value (see Private Letter Rulings 201448031, 201448028, 201448027, 201448025, 201448023, 201445017, 201129049, 200927041, 200722029, 200024052, 199930048, 199924069 and 9724018).

Comment. In certain situations, there is no need for the parents to sell options to the children because they will have similar arrangements under customary business succession plans (i.e., pursuant to buy/sale agreements for closely-held businesses, partnerships and limited liability companies. See Private Letter Rulings 200207028 and 200207029).

  1. Step 3. Each child may exercise their option and purchase the option assets with cash (perhaps from insurance proceeds), or with an installment note (a collateralized balloon payment type), or a combination of these two. When promissory notes are used to purchase the option assets, they must bear interest at the applicable federal rate for such notes, determined under IRC §1274(d), and they should be secured by the option asset purchased or an amount acceptable to the seller (see Private Letter Rulings 201448031, 201448028, 201448027, 201448025, 201448023, 201445017, 201206019, 201129049, 200927041, 200722029, 200124029, 200232033, 200233031, 200635015, 200635016 and 200635017).

Comment. The options would bind the current and successor executors and trustees of the surviving parent’s estate, and if the option assets are distributed to the T-CLAT, the options will apply to the option assets of, and will bind the trustees of, the CLAT.

  1. Step 4. The CLAT term will end before the Promissory Note balloon payment is due. The Note will pass to the children, who will then simply tear it up and no balloon payment will ever have to be made.

* Also, see page 6 below regarding the benefits of transferring a promissory note to an LLC and subsequently transferring non-voting LLC units to the T-CLAT, instead of transferring a promissory note directly to the T-CLAT.

Comments regarding the Self-Dealing Rules that Govern the T-CLAT

Like Private Foundations, the CLT is governed by the self-dealing rules under IRC §4941. Certain exceptions to the general rules can be found under Section 53.4941(d)-1(b)(3) of the Foundation and Similar Excise Taxes Regulations. This Section excepts certain transactions carried out during the administration of an estate (“the Estate Administration Exception”) from the definition of self-dealing. Specifically, Section 53.4941(d)1(b)(3) provides that the term “indirect self-dealing” shall not include a transaction with respect to a private foundation’s interest or expectancy in property (whether or not encumbered) held by an estate or revocable trust (including a trust which has become irrevocable on a grantor’s death), regardless of when title to the property vests under local law, if:

(i) The administrator or executor of an estate, or trustee of a revocable trust either — (a) Possesses a power of sale with respect to the property, (b) Has the power to reallocate the property to another beneficiary, or, (c) Is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust); (ii) Such transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate (or trust), or over the private foundation); (iii) Such transaction occurs before the estate is considered terminated for Federal income tax purposes pursuant to paragraph (a) of section 1.641(b)-3 of the regulations (or in the case of a revocable trust, before it is considered subject to section 4947 of the Code); (iv) The estate (or trust) receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust); and (v) With respect to transactions occurring after April 16, 1973, the transaction either — (a) Results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up, (b) Results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or (c) Is required under the terms of any option which is binding on the estate (or trust).

Planning Opportunities

Life Insurance

Typically, life insurance is a common component in many estate plans. Suppose your client previously bought life insurance years ago to pay future estate taxes. However, since the life insurance purchase, the client’s estate is much larger today and the insurance coverage now needed is unavailable because it’s too expensive or the client is uninsurable. The client’s estate can sell the children all of the assets, which will have a step up in basis, in exchange for an interest only promissory note. The children can pay the interest payments to the T-CLAT using the insurance proceeds and/or the investments earned on the insurance proceeds, rather than using the insurance to pay estate taxes.

Another life insurance option would be to buy only enough life insurance to cover the promissory note interest payments, rather than to buy enough life insurance to pay higher estate taxes.

If purchasing life insurance seems to be a more simple straightforward approach for handing the Promissory Note (discussed below), the client may want to consider 1 of 2 approaches below.

  1. Purchase a 9 year term life insurance policy.

  2. Purchase a term life insurance policy for, say, a 20 year term that also has a convertible-to-permanent life insurance feature in the policy (which does not require a new medical exam prior to the conversion). After the first 9 years, the client can sell the policy under a Life Settlement arrangement that may enable him to not only recover all the prior 9 years of premiums but also a significant percentage of the face amount, making it compare quite favorable to other types of investments.

Structuring a plan to create a Life Settlement, using term insurance with a convertible-to-permanent life insurance benefit is a very common practice today among sophisticated insurance advisors.

