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, then 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 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 remainder to grandchildren at the expiration of that term.
Non-Grantor Lead Trust
A non-grantor charitable lead trust (CLT) is generally not a permissible S corporation shareholder. Treasury regulations finalized in 2002 indicate, however, that a non-grantor CLT may own S corporation stock by qualifying as an electing small business trust (ESBT). Reg. 1.641(c)-1(l), Example (4). While qualifying as an ESBT allows a non-grantor CLT to receive S corporation stock, the opportunity comes with significant drawbacks.
First, an ESBT pays income tax at the highest trust tax rates. Second, unlike most non-grantor CLT's, an ESBT may not deduct payments to charity. This means that all of the ESBT's income is subject to tax at the highest trust tax rates each year, even if all of that income is distributed to charity. These two drawbacks could trigger a great deal of income tax liability to the non-grantor CLT each year, thereby decreasing the value of the trust.
To become an ESBT, a CLT must meet the following requirements: (1) all beneficiaries must be individuals, estates or charities; (2) the S corporation stock in the trust may not be acquired by purchase (i.e. it must be received by gift or bequest); (3) it cannot be an electing qualified Subchapter S trust, and (4) each potential current beneficiary of the CLT will be treated as a shareholder for the purpose of the S corporation eligibility rules.
Example 4.14.9 A
Nola Nurse inherited stock of Newspaper, an S corporation, several years ago. She anticipates that Newspaper stock will substantially grow in value over the next 20 years. Nola eventually wants her children to own the Newspaper stock but in the meantime hopes to remove the stock and its appreciation from her estate and benefit Mercy Hospital, a public charity, at the same time.
Nola contributes her Newspaper stock to a non-grantor CLT that meets the requirements of an ESBT. She does not receive an income tax deduction for her gift. The non-charitable portion of the CLT is a taxable gift to her children and she reports this small amount on a gift tax return.
Over the 20 year CLAT term, the Newspaper stock grows substantially in value; the stock also pays an average 8% dividend each year. Every year, the CLT pays 7% to Mercy Hospital. Because it is an ESBT, the CLT can't deduct these payments even though they go to charity and when it files its trust tax return must pay income tax on this income at the highest trust rates. At the end of the 20 year CLT term, the Newspaper stock is distributed to Nola's children. Nola was able to transfer a significant asset to her children at relatively low gift tax cost.
Nola is happy with the result despite the fact that the CLT paid income tax at high rates on all of its income.
For more information on non-grantor lead trusts, see GiftLaw Pro 3.5.1.
Grantor Lead Trust
A grantor CLT is a permissible S corporation shareholder. Sec. 1361(c)(2)(A)(i). This is because a grantor lead trust has no identity separate from its grantor. As long as the grantor is a permissible S corporation shareholder, a grantor CLT may own S corporation stock. PLR 199936031, PLR 199908002.
In the case of a grantor CLT, the grantor will receive an income tax deduction for the fair market value of the stock subject to possible reduction and limitation discussed in GiftLaw Pro 4.14.11. During the CLT term, the trust income is taxable to the grantor (even though he or she doesn't actually receive the income). Finally, when the CLT terminates, the S corporation stock will be returned to the grantor. For more on grantor lead trusts see GiftLaw Pro 3.5.4.
If the grantor dies during the CLT term, the CLT ceases to be a grantor trust. Sec. 1361(c)(2)(A)(v) & (e). It is important, in this event, that the CLT be drafted to include provisions that convert the trust to a permissible S corporation shareholder - generally an electing small business trust (ESBT) - so that the S corporation will not be disqualified.
Example 4.14.9 B
Griselda Grantor owns stock in Gypsy Records, an S corporation that records and distributes eclectic music. Griselda knows she will have a huge income tax liability this year and wants to generate a large charitable deduction by contributing to the Gymnastics Federation, an amateur sports organization that is a qualified public charity. Griselda doesn't have any cash and wants to contribute her Gypsy Records stock but for sentimental reasons doesn't want to lose it forever.
Griselda contributes her Gypsy Records stock to a grantor charitable lead trust ("CLT") and achieves all of her goals. She receives a significant tax deduction to offset her income this year, provides Gymnastics Federation with an income stream over the 10 year term of the CLT, and will get her Gypsy Records stock back at the end of the CLT term. Griselda will have to report the CLT's income on her own tax return for each of the next 10 years and is comfortable with doing this.
For more information on grantor lead trusts, see GiftLaw Pro 3.5.2 & 3.5.3.
Super Grantor Lead Trust
Because a grantor CLT is a permissible S corporation shareholder, a super grantor lead trust is also likely a permissible S corporation shareholder. More information about a super grantor lead trust is available in GiftLaw Pro 3.4.3. Generally, a super grantor lead trust offers the benefits of both grantor and non-grantor lead trust. The trust is not included in donor's taxable estate (producing the gift and estate tax benefits of a non-grantor lead trust) but is taxable to the donor. To achieve this result, the grantor may not retain a reversion or control over the distribution of income, Sec. 2036(a), but does include a power that causes the trust to be a grantor trust such as the power in a non-adverse party to reacquire trust assets, Sec. 675(4).
