Thursday April 25, 2024

3.5.1 Family, or Non-Grantor, Lead Trusts

Family, or Non-Grantor, Lead Trusts

Lead Trust Types:   There are two basic types of living charitable lead trusts.

Leveraging the Gift or Estate Exemption:   A lead trust is an excellent means for leveraging the exemption.

Charitable Recipients:   The charity receiving payouts must be qualified exempt and thus able to receive charitable transfers under Sec. 2055 for estate tax or Sec. 2522 for gift tax purposes.

Family Lead Trust Income Taxation:   In contrast to a charitable remainder trust, which is normally exempt from trust income taxation, the lead trust remainder will pass to family.
Vulture Lead Trust Regulations:   Regulations under Secs. 170 and 2055 for lead trusts have been published for living and testamentary transfers created on or after April 4, 2000.

Lead Trust Types

There are two basic types of living charitable lead trusts. These are the grantor lead trust and the non-grantor, or family, lead trust.

The basic requirement for a qualified lead trust is that it must make an annuity or a unitrust payment at least annually to one or more qualified charities. Reg. 20.2055-2(e)(2)(vi). If the lead trust is qualified and makes an annuity or unitrust payment to charity, the donor will qualify for a gift or estate charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).

In contrast to charitable remainder annuity trusts or unitrusts, which must pay out a minimum of 5% and a maximum of 50%, a lead annuity trust or lead unitrust does not have payout restrictions. It may pay as little as 1% or as high as 100%. The percentage used and the duration of the trust will merely produce a smaller or larger charitable deduction for gift or estate tax purposes.

Similarly, there is a wide latitude in selecting the duration for a lead trust. A lead trust may pay to charity for the life of the donor, for a term of years or even for the lesser of a life or a term of years. In contrast with the charitable remainder trust that is limited under Sec. 664 to a maximum of 20 years, a lead trust does not have a limit for a term of years. In some circumstances, individuals have created lead trusts for 30 or 35 years, with remainders to grandchildren at the expiration of that term.

Leveraging the Gift or Estate Exemption

A lead trust is an excellent means for leveraging the exemption. If the exemption for illustration purposes is $11 million and a lead trust funded with $13 million produces a charitable gift deduction of $3 million, the remaining $10 million may be covered by the gift exemption. The $13 million in the lead trust will earn income for the selected term of years and pay the stated annuity or unitrust amounts to charity. At the end of that time, the $13 million plus growth may be transferred to family. Through use of the lead trust, the exemption has effectively been doubled for the benefit of family.

The charitable deduction may be calculated using the Applicable Federal Rate from the current month or one of the two prior months. Sec. 7520(a). Since the payout is fixed with an annuity lead trust, the lower the AFR, the less assumed earnings will accrue to the remainder recipient and the smaller the taxable gift. Since all split interest calculations use an assumed interest or earnings rate to determine the value of the income interest and the value of the remainder interest, the most favorable result for a lead trust is to use a low AFR. For living lead trusts, the optimum time for funding the trust is during a period of low interest rates but good return on equities or real estate in the trust.

Example 3.5.1A

For example, assume that a $1 million annuity lead trust will pay a 7% annuity, or $70,000, to charity for a term of 15 years. Depending upon the Applicable Federal Rate, the taxable gift may vary from just over $160,000 to over $300,000.

AFRPrincipalCharitable DeductionTaxable Gift
3%$1 Million$835,653$164,347
4%$1 Million$778,288$221,712
5%$1 Million$726,579$273,421
6%$1 Million$679,854$320,146

Charitable Recipients

The charity receiving payouts must be a qualified exempt charity and thus be able to receive charitable transfers under Sec. 2055 for estate tax or Sec. 2522 for gift tax purposes. For a family lead trust, since it is permissible to make a gift or estate charitable transfer to a foreign charity, it is also permissible for the distributions to be made to a foreign charity. However, counsel should exercise caution to ensure that the transfer to the foreign charity is limited to exclusively charitable purposes.

It is permissible to retain the power to name the charitable recipients after the trust is created. Normally, this power is not retained by the trust grantor to avoid estate inclusion if he or she passes away prior to the expiration of the lead trust. Sec. 2036(a). However, it is permissible for the children of the trust grantor to select each year the qualified exempt charities. PLR 200029033.

Family Lead Trust Income Taxation

In contrast to a charitable remainder trust, which is normally exempt from trust income taxation, the lead trust remainder will pass to family and is therefore a non-grantor trust taxable under Subchapter J of the Code. As such, it must file Form 1041 and pay taxes on its ordinary income and capital gain.

