Whether the primary object of a family's charitable giving is a private foundation, supporting organization, donor advised fund or specific public charity, the family's income tax and estate planning goals may be significantly enhanced by financing the entity through charitable trusts — whether they be CLATs, CLUTs, CRATs or CRUTs (charitable lead annuity trusts, charitable lead unitrusts, charitable remainder annuity trusts or charitable remainder unitrusts).

The charitable trust is not new; its roots back trace to 16th-century England.1 What is new is integrating it with other family entities through the use of sophisticated financial models — an approach our firm calls structured charitable planning (SCP).

SCP can provide substantial benefits to the high-net-worth contributor. For example, because the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), adopted in May, reduces rates on dividends and long-term capital gains, it encourages long-term investing. Accordingly, the pooling of assets in a family limited partnership (FLP) or family limited liability company (FLLC) may prevent a trustee for a CLAT or CRAT from having to incur short-term capital gains, or invest in high-yield bonds (taxable at relatively high rates) to satisfy the trust's annuity obligation. Further, by pooling family assets with charitable trust assets, even significant fluctuations in value may not disrupt the charitable trust's payout structure.

Of course, before implementing any charitable plan, the high-net-worth contributor should consider a number of factors, including personal cash flow needs, liquidity of assets, overall net worth, ongoing charitable commitments, risk tolerance and personal tax position. Well-advised donors also will find that they can leverage the benefits of charitable trusts by taking into account the impact of tax rates, the applicable federal discount rate (the Internal Revenue Code Section 7520 rate)2 and the total return on investments with each planning alternative.

SCP

While understanding the effect of tax rates, interest rates and total return goes a long way toward achieving high-net-worth donors' goals, only SCP can truly harness the power of charitable trusts. SCP involves the integration of split-interest charitable trusts with family entities and includes the use of sophisticated financial models. (See “Financial Modeling,” page 66.)

The use of a centralized family entity — such as an FLP, FLLC or family limited liability limited partnership (FLLLP) — can add significant value, and provide unlimited flexibility, when combined with one or more charitable trusts. On top of the typical benefits of asset diversification, centralized management and retained control over investments, centralized family entities also provide the ability to combine the benefits of different types of charitable trusts, minimize the disruption in asset management otherwise created by charitable trusts, and provide potentially favorable tax allocations.3

Instead of donors contributing assets directly to a charitable trust, they give the assets to an FLP, for example, and contribute a partnership interest to the charitable trust. The donors retain control over the FLP's investments by keeping a general partner interest, directly or through the use of a corporation or LLC as a general partner.4 Other estate-planning vehicles, including grantor remainder annuity trusts (GRATs) and dynasty trusts, also could contribute their assets to the centralized family entity.

There are many situations in which charitable planning cannot, and should not, dictate a donor's investment strategy. For instance, a corporate executive, anticipating a large bonus (or earnout) in a given year, may want to create a grantor CLAT to reduce his current taxable income. But he may hold a large block of restricted stock in his company individually and in one or more dynasty trusts, and not have liquid assets to contribute to a CLAT. To solve this problem, he and the dynasty trusts might pool all their stock in one centralized family entity. The dividends from the combined stock may be enough to satisfy the CLAT's cash flow demands. The asset pooling also provides a hedge against a market downturn: The CLAT trustee will not have to sell long positions to satisfy cash demands if he expects the market to rebound.

SCP also involves the use of a sophisticated partnership (or LLC) agreement, which may include multiple classes of ownership. For example, a CLAT may benefit from holding preferred or guaranteed interest, while a dynasty trust (which is exempt from generation-skipping taxes) may benefit from holding a pro rata or growth interest. Further, it may be possible to use preferred interests in combination with tax-exempt trusts to minimize the centralized family entity's taxable income. This type of structure will make additional assets available through the centralized family entity to meet charitable goals and obligations, and avoid situations in which the failure to do so may cause adverse tax consequences. SCP's benefits also include the opportunity to amend the partnership (or LLC) agreement from time to time, to accommodate partners' changing circumstances.5

