Everything you always wanted to know about charitable lead trusts but were afraid to ask.

By Kathleen Stephenson and Lisa B. Petkun

We have previously looked at charitable remainder trusts and their role in philanthropic giving. Now let’s look at the other side of the coin: charitable lead trusts. While a charitable remainder trust combines a present non-charitable interest with a remainder interest that passes to charity, a charitable lead trust is a charitable interest followed by a non-charitable remainder.

With a charitable lead trust, the organization doesn’t have to wait until the expiration of the non-charitable interest but rather receives the interest at the start. As with remainder trusts, there are requirements governing lead trusts.

Properties of CLUTs and CLATs
For starters, a charitable lead trust can be a charitable lead annuity trust or a charitable lead unitrust.

A CLAT pays a set annuity to the charity during the trust term. The trust can stipulate that income earned in excess of the annuity should be paid to the charity. However, the value of the charitable deduction will be limited to the value of the annuity interest.

A CLUT pays a specified percentage annually based on the fair market value of the trust principal. With a CLAT, the amount passing to the charity each year doesn’t change. With a CLUT, the amount will change depending on the investment performance of the trust assets.

Charitable lead trusts have another variation that charitable remainder trusts do not: It can be either a grantor or a non-grantor trust. (A grantor trust is ignored for federal income-tax purposes.) If the charitable lead trust is a grantor trust, the settlor can claim an income tax deduction when the trust is created equal to the value of the charitable interest.

However, because the trust is a grantor trust, the settlor will be taxed on the income earned during the term — even though income may be paid to the charitable organization.

If the charitable lead trust is a non-grantor trust, the settlor will not be taxed on income earned by the trust — the trust will be taxed instead. But, the settlor will not be entitled to an income-tax deduction for the value of the charitable interest when the trust is created.

In both grantor and non-grantor situations, the settlor will be entitled to a federal-gift tax deduction or federal-estate tax deduction depending on when the transfer is made.

The amount of the deduction, for income, gift or estate-tax purposes, is the actuarial value of the charitable interest. Like charitable remainder trusts, the applicable federal rate for the month the transfer rate is made or the two previous months may be used.

The applicable federal rate, the amount of the annuity or unitrust interest and the length of the lead term are used to calculate the value of the charitable interest. With respect to a CLAT, that rate may have a significant impact on the charitable deduction. (Lower rates produce a greater charitable deduction.)

A charitable lead trust may run for a term of years or for the life or lives of specified individuals. Unlike a charitable remainder trust, the Internal Revenue Code does not impose a limit on the number of years a charitable lead trust may run. Only the settlor (in the case of a lifetime transfer), the settlor’s spouse and an individual who is a lineal ancestor or spouse of a lineal ancestor of a remainder beneficiary may be the measuring life.

For example: If the charitable lead trust provides that the remainder is to be distributed to the settlor’s children, the measuring life for the interest may be the father but not a friend.

Most charitable lead trusts are annuity trusts, also known as CLATs. This is because the charitable interest is fixed at the start, and all growth in excess of what is needed to satisfy the annuity will pass to the non-charitable beneficiary.

In the same vein, most charitable lead trusts are non-grantor trusts. Here the settlor doesn’t claim a charitable-income tax deduction for the transfer to the trust and is not taxed on the trust income during its term.

A charitable lead trust reduces the value of the amount ultimately passing to the non-charitable remainder beneficiary by producing a charitable-gift or estate-tax deduction on the transfer.

For example: A donor transfers $500,000 to a charitable lead annuity trust, specifying that an annuity of $15,000 be paid to a nonprofit for 10 years. On the month the transfer is made, the applicable federal rate is 5 percent. The value of the remainder interest at the time of the transfer is $384,174.

The donor will be entitled to a gift-tax charitable deduction of $115,825. In effect, the donor will be able to transfer $500,000 of assets — and all the appreciation on those assets — to the non-charitable beneficiary while only making a taxable gift of $384,174.

If the applicable federal rate was 4.6 percent, the value of the interest passing to the non-charitable beneficiary drops to $381,890 and the charitable deduction increases.

How to minimize the transfer tax impact
While charitable lead trusts are always an effective means of benefiting a charity while reducing the transfer tax cost of passing assets to non-charitable beneficiaries, they’re particularly beneficial when interest rates are low.

One technique to truly minimize the transfer tax impact is a zeroed-out CLAT.

Here the value of the annuity passing to the charity is equal to the value of the assets transferred to the trust. The value of the interest passing to the non-charitable beneficiaries at the start of the trust is zero. The intent is that the trust assets experience significant appreciation in value that ultimately will pass to the non-charitable beneficiaries. A zeroed-out CLAT can only run for a term of years.

Let’s take our earlier example of a transfer of $500,000 to a CLAT that is to run for 10 years with an applicable federal rate of 5 percent.

If the annual annuity paid to the charitable organization is $63,216, the value of the remainder interest at the time the trust is created is zero. However, if the trust assets realize an annual return of 8 percent, the non-charitable remainder beneficiaries will receive $127,747 at no gift-tax cost to the settlor. And, of course, the charity will have received $632,160!

The benefits of charitable lead trusts
Charitable lead trusts are best used when the donor wants to reduce the gift-tax value of assets passing to non-charitable beneficiaries.

Whether the transfer occurs during lifetime or at death, inserting an intervening charitable lead interest will permit a donor to maximize the amount that can pass to non-charitable beneficiaries.

Charitable lead trusts may be subject to generation-skipping transfer tax depending on the identity of the non-charitable remainder interest. If the charitable lead trust is a CLAT, any allocation of generation-skipping transfer tax exemption will not be effective until the expiration of the charitable interest. As a result, the GST exemption should not be allocated to the trust until the interest in the non-charitable beneficiaries vest.

As with charitable remainder trusts, charitable lead trusts are technical entities and must be carefully drafted and administered. However, they produce an immediate benefit for the charitable organization and an excellent tax benefit for the donor.

Kathleen A. Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa B. Petkun is a partner in the tax department of Pepper Hamilton.