Let’s suppose Donor creates a CLAT with $1 million in cash. The CLAT is to pay $50,000 a year to Charity for 12 years and then distribute all of its assets to Donor’s daughter, Sue. This fact pattern is as plain vanilla as can be, which is good for teaching.
For federal gift tax purposes Donor has made two gifts:  a gift to Charity, and  a gift to Sue. These gifts are made on the day Donor funds the CLAT … on that day only.
The gift to Charity consists of the right to receive $50,000 a year for the next 12 years. The gift to Sue is the right to receive what remains in the CLAT at the end of the next 12 years. Each of these rights has a present value, which is a portion of the $1 million used to fund the trust.
If we assume a 2.0 percent IRS discount rate, the gift to Charity is $532,735, and the gift to Sue is $467,265. These two gifts add up, they must add up, to the $1 million used to fund the trust. If Donor has remaining at least $467,265 of his lifetime gift tax exemption ($5,450,000 for 2016), Donor will not incur any gift tax on the gift to Sue. The gift to Charity is not subject to federal gift tax, because of the unlimited gift tax charitable deduction. The calculated numbers, by the way, fall out of a computer.
Note that if we assume a 1.8 percent IRS discount rate, the rate for July 2016, the gift to Charity increases to $538,905, and the gift to Sue decreases to $461,095. The applicable IRS discount rate is what the IRS assumes on the day the trust is created the CLAT will earn for its entire 12 years. This assumption is made so that the gift tax consequences of creating the CLAT can be figured on the day the CLAT is created.
We’ll continue this example next time, when we’ll look at  how things play out for the trust itself over the 12 years, and  how Sue is treated from a tax standpoint when she receives all the trust assets at the end of 12 years.
by Jon Tidd