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Saturday July 4, 2020

Article of the Month

Charitable Lead Trusts in a Low Interest Rate Environment


Charitable lead trusts are a creative estate, income and charitable tax planning strategy for high-net-worth individuals. Lead trusts often involve significant legal and administrative costs and are more complex in nature than other charitable vehicles. However, with historically low applicable federal rates (AFRs), charitable lead trusts have become more attractive as a planning tool.

A charitable lead trust (CLT) is an irrevocable charitable trust where the annuity or unitrust payouts are made at least annually to a selected charity or charities. Reg. 20.2055-2(e)(2)(vi). Because the charity receives the interest first, it has the “lead” interest. After the lead interest terminates, the trust corpus will return to the grantor of the trust or to beneficiaries selected by the grantor, usually family members. If the lead trust is qualified and makes an annuity or unitrust payment to charity, the donor will qualify for a gift, estate or income tax charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).

While many charitable trusts are tax exempt, lead trusts are not. The taxation of the lead trust and the benefits to the donor will depend on the drafting of the lead trust. It is the structure that creates unique income, estate or gift planning opportunities for the grantor of the trust. This article is Part I in a two-part series. This article will discuss the structure and taxation of the three different types of lead trusts: grantor lead trusts, non-grantor lead trusts and intentionally defective grantor lead trusts. Part II will discuss the unique planning opportunities currently available with CLTs with a focus on the historically low applicable federal rates (AFR).

Grantor Lead Trust

The goal of a grantor lead trust is to generate a current income tax deduction. The grantor of a grantor trust retains certain powers over the trust. With a grantor lead trust, the remainder of the trust corpus reverts to the grantor or to the grantor’s estate at the end of the trust term. These powers make the trust includable in the current assets or the estate of the grantor. If a lead trust is created with a reversion of trust assets that exceed 5% of value to the grantor, the lead trust will be deemed a grantor trust. Sec. 673(a). The grantor trust is subject to the grantor trust rules of Sec. 671-678.

The primary benefit of the grantor lead trust is an income tax charitable deduction. With a grantor lead trust, the donor (or grantor) will receive an up-front income tax deduction for the present value of the income that is projected to be paid to charity. Sec. 170(f)(2). The donor must pay all taxes during the term of the trust for any taxable events that occur within the trust. The donor will recognize all income and capital gain on the donor’s Form 1040. The income distributed to charity will be reported in the donor’s personal adjusted gross income. This means for each year of the duration of the trust, the donor will be responsible for the tax implications of the trust. Sec.170(f)(2)(B).

The assets in the trust are usually invested in such a way as to minimize recognition of income (such as income that occurs on the payment of stock dividends or the sale of highly appreciated capital assets). Because the donor is personally paying these taxes during life, the trust corpus is preserved from tax depletion. Note that if a grantor passes away during the trust term, there is a recapture of part or all of the income tax deduction, because the trust ceases to be a grantor trust. The recaptured amount must be reported as gross income on the donor’s final income tax return. Reg. 1.170A-6(c)(4).

A grantor lead trust is usually funded by a high-income donor who could benefit from an immediate income tax deduction. Such a donor may have had one single large income-generating event that will create a large tax bill in a year, which may be offset by the charitable deduction. Alternatively, the donor may presently be in a high income tax bracket where the donor will benefit from a charitable deduction now, and anticipates being in a lower tax bracket in the future when the remaining assets will be transferred back to the donor or the donor’s estate. The distribution of the trust corpus to the grantor is not a taxable event because the tax implications are handled throughout the duration of the trust.

Non-Grantor Lead Trust

The non-grantor lead trust is often referred to as a family lead trust because the remainder passes from the trust to the grantor’s family members. The goal of a family lead trust is to generate a gift or estate tax deduction which allows assets to be passed to family or other beneficiaries at a reduced gift or estate tax cost. One of the greatest benefits of a family lead trust is that the charitable deduction generated by the gift may reduce future estate taxes.

A family lead trust is its own taxable entity and must file IRS Form 1041. This means that the trust itself pays taxes on all income generated, including capital gains income, in excess of the charitable payments. If the family lead trust is funded with appreciated property and that property is sold by the trust, the payment of capital gains tax could cause a significant reduction in trust corpus.

Unlike the grantor lead trust, there is no up-front income tax deduction for a family lead trust. The family lead trust generates an up-front gift tax deduction if it is an inter vivos trust or an estate tax deduction if it is a testamentary trust. In addition, the trust itself is able to deduct charitable payments made each year against income generated from the trust.
Example: Caroline plans to create a $15 million non-grantor charitable lead annuity trust (CLAT). The CLAT will have a fixed payout of $300,000 per year, a 20-year term and Caroline’s children will be the remainder beneficiaries. Caroline funds the trust with $15 million of stock.