However, so long as the lead trust does not have unrelated business taxable income, there is an unlimited income tax deduction for distributions to qualified charities. Sec. 642(c). For this reason, it is important to make certain that the lead trust does not have UBTI under Sec. 512, or it will be restricted to a 50% charitable income tax deduction under Sec. 170. See Sec. 681.

Generally, the lead trust is funded with securities. Each year, the interest from fixed income securities and the dividends from stocks are used to pay the annuity or unitrust amounts. Since most lead trusts have a higher payout than the ordinary income from bond interest and stock dividends, a portion of the stock growth is recognized to cover the balance of the required payments. It is very helpful for the trustee if the distribution to charity is an annual payment, since he or she must then sell stock only once per year to make the full payout.

For inter-vivos, or living, family lead trusts, the trust assets must be selected carefully. Normally, since the trust is taxable, it is undesirable to sell, pay capital gain tax on the sale of the asset and then invest after-tax proceeds. Usually, the most favorable economic result is to hold the assets contributed to the trust and attempt to generate the desired annuity or unitrust payout to charity with the income and appreciation of the contributed assets. If there is no diversification of the assets contributed to the trust, the investment risk is greater. This higher risk with an undiversified portfolio must be understood by the lead trust grantor prior to funding the lead trust.

With a testamentary lead trust for family, the step up in basis normally will allow diversification of trust assets. The trustee of the charitable lead trust may then acquire a portfolio designed to produce maximum return. Most trustees create a portfolio that is approximately 60% or 70% equities, with the balance in fixed return securities.

With a living lead trust, the basis of assets is not stepped up for either the trust or family remainder beneficiaries. Therefore, if low basis assets are contributed to the lead trust, the family will eventually receive those assets with a low cost basis. However, it could be possible for family members at that time who desire to sell the assets to use a sale and unitrust combination to zero the capital gain tax upon sale.

Vulture Lead Trust Regulations

Regulations under Secs. 170 and 2055 for lead trusts have been published for living and testamentary transfers created on or after April 4, 2000. The purpose of the regulations was to preclude individuals from using "Vulture Trusts." With a Vulture Trust, the donor searches hospital wards for a person who is likely to die in just over 18 months. The life of this terminally ill person is used as the measuring life, with the children or grandchildren of the lead trust donor as remainder recipients. The regulations require the measuring life for lead trusts to be the donor, a spouse, or a lineal ancestor or the spouse of a lineal ancestor. This expands the beneficiaries to stepchildren and step-grandchildren. In addition, if a contingent beneficiary is not within the lineal descendent category, there is an additional 15% probability test. If there is less than 15% probability that the non-lineal descendent contingent beneficiaries will receive trust corpus, then the lead trust is still valid. Reg. 1.170A-6(c)(2)(ii).

Case Studies on Family, or Non-Grantor, Lead Trusts

Southern Brat Delicious Lead Trust Bailout:   Peter and Sue Olson were raised in the great North Country. After college, they were married, and Peter accepted a position with one of the nation's largest discount stores. He rose through the ranks and finally was promoted to be manager of the New Orleans branch of the store.

A Lead Trust Story with a Charitable Ending:   Rodney Edwards, age 60, is a real estate mogul and owns a number of income-producing properties. One of his prime properties is a 30-unit apartment building valued at $2 million. His net annual income return on the property is $200,000 per year.

A Pledge Fulfilled to Both Charity and Children:   John and Mary Jones own a strip mall that they purchased a number of years ago for $250,000. The property is debt free and currently valued at $1 million. It produces net income from fixed-payment leases of $80,000 per year. Also, John and Mary estimate that the property will continue to grow in value by the rate of inflation over the next 10 years. They do not need the income from this property and are interested in transferring this asset to their children, but they are very concerned about the gift and estate tax consequences. Their combined estate value is $7 million and, therefore, they are in the top estate tax bracket. Their alma mater has recently begun a $50 million capital campaign and they have been challenged to make a gift of $800,000.

The Lead Trust - An Estate Planning Tool for a Down Market:   Howard and Elizabeth Young, both in their late 50s, have been married for 25 years and have four children. Howard has been actively trading in the markets for many years and for the past year and a half has been trading online. He has a diversified and well-balanced portfolio that has done well, but over the last few months the market has turned downward for his particular investments. The portfolio was worth over $1.2 million earlier this year but due to a market downturn, is now valued at $800,000. Howard feels that his portfolio is very solid, as the stock holdings include many blue chip companies. He is very confident the values will recover, so he has no inclination to sell any of the holdings.

Private Letter Rulings

PLR 199915058 Testamentary Lead Trust Reformation Under Sec. 2055(e):   Since many charitable trusts in wills fail to qualify under IRC provisions in effect as of date of death, Sec. 2055(e)(3) permits reformation and qualification of lead and remainder trusts. This 1997 testamentary lead trust required reformation. The reformed trust pays an annuity equal to 9.612% of the initial net fair market value of trust assets for a term of 18 years. While the payout is to a family foundation, there will still be a full charitable estate deduction under Sec. 2055 for the present value of the annuity payouts.

