What is a charitable giving technique that doubles as a wealth transfer technique to avoid estate taxes and at the same time works especially well in a low-interest rate environment (as we find ourselves in now)? The Charitable Lead Trust.
First, let’s set the stage. This type of trust is usually implemented after other basics are done—things like your will and powers of attorney and health care directive. Also, it is usually (but not always) in the category of trusts set up during your lifetime and not after your death. It is a separate, standalone trust. Assume we have a couple with some extra money who want to benefit a charity, here’s how it could work…
The couple has an attorney draft a Charitable Lead Trust (CLT). The terms of the trust say that, for the lifetime of the couple (or the surviving spouse), the CLT will annually pay 5% of the trust to a qualified charity. At the death of the surviving spouse, the money left in trust will go to (presumably) the couple’s children.
Because of the way it is set up, it is referred to as a “split-interest” gift where a portion of the gift to the trust goes to charity and a portion will ultimately go to the children. Where do interest rates come in? The current interest rate is used to actuarially determine the amount of the gift going to the children, which the parents will use to file a gift tax return. Of course, with limited exception, there is not actual tax assessed on a gift like that, it is just mandatory to report gifts that size to the IRS. So, in low interest rate environments, the calculated (aka the actuarially determined) amount going to the children will appear to be lower but the actual amount could be much higher, depending on the performance of the assets in the trust. And, for the calculation, because the amount going to the children appears lower, the calculated amount going to the charity must be higher.
Neither the parents nor the children receive anything from the trust during the parents’ lifetime. In that sense, the technique is similar to a will – nothing goes to the children until the death of the parents. What makes this technique compelling is the added ability to give to charity and engage in potential wealth transfer tax mitigation.
Now, a quick illustrative example. Assume parents are ages 65 and 66 and that they contribute $1M to a CLT. The terms of the CLT provide that, for the rest of their joint lives, 5% of the trust is paid out each year to the charity of their choice. The calculation changes all the time, but let’s assume it would show a “gift” to the children of somewhere around $350,000 ballpark. The small amount of the gift is predicated on the current low interest rate. So, if the trust achieves long term average market returns of, say, 8-9%, but the trust is only paying out 5%, then the trust should actually grow over the term of the trust.
In that case, while the calculation shows a low gift of around $350k, the actual gift might be well over $1M. On the flip side, there always exists the possibility that the assets in the trust would underperform the estimated growth and lead to less (or even nothing) going to the children. Of course, there is uncertainty as to the results of the stock markets, so the technique is not for the faint of heart.
The parents would have to file a gift tax return showing a gift of that actuarially-determined value to the kids: $350,000.
Now, most people don’t have to worry about the estate tax as it only applies to people that have large estates. But, if a couple has an estate subject to both the Washington state estate tax and the federal estate tax, the ballpark combined tax burden could be as high as 50% (RCW 83.100.040). Accordingly, in the illustration above, assuming historical market performance, the transfer tax savings could be hundreds of thousands of dollars. And, while some people are put off by complex estate planning techniques, the savings speak for themselves. Perhaps a little complexity is worth the estate tax savings?
In addition to the potential to mitigate or eliminate estate taxes, the trust offers another benefit: it potentially provides a consistent and reliable stream of income to your favorite charity for years to come. So, in addition to acting as a legally-sanctioned wealth transfer technique, it provides a wonderful benefit to worthy organizations.
Many ask whether they would receive a tax deduction for this type of gift, and while the answer to the question is “maybe”, the explanation is longer and more complex than this article allows.
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* Licensed, not practicing.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect actual current or future interest rates. The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.
