October 20, 2011   Giving

Testamentary Charitable Lead Annuity Trusts (A Brief Overview)

By Sean R. Kenney, J.D.
Charitable lead annuity trusts (“CLATs”) are an interesting vehicle for testamentary planning due to the historically low interest rates. Further, proper use of a testamentary CLAT not only zeroes out the estate tax but also offers a donor the chance to leave a charitable legacy with the organization of his or her choosing. This short article has two main goals: (1) to present the estate planner with a brief overview and description of a testa­mentary CLAT and (2) suggest assets this author finds most suitable for funding a CLAT. As the title suggests, this is a brief overview of these two topics, and for those who want a more in-depth discussion, I suggest visiting the Leimberg Information Services website at http://leimbergservices.com/wc_access.cfm, and doing a search for “CLAT,” where one will find a bevy of interesting and more nuanced mate­rials.
 
So, what is a CLAT? Simply put, a CLAT is a split inter­est trust that pays an annuity over a term of years to a lead beneficiary, namely a charity, until the end of such term at which time the remainder of assets in trust are distributed to a non-charitable beneficiary, such as an individual or non-charitable trust. As noted above, the estate tax can be reduced to zero per charitable deduction, which is based on the value of the present interest of the annuity payable over a term of years. The annuity amount is calculated from the term of the CLAT and the applicable 7520 Rate applicable at which time the CLAT is employed. It just so happens that the September 2011 7520 Rate is at 2%, which is a historically low rate. The lower the 7520 Rate, the lower the annuity amount payable to the charitable lead benefi­ciary. This is in contrast with the term of the CLAT, i.e. the longer the CLAT term the smaller the annuity payment. Although not discussed in this article, it is imperative to know that CLATs are subject to the private foundation rules per Internal Revenue Code Section 4941. It also should be noted that testamentary CLATs are preferable when there is considerable other wealth that passes onto to the beneficia­ries, so as the beneficiaries do not have to wait until the end of a specified term to receive a bequest.
 
Take for example a testamentary CLAT funded with an asset worth $1,000,000 with a ten-year term that became effective as of September of 2011, with a 7520 Rate of 2%, and contrast it with a testamentary CLAT funded with an asset worth $1,000,000 with a ten-year term that became ef­fective as of September of 2008, with a 7520 Rate of 4.2%.
 
September 2011 Annuity Payment to Charitable Benefi­ciary: $111,326.35
 
September 2008 Annuity Payment to Charitable Benefi­ciary: $124,522.15
 
That’s over a $13,000 a year difference in annuity pay­ments. In only 2007 for example, 7520 Rates were as high as 6%. Thus, when drafting a testamentary CLAT as a sub-trust in a revocable living trust, it would behoove the practitioner to be very much aware of the current 7520 rate and adjust any planning as needed.
 
A fair question from a grantor of a revocable living trust debating whether to incorporate testamentary CLAT provi­sions in their trust instrument is “how much do the remain­der beneficiaries receive at the end of the ten year term of the CLAT?” The answer, in good lawyerly fashion is “it depends,” which provides a nice segue into the next section of this article.
 
Think about all of the above from a practical standpoint using as an example the CLAT funded with $1,000,000 pay­ing out for a term of ten years at $111,326.35. That means that after the tenth payment the CLAT will be worthless provided that there was zero growth within the asset or as­sets used to fund the trust. To examine further, review the numbers below listing average annual growth rate for the term of the trust and the remainder that the beneficiaries receive at the end of the CLAT term: 

1% Annual Growth: 0 to Remainder Beneficiaries

2% Annual Growth: $1.96 to Remainder Beneficiaries
 
3% Annual Growth: $67,684.55 to Remainder Beneficiaries
 
4% Annual Growth: $143,648.21 to Remainder Beneficiaries
 
5% Annual Growth: $228,643.76 to Remainder Beneficiaries
 
6% Annual Growth: $323,477.92 to Remainder Beneficiaries
 
7% Annual Growth: $429,016.64 to Remainder Beneficiaries
 
8% Annual Growth: $546,188.87 to Remainder Beneficiaries
 
12% Annual Growth: $1,152,211.61 to Remainder Beneficiaries
 
It is important to remember that any amount, including the $1.96, is to some degree a windfall because the beneficia­ries really was not supposed to receive anything due to a looming estate tax. Realistically, the beneficiaries will likely want to do somewhat better considering there will be legal and accounting expenses. Thus, a balanced portfolio of marketable securities and bonds are generally the preferred assets for funding a testamentary CLAT. For a number of reasons, which are outside the scope of this article, funding a testamentary CLAT with real estate that has debt on it and/ or using small businesses interests (a non-grantor testamen­tary CLATs can generally not be a qualified shareholders of an S corporation) that produce dividends are generally not acceptable assets for funding a testamentary CLAT.
 
However, what if you could fund a CLAT with assets that gave the annuity producing assets more leverage in actu­ally yielding at a higher rate? In other words, can a CLAT be funded with minority membership interests in a lim­ited liability company that were discounted due to lack of marketability and control where the underlying assets were a balanced portfolio of marketable securities and bonds? There are many different considerations here, again which are outside of the scope of this article, but with the proper planning you can utilize these marketability discounts to reduce the amount of annual growth in the CLAT needed to produce favorable results.
 
About the Author 
Sean R. Kenney is a Senior Associate with Myers Urbatsch PC, located in San Francisco, California, where his practice focuses on estate planning, with a special emphasis on gift and estate tax audits and controversy. Mr. Kenney has helped design, imple­ment, and successfully defend against IRS attack, estate plans for high net-worth individuals throughout the state of California. In his spare time, he likes having impromptu dance parties with his one-year-old son and wife, and finding the best Pho and Ramen restaurants in San Francisco. 
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