In this final installment in our three-part series, we discuss the planning technique known as Charitable Lead Annuity Trusts (CLATs). Like Intra-Family Loans and Grantor Retained Annuity Trusts (GRATs) described in previous blogs, a CLAT is an excellent strategy to use during a low-interest-rate environment, and is particularly effective for individuals who are either currently making, or intend to begin making, sizeable annual gifts to charity and who also wish to transfer wealth to younger generation family members in hopes of minimizing estate and gift taxes.
A CLAT is similar to a GRAT in that it is established through an individual’s gift of assets to a trust to be held for a defined period of time, after which the remaining CLAT assets, if any, will be distributed to younger generation family members. The primary difference between a GRAT and a CLAT is that the annual annuity payments paid by the CLAT are not paid to the individual establishing the trust (the grantor), but rather are paid to one or more charitable organizations.
A charitable income tax deduction is available for the present value of the charitable annuity payments. The present value calculation uses the IRS-prescribed interest rate known as the “7520 rate,” which references the Internal Revenue Code section detailing how the rate is determined, in effect for the month of the grantor’s gift to the CLAT (or for one of the two preceding months, if that produces a larger deduction). The November 2016 7520 rate is 1.6%.
As with a GRAT, it is possible under current law to set the present value of the charitable annuity payments to equal the initial value of the assets transferred to the CLAT, so that the value of the taxable gift made to the CLAT is zero or close to zero. So, if the CLAT assets appreciate at a rate greater than the 7520 rate, there will be residual assets remaining in the CLAT at the end of its defined term to pass to younger generation family members, just as with a GRAT.
The principal objectives in establishing a CLAT are to create a win-win situation whereby you receive a charitable income and gift tax deduction for the value of some or all of the assets gifted to the CLAT, and also benefit lower generation family members to the extent the CLAT assets earn a rate of return greater than the 7520 rate during the defined CLAT term. Any excess appreciation will pass to non-charitable beneficiaries (i.e., younger generation family members) at the end of the CLAT term at no additional gift tax cost. Thus, a CLAT works best in a low-interest-rate environment since there is a greater probability of an investment return in excess of the 7520 rate. For this reason, CLATs are an ideal choice for individuals wishing to combine charitable pursuits with (tax efficient) transfers of wealth to family members.