Understanding Charitable Lead Trusts for Smart Estate Planning

A charitable lead trust is an irrevocable trust that distributes income to a charity for a fixed period. At the end of this term, the remaining property will be distributed to the beneficiaries. Typically, CLTs are used by high-net-worth individuals who wish to donate to their favorite charities and transfer appreciated assets to future generations. 

The primary difference between CLTs and other estate planning strategies is that, while most estate planning strategies have a sole purpose (e.g., tax avoidance), CLTs integrate tax strategy, charitable giving, and long-term family asset management.

Key Takeaways

• A Charitable Lead Trust (CLT) allows charitable organizations to receive income from trust assets; after the income is paid to the charitable organization, whatever is left over goes to your beneficiaries. 
• The CLT reduces estate and gift taxes by lowering the amount of assets transferred that are subject to tax. 
• There are essentially two different types of CLTs: the Grantor CLT and the non-grantor CLT. 
• The Section 7520 interest rate established by the Internal Revenue Service (IRS) significantly affects how efficiently a CLT performs as an income tax vehicle. Because of this factor, many families plan their CLTs just prior to a large transfer event (i.e., death), or when they expect a significant increase in the value of one or more family assets.
• Proper planning and execution of a CLT are vital to ensure it does not fall short of its potential performance due to excessive tax burdens or other compliance issues.

What Is a Charitable Lead Trust and How Does It Work?

A charitable lead trust is an irrevocable trust that provides for income to be distributed to one or more charitable organizations over a set period of time. At the end of the charitable term, the balance of the trust will be distributed to the named individuals, typically family members or heirs.

Here’s a general outline of how a typical CLT functions:

1. The donor places cash, stocks, business ownership, or other forms of personal property into the charitable lead trust.
2. For a specific number of years, the charitable lead trust distributes either a fixed annuity or a percentage of its net worth to one or more selected charities.
3. Upon completion of the charitable term, the remaining balance within the trust is transferred to the designated heirs.

In simple terms:

Donor → Charitable Lead Trust → Charity (Income Phase) → Family (Remainder Phase)

The appeal of using a charitable lead trust lies in how the Internal Revenue Service (IRS) calculates the value of the transfer to heirs at some point in the future. Because the charity receives all the income during the charitable term, the IRS reduces the taxable value of the transfer of the remaining assets to heirs. 

In addition, if the growth of the trust’s assets exceeds IRS projections, that excess will also pass through to the heirs with little additional transfer tax paid.

Types of Charitable Lead Trusts

There are two primary forms of CLTs. Both have differing tax ramifications.

Grantor Charitable Lead Trust

A grantor CLT is one where

• The donor can claim an income tax deduction at the time the charitable payments begin, based on the present value of those payments.
• The donor will be required to file an annual personal tax return, which includes all of the trust’s income.
• Most commonly, this type of CLT is used by donors with unusually high incomes who prefer a large deduction for strategic reasons.

More importantly than creating an immediate deduction, this form of CLT provides an effective means for income tax planning.

Non-Grantor Charitable Lead Trust

As opposed to the previous type, non-grantor charitable lead trusts mean:

• No deduction is available to the donor prior to or immediately after the charitable payments begin.
• The trust itself will pay its own taxes.

The primary advantage of the non-grantor charitable lead trust is that it helps the donor reduce their overall estate and gift tax burden.

Tax Benefits of a Charitable Lead Trust

Tax benefits from a charitable lead trust (CLT) include tax reductions due to the specific type, timing, and potential for asset growth. The following are the most important tax-reducing aspects of a charitable lead trust.

1. Estate Tax Reduction

Many families use CLTs to reduce their estate taxes. As stated previously, when a family funds a CLT, the IRS determines the amount that their heirs will eventually receive by calculating the “present” value of all payments anticipated by the heirs. This present value is determined using a factor based on the Section 7520 rate (the assumed interest rate at which the U.S. government would invest the money). Therefore, the larger the charitable benefit, the less valuable the taxable gift remaining for their heirs.
It gets interesting here; if the investments within the trust grow at a higher rate than the Section 7520 rate, then any additional investment returns are paid to the family members without any further federal transfer taxes. Thus, strong asset performance works in the family’s favor.