If Caroline funds the lead trust with her stock, the annual annuity payment will consist of dividend income and realized capital gain, totaling $280,000. Because the trust will pay out $300,000 per year to charity, it will be able to deduct the entire $280,000 from its taxable income. The trustee may sell $20,000 of the stock each year to make up the difference to charity. The tax on the $20,000 is offset by the Sec. 642(c) charitable income tax deduction.

Lead Supertrust

The third type of lead trust is called a defective grantor lead trust by tax professionals. A better marketing term is a lead supertrust. The same rules generally apply as to a grantor lead trust, however instead of the trust assets reverting to the grantor at the end of the term, the remainder passes to the grantor’s family. Defective grantor lead trusts are sometimes called lead supertrusts because they achieve the goals of generating a current income tax deduction and a gift tax deduction.

With a lead supertrust, the donor receives an up-front income and gift tax deduction for the present value of the income projected to go to charity. The donor pays all taxes during the term of the trust for any taxable events that occur within the trust, in a manner similar to a standard grantor lead trust. However, instead of the trust corpus reverting to the grantor or the grantor’s estate at the end of the trust term, the remaining trust corpus will pass to the donor’s family. Additionally, the lead supertrust is not included in the grantor’s taxable estate.

In order to qualify as a lead supertrust, the trust must qualify as a grantor trust, which allows the income tax deduction. But, unlike the requirements for a standard grantor lead trust, the trust must also qualify as a complete gift. The grantor must not retain certain powers over the trust, which will allow the trust to be excluded from the donor’s estate. The grantor must not retain a right of reversion of trust assets or the right to control the distribution of income. Sec. 2036(a). The preferred retained power to allow the trust to qualify as a grantor trust, but exclude the trust assets from the grantor’s estate is the power of a non-adverse party to reacquire trust assets. Sec. 675(4). A non-adverse party may be any party not subject to the self-dealing rules under Sec. 4941. While a grantor could argue that retaining and exercising such a power would be permitted under the “incidental exception” to the self-dealing rules (Reg.53.4941(b)-3), a more conservative option is often to give a sibling of the donor the power to reacquire the trust assets. The Sec. 4941 disqualified persons category includes spouses, children, grandchildren and their spouses, but not brothers or sisters, so this provision would not violate the self-dealing rules. Sec. 4946(d). The sibling would also need to be able to exercise this power in a non-fiduciary capacity to cause the lead trust to be a grantor trust. See PLR 200010036.

In the year when the assets are transferred to the trust, the donor will receive an income and gift tax deduction for the present value of the remainder interest to charity. The donor must file a Form 709 gift tax return. On the gift tax return the donor will report the trust value, the charitable gift deduction and the taxable transfer to the remainder beneficiary. The donor may use gift exemptions to cover the taxable transfers.
Example: John sold a commercial building this year that he inherited many years ago from his parents. He has a spike in his taxable income due to the sale and would like to generate a charitable deduction to offset some of the taxes. John would also like to provide a nice inheritance for his children, but he wants to give his children time to mature and make their own way before receiving a large lump sum.

John decides to transfer $3,000,000 to a 15-year lead supertrust. The present value of the annual 3% payout to charity is $1,350,000. Because his income is about $3,300,000 this year, John will be able to use $990,000 of the deduction this year under the 30% of adjusted gross income limit. He will carry forward the remaining $360,000 to use in the next year. He can carry forward his deduction for up to five years.

The trust remainder will be transferred to his children at the end of the trust duration. John does not retain control over the income or a reversion in the trust. He gives his sister, Rebecca, a Sec. 675(4) power to reacquire the trust assets, enabling the trust to qualify as a grantor trust. In the year the trust is funded, John must file a Form 709 gift tax return. He will report a charitable gift tax deduction of $1,287,342, which reduces the taxable transfer to his children from $3,000,000 to $1,712,658. He uses part of his unified estate and gift exemption ($10 million plus indexed increases) to cover the $1,712,658 gift.

Over the 15-year period of the trust, assuming the invested assets produce a total return of 6%, the trust will grow to over $5,000,000. John will benefit from a sizeable income tax deduction, receive a gift tax deduction and be able to transfer over $5,000,000 to his children. The $5,000,000 to the children will be tax-free upon receipt, as John has paid all taxes during the term of the trust. The combined benefits of the plan make this an effective planning strategy for John.


Due to the multiple ways to structure a lead trust, individuals with high net worth may find a charitable lead trust to be a good solution for estate, gift or income tax planning. The structure of the lead trust determines the unique income, estate or gift planning opportunities for the grantor of the trust. This article is Part I of a two-part series. Part II will discuss the unique planning opportunities currently available with CLTs with a focus on the historically low applicable federal rates (AFR).

