Eating your cake and still having it too: Using CLATs for a charitable deduction
By: James J. Lanham, OSBA Certified Specialist in Estate Planning, Trust and Probate Law and Roger D. Proper Jr., LL.M. (Tax), OSBA Certified Specialist in Estate Planning, Trust and Probate Law | Critchfield, Critchfield & Johnston, Ltd. 1
The age-old challenge is to "have your cake and eat it too." ESPN sports talk host Mike Greenberg has argued that the saying should be to "eat your cake and have it too," since everybody who has a cake already gets to eat it too, but still having the cake after eating it is the true miracle. With a $25,100 standard income tax deduction in 2021 for couples filing a joint return, many taxpayers will no longer receive any tax relief for charitable deductions.
One solution is to create a Charitable Lead Annuity Trust (CLAT) and make a large contribution to the CLAT resulting in (1) an up-front large charitable deduction; (2) annual charitable gifts to the charities you regularly support; and (3) assets passing to your family at the end of the trust term. Eat your cake and have it too!
A CLAT is an irrevocable trust into which you contribute funds, then the trust pays an annual annuity amount (i.e., the "lead interest") to the charities designated in the trust for the term. The term is the length of time over which the charities are to receive payments and can be for a measuring life (or lives) or a term of years. At the end of the trust term, the funds are returned to you or, if you face estate taxes, the funds can pass to your heirs (i.e., the "remainder interest") at no estate or gift tax cost. To obtain the up-front charitable deduction, the CLAT must be a grantor trust requiring the donor to pay income taxes throughout the trust term on the trust’s annual income. A CLAT has been referred to as a "wait a while" trust since the heirs must wait a while until they enjoy the benefits from the CLAT. The following examples will illustrate the benefits of a CLAT, including taking care of your favorite charities.
Joe has a tremendous year with his small business, but the extra $100,000 he made over the prior year will be subject to a 41.8% federal and state income tax bill. Joe creates a CLAT with $100,000, invested in assets that will grow 5% annually. The CLAT provides an annual payment of $5,213 to a donor-advised fund at Akron Community Foundation for a period of 20 years. Because the applicable IRS interest rate (§ 7520 rate) is so low (currently 0.40%), the formula calculations at that rate results in a projection of no remainder for Joe’s family, but results in a $100,000 income tax deduction. The actual growth (5%/year), however, far outperforms the 0.40% projected return, so Joe’s children – the ultimate beneficiaries of the trust after 20 years – will receive $92,969 when the trust terminates.2 Had Joe simply donated $100,000 to the foundation as an outright gift, he would have enjoyed the same up-front income tax deduction,3 but the gift would not provide any funds for his family. Joe also gets to advise the foundation each year which 501(c)(3) charities will benefit from his gifts to the donor-advised fund.
An example of using a CLAT to leverage an estate plan for high net worth folks was illustrated in the September 2020 Estate Planning Magazine in an article titled "The Optimized CLAT: A Compelling Income Tax Deduction Vehicle Hiding in Plain Sight." The grantor transfers her $1 million bonus to a CLAT with back-loaded charitable distributions over 30 years. The IRS allows a CLAT to make minimal charitable distributions during the early years of the CLAT, then ramp up charitable distributions at the back end. The grantor gets a $1 million income tax deduction this year, and the trust generates 6.3% in annual growth. When adjusted for income taxes and estate taxes, the results are astonishing. Had the grantor kept the bonus, paid income tax on that $1 million bonus, then invested it at 6.3% growth for 30 years, her family would end up with $1,431,633 after estate taxes, and the charities would reap zero dollars. By funding the CLAT, the family receives $2,766,297 after income taxes (but estate tax-free), while the charity – e.g., a community foundation donor-advised fund – receives $1,229,155. Despite the grantor’s large up-front income tax deduction with the charity receiving over $1 million, the grantor’s family will still be able to have the proverbial "cake" when the trust terminates.
Your knowledgeable estate planning attorney can design the CLAT for you. Your CPA can run various projections to settle on the term and contribution amounts for the CLAT to meet your goals. Your investment advisor can assist with sound investments to attain the returns you are seeking for the CLAT. Your favorite charity, perhaps a donor-advised fund at Akron Community Foundation, would be delighted to receive the annual CLAT payments. Eat your cake and have it too!
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2 To qualify for the up-front deduction, this remainder number is reduced over the 20-year term because Joe pays income tax each year on any income created in the CLAT at Joe’s income tax rate. As an example, if the annual growth includes $3,000 of income and Joe is typically in the 24% bracket, he would pay $720 of income tax for 20 years, or $14,400 of income tax. But the resulting up-front deduction of $100,000 reduces Joe’s income tax bill when the CLAT is created by $41,800 in the example, so Joe still comes out ahead.
3 Note that in 2020 under the CARES Act, direct donations to most charities do not have a cap based upon adjusted gross income (AGI), so 100% of most gifts may be deducted or carried forward to the extent not used. Donor-advised funds, however, do not qualify for the special 100% deduction in 2020. Gifts to donor-advised funds may be deducted up to 60% of AGI for cash and up to 30% of AGI for securities and other appreciated assets. In subsequent years, the usual AGI caps will limit deductibility for all donations. Thus, Joe would need total income in future years of $166,667 in order to claim a $100,000 charitable gift under the 60% AGI cap.