Charitable Trusts

Friday, July 18, 2008 by James R. Modrall

Charitable Lead Annuity Trust. A Charitable Lead Annuity Trust
("CLAT") is a charitable trust designed to pass significant wealth to
the next generation without transfer tax. The CLAT was publicized
after the death of Jacqueline Kennedy Onassis who had reportedly
established a CLAT in her will or revocable trust for the benefit of
her children.

Basically, the idea of a CLAT is to provide for sufficient annual
payments from the trust to a charity over a period of years so that
the remainder gift to children, at the end of the term, has a tax
value of zero or close to it.

How Does This Work? I was alerted to the impact that the rapidly
changing interest rates will have on a zero gift CLAT. Each month the
IRS publishes the applicable interest rate for the next month based on
Federal mid-term interest rates. For example, the applicable rate for
May was 3.2%. For June and July, 2008 the rate is 3.8%, and for
August, 2008 the rate is 4.2%. In calculating the value of the
remainder gift to family, the IRS assumes that the earnings of the
trust will be equal to the applicable interest rate ("AFR").

Example. Suppose $1 million is transferred to a twenty year CLAT with
annual payments to a family foundation (or a public charity) at the
May AFR of 3.2%. The annual payment to the charity from the $1 million
trust would be $68,464.54 for a 20 year trust. Using the May AFR of
3.2%, the taxable gift would be zero. If the trust earns more than
3.2% there will be a tax free remainder at the end of the twenty year
term. For example, if the trust earns 6.85%, the earnings will exceed
the payments to charity and there will be $1 million remaining after
20 years. If the trust earns more than 6.85%, the remainder value will
be greater than $1 million .

Similarly, if the trust earns less than 3.2% there will be no
remaining assets for family. (How many financial advisors tell their
clients that they can expect to earn less than 3.2% on their portfolio
over a twenty year period?)Why The Urgency?

Why The Urgency? The IRS regulations permit the grantor of the trust
to use the AFR for the month of the transfer or either of the two
previous months. Thus, a CLAT done before the end of July, 2008 will
qualify for the 3.2% rate.

Why is this important? If the grantor delays until August when the
lowest AFR is 3.8%, the annual payment to charity would have to be
$72,284.63 for the 20 year term in order to have a zero gift. That is
a difference of $3,820.09 per year to accomplish the same result, a
taxable gift valued at zero.

Using a compound growth rate of 5% for 20 years, that saving would
amount to $126,312 (assuming an annuity in arrears). As they say,
"this ain't chicken feed!"What Is The Benefit?

What Is The Benefit? Why would a client want to do a CLAT in the first
place? First, this interests clients who are pretty sure to have an
estate tax at death. That is, clients that have total assets more than
$3.5 million (the exemption in effect for 2009 and likely to be in
effect in the future).

Second, clients may have a charity or private foundation that they
want to benefit. We have done CLATs benefitting both family
foundations and public charities where there is a strong charitable
interest.

Third, we have had clients who want to delay distributions of wealth
to family members for various reasons. Among them are maturity of
grandchildren, retirement funds for children, or delays for reasons of
divorce credit or claims, etc. (Delays can also be useful in the case
of incarcerated relatives but we assume that no readers of this
newsletter would fall into that category.)

More On CLATS.

We have talked about why people would use a CLAT. CLATs come in two
flavors. In the most commonly used CLAT in our experience, the donor
does not claim an income tax deduction, but the trust gets an income
tax deduction for all the payments to the charity. The alternate form
provides a charitable deduction for the discounted value of the
charitable payments, but the trust is taxed on the income. In either
case the objective is the same: payments to a charity and a tax free
gift to children at the end of the term.

In some cases clients may elect to use several CLATs of different
terms if part of the objective is to use up the taxable gift exemption
of $1 million, for example, by reducing the annual payments to
charity, the length of the trust term, or some combination of both.

Conclusion. There is not a lot of time left to set up a CLAT before
the end of July, 2008. However, with another jump in interest rates
imminent, there is still a substantial advantage to a trust
established in August, 2008, using the June rate of 3.8%. A CLAT can
be an important estate planning tool for wealthy clients with a
charitable intent. (There is an especially strong reason to use a CLAT
if a client has a Private Foundation where the client's family will
retain an element of control over the activities of the Foundation.)
You don't have to be a Ford or a Rockefeller to establish a Private
Foundation!

©BRANDT, FISHER, ALWARD & ROY, P.C.