By Robert F. Sharpe, Jr., Chief Consultant
As the dust settles and the many implications of the Tax Cuts and Jobs Act of 2017 (the Act) on income and estate tax planning become increasingly clear, a number of new and different uses for familiar charitable planning tools are beginning to emerge.
Take charitable lead trusts (CLTs), for example. In the past, they’ve been used primarily as a way to make substantial charitable gifts before transferring large amounts of wealth to family and others on a tax-favored basis.
In the wake of 2017 tax reform, it is becoming increasingly clear that CLTs will continue to play an important role in philanthropic planning. CLTs can help donors make larger charitable gifts while maximizing both their estate and gift tax exemptions and the income tax benefits of their charitable gifts.
Let’s look at one example of how the use of a CLT can help motivated donors meet multiple objectives.
Retired couple faces challenges
David and Lisa, both age 65, have recently retired after selling a successful business they spent 30 years building together. Their net worth is now just over $20 million. In past years, they made transfers that absorbed the roughly $11 million federal estate and gift tax exemption they were entitled to prior to 2018. They’ve become aware they will likely owe federal and state estate taxes despite the additional $11 million exemption that was provided for by the Act. Their state also imposes an estate tax beginning at much lower amounts. Given this reality, they’ve decided it’s time to review their estate plans and use their expanded gift and estate tax exemption as effectively as possible.
David and Lisa both sit on nonprofit boards, and each is serving as chair of a separate capital gifts development effort. They would both like to make gifts in the $1.25 million range. Both campaigns are open to crediting multiyear commitments as well as bequests, charitable remainder trusts (CRTs) and other split-interest gifts at face value when donors are age 70 and older.
They’ve received information from one of their charitable interests describing the advantages of CRTs. They’ve rejected this idea, however, because they have no need for additional income that would simply serve to increase their income tax burden.
A practical alternative
Suppose David and Lisa instead created a charitable lead annuity trust (CLAT) today and funded it with $4 million from their diversified securities investment portfolio. The CLAT would pay an annuity of 6.25%, or a total of $250,000 per year. The annual payments would be sufficient to fund a charitable commitment of $1.25 million each to the two different charities over a 10-year term.
For federal gift tax purposes David and Lisa are making a $4 million gift to their children when they fund the trust. They are, however, entitled to a charitable gift tax deduction of $2.11 million to account for the upfront charitable distributions, leaving a taxable gift of just $1.89 million in the year the trust is created.
It would require the use of only a relatively small portion ($1.89 million) of their remaining $11 million exemption amount to offset the taxable gift to their children, resulting in a gift of $4 million (more or less, depending on the performance of the trust assets) to their children in 10 years at a “cost” of only $1.89 million of their exemption amount.
An investment of $1.89 million would have to grow at a compound rate of nearly 8% per year to be worth $4 million in 10 years. The trust, however, need only earn 6.25% to preserve the $4 million initial value of the trust for the children. If the trust assets were to average an 8% total return over the term of the trust, there will be more than $5 million remaining for the children at its termination.
From that perspective, they see the use of a portion of their estate tax exemption as a tax-efficient way to make the desired gift to their children when they are in their mid40s. The children receive a portion of the funds their parents already planned to leave them while their parents are still alive and they are at a point in life where they may need additional resources to fund education and other needs.
David and Lisa have, in effect, “accelerated” an inheritance to their children in a way that both fulfills their charitable intentions and eliminates a significant potential estate tax liability.
Unexpected income tax benefits
From an income tax planning standpoint, note that the annual lead trust payments are not considered income to David and Lisa. This means the payments are not taken into account for purposes of adjusted gross income (AGI) charitable contribution limits or Medicare taxes on unearned income. The payments also don’t serve to increase their AGI for purposes of phasing out certain other tax benefits. This strategy also allows them to deduct their other charitable gifts rather than having the lead trust payments use up their charitable deduction AGI limits.
For donors who don’t itemize their tax deductions, a CLT may be attractive as a way to achieve benefits that are much the same as those they would enjoy if they itemized. That is because not receiving income is the same as receiving it and being able to fully deduct it. I believe this strategy will be used in combination with donor advised funds (DAFs) to help donors achieve the equivalent of full deductibility of gifts, the timing of which they can effectively control through the DAF.
Assets do double duty
This case illustrates just one of many ways effective charitable gift planning will continue to help philanthropically inclined individuals make meaningful charitable gifts in ways that allow assets to be used for the benefit of both charitable interests and loved ones while maximizing all available tax benefits.
This article is based on an article originally published in the July 2018 Trusts & Estates magazine. Click here to read the original feature. ■
Robert Sharpe is Chief Consultant of Sharpe.