Thursday April 25, 2024
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3.6.7 Increasing Payment Lead Trust
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Overview - Annuity Lead Trust With Increasing Payouts
A charitable lead annuity (CLAT) trust may have increasing payments. In Rev. Proc. 2007-45, IRB 2007-29 (16 Jul 2007), the Service approved the concept. Under 02 Annotations for Paragraph 2, Payment of Annuity Amount, the IRS stated in Section 4, "Alternatively, the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded."
With increased volatility in stock markets, there are persuasive economic reasons for a CLAT with increasing annuity payouts. Annuity trust remainder recipients benefit from the difference between the applicable federal rate and the actual economic return. If the applicable federal rate is fairly low at 4% or 5%, and the trust assets are able to produce total return of 8% or 9%, then the family benefit is increasing by 4% or 5% each year.
With a fixed payout annuity lead trust, the economic benefit is limited to the 4% or 5% per year. However, by making lower payments in the early years and larger payments in the later years, the economic benefit compounds and increases the total distribution to family. In effect, part of the charitable annuity value during early years is retained in the trust and increases the trust corpus. Even with the payment of an increased annuity to charity in later years, there is a larger principal amount to family at the termination of the lead trust.
This benefit is particularly helpful if there is an economic downturn in the early years of the trust. The favorable benefit for family with a fixed annuity is that growth can compound and significantly increase the distribution to family. However, if there is a fixed annuity payout and an economic downturn in the early years of the trust, then most, and in some cases all, of the principal of the trust may be used to make the annuity payment.
By reducing the payouts in the early years and then increasing significantly the payouts to charity in the latter years of the trust, there is added protection against the early economic downturn. While the economy and markets could produce below-average returns in the early years, the low payouts will not require significant sales of trust equities during the down markets. The trust is then able to recover and benefit from potential higher returns during the latter years when the payouts to charity are greater.
Increasing Payouts Family Lead Trust
For a lead trust with remainder to family, the charitable deduction for gift tax purposes is the present value of the income to charity. The trust is a taxable trust and must file IRS Form 1041. Fortunately, the trust may be managed so that the ordinary income does not exceed the payout to charity. Because under Sec. 642(c) the trust with no unrelated business taxable income qualifies for a 100% charitable income tax deduction, if all income earned is distributed to charity under the annuity provision, there is no trust income tax.
Because the initial payouts to charity may be quite modest, it is important to consider the probable ordinary income earnings of the portfolio in order to avoid payment of income tax on ordinary income retained in the trust. In the following example, the equities portfolio is assumed to earn 1% ordinary income and 7% capital appreciation.
Example 3.6.7A Smith Family Lead Trust
John Smith is a surviving spouse and plans to transfer a substantial inheritance to family. Based on his present age of 62, he would like to fund a lead trust with $1 million of stock that has a cost basis of $200,000. Because the stock has increased in value to $1.6 million and, due to a market downturn, is now back to $1 million in value, it is a very favorable time to fund a lead trust.
John transferred the $1 million in stock to a lead trust for a term of 15 years. The lead trust paid an annuity each year to favorite charity. The annuity for the first three years was 2% of initial value. For the next three years it was 4%, then 6% for three years, 8% for three years and 10% for the final three years of the fifteen year term. Based upon the $1 million in funding and distributions to charity that total $900,000 over 15 years, the charitable deduction is $649,649. John used $350,353 of his gift exemption to offset the balance of the taxable transfer.
With an assumed 1% ordinary and 7% capital growth, the trust must file Form 1041, but pays no income tax during the 15 years. When the trust terminates, the trust has benefited from the equities growth, particularly in the early years, and $1,788,187 is transferred to the Smith children. Because this is a living annuity lead trust, the children receive the assets with the original cost basis of $200,000. However, the children can avoid payment of capital gains tax through a zero tax sale and unitrust method.
John achieved two goals -- his favorite charity received $900,000 and the family received nearly $1.8 million. He accomplished this with no payment of gift taxes and used of a modest portion of his gift exemption. The gift exemption amount was leveraged over five times for the benefit of his children.
Increasing Payment Grantor Lead Trust
If a lead trust is created with a reversion to the grantor of trust assets that exceed 5% of value, the lead trust will be a grantor trust. Sec. 673(a). The grantor trust is subject to the Sec. 671-678 rules. All income and gains will flow through and be taxable to the grantor on his or her personal income tax return.
The grantor lead trust qualifies for an income tax deduction. Sec. 170(f)(2). While the trust annuity payments 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. The charitable income tax deduction for the distributions over the term of the lead trust is deemed "for the use of the charity" and qualifies as a 30% type deduction. Sec. 170(b)(1)(B).
The income tax deduction may be enhanced through use of an increasing payment grantor lead trust. Most grantor lead trusts last from four to eight years, with an income tax deduction in the year the trust is created and a return of the assets to the donor at the termination of the trust. Because the donor is taxable on the distribution to charity, a grantor trust frequently will be funded with cash and invested in municipal bonds. The municipal bond income distributed under the annuity provision to charity will not create income tax for the grantor.