Published July 1, 2020
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Theodore Diamandopoulos
Memorial Scholarship

"I am currently a senior double majoring in biochemistry and economics and minoring in Innovation & Entrepreneurship. I cannot express enough how much I appreciate the Theodore Diamandopoulos Memorial Scholarship, without it, my Lawrence experience would not be possible. I have enjoyed being a mentor in the CORE freshman mentorship program, playing and working for the Women's Basketball team, competing in Model United Nations, interning as a lab assistant at the MD Anderson Cancer Center in Houston, hosting a pilot STEM program for young unaccompanied refugees in Greece, and volunteering through KidsGive during a field trip to Sierra Leone. Thank you so much for supporting me in doing the things I dream to do."

Jelani Jones, 2021
Marie Dohr Memorial Scholarship

"Being at Lawrence has and continues to be a joy for me. I feel that I have grown so much as a musician, a teacher, and a friend through the awesome community of professors and friends I have met here. I feel that I am blessed to have such an awesome violin professor, and all the faculty members in the education department are so amazing. I have come to see Lawrence and the state of Wisconsin as my home, and I wouldn't change a thing."

Maggie Wright, 2021
Margaret S. and W. Paul Gilbert Memorial Scholarship

The scholarships I receive at Lawrence allow me to experience anything that I want to. I can pursue my love of Biology and Chemistry in classes that are engaging, with professors who care individually about their students. These scholarships also give me the freedom to participate in numerous extracurriculars that Lawrence offers as well, like the Fencing Team and the American Medical Students Association. All of the opportunities Lawrence offers me remind me how grateful I am to have received the Margaret S. and W. Paul Gilbert Memorial Scholarship."

Molly Chadwick Reese, 2020
Anne Prioleau Jones Tuition Scholarship in French

"Attending Lawrence is a privilege few are granted. Every moment spent at Lawrence solidifies a lifelong membership in a special group of peers, known as Lawrentians. The esprit de corps that Lawrence fosters makes the connection between students and mentors new and challenging, with both parties in a constant state of curiosity, respect, and encouragement. My experience as a language learner at Lawrence has not only helped my comprehension of the French language, but has enhanced my ability to communicate and connect with people in ways I never expected before attending Lawrence. As a French major and a student following a pre-medicine track, I have been afforded the privilege of diving into the sumptuous depths of the humanities, while satiating my hunger for scientific knowledge in concert. From this, I am able to fully appreciate the wonders of a liberal arts education. If not for the Anne Prioleau Jones Scholarship in French, I would be unable to join my peers in this quest for knowledge. I am very grateful for the donors' generosity."

Milwaukee-Downer Scholarships and Professorships

Some of the many recipients of Milwaukee-Downer scholarships gather for a photo with Carolyn King Stephens M-D'62 and Marlene Crupi-Widen M-D'55 in January 2014 at the annual scholarship luncheon.

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James G. and Ethel M. Barber Scholarship
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Berk Scholarship
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Anne Barman Caldwell Scholarship
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Jessie Mabbott Daniels Scholarship
F. T. Day Scholarship
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Julia P. Ely and Hannah R. Vedder Memorial Scholarship
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Dr. Alfred W. and Mrs. Ada F. Gray Scholarship
Berenice E. Hess Scholarship Endowment
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Helen McDermott Jurack and Ronald J. Mason Scholarship
Marjorie S. Logan Scholarship
Nellie Maxwell Scholarship
S. Annabelle & Paul McGuire Scholarship
Memorial Scholarship Fund - Milwaukee-Downer
Milwaukee-Downer Class of 1953 Scholarship
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O'Neill-Anderson Family Scholarship Endowment
Elizabeth A. Olson Scholarship
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Aleida J. Pieters Scholarship
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Elizabeth Rossberg Scholarship
Charles Frederic Sammond Scholarship
Mildred L. Schroeder Scholarship
Sivyer Educational Fund for Women
Marion Merrill Smith Scholarship
Dr. Elizabeth A. Steffen Scholarship
W. Mead and Elizabeth McKone Stillman Scholarship
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Clare Scherf Sweetman Scholarship
Raymond H. and Jane K. Taylor Scholarship
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Barbara E. Wehr Fund
Harmony Weissbach Scholarship
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T. A. Chapman Professorship in Music
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Angela Small Fry Intia, 2019
Maurine Campbell Scholarship

"Thanks to the Maurine Campbell scholarship, I have been able to attend the amazing school that is Lawrence University. With the help from this scholarship, I have been able to pursue my dream career in chemistry working with the outstanding and extremely helpful faculty here. Even outside of chemistry I take the time for exploration into my interests and want to give back through my work as a resident life advisor, stock room assistant, and student supervisor at Bon Appetit. Everything I have