One potential drawback to integrating one or more charitable trusts with donors' other family assets is that the charitable trusts may subject all of the centralized family entity's assets to certain investment restrictions. If, for example, a deduction exceeds 60 percent of the value of the contribution, a charitable lead trust (CLT) would be subject to the restrictions on private foundations against excess business holdings and jeopardy investments.6 Both charitable remainder trusts (CRTs) and non-grantor CLTs are subject to restrictions on unrelated business taxable income (UBTI), which generally involve income from active businesses or debt-financed income.7 All charitable trusts are subject to the limitations against self-dealing.8 There may be ways to avoid these restrictions, including the creation of a separate centralized family entity for leveraged or alternative investments. Where the family entity holds a typical portfolio of marketable securities, for example, these restrictions generally will not create an issue.

It also is important to avoid having the family entity fall within the definition of a controlled entity, again because of the rules generally applicable to private foundations. Even when charitable partners hold only limited partnership interests, they may indirectly commit prohibited acts of self-dealing (for example, if any of the general partners or trustees violate their fiduciary duty). It is critical that the family entity be respected as a separate business entity, with all parties enforcing their material rights and living up to their respective obligations.

BASICS

Before advisors employ sophisticated combinations of charitable trusts with general estate plans, they must have a firm grip on the basics. Know, for example, that split-interest charitable trusts fall into two general categories. Charitable lead trusts provide for the income (lead) interest to be payable to charity and the remainder interest to pass to non-charitable beneficiaries, while charitable remainder trusts are the mirror image.

In any split-interest charitable trust, lead payments must be made at least annually, for a term of years or based on one or more measuring lives. Lead payments must take the form of either a guaranteed annuity (in the case of an annuity trust) or, alternatively, a fixed percentage of the net fair market value of the trust assets, valued annually (in the case of a unitrust).9 There are additional requirements depending upon the particular type of charitable trust utilized.10

A donor may create a CLT during life or by testamentary instrument.11 A lifetime CLT also may be created as a grantor trust, if certain rights are retained by the grantor.12 In such circumstances, the contributor would receive an immediate income tax deduction, at the time of creation, equal to the present value of the periodic payments that will be made to charity.13 The deduction is generally limited to 30 percent of the contributor's adjusted gross income (or 20 percent, in certain cases where the donor contributes capital gain property and a private foundation is a permissible recipient of lead payments). However, the donor may carry forward any unused amount for the succeeding five years.14 For federal income tax purposes, the grantor is treated as the owner of the assets transferred to the trust, and remains taxable on all income and gains allocable to the trust; he also receives the benefits of any deductions or credits.

For a donor who cannot effectively use additional charitable deductions, such as a large contributor who has reached his deduction limit (or expects to in the future), the non-grantor CLT may be a better option. As a separate taxpayer, the trust would not be subject to his charitable deduction limitation. The donor can most effectively use a non-grantor CLT by contributing those assets that have a high yield and produce income taxable at a high rate, such as corporate bonds.

The CLAT is generally more popular than the CLUT, because all trust income and growth in excess of the 7520 rate inures to the benefit of the non-charitable remainderman. The remainder interest of a CLAT also can be zeroed out (or of limited present value) for gift tax purposes.

With CLUTs, the charitable lead beneficiary receives a percentage of the value of trust assets each year and, in a sense, becomes the remainderman's partner. There may, however, be cases in which the donor has concerns regarding investment performance, and wants to be certain that at least some value will pass to the next generation. Such is not always the case with a CLAT in which the assets perform poorly. CLUTs also are treated more favorably than CLATs for generation-skipping tax (GST) purposes, although the GST exemption is more effectively utilized by other planning techniques that include dynasty trusts.15

Unlike the CLT, the CRT is a tax-exempt trust.16 Upon contributing an asset to a CRT, the donor receives an income tax deduction based on the value of the remainder interest. The primary benefit of a CRT, though, is tax deferral. A donor may contribute an appreciated asset to a CRT to defer or avoid gain upon future sale of the asset. Then, the trust can reinvest the full amount of the sale proceeds, and annual items of income and gain within the CRT will not be subject to immediate taxation. Income is taxable only as payments are made to the non-charitable beneficiary. The character of these payments then is determined under a four-tier ordering system that maintains the character of the income while reordering it so that accrued ordinary income items are distributed first.17

