Charitable Lead Annuity Trusts and Limited Liability Companies—both outlined in this alert—are useful vehicles for minimizing gift and estate taxes when transferring assets to family members.
Charitable Lead Annuity Trusts
For individuals who are charitably inclined, a charitable lead annuity trust can be a good technique both to benefit charity and transfer assets to family members at a reduced gift tax cost. This is a particularly good time to establish a CLAT because current, historically low statutory interest rates can allow for greater wealth to pass to non-charitable beneficiaries.
Under the terms of a CLAT, the trustees are directed to make annual payments to one or more charities of the donor’s choosing for a fixed period of years, also selected by the donor. This is known as the “charitable lead interest.” After the charitable lead interest ends, the “remainder interest”—the property remaining in the trust after all the charitable payments have been made— will pass to noncharitable beneficiaries designated by the donor.
The income earned by the CLAT will be excluded from the donor’s income tax return, and instead be taxed to the trust. The trust, in turn, will receive an income tax deduction for the annuity payment passing to charity each year. Thus, although the donor will not be able to take an income tax deduction for the payments to charity, the donor’s income taxes will nevertheless be reduced over the term of the trust because the CLAT income will no longer be included on the donor’s own tax return. This is especially advantageous for donors who have already made charitable gifts to the full extent of their income tax charitable limits.
The donor will be subject to gift tax upon the initial funding of the CLAT unless the donor or the donor’s spouse is the remainder beneficiary, but the value of the gift is reduced by the “present value” of the charitable lead interest. The present value of the charitable lead interest will depend on the statutory rate of interest established by the IRS for the month of the transfer (or either of the prior two months), the length of the CLAT term and the amount of the annuity payments to the charitable lead beneficiaries. Because a lower statutory interest rate produces a lower taxable gift, now is a particularly good time to fund a CLAT.
Furthermore, the current historically low interest rates also mean that more property is likely to pass to the donor’s chosen remainder beneficiaries, since the amount of the remainder interest depends, in part, on whether the investment performance of the assets in the CLAT exceeds the statutory rate of interest established by the IRS.
For example, assume a donor establishes a ten-year CLAT in May, funds it with $1 million, and sets the annuity payments to charity at 6% of the initial trust value ($60,000 each year or $600,000 over the life of the trust), with the property to be distributed to the donor’s children at the end of the tenyear term. Using the statutory rate of interest for May of 2.4%, the “present value” of the right to receive the remaining assets at the termination of the trust in May of 2019 would be $472,150, and this is the measure of the taxable gift. If, however, the contributed assets grow at a rate of 7% each year during the ten-year term, the remainder interest actually payable to the donor’s children in 2019 would be $1,637,497, substantially more than the amount of the gift in 2009.
In summary, a CLAT is most attractive for donors who wish to make charitable gifts while transferring property to their children (or other noncharitable beneficiaries) at a reduced gift and estate tax cost.
Limited Liability Companies
A Limited Liability Company is another estate planning vehicle that may be used to transfer assets to family members at a reduced gift and estate tax cost. Generally speaking, a limited liability company is a voluntary business association between investors (called “members”) who contribute assets to the LLC in return for LLC membership interests. (A limited partnership is a similar entity with a slightly more complicated structure that requires the formation of a separate LLC to serve as a general partner.)
There is a broad range of assets that can be contributed to an LLC, including liquid assets (securities, bonds and cash), business assets, real property and even personal property such as artwork. A federal Court of Appeals recently ruled that valuation discounts, discussed more below, are available for undivided interests in artwork, making art a viable investment option for an LLC.
For estate planning purposes, the most important benefit of contributing a portion of the donor’s assets to an LLC is that the LLC interests the donor takes back in exchange for the assets he or she contributes will be worth less than the contributed assets. This is so because interests in an LLC are entitled to discounts for lack of control (because the donor is no longer managing the assets) and lack of marketability (because there will not be a ready market for the LLC interests). In some cases, the IRS has allowed combined discounts as high as 40%. If the LLC is formed and operated correctly, the discounted LLC interests, rather than the full value of the assets initially contributed to the LLC, will be included in the donor’s estate when he or she dies.
Furthermore, gifts of the LLC interests that the donor makes to family members or other beneficiaries would similarly qualify for discounts. This means that the gifts will use up less of the donor’s $1 million lifetime gift tax exemption, or (once the donor has exceeded the exemption amount) incur less gift tax, than if the donor was to give the underlying, undiscounted assets directly.
In order for these discounts to be available, the LLC must meet several requirements found in the Internal Revenue Code and federal court cases, including the following:
- the donor may not retain control over the assets that are contributed to the LLC
- the manager of the LLC must actively manage the LLC’s assets
- the donor must keep sufficient assets in his or her own name (and out of the LLC) so that the donor can support himself or herself in his or her accustomed standard of living without relying on distributions from the LLC.
There is currently a bill before Congress that would reduce the availability of discounts for intrafamily transfers that use vehicles such as LLCs. Therefore, clients who are interested in using LLCs to transfer assets at a reduced gift and estate tax cost to family members should act sooner rather than later.