We have been told that the only two certainties in life are death and taxes. The former is a certainty but the latter is certainty to change. We all know a major tax change is imminent. Although we don’t know the specifics we do know enough to begin to formulate some tax strategies for 2017.
We know that income tax rates are going to be coming down and we know that interest rates are going up. Both of these upcoming changes make Charitable Lead Trusts (CLT) one of the best planning tools for 2017. This type of trust can be used in a way to create significant income tax deductions or it can be used in a way to allow for significant estate tax savings.
From an income tax planning standpoint the thunder of a Charitable Lead Trust is that it allows for an annuity payment to be made to charity for 5 years, yet you get the entire deduction up front, subject to some limitations. As a rough example (these numbers are not exact but illustrate several points—you will need to seek tax advice to run the specific numbers) let's assume that a single or married taxpayer contributed $1 million of an asset to a CLT. (The asset could be stocks and bonds, real estate, or just about anything.) The taxpayer is 70 years old and decides to serve as the Trustee of the CLT. He then has the investment power, subject to some limitations, to invest the $1 million as he chooses during the 5 year period. He designs the CLT to pay out an annuity stream of 6 percent each year for a 5-year period. At the end of the 5-year period the assets in the trust, along with the appreciation, comes back to the taxpayer. Thus, the "lead interest" passes to charity, and the "reversionary interest" passes back to the taxpayer. Let's assume an 8 percent yield on the assets each year for the 5-year period.
Over the 5-year period approximately $300,000 will be passing to charity. Although the assets will be growing at the rate of 8 percent per year, the charitable deduction will be calculated based upon an IRS assumed growth rate which is approximately 1.5 percent. This creates a larger present value calculation causing a larger charitable income tax deduction. Essentially, the taxpayer will be able to deduct $300,000 up front, although it takes charity 5 years to get the $300,000. Note that this is significantly better than instead of a CLT, the client just contributes $60,000 a year to charity and deducts $60,000 each year. This is especially true if, for whatever reason, the taxpayer will have a very high tax bracket in the year the CLT is established. Tax planning 101 is that a deduction has the most value in a year with the highest income tax bracket.
During the 5-year period, the income tax consequences of the interest and dividends inside the CLT continue to be taxed back to the taxpayer as though he still owned the assets. (This is what the IRS calls a "Grantor Trust" for income tax purposes.) At the end of the 5-year period, all of the assets inside of the CLT "revert" back to the taxpayer. Thus, economically, it is the same tax treatment as though the taxpayer kept the asset, the income, and growth, and donated the $60,000 per year to the charity with the major exception that he got 5 years' worth of deductions in year One.
Now, let's shift gears and design the CLT trust to be an estate tax savings strategy instead of an income tax strategy. Here, instead of the taxpayer keeping the "reversionary interest" he instead gifts that interest to his children. So, at the end of the 5-year period the asset, and the growth and appreciation on the asset, passes to the children. The charity or charities selected by the taxpayer continue to receive the "lead interest" of $60,000 a year for 5 years.
Under this "non-grantor CLT" structure, instead of receiving an income tax deduction up front for $300,000 the taxpayer receives a "gift tax deduction" for $300,000. So, instead of reporting a gift of $1 million to the children on creation of the trust the taxpayer only reports a gift of $700,000. No gift taxes will be owed if the taxpayer subtracts the gift amount of $700,000 from his exemption amount of $5.400 million which can be used on a gift tax return instead of his estate tax return at death. Now, remember that the assumed IRS growth rate is only 1.5 percent on the assets when in reality the yield that we are anticipating is 8 percent. This drives that deduction to be larger than it would be with a higher IRS assumed growth rate.
Now, if you really want to do something exciting, instead of funding the CLT with $1 million of stocks and bonds, fund the $1 million to a family limited partnership first and then gift limited partnership interests to the CLT. This will allow you to further "discount" the gift reported to the IRS by another $300,000 because the asset gifted can be discounted for lack of control and lack of marketability. (That is another discussion for another day,) So, on a gift of $1 million to the CLT, the amount of gift reported on the gift tax return using the taxpayer's exemption is only $400,000.
At the end of the 5 years, the CLT terminates and the asset and the growth passes to the taxpayer's children. In our example above, we are assuming that there will be $1.2 million in the CLT at the end of the 5-year period, after the payment of the $300,000 to charity. So, the thunder is that for a reportable gift of $400,000 to the IRS, the children receive an asset of $1.2 million 5 years from now and charity receives $300,000 spread over 5 years. I see the children smiling, and I see the client smiling, and I see the charity smiling. The only frown I see is on the IRS, but that's OK and it totally legal.
Under the non-grantor CLT, the one where the remainder interest passes to the children, the taxpayer does not get any income tax deductions up front. But, the trade-off is that during the 5-year period, the CLT does not have to pay income tax on the interest and dividends that it earns. So, the last tax benefit is that the CLT is growing income tax deferred, like an IRA, allowing larger growth and more money to be available for the children after the 5 years. The children win in four ways: the 30 percent discount from the Family Limited Partnership; the 30 percent charitable gift tax deduction; the appreciation of the assets during the 5 years above the payout percentage to the charity; and the fact that the assets are growing income tax deferred inside the CLT during the 5-year period.
Yes, it is true that the estate tax may be repealed under the Trump administration. However, it is also true that the gift tax will not be repealed. As such, the gifting rules that we have in effect will also remain after estate tax repeal. It seems to this author that if the estate tax is repealed, that most taxpayers will want to "download" as many assets as they can to trusts created for their children so that in the event the estate tax ever did come back (remember tax law changes are a certainty—and remember that the estate tax was repealed in 2010 for one year and was reinstated in 2011)—that these gifted assets are no longer part of an estate tax inclusion.