Example 3.6.7B Increasing Payout Grantor Lead Trust
John Jones has had a very successful year. His professional work from the past several years has resulted in a very large income this year. As a result, he desires a substantial charitable income tax deduction, but would like to retain the asset.
John funds a grantor charitable annuity lead trust with payouts to charity for a term of eight years. The trust invests in municipal bonds. At the end of the eight years, the bonds will be returned to John.
In order to maximize the benefits, the trust pays an annuity equal to 2% of the initial value for the first two years, 4% the next two, 6% the next two and 8% the final two years. Because the bonds are tax-exempt, the excess income in the early years is used to acquire more municipal bonds.
Even if bond interest rates should change or bonds are called during the duration of the trust, the high probability is that the trust principal will be retained for the donor. At the end of the eight years, John Jones receives $1,023,233. However, he benefited from an income tax deduction of $333,612 when the trust was created. Finally, with the tax-free municipal bond income distributed to charity or accumulated in the trust, there is no additional income taxation to John.
Increasing Payouts Super Lead Trust
A creative option for a charitable lead annuity trust is to create a trust that includes a grantor trust power, but is not included in the taxable estate. The power to reacquire assets under Sec. 675(4), when held by a non-adverse party and exercised in a non-fiduciary role, causes the trust to become a grantor trust. Because there is no reversion or control over the income, there is no Sec. 2036(a) retained interest or inclusion in the estate of the grantor.
Example 3.6.7C Annuity Lead Super Trust
Mary Wilson is interested in creating a trust for the benefit of family. However, she also has a very large income for the next six years as a result of royalties from inventing a new machine that produces hydrogen to power environmentally-friendly automobiles. She takes $1 million of stock with cost basis of $500,000 and funds a term of 15 years lead trust. At the end of 15 years, the trust will distribute to family.
Because she wants to maximize the potential benefits to family, the trust pays an annuity of 2% of the initial value for the first 14 years and then 120% of the initial value ($1,200,000) in year 15. With a total payment to charity of $1,480,000, she receives an income tax deduction of $946,613. Her taxable gift of $53,387 is covered by a portion of her gift exemption.
After the 15 years of maximum growth in the trust, the charity and family approximately divide the benefits. With the payment in year 15 of $1,200,000 to charity, there is a balance of $1,449,127 for family.
Since this is a grantor lead trust, Mary is subject to income taxes on the distribution to charity. However, she chooses to invest the initial tax savings on the deduction. Even with a substantial tax payment, largely at capital gain rates, the net remaining benefit at the end of the 15 years is $424,520. Not only has Mary transferred over $1.4 million to family with a taxable gift of only $53,387, she has also benefited from a net income tax savings of $424,520, valued at the end of the trust term.
Increasing Payment Testamentary Lead Trust
For senior donors, a testamentary lead trust may be quite attractive to transfer substantial assets through to family members. Normally, there are combinations of gifts during life and trusts set up by other family members that provide a substantial inheritance to children or other heirs. The testamentary lead trust is an additional distribution that will frequently be designed to provide extra economic security during their retirement years.
Example 3.6.7D Green Family Testamentary Lead Trust
Clarence Green has a $12 million estate and plans to benefit four nephews and nieces. Because there are other inheritances from their parents, Clarence would like to provide a substantial addition during their retirement years. Clarence establishes an estate plan that transfers $10 million to a family limited partnership (FLP). With liquid assets in the FLP, the assumed discount is 27% in the estate. The FLP is therefore valued at $7,300,000.
The FLP with value of $7,300,000 is transferred to a testamentary lead trust for 15 years. The lead trust pays an annuity equal to 3% of the initial value for three years, 5% for three years, 7% for three years, 9% for three years and 11% for the final three years. The total distribution to charities will be $7,665,000. Because the trust grows significantly in the early years, the distribution to family from the lead trust will be $15,505,623. If the assets were distributed from the FLP outright to family, their value would be $21,240,579.
Clarence passes away in 2011. In his estate, the lead trust is first reduced in value by the FLP discount and then by a charitable deduction of $5,589,202. With the reduced value of the taxable transfer in the lead trust and the remaining asset value, the total taxable estate is under $5 million. Therefore, there is zero estate in 2011. Clarence is especially pleased that he has transferred over $20 million in value to family, provided $7.6 million to favorite charities, reduced the market risk for lead trust investments and paid zero estate tax.
Benefits of Increasing Payouts Lead Trust
With the ongoing volatility in stock markets and the variations in values of real estate, the increasing payouts lead trust will be very popular. Individuals with large estates can transfer tens of millions to family through the lead trust, but gain greater assurance that market fluctuations will not adversely impact the plan.
Because many parents are currently attempting to encourage children, grandchildren and other heirs to learn effective family philanthropy, the lead trust is a natural choice. It facilitates both funding of the charitable plan and a substantial inheritance for family members. With the increasing payouts lead trust, this option is one of the best possible ways to reach both objectives for family and charity.
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Private Letter Rulings
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
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
201216045 Lead Annuity Trust May Change to Increasing Annuity Payout:
Decedent's estate plan created a testamentary charitable lead trust (the trust). The estate filed Form 706 and claimed a deduction under Sec. 2055(a) on Schedule O.
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