As a result of this aspect of CLTs, many families use CLTs in conjunction with investments that have the potential for significant increases in value, such as:

• Pre-initial public offering (IPO) shares
• Private equity interests
• Stock concentrated ownership positions
• Transfers of family businesses

If structured properly, the combination of reduced value from discounting and subsequent long-term appreciation creates substantial estate-planning leverage.

2. Gift Tax Efficiency

A second reason for utilizing a CLT is to maximize the reduction in the taxable value of gifts given to heirs. Because charities are required to receive the income generated by trusts before making distributions to beneficiaries, the amount distributed to beneficiaries is reduced in value for tax purposes. In some cases – dependent upon how long the trust has been established and how much income is generated annually – this estimated gift value could potentially be very low and/or near zero.

However, like anything else, the actual result is contingent upon how the trust is designed, and therefore, the specifics do indeed matter.

3. Income Tax Considerations

Income tax adds another layer of complexity to decision-making. Depending on whether the trust will be established as a grantor CLT (the donor) or a non-grantor CLT (a separate entity), the way in which you are taxed by the IRS varies. If you establish your trust as a grantor CLT, you would have received a charitable deduction immediately from donating money to your CLT, but you would continue to report all of your trust’s income on your annual tax returns. On the other hand, if you establish your trust as a non-grantor CLT, then your trust pays its own taxes based upon the amount of money that flows through it.

This being the case, it is essential to carefully consider all possible scenarios when modeling how your CLT may impact your overall financial plan. A CLT is simply one part of your entire financial plan; therefore, it is extremely important that you do not inadvertently create any unforeseen tax implications for yourself.

The Role of the Section 7520 Rate

The primary element of charitable trusts that many do not consider when creating charitable trust strategies is the IRS Section 7520 rate.

This section of the code dictates how the present value of charitable payments (the lead) and remainder interests are determined.

When interest rates are lower:

• Charitable lead interest value increases.
• Remainder interest values decrease.
• Estate planning efficiency improves.

However, as interest rates fluctuate, strategic timing becomes important. A charitable lead trust with an established charitable lead interest at a low rate may yield significantly different results than one created at a higher rate.

When a Charitable Lead Trust Makes Strategic Sense

Charitable lead trusts, such as all trusts, have their own set of advantages, however, they are not right for everybody. They can be particularly useful when:

• Your family is at risk of paying estate taxes.
• You anticipate a liquidity event (i.e., you will receive cash or other liquid assets).
• You hold an asset that has appreciated (i.e., its value has increased).
• You consistently give to charity.
• You plan to transfer wealth from one generation to another.

As an illustration, take a business owner who contributes $5 million of his pre-sale stock to a 15-year CLT. Over this period, if the stock increases dramatically, the increase in value could pass to the next generation with a lower tax burden due to transfer taxes.

In many cases, charitable lead trust estate plans focus less on “charity first” and more on using charitable giving to strategically sequence your wealth.

CLT vs CRT: Understanding the Difference

Many people confuse Charitable Lead Trusts (CLTs) and Charitable Remainder Trusts (CRTs). But fundamentally, they work in opposite ways.

A CLT provides an income stream to a charity for a fixed term. At the end of that fixed term, what’s left over in the CLT will be distributed to your heirs. Because this is a good way to pass on appreciating assets to younger generations in a tax-efficient manner, as well as fund charities during your lifetime, many use the CLT in this way.

In contrast, a CRT does just the opposite. First, a person (and/or their spouse) will receive income from the CRT for their lifetime. Once that income stream ends, what’s left over in the CRT goes to the charity. Many people create CRTs to generate regular income from highly appreciated assets and/or to avoid capital gains taxes.

It would appear at first glance that there is very little difference between a CLT and a CRT. However, this difference could not be more dramatic. A CLT is going to allow you to support your heirs after you’ve supported your favorite charities. In contrast, a CRT will provide income today and allow your favorite charities to benefit from whatever is left over.

