Many people become passionate about certain causes and seek to provide continuous funds to charitable organizations whose missions and values align with their own. If you are seeking to provide this type of long-term support and plan on making gifts to younger generations, a Charitable Lead Annuity Trust (CLAT) can allow you to combine these two goals and achieve a positive tax result.

The annuity payment from the CLAT is directed to one or more charities for a period of time. The time period can be a number of years or the lifetime of one or more people.[1] At the end of the trust’s term, any remaining assets in the trust are distributed to the named beneficiaries. A CLAT can be created under an agreement written during your lifetime or at death under the terms of your estate plan.

To illustrate the CLAT’s fundamental features, we focus on the “zeroed-out CLAT.” It is the type used when a goal of the person who creates the trust, known as a grantor, is to benefit one or more charities and pass assets to children and/or grandchildren free of federal estate tax due to the “zeroed-out” remainder interest passing to family.

Basic Concepts

A CLAT receives either a transfer of assets from the grantor or from a bequest from the grantor’s estate. The grantor chooses the term of the trust and annuity rate that will be paid to charity. This is usually done with the help of advisors because of the actuarial calculations required to achieve a zeroed-out CLAT. The grantor may be able to create a gift or estate tax deduction that will allow any remaining trust assets to pass without tax to the grantor’s family beneficiaries.

Generally, the larger the annuity payment or the longer the term, the larger any potential deduction.

Once the annuity amount is determined, the beneficiary organizations work with the grantor to decide how the distributions will be made to them. They can ask for an annual payment or a quarterly or monthly pro-rata distribution.

At the time the CLAT is funded the present value of the planned future payments that will go to charity is determined by an interest rate in accordance with the provisions of the Internal Revenue Code (IRC).[2] The present value provides a charitable deduction for gift tax purposes if the CLAT is created during the grantor’s lifetime, or for estate tax purposes if the CLAT is created at the grantor’s death. If the present value of the charitable annuity equals or exceeds the value of the assets initially transferred to the CLAT, then no gift or estate tax will apply to any balance of assets. That means any remaining assets pass tax‑free to the noncharitable remainder beneficiaries (the children or grandchildren) at the end of the trust term.

Achieving zero gift or estate tax gives rise to the moniker zeroed-out CLAT. If the net investment return of the CLAT assets exceeds the applicable interest rate used to value the charitable lead annuity, then there will be at least some assets remaining at the close of the charitable lead term to pass without federal transfer tax to the remainder beneficiaries. Consequently, the applicable interest rate is often referred to as the hurdle rate. It should be noted that if the performance lags the hurdle rate, the trust principal, and therefore the remainder benefit to the charity, would be reduced.

A CLAT, though it may be flexible, is irrevocable, which means once assets are gifted to the trust, their value cannot be removed for purposes other than specified by the trust. A CLAT is sometimes thought of as the inverse of a Charitable Remainder Annuity Trust (CRAT). A CRAT pays an annuity to the person who sets up the trust and leaves the remaining assets to charity when the trust comes to term. For more information on Charitable Remainder Trusts, please see the article “Charitable Remainder Trusts.”

An Example

Grace wants to create an income stream for a local museum and a charity focused on addressing inner-city food deserts for the next 20 years. She also wants to pass as much of her taxable estate as possible to her children. She decides to fund a CLAT with $500,000[3]. It names her two children as the remainder beneficiaries. She chooses an annuity rate of 6.476%, which will pay $31,775 between the two organizations every year for the next 20 years. The value of that gift for gift tax purposes is $0. Assuming a 6% growth rate for the principal of the trust, at the end of the trust term her children would receive about $412,450 between them.


Using CLATs to Teach the Next Generation

In many cases, a CLAT’s remainder beneficiaries are the grantor’s children or grandchildren. This can create a unique opportunity to use the CLAT to teach the next generation about how charitable organizations, charitable gifts, and investments work.[4]

For example, the children and/or grandchildren can decide the proportions of the payments each charitable organization receives in cases where there is more than one beneficiary organization. Part of doing this would be learning about each organization and how they plan to use the donation.

The children and grandchildren may also be given some direct involvement in decisions regarding trust investments. This could be a knowledge incubator for teaching about various asset types, risks, and rewards.

Opportunities

  • Can provide predictable support to the charity.
  • Can facilitate potential tax-free transfers to heirs.
  • Can be advantageous in a low interest rate environment.
  • There is a potential for intergenerational philanthropic activity.

Challenges

  • It may not be possible to avoid generation-skipping transfer taxes.
  • The CLAT is irrevocable.
  • There is a loss of control of assets.

For more information, please contact your PNC advisor.