The CRAT is a good vehicle for someone who holds a low-basis asset and is dependent upon a steady flow of income. As payments are fixed at the outset, all appreciation or depreciation of the trust property inures to the benefit of (or is borne by) the charitable remainderman. The CRAT therefore is not popular with contributors who expect the trust assets to grow significantly in value.18 In contrast, the CRUT allows the donor and family members to benefit from the growth and appreciation in the value of the contributed assets, since the periodic payments to the non-charitable beneficiary are based upon the annual value of the trust corpus.

Two variations of the CRUT that capitalize on the tax-exempt nature of charitable remainder trusts in general include the NIMCRUT, an acronym for net-income-with-makeup CRUT, and the “flip” CRUT. A NIMCRUT pays the income beneficiary the lesser of trust accounting income or the unitrust amount in any given year. Any shortfall in the annual unitrust amount because of the trust accounting income limitation can be made up and distributed out of trust accounting income in excess of the unitrust payment amount in any future year.19 A flip CRUT is a further variation that begins as a NIMCRUT, then converts to a standard CRUT upon the occurrence of an event (such as the sale of an asset).20 A flip CRUT may be useful to someone who is temporarily limited by illiquid assets.

For a client who is not dependent upon the trust for current income, the NIMCRUT provides the most flexibility and operates similar to a tax-deferred retirement plan. To maximize the benefits of tax-deferred growth, the NIMCRUT instrument can provide for certain capital gains to be allocated to income. Several states, including South Dakota, Delaware, Indiana and Alaska,21 have modified their versions of the principal and income act to accommodate this.

To compute the lead and remainder interests for all these charitable trusts, one must take into account:

  • the value of the assets contributed,

  • the term,

  • the payout rate or amount,

  • the frequency (annually, semiannually, quarterly or monthly) and timing (either at the beginning or end of the year) of payments, and

  • the applicable rate under IRC Section 7520.22

The 7520 rate is essentially 120 percent of the applicable federal mid-term rate in effect pursuant to IRC Section 1274(d) for the month in which the trust is formed. A donor also may choose to apply the 7520 rate for either of the two preceding months.

The impact of the 7520 rate differs significantly, depending upon the particular technique utilized. Annuity trusts such as the CLAT and the CRAT are very interest rate-sensitive, while unitrusts such as the CLUT and CRUT are not. For example, with a CLAT, the same stream of annuity payments will yield a higher charitable deduction when the 7520 rate is lower, but a smaller deduction when the 7520 rate is higher. (The CRAT works in the reverse, so a higher 7520 rate produces a larger deduction.) This happens because annuity interests are calculated by using the 7520 rate to discount future payments to their present value.

The value of a unitrust remainder, in contrast, is simply the future value of the initial contribution reduced each year by the payout percentage for the term of the trust. This can be expressed by the formula [(1 - P)N × C], where C is the amount of the contribution, P is the payout rate, and N is the number of years. For example, if $1 million is contributed, the payout rate is 10.875 percent and the term is 20 years, the value of the remainder will be $100,000 [(1-.10875)20 × $1,000,000]. The 7520 rate plays a role only when the trust makes payments more frequently than annually or when there is a delay between the valuation date and the payment date, although even in these situations, the effect is minimal.23

When interest rates are low, a donor can further enhance the benefits of a grantor CLAT, in particular, by increasing the payments by predetermined annual amounts and lengthening the term of the trust.24 CLTs are not subject to the rule limiting a term interest to 20 years, as in the case of CRTs. This is particularly noteworthy in situations where there is a significant discrepancy between federal long-term and mid-term rates, as the CLAT deduction is a derivative of the mid-term rate notwithstanding the actual term.

A low-interest-rate environment is also beneficial for gift-tax planning. All growth and income (total return) in excess of the 7520 rate passes to the remainder beneficiaries free of gift tax. It's easier to maximize the value of the remainder interest in a CLAT when the 7520 rate is at or near historic lows.

