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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 1 - The Traditional Tax Free Approach
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Case:
Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly tries class action lawsuits against large, multinational corporations. As a result of the high stakes and high dollar amounts involved, it is not uncommon for a jury to award a judgment of over $100 million. In fact, Lynn is among a select group of attorneys with ten or more successful $100+ million judgments. Accordingly, Lynn is an extremely wealthy woman. In addition to her salary, her firm represents most class action lawsuits on a contingency basis. In other words, the firm receives between 15% and 40% of any favorable judgment (plus costs). As a result, the firm's share of a victory is very substantial.
Recently, Lynn won a major trial against a financial institution. The jury awarded her clients $20 million, and the firm's share was approximately $6 million. As a result of the successful conclusion, Lynn received a $1 million bonus. While extremely pleased with this large bonus, Lynn shudders at the thought that over $400,000 would go to Uncle Sam.
In addition to this year's bonus, Lynn regularly earns about $500,000 a year, which places her in the highest federal and state income tax brackets. Not surprisingly, Lynn desperately wants to minimize her tax liability. She therefore meets with her tax advisor Frank Thomas to discuss her options.
Lynn's primary goals are tax reduction and some basic retirement planning. Lynn is also open to charitable giving if it can help her accomplish her primary goals. Lastly, because Lynn receives a large annual salary, she does not have any immediate need for the $1 million bonus.
Question:
What plan may accomplish Lynn's goals? Does it fit within her parameters? What are the upsides and downsides to the plan?
Solution:
Frank suggested that Lynn fund a Grantor Charitable Lead Annuity Trust (CLAT) for a period of 10 years with the $1 million bonus. The payout rate on the trust would be 5% or $50,000 per year which would be payable to her favorite charities. The creation of such a trust would produce a charitable income tax deduction of approximately $400,000. With adjusted gross income of $1.5 million this year (bonus plus salary), Lynn may deduct up to $450,000 or 30% of AGI this year. Therefore, assuming a combined tax rate of 40%, Lynn would save $180,000 in taxes!
Since this would be a grantor trust for income tax purposes, Lynn would be taxed on all the trust income. However, if the trust investments were municipal bonds (which are exempt from federal taxes), then all the income from the trust would be tax-exempt income. This tax-free investment decision would allow Lynn to avoid any taxable phantom income problem during the trust's ten-year term.
Frank further explained that at the end of the ten-year term the trust assets would return to Lynn. The $1 million original contribution may rise or fall depending on investment performance. The return of a significant portion of the $1 million would provide Lynn with a wonderful retirement nest egg. The money could be invested for future use or accessed immediately if Lynn so desired. Again, the CLAT provided Lynn with great flexibility. Finally, $500,000 would be distributed to Lynn's favorite charities. She was amazed at this enormous additional benefit.
In the end, Lynn was completely happy with Frank's plan. She would cut her tax liability significantly, retain flexibility over much of her wealth and contribute a generous gift to her favorite charities. While always philanthropic, Lynn's CLAT would make her a major donor overnight, a title that brings a very warm smile to her face.
Editor's Note: A grantor charitable lead annuity trust produces a charitable income tax deduction equal to the present value of the charity's income interest. When computing the present value, an applicable federal rate must be used pursuant to Section 7520. With CLATs, the lowest AFR produces the largest charitable income tax deduction.
Tax tip: Even though cash was contributed to the CLAT, the 30% of AGI limitation applied. Although cash-type gifts normally qualify for the 50% of AGI limitation, charitable lead trusts are an exception to the rule. For further explanation of this exception, see GiftLaw Pro Chapter 3.5.2.
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