PLR 199952093 Lead Trust Commutation Approved With Full Annuity Payments:   Charitable lead trusts are qualified if they pay an "annuity amount" to a charity. Normally, annuity lead trusts will pay to charity for a term of years and then distribute the remainder to children or grandchildren. If the trustee is very successful in investments, there may be significant aggregation of trust value and the ability to pay the annuity to charity at an earlier date. This would accelerate both the benefit to the charity and the benefit to family.

PLR 200018062 Lead Trust May Hold Limited Partnership Units:   A charitable lead unitrust was created in the husband's estate in 1989. In the wife's 1996 estate, a substantial addition was made to the lead unitrust. The lead unitrust pays charity 8.15% for a term of nine years, with the remainder to children and grandchildren.

PLR 200021020 Trustees May Select Charities in 34-Year Lead Trust:   The grantor plans to fund a charitable annuity lead trust. Two unrelated persons and an unrelated corporation will serve as trustees and will annually select the charitable recipients. An annuity will be paid from current income, then from prior accumulated income and, if necessary, from principal to charities qualified exempt under Secs. 170(c) and 2522(a).

PLR 200024052 "Well-Oiled" Lead Trust Approved:   Taxpayer plans to create a charitable lead unitrust and a charitable lead annuity trust after both taxpayer and spouse pass away. The trusts will be funded with stock from an investment company that owns working interests in oil and gas.

PLR 200029033 Children May Select Charities for Annuity Lead Trust:   Donor X created a charitable annuity lead trust with shares 1, 2 and 3. A bank is trustee of the lead trust. The lead trust pays a graduated formula, which is a permissible interpretation of the annuity requirement rules. The graduated formula is more frequently found in grantor annuity trusts but may be used in a non-grantor lead trust. The lead trust pays 3% for the first two years and then an annuity amount that is increased by a factor of 1.133 in succeeding years.

PLR 200030014 Lead Trust for Grandchildren May Pay to Family Foundation:   Donor A desires to create a 25-year 7% lead unitrust with remainder to his grandchildren. Donor's spouse B and children C and D will be directors of a family private foundation that is to be created and receive funding from the lead trust. Neither the donor nor the donor's spouse will be a trustee of the lead trust. A also will not be an officer or director of the private foundation. In addition, B, C and D will be permitted to receive expense reimbursements but will not receive salaries from the private foundation.

PLR 200108032 Charitable Lead Trust to Last for Two Lives or 20 Years, Whichever is Longer:   Taxpayers propose to create a family (non-grantor) charitable lead annuity trust. The trust is to last for the longer of 20 years or until the death of the taxpayers. The terms of the trust further provide that two charities will be the income beneficiaries and the taxpayers' children will be the remainder beneficiaries. With respect to both charitable beneficiaries, taxpayer is an officer and a board member. However, taxpayers are not permitted to serve as trustees of their CLAT.

PLR 200124029 CLAT's Installment Sale to Disqualified LLC Not an Act of Self-Dealing:   Taxpayer created an estate plan where, at his death, his property would pass to a marital trust for the benefit of his wife. At his wife's death, the marital trust would distribute assets to children and five charitable lead annuity trusts (CLATs). Each CLAT was designed to generate an estate tax deduction equal to 100% of the estate tax value of the CLAT assets. In short, the transfer to the CLATs would not generate any estate tax liability.

PLR 200207028 No Self-Dealing Where Disqualified Person Purchases LLC Interests From Charitable Lead Trusts:   H and W created a trust during their lifetimes. Upon H's death, the trust was divided into a survivor's trust and a decedent's trust. The decedent's trust was primarily to benefit W's children and grandchildren. However, the survivor's trust was to benefit an individual during W's lifetime, but at W's death would fund a charitable lead unitrust (CLUT) and a charitable lead annuity trust (CLAT). Both charitable lead trusts (CLTs) were designed to benefit W's private foundation, with the eventual remainder to W's family.

PLR 200225045 Early Termination of CLAT is Not an Act of Self-Dealing:   Taxpayer created a charitable lead annuity trust pursuant to Sec. 4947(a)(2). The CLAT term was 12 years and 9 months and had a 12% annuity payout. For the duration of the trust, C, a private foundation, was the sole charitable income beneficiary.

PLR 200536013 Trustees' Power To Select Lead Trust Charities Will Not Cause Grantor Trust Status:   Grantor established a charitable annuity lead trust. The trustees are two of the grantor's three children and another individual unrelated to the grantor. Upon grantor's death, the third child is also to become a co-trustee, along with the individuals already mentioned. The donor does not retain any power or control over any portion of the trust.