Therefore, if you don’t know what outcome you want, you won’t know which plan to choose.

Example: How a CLT Reduces Estate Tax Exposure

Assume a $5 million contribution into a 20-year Charitable Lead Annuity Trust (CLAT). If the IRS Section 7520 rate is 5%, the present value of the charitable interest may significantly reduce the taxable gift value transferred to heirs.

Risks and Limitations

Although charitable lead trusts provide planners with several highly effective strategies for transferring wealth, they also have potential drawbacks. 

The main risk factors associated with charitable lead trusts involve:

• Irreversibility: Generally, once you have created a charitable lead trust, it can’t be changed or revoked.
• Underperformance of Assets: If the investments contained in the trust don’t perform as well as the IRS assumes (or better), then there will likely be little remaining after the term of the trust expires for your beneficiaries.
• Complexity of administration.
• The cost of compliance/regulatory obligations.
• Changes to estate tax levels by the legislature.

Establishing a CLT requires making accurate projections, especially if you have overly optimistic expectations about investment performance.

Interest Rate & Timing Considerations

Timing can have a significant impact when creating a Charitable Lead Trust (CLT).

The exemption from federal estate taxes is set to decline over the next few years. Families who anticipate they will be subject to higher exemptions in the future may use a CLT in conjunction with other strategies to mitigate their potential long-term exposure to federal estate taxes.

Market conditions also affect interest rates and, therefore, the efficiency of the charitable lead trust. The charity’s share of the trust’s income is determined using an interest rate established by the Internal Revenue Service (IRS). In addition, contributing assets to a CLT while their values are temporarily low could increase the amount transferred to beneficiaries when those same assets increase before the end of the trust term.

In general, timing can be directly related to how beneficial or effective a CLT will be.

Advanced Planning Considerations

Some sophisticated planners use CLTs as a building block within larger wealth transfer plans by combining them with:

• Other advanced wealth transfer options, such as generation-skipping trust planning,
• Discounted transfers of interest in LLCs,
• Grats (grantor retained annuity trusts),
• Charitable lead annuity trusts (CLATs) versus charitable lead unitrusts (CLUTs).

Charitable lead annuity trusts (CLATs) pay out a fixed dollar amount each year to charity.

Charitable lead unitrusts (CLUTs) pay out a specified percentage of the trust’s annual value to charity.

Depending on which option you choose, those funds will grow over the term of the trust, and ultimately, a certain percentage of the remainder will pass to beneficiaries after the term has expired.

When dealing with more complex estates, the importance of analyzing and modeling multiple possible payout scenarios, durations, and growth rates cannot be overstated. What appears to be a minor difference in the structure of the CLT could result in significant changes to long-term outcomes.

Is a Charitable Lead Trust Right for You?

A charitable lead trust is certainly a useful planning vehicle; however, it does not fit every situation. The most important thing before deciding whether or not to move forward is to answer these fundamental questions honestly:

• Will the assets you are considering likely grow significantly over time?
• Is there actually a real risk of estate taxes for your family?
• Do you have a genuine desire to make charitable contributions going forward?
• Are you willing to place your assets into an irrevocable structure?
• Does your total estate plan provide sufficient support for using a CLT, which could last for many years?

Summary

A Charitable Lead Trust (CLT) is an irrevocable estate planning strategy in which income from a donor’s assets is paid to one or more charities for a fixed period before the assets are transferred to their heirs. Due to its ability to reduce the taxable value of the “remainder” portion of the donor’s assets, the CLT may significantly reduce both estate and gift tax liabilities (particularly when using appreciable assets). 

There are two primary forms of CLTs: Grantor CLTs allow for immediate income tax deductions at the expense of requiring ongoing income reporting by the donor, whereas non-grantor CLTs are generally utilized for long-term estate tax mitigation. The Internal Revenue Service (“IRS”) Section 7520 rate directly influences the determination of the planning efficiency associated with each type of CLT. Although potentially highly effective, the use of a CLT requires careful modeling, consideration of interest-rate conditions, and alignment with the donor’s broader wealth-transfer objectives.

Frequently Asked Questions