A CLT is an irrevocable agreement where a donor transfers assets to a trust that creates a current income, or “lead”, interest payable to one or multiple charities. The trust's remainder interest either comes back to the donor or passes to some other non- charitable beneficiary which is most often the donor's heirs.
Attorneys David Wheeler Newman and Daniel Cousineau recently published an article titled “Is this the Golden Age of CLATs?” The authors cite the “convergence of two factors that are critically important in the planning dynamic for charitable lead annuity trusts (CLATs)”.
Factor One: Historically low IRS interest rates.
The authors do a great job of pointing out first that the calculation of the charitable gift tax deduction is sensitive to the section 7520 rates. They reminded us that the early months of 2019 saw the section 7520 rate at over 3.0%.
|Month||Section 7520 Rate|
For even more proof of the significance of these low rates, below is an example from GiftWizard where I compare a 2% rate to a 4% rate to visually recognize the power of low rates.
Table 1 are various payout rates and charitable terms, assuming a 2.0% AFR. Table 2 illustrates the impact of multiple payout rates and charitable terms, considering a 4.0% AFR.
Factor Two:Depressed Asset Values
The other factor the authors put a fine point on is the power of gifting asset to their loved ones when assets values are depressed, and magnifying the tax impact of that gift through typically a non-grantor CLAT. As the authors cite,
“those opportunities are multiplied due to the CLAT planning dynamic, which involves the arbitrage between the projected average rate of return of CLAT assets over the term of the CLAT and the rate that is assumed for purposes of calculating the gift tax deduction, i.e. the section 7520 rate. The greater the difference between these two percentages, the greater the potential tax-free wealth transfer to the younger generation.”David Wheeler Newman and Daniel Cousineau
Depressed asset values resulting from the Covid-19 crisis not only presents the normal opportunity for wealthy families to transfer assets to their children at a lower transfer tax cost, they also increase the “potential arbitrage” between the current very low section 7520 rate and increased portfolio returns that are anticipated over the term of the CLAT.
The Power of Back-loading the CLAT
This authors mention the concept of “back-loading” the CLAT payouts because that “makes a huge difference in the value of assets that may be transferred at lower transfer tax cost, since it allows more time for CLAT assets to be invested,” which is an technique often used with the “cousin” of the CLAT known as the “GRAT” grantor retained annuity trust.
Because both GRATs and CLATs calculate the resulting taxable gift upon contribution applying section 7520, some tax planners believed that one could back-load CLAT annuity payments in a comparable manner as a “qualified interest.” Over the term of a GRAT, the annuity distribution does not have to be an identical amount each year. Back-loading, however, is set forth by the Treasury Regulations that annuity payments cannot increase by more than 20% from the previous year.
Aside from Rev. Proc. 2007-45, no other guidance has been issued regarding the ability to apply the back-loading in structuring a CLAT. The IRS did approve a CLAT where “the 'minimum' annuity amount payable varies each year”. Other than that ruling the IRS has not taken a position on this subject.
Wheeler-Newman is legendary in the world of charitable planning and fairly obvious that he has much real world experience working with charitable lead trusts of all varietals. The two factors the authors cite are clearly present a planning opportunity. If you include a third factor, which I think in 2020 is nearly as important is the planning opportunity for a wealth family to make a gift to their loved ones to lock in the higher federal estate tax exclusion which is currently about $11.5m. Some pundits have suggested that if the Democrats sweep the election soon there after new legislation will be proposed to reduce the federal estate tax exclusion from $11.5m down to as low as $3.5m.