PLR 200537020 Trust with Distributions to Family Foundation Permissible:   Alan and Barbara created a private foundation. Alan and Barbara have recently established a charitable lead unitrust for a term of 15 years. Their private foundation will be the lead beneficiary and their grandchildren will be the remainder beneficiaries of the lead trust. An unrelated third party will serve as trustee. Barbara and Alan are requesting that the lead trust will be a completed gift so that they will be entitled to a gift tax deduction. Further, they request that upon their deaths, no part of the lead trust will be includible in their estate.

PLR 200747001 CLAT is a Completed Gift with No Excess Business Holdings:   Spouses H and W propose to create a charitable lead annuity trust (CLAT) to pay to a qualified public charity a fixed percent annually for the lesser of five years or the death of the second spouse.

PLR 201730012 Conversion of Charitable Lead Annuity Trust from Non-Grantor to Grantor Trust:   Grantor, as settlor and trustee, created a charitable lead annuity trust (Trust). Grantor sought approval to amend Trust's agreement, which would convert Trust from a non-grantor lead trust to a grantor lead trust.

PLR 9604015 Lead Trust Powers - Children May Select Charities:   A lead trust makes distribution of either a fixed amount or a fixed percentage to charity for a period of time, usually a term of years. After all payments have been completed, the remainder is distributed either back to the grantor or to family. This lead trust will make distribution to charities for a 10-year term, with the remainder to family. The service noted that the trust would not be a grantor trust, and since there would not be unrelated business income, all distributions to charity would qualify for a deduction on the annual trust income tax return. Furthermore, there will be a charitable gift tax deduction for the value of the income transferred to charity and it will be permissible for the children serving as trustees to select the charities.

PLR 9734057 No Commutation of Lead Trust:   The Service has generally been reluctant to allow commutation of lead trust payments. In theory, under state law, both the income and remainder recipients own property interests. Thus, it should be permissible to buy or sell those interests at a fair value. Nevertheless, the Service has been reluctant to allow major changes in irrevocable trusts. Specifically, the Service has been reluctant to allow charitable lead trusts to accelerate payments to charities and, thereby, accelerate the remainder interests to families. In the view of the Service, allowing this commutation or acceleration of payments would be "inconsistent with the regulatory requirements for charitable lead interests." Thus, commutation does not seem to be a viable option.

PLR 9819031 Corporate Recapitalization Funds Lead Trust:   The IRS, in this ruling, stated that a corporate recapitalization did not constitute a taxable dividend distribution and the "new stock" could be used to fund a charitable lead annuity trust.

PLR 9840036 Testamentary Lead Trust Drafting Provisions:   The testator and spouse desire to establish a lead trust upon the demise of the survivor. The Service rules that the present value of the unitrust interest in a testamentary charitable lead trust will qualify for an estate tax charitable deduction upon the survivor's death. The term of the charitable lead unitrust is to be set at the surviving spouse's death by calculating the amount necessary to produce an initial value for the remainder interest equal to the surviving spouse's available generation-skipping transfer tax exemption. The Service observes that the formula for determining the term of the charitable lead unitrust will be fixed and ascertainable as of the surviving spouse's death. With respect to generation-skipping transfer tax, the charitable lead unitrust will have an exclusion ratio of zero if the appropriate amount of the surviving spouse's exemption is allocated to the trust. Finally, the ordering rules for the payment of the unitrust amount will be disregarded for federal income tax purposes.

Related Topics on Family, or Non-Grantor, Lead Trusts

3.5.6  Gift/Estate Tax Deductions for Lead Trust:    A charitable lead unitrust or annuity trust must pay the fixed unitrust percentage or the fixed annuity to one or more qualified charities each year to qualify for gift or estate tax charitable deductions. Reg. 20.2055-2(e)(2). Reg. 25.2522(c)-3(c)(2).

3.5.7  Lead Trust Income Taxation:    A charitable lead trust may be either a non-grantor or a grantor trust. With a non-grantor, or family, lead trust, the trust is taxable and must file Form 1041 each year. Alternatively, a grantor lead trust will cause all income and capital gain to be recognized on the donor's Form 1040.

3.5.8  Lead Trust Generation-Skipping Transfer Taxation:    Generation-skipping transfer taxes (GSTTs) are particularly significant for charitable lead trusts. Since the goal of many grandparents is to allow grandchildren to grow to greater levels of maturity before receiving a significant inheritance, the opportunity to leverage an inheritance through a lead trust for grandchildren is quite attractive. It is possible to pass two to seven times the exemption amount to grandchildren with a testamentary lead trust and still have zero GSTTs.

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