The IRS recently addressed in a private ruling (PLR 200920031) the income tax consequences of a charitable lead annuity trust (“CLAT”) using appreciated property to make one of the annual required annuity payments to the charity. The taxpayer had set up a lifetime grantor CLAT which provided that a charity was entitled to receive an annual payment for 20 years that was equal to a stated percentage of the initial value of the assets transferred to the trust. The ruling does not say what happened to any trust assets remaining after 20 years but normally they would go to the taxpayer’s children.
The trust instrument provided that the taxpayer reserved the right to withdraw property from the trust without the consent of any other party and replace the property with other property of equivalent value. This power caused the trust to be treated as a “grantor” trust under IRC Section 675(4). A grantor trust is one where the trust’s items of income and deductions are reported by the grantor of the trust on his own tax return, as though he still owned the assets that gave rise to the income and deduction items.
Lifetime charitable lead trusts are usually set up to be grantor trusts because IRC Section 170(f)(2) (B) provides that the grantor of the trust is not entitled to any income tax deduction attributable to the property he puts into the trust unless the trust is a grantor trust. If the trust is a grantor trust, as this one was, the grantor receives an income tax deduction equal to the actuarial value of the term interest the charity will receive over the 20 years. The grantor gets his deduction in the year he transfers the property to the trust, and then each succeeding year he must report the trust’s income and deductions on his own tax return and does not receive any further charitable contribution deduction. In effect, he gets a large deduction in the first year and then pays it back by reporting the trust’s income over the term of the charitable interest.
The value of the remainder interest is a taxable gift to his children, but where the charitable lead interest goes on for 20 years, the gift amount is usually very small. If the trust assets grow at a rate in excess of the discount rate that was required to be used to determine the value of the remainder when the trust was created, there will be an untaxed surplus remaining for the children upon the termination of the charitable lead interest.
In his ruling request to the IRS the taxpayer/grantor asked the IRS to rule that he would not have to recognize any capital gain if the trust transferred an appreciated asset to the charity to satisfy one of the annual payments. For authority, the taxpayer relied on Rev. Rul. 55-410 which held that the use of an appreciated asset to satisfy a pledge to a charity did not cause the donor to recognize a capital gain as though he had sold the property. However, the IRS did not believe this was the same case. The IRS said the key to Rev. Rul. 55-410 was that the pledge to the charity did not constitute a debt of the taxpayer. Here, the charity has a claim against all of the trust’s assets and the IRS said that is the same thing as a debt. If appreciated property is used to satisfy one or more of the payments, the trust and its grantor will be required to recognize any resulting capital gain.
The lesson here is simply that the trust should not use appreciated assets to make the annual annuity payments to the charity. If the trust does not have enough cash to make the payment to the charity, the grantor can use his power of substitution to take out assets and put in cash of an equivalent amount. The withdrawal of assets by the grantor does not cause capital gain to be recognized because the grantor of the trust is already treated as the owner of those assets for income tax purposes.