Many clients are charitably inclined, but some are hesitant to make large charitable planning decisions because they understandably want to make certain they are taking care of their families as well. And, if there is one thing to learn from the Covid-19 pandemic, it is that the future is hard to predict. Charitable split interest trusts – such as charitable lead trusts and charitable remainder trusts – offer clients a way to help charity without neglecting family, with a large menu of options to suit specific client goals. This article is intended to provide a detailed road map to practitioners whose clients want to deploy their benevolence in a way that is also good for their bloodline.
The Basics.
A charitable lead trust (CLT) is an irrevocable trust created during life or at death which gives charity the first or "leading" interest in the trust. Payments are made to charity for a lifetime or a predetermined number of years, with either a reversion in the grantor or a remainder in family members (typically, the grantor's children or descendants) or other non-charitable remaindermen.1 A charitable remainder trust (CRT) is an irrevocable trust created during life or at death which gives the grantor (or other named beneficiaries) an income stream from the trust for a term of years or for life. Charity receives the remaining trust assets at the end of the trust term.2
Four Types of CLTs
Nongrantor CLTs. Nongrantor CLTs are the most common type of CLT. They can be formed during life or at death and are designed to transfer property to the grantor's descendants or other designated beneficiaries at a reduced gift or estate tax cost. They are typically designed to produce an estate tax or current gift tax charitable deduction that effectively removes the transferred assets from the grantor's federal taxable estate, but the grantor is not entitled to an income tax charitable deduction with respect to any portion of the transfer to the trust. The primary tax benefit for an intervivos nongrantor CLT is a gift tax charitable deduction for the value of the charitable lead interest and potentially removing an appreciating asset from the estate of the grantor. Grantor is entitled to an estate tax charitable deduction for the value of the charitable lead interest and the property is included in the grantor's estate with result that there is a steppedup basis in the property contributed to the trust and eventually passing to the non-charitable beneficiaries.
Grantor CLTs. Grantor CLTs allow a grantor to obtain an immediate income tax charitable deduction upon the funding of the trust equal to the value of the lead interest passing to charity, but the grantor remains taxable on the income subsequently earned by the trust and does not receive any additional income tax deductions for distributions made to charity over the term of the trust. As a result, the initial deduction is "recaptured" over the term of the trust as the trust's income is taxed to the grantor. A grantor CLT must be established during life. In most instances, the corpus of the trust will be includible in the grantor's estate for federal estate tax purposes. Grantor CLTs allow grantors to consolidate deductions for future donations into a larger deduction for a single year. With the increased standard deduction, the limitations on deductions for state and local taxes, and the elimination of many other deductions that taxpayers relied upon in the past that came with the 2017 Tax Cuts and Jobs Act, taxpayers who now itemize benefit greatly from grantor CLTs.
Intentionally Defective Grantor CLTs aka Super CLTs. Super CLTs are designed to achieve both income tax and estate tax benefits – they have both grantor trust and nongrantor trust characteristics. A super CLT is designed to transfer property to the grantor's descendants or other designated beneficiaries, but the grantor retains just enough rights in the trust for the trust to be considered a grantor trust for income tax purposes and a nongrantor trust for gift and estate tax purposes. As a result, the grantor pays tax on the trust's taxable income, but the trust's assets are excluded from the grantor's estate. The grantor receives both an income tax deduction and gift tax deduction in the year the trust is created. Super CLTs are not specifically authorized in the tax law, but the IRS has issued multiple private letter rulings to individual taxpayers approving these hybrid trusts.3
Nonqualifying nongrantor (common law) CLTs. Nonqualifying nongrantor CLTs are designed to keep the income of the trust from being taxed to the grantor while avoiding the private foundation restrictions.4 By design, these trusts do not provide a guaranteed annuity or unitrust interest (which is why they are not qualified), and therefore do not qualify for an initial income or gift tax charitable deduction by the grantor. Such trusts can claim an annual income tax charitable deduction under Section 642(c) when amounts are transferred to charity while avoiding alternative minimum tax and private foundation restrictions. Although no income tax deduction is available to the grantor, neither is any of the trust's income taxable to the grantor, so the net effect to the grantor is as if he or she received a full charitable deduction, even if he or she previously exceeded his or her adjusted gross income (AGI) limits. That could be the case if the grantor has contributed cash or appreciated property to a private foundation with 30% and 20% AGI limits respectively. These trusts also may be attractive to grantors looking to exclude income that could drop the grantor into a lower marginal income tax bracket. Another advantage is that the grantor would have complete flexibility in the choice of what asset to use to fund the trust.5
Two Types of CRTS. CRTs cannot be grantor trusts. Qualified CRTs (meaning a trust that meets the requirements under Section 664) are exempt from all taxes unless the trust has unrelated business taxable income within the meaning of Section 512, which is taxed at 100%. CRTs must be either annuity or unitrusts – no hybrid options, although as described below, there are permutations within those categories.
Nonqualified CRTs do not have any of the same tax advantages, but they also need not comply with the term or other restrictions applicable to qualified CRTs. Nonqualified CRTs are frequently established at death to take advantage of the stepped-up basis rules. Such trusts don't have mandatory payout requirements, but their income is taxed like any other complex trust. As such, it often makes sense to distribute all of the trust's current income every year to avoid income taxes and potentially the net investment income tax.
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Footnotes
1. See generally I.R.C. Section 170(f)(2)(B) and Treas. Reg. section 1.170A-6(c)(2)(i) and (ii).
2. See generally I.R.C. Section 664 and Treas. Reg. section 1.664-1.
3. PLR 199922007 (qualified unitrust that was grantor trust due to retained 675(4) power); PLR 200010036 (level super CLAT approved that held marketable securities); and PLR 199936031 (lead "super" CLT approved that held S-corp stock).
4. When all of the noncharitable interests have expired, private foundation restrictions may apply pursuant to I.R.C. Section 4947.
5. See PLR 9810019, 9407014, 199936031 (involving trusts that qualify for an initial income tax deduction).
This article originally appeared in Estate Planning, a Thomson Reuters publication © 2022.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
