Wednesday April 24, 2024
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3.5.7 Lead Trust Income Taxation
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Lead Trust Income Taxation
Family Lead Trust Income Taxation: In contrast to a charitable remainder trust, which is normally exempt from trust income taxation, the lead trust remainder is taxable under Subchapter J of the Code.
Grantor Lead Trust: The grantor lead trust qualifies for an income tax deduction.
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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.
Family Lead Trust Income Taxation
In contrast to a charitable remainder trust, which is normally exempt from trust income taxation, the non-grantor, or family, lead trust is taxable under Subchapter J of Code. As such, it must file Form 1041 and pay taxes on its ordinary income and capital gains.
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 unrelated business taxable income under Sec. 512, or it will be restricted to a 60% 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 gains tax 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 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, then 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 gains tax upon sale.
Grantor Lead Trust
The grantor lead trust qualifies for an income tax deduction. Sec. 170(f)(2). The income tax deduction will be equal to the present value of the annuity or unitrust payouts to charity for the selected term of years. However, in order to benefit from the income tax deduction, the trust must be a grantor trust. This grantor trust status includes one important rule. While the trust annuity payments or unitrust amounts are transferred to charity, the grantor must report these amounts as taxable income on his or her personal tax return. Sec. 170(f)(2)(B). In addition, if the trust recognizes capital gain, the grantor is taxable on the gain, even though the gains are held in the trust until maturity.
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Private Letter Rulings
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
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.
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