VARIOUS TAX RATES

Tax rates also may have a significant impact on the effectiveness of any charitable technique. Recent legislation lowered the rate on capital gains, and significantly reduced the rate on dividend income.25

This drop in rates will increase the benefits of grantor CLATs in particular. The donor can use the immediate income tax deduction to offset income items that are highly taxed, such as wage or interest income.26 Then, during the term of the CLAT, depending upon the trust's investment strategy, the donor would be subject to taxation at much lower rates. There may be little or no benefit to these lower rates with a non-grantor CLAT, as the trust's annual charitable deductions may be taken against items taxable at lower rates.27

From a gift-tax perspective, the drop in rates will not affect the grantor CLAT, because its taxes are borne by the grantor. The non-grantor CLAT, on the other hand, may benefit from the drop in rates to the extent that annual income exceeds the annual charitable deduction. In such a case, lower rates would allow more wealth to accumulate for the benefit of the remainderman.

Existing CRTs holding dividend-paying stocks will typically benefit from these lower tax rates, as dividends are first-tier income.28 Under the new tax act, short-term capital gains, which are second-tier income, would be taxed at a higher rate than dividends. In any event, it may not be advisable to predicate planning on temporary rate reductions when CRTs tend to have very long terms.

SCP is in its infancy. Absent adverse legal precedent, we can expect that a number of factors will result in increasingly imaginative methods of integrating philanthropy with a family's overall estate plan.

The authors thank Gerard W. Kervel, financial analyst at Akerman Senterfitt in Miami, Florida, for his contributions to this article.

Endnotes

  1. Robert F. Sharpe, Jr., “Philanthropy in Uncertain Times,” Trusts & Estates, March 22, 2002 (Online Exclusive).
  2. IRC Section 7520 was enacted in 1989 and is commonly used in connection with the valuation of various temporal interests for estate planning purposes. It is essentially a composite yield of treasury securities.
  3. The general allocation rules that govern charitable trusts tend to be unfavorable. With CRTs, for instance, the tier system provides for the recognition of ordinary income items first. The taxation of non-grantor CLTs is also unfavorable because of the government's position regarding the pro rata nature of the annual charitable deductions. Conversely, the partnership allocation rules tend to be much more flexible and favorable. A well-advised taxpayer generally will fare better under the Section 704(b) allocation regime than under the charitable trust rules.
  4. To the extent the centralized family entity holds stock in a controlled corporation and estate planning is a primary motive, the grantor should consider the potential impact of Section 2036(b).
  5. The partners should, however, be mindful of the restrictions against self-dealing.
  6. IRC Sections 4943, 4944 and 4947.
  7. IRC Section 512.
  8. IRC Section 4941.
  9. IRC Sections 664(d), 2522(c), 2055(e)(2)(B) and 170(f)(2)(B).
  10. For instance, with a CRT, no less than 5 percent and no greater than 50 percent of the value of the trust assets may be paid annually. In addition, the minimum present value of a CRT remainder interest (utilizing the principles of Section 7520) must be at least 10 percent of the value of the property placed in the trust at the time of creation. IRC Section 664.
  11. IRC Section 2055(e)(2)(B).
  12. IRC Sections 671-679. For additional estate planning benefits, the grantor should not retain any power over trust administration or right to income or principal of the trust that would cause inclusion in his gross estate.
  13. IRC Sections 170(f)(2)(B) and 7520. See IRS Publications 1457 (regarding an annuity interest) and 1458 (on a unitrust interest).
  14. IRC Sections 170(b)(1)(B) and (D) and Treas. Reg. Section 1.170A-8(a)(2). The IRS previously had taken a contrary view in PLR 8824039, although it appeared to retreat from that position in PLR 200010036.
  15. Steven J. Oshins, Al W. King III and Pierce H. McDowell III, “Sale to a Defective Trust: A Life Insurance Technique,” Trusts & Estates, April 1998; and Al W. King III, “A Generation Skipping Trust: Unlimited Duration? Why Not?” Trusts & Estates, June 1999.
  16. A CRT will be subject to income tax on all of its income and gains in any year when it receives even one dollar of “unrelated business taxable income.” Section 512, Leila G. Newhall Unitrust v. Com'r, 105 F.3d 482 (9th Cir., 1997).
  17. IRC Section 664.
  18. Upon formation of a CRAT, there must be less than a 5 percent chance that the trust fund will be exhausted prior to the end of the term. This requirement may become an issue when the 7520 rate is low.
  19. IRC Section 664(d)(3).
  20. Treas. Reg. Section 1.664-3(a)(1)(i).
  21. SDCL Section 55-13-7, 12 Del. C. Section 6112, I.C. 30-4-5-5a and A.S. Section 13.38.060.
  22. Treas. Reg. Sections 1.170A-6(c)(3), 20.2031-7 and 25.2512-5.
  23. Lawrence P. Katzenstein, “Estate Planning in a Time of Low Interest Rates,” 37th Ann. U. Miami Est. Plan. Inst. (Fundamentals Program).
  24. In the event the grantor does not survive the term of a grantor CLT, a portion of the deduction (taken in the year of formation) would be recaptured, and taken into income, in the year of death. The recapture of income, in the case of a grantor CLAT, is based upon present value of the remaining annuity payments that had not been made as of the date of death (valued in accordance with Treas. Reg. Section 1.170A-6(c)(4)). The CLAT, then a non-grantor trust, would deduct payments made to charity on a year-by-year basis. It is worth noting here, in particular, that when a grantor CLAT is created during a period of relatively high 7520 rates, the conversion to non-grantor status may actually be beneficial in later years, due to this method of calculating the recapture.
  25. Pursuant to the Jobs and Growth Tax Relief Reconciliation Act of 2003, the top rate for dividend income fall from 38.6 percent to 15 percent, from January 2003 to December 2008. From May 2003 to December 2008, the top rate for long-term capital gains falls from 20 percent to 15 percent.
  26. Capital gains and dividend income, although taxed at lower rates, still would increase the donor's adjusted gross income for purposes of the percentage limitations on charitable deductions.
  27. The government has taken the position with non-grantor CLTs that the annual charitable deductions cannot be allocated against ordinary income items first. Instead, deductions are to be allocated pro rata among the trust's overall taxable income and gains.
  28. There are no assurances that this favorable rate on dividends will continue past December 2008, or that dividends will remain first-tier income.

