28 May 2020

Qualified and Nonqualified Charitable Lead Trusts

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The inflation adjustment of the unified gift and estate tax exemption to $5.43 million, coupled with a low interest rate environment, opens the door to yet another year for creating a qualified charitable lead trust (CLT) to transfer wealth to family and charities. For existing CLTs, the continued strong performance of the capital markets should compel trustees to evaluate the usefulness of commuting the charitable interest. Not only do CLTs continue meriting serious consideration, but also there may be planning opportunities for nonqualified CLTs benefiting non-lineal heirs, especially for owners of highly appreciating assets generating no immediate or small income. 

Opportunities With Qualified CLTs 

The qualified CLT offers philanthropic clients a way to do good and transfer assets to family members with reduced transfer tax cost. In designing a qualified CLT, the planning goal is to zero-out so that there’s no taxable gift to the remaindermen. Because the gift and estate exemption is near historic highs, a donor may be willing to incur a taxable gift to the remaindermen. The amount of the taxable gift likely generates no immediate gift tax but will draw down the exemption.  

The payment to the charity must be expressed as a fixed percentage of the initial amount of trust (annuity amount) or as a fixed percentage of its annual value (unitrust amount). The duration of the payments may be for a fixed term of years or permitted measuring lives. The amount of the taxable gift from the remainder interest is determined by a combination of the duration and amount of the charitable payments, as well as the Internal Revenue Code Section 7520 rate.

Opportunities With Nonqualified CLTs 

Income tax consequences. A nonqualifying non-
grantor CLT provides for payment of the net income from the trust. Because the payment to the charitable beneficiaries is neither a unitrust nor annuity trust amount, the trust isn’t qualified.  The donor to the charitable income trust receives neither an income tax nor a transfer tax deduction. Notwithstanding these tax disincentives, such a nonqualified trust has a powerful income tax-related advantage. Because the 
nonqualifying CLT can be non-grantor for federal income tax purposes, the donor isn’t taxed on the income earned from it. The net effect to the donor is as if he received a full charitable deduction, even if he previously exceeded his adjusted gross income (AGI) limits. That could be the case if the donor has contributed cash or appreciated property to a private foundation whose limits are respectively 30 percent and 20 percent of AGI. 

Its other advantage arises from the flexibility in the choice of funding asset. The ability to fund a CLT with a highly appreciated asset with additional growth potential but insufficient income is possible. Because the charitable income trust isn’t required to pay out an annuity or unitrust amount, the trust isn’t compelled to sell all or a portion of such an asset.

Estate and gift tax consequences. Because the charitable lead income trust is nonqualified, there’s no gift or estate tax deduction for the charitable interest at the time of funding. To avoid consuming the unified exemption, the donor should retain the power to determine annually the charitable beneficiary.

Because the charitable lead income trust is likely to be funded with illiquid assets, it’s critical that the charitable income beneficiary still have a “degree of beneficial enjoyment” within the meaning of the regulations under Section 7520. 

Appeal of Lead Trusts: Even a doubling of the Section 7520 rate from 2 percent to 4 percent in the near future won’t dramatically diminish the utility of qualified CLTs. While Congress can always reduce the gift and estate exemption as part of a revenue-raising bill or even a revenue-neutral tax reform, CLTs remain attractive. The nonqualified, non-grantor charitable income trust merits study to benefit heirs, such as nieces and nephews who aren’t family members within the meaning of IRC Section 2702(c)(2).  

Click here to access the full article n WealthManagement.com

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