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

by Randy A. Fox & Dan Rice

Introduction

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.