FINANCIAL MODELING

Optimizing investments for charitable trusts is a complicated business

The use of spreadsheet models and statistical analysis will significantly improve a family's ability to meet its financial and charitable planning goals. For instance, Monte Carlo simulation, a mathematical technique initially used in the late 1940s by atomic scientists to model nuclear fission probabilities, is now used in financial forecasting. It utilizes statistical random sampling to estimate the probability of achieving a future target or goal.

Quite often, financial plans assume a constant rate for variables such as total return and interest rates. But this can be a serious mistake since, in the real world, rates fluctuate. Monte Carlo simulations take into account the volatility and inconsistency of market performance and can provide a guideline for the optimal asset mix and annual cash flow based upon a given risk tolerance.

Creating an overall rational approach to the allocation of family assets can be further complicated by the need to customize strategies — especially as each type of charitable trust necessitates a different approach, and that approach may need to change over time. The trustee of a grantor charitable lead annuity trust, for example, may invest in income-producing assets that are either taxable at low rates or non-taxable. But this strategy would no longer be appropriate if the CLAT became a non-grantor trust (because, for example, the grantor died prematurely).

The consolidation of family wealth in a centralized family entity may alleviate some of the complications of asset allocation where charitable trusts are involved. But even within the confines of an asset-rich FLP or FLLC, optimal asset allocation can be challenging in light of varying interest rates, market uncertainty, changing tax rates and greater access to alternative investments (hedge funds, derivatives, synthetics and the like).

To manage these variables, software products for charitable and personal wealth planning have proliferated. Certain financial institutions, particularly those that emphasize investment advisory services, have developed their own software products, some of which include statistical sampling-based modeling. In formulating any comprehensive charitable plan, donors should consider bringing in money managers or financial institutions who understand the charitable techniques employed and who can integrate these techniques with their financial models. At our firm, we have adapted commercially available software with algorithms that we have developed for this purpose. The result: We can structure both direct investments by different charitable vehicles along with the creation of different classes and differing types of equity interests within the limited partnership or LLC format.