Promissory Note from Intentionally Defective Irrevocable Trust

If the intentionally defective irrevocable trust (IDIT) promissory note drops into a T-CLAT, you may have to go to court to reissue the notes, to avoid self-dealing problems longer term. Why? Under the self-dealing rules, a promissory note with a disqualified person, that is transferred into a T-CLAT (or private foundation, or any trust governed by the private foundation rules), even though the promissory note pre-existed the T-CLAT, creates a self dealing problem, unless you go to court to swap the note out for a new, identical note.

Is a T-CLAT funded with a promissory note of any real benefit over simply using a private foundation, or an outright gift to a public charity, or a public charity’s Supporting Organization created for the donor? If the children purchase the estate assets from a private foundation with a promissory note, the interest payable on the note will be the applicable federal rate (AFR) under IRC §1274(d). However, the T-CLAT interest rate is the IRC §7520 rate, which is 120% of midterm AFR and is almost always higher than even the long-term AFR. The T-CLAT would be designed to only earn the AFR from the note, but the interest rate applicable to the charitable payout would be the IRC §7520 rate, which is higher. So most T-CLATs funded with such notes would actually run out of money before the end of the term. Therefore, in many cases, a private foundation, or an outright gift to a public charity, or a public charity’s Supporting Organization created for the donor, has the same economics for the family.

There is the possibility of discounting the note values, by comparing the IRC §7520 rate at time of death versus at the time the IDIT note was issued, etc., so the analysis is very much case-by-case.

*Transfer Promissory Note to LLC Prior to Testamentary Funding of CLAT or Private Foundation and Transfer Non-Voting LLC Units to CLAT or Private Foundation

See PLRs 201446024, 201723005 and 201723006.

Citations of Authority

Income tax charitable deduction — Only allowed if all the income earned by the trust, including the income paid to the charity is taxable to the donor; and, the charity’s interest is a guaranteed annuity or unitrust interest. IRC §170(f)(2)(B); Reg. §1.170A-6(c)(2). The charitable deduction substantiation rules do not apply to charitable lead trusts. Reg. §1.170A-13(f)(13).

Ceiling on deduction — 30% of adjusted gross income, with a 5-year carryover for any excess. IRC §170(b)(1)(B). Different rules may apply when the lead interest beneficiary is a non-operating private foundation. IRC §170(b)(1)(D).

If the donor ceases to be treated as the owner before the trust terminates, the deduction is recaptured. IRC §170(f)(2)(B).

Capital gain:

Reversionary interest — Donor is taxed on the gain in year realized by the trust.

Non-reversionary interest — Trust is taxed on the gain in year realized by the trust.

Gift and estate tax — To avoid gift and estate tax on the charity’s income interest, the interest should be a guaranteed annuity or unitrust interest. IRC §§2522(c)(2)(B) and 2055(e)(2)(B); Reg. §§25.2522(c)-3(c)(2) and 20.2055-2(e)(2); Rev. Rul. 77-300, 1977-2 CB 352. Also, some commentators state that Rev. Rul. 82-128, 1982-2 CB 71, dealing with charitable remainder trusts, could also apply to charitable lead trusts.

Generation-skipping tax — There is no generation-skipping tax on the remainder to a grandchild whose parents are not living on the trust’s creation; nor for the remainder to a grandnephew or grandniece if the parents are not alive at the trust’s creation and the trust grantor has no lineal descendants. IRC §2651(e).

Treasury table citations for computing value of charity’s lead interests: Unitrusts — Reg. §§1.664-3(d) and -4; IRS Pub. 1458.

Annuity Trusts — Reg. §§1.664-2(c) and 20.2031-7; IRS Pub. 1457.

Federal midterm rates — IRC §7520; Reg. §§1.7520-2, -3.

When Treasury-issued actuarial tables are disregarded — Reg. §§1.7520-3(b); 20.7520-3(b) and 25.7520-3(b).

IRS Sample Forms for Inter Vivos CLAT: Rev. Proc. 2007-45

Issued: Friday, June 22, 2007

IRS Sample Forms for T-CLAT: Rev. Proc. 2007-46

Issued: Friday, June 22, 2007

IRS Sample Forms for Inter Vivos CLUT: Rev. Proc. 2008-45

Issued: Friday, July 28, 2008

IRS Sample Forms for Testamentary CLUT: Rev. Proc. 2008-46

Issued: Friday, July 28, 2008

Contact Two Hawks Consulting to determine if Testamentary Charitable Lead Annuity Trust (TCLAT) might be an option for you.


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