Certain states, such as Delaware, further accommodate this flexibility in limited partnership or LLC planning by providing for the establishment of different classes or series of ownership interests. Each respective series may have a different business purpose or investment objective. More specifically, each separate class may have different rights, powers and duties with respect to specified property or obligations of the limited partnership (or LLC), or with respect to profits and losses associated with specified property or obligations. (6 Del. C. Sections 17-218 and 18-215.)
— H. Allan Shore and Seth R. Kaplan

WHERE THE MONEY GOES

How charity lead trusts fare under varying 7520 rates and with different investment returns*

Assumption
7520 Rate Payout Deduction Initial Trust Funding Deduction Amount 7520 Rate Payout Deduction Initial Trust Funding Deduction Amount
3% 6.049% 90.00% $111,111 $100,000 3% 6.049% 70.20% $142,457 $100,000
6 7.847 90.00 111,111 100,000 6 7.847 78.52 127,352 100,000
9 9.859 90.00 111,111 100,000 9 9.859 84.99 117,668 100,000

*NOTES: All trusts are for a 20-year term. Also, all funds that are contributed to a charitable split-interest trust, together with the cumulative investment return, ultimately pass, in different proportions, to one of the following entities or individuals: A charity, the settlor (or his family) or the IRS. Negative percentage shares relative to the IRS indicate a loss of revenue to the government, resulting in a subsidy to either or both the settlor and the charity.

For illustrative purposes, several assumptions were made. First, to provide a more meaningful comparison between the lead trusts and the remainder trusts (which are tax-exempt), the lead trusts are illustrated as grantor trusts. In both grantor lead trusts and remainder trusts, the primary burden of taxation falls upon the settlor, even though taxation is determined in a different manner. Second, the immediate income tax deduction generated by each trust was targeted at $100,000, and the payout percentages were fixed relative to the varying 7520 rates. The required funding of each trust to yield this deduction therefore varies, depending upon the type of charitable split-interest trust, thereby producing differing deductions as a percentage of funding. Third, all taxes were calculated based on a blended 15 percent rate for portfolio investments, and all immediate income tax deductions were taken (by the settlor) against ordinary income, at an assumed rate of 35 percent.

MAKE YOUR CHOICES

How charity remainder trusts fare under varying 7520 rates and with different investment returns*

Assumption
7520 Rate Payout Deduction Initial Trust Funding Deduction Amount 7520 Rate Payout Deduction Initial Trust Funding Deduction Amount
3% 6.049% 29.80% $335,533 $100,000 3% 6.049% 10.00% $1,000,000 $100,000
6 7.847 21.48 465,598 100,000 6 7.847 10.00 1,000,000 100,000
9 9.859 15.01 666,009 100,000 9 9.859 10.00 1,000,000 100,000

*NOTES: All trusts are for a 20-year term. Also, all funds that are contributed to a charitable split-interest trust, together with the cumulative investment return, ultimately pass, in different proportions, to one of the following entities or individuals: A charity, the settlor (or his family) or the IRS. Negative percentage shares relative to the IRS indicate a loss of revenue to the government, resulting in a subsidy to either or both the settlor and the charity.

For illustrative purposes, several assumptions were made. First, to provide a more meaningful comparison between the lead trusts and the remainder trusts (which are tax-exempt), the lead trusts are illustrated as grantor trusts. In both grantor lead trusts and remainder trusts, the primary burden of taxation falls upon the settlor, even though taxation is determined in a different manner. Second, the immediate income tax deduction generated by each trust was targeted at $100,000, and the payout percentages were fixed relative to the varying 7520 rates. The required funding of each trust to yield this deduction therefore varies, depending upon the type of charitable split-interest trust, thereby producing differing deductions as a percentage of funding. Third, all taxes were calculated based on a blended 15 percent rate for portfolio investments, and all immediate income tax deductions were taken (by the settlor) against ordinary income, at an assumed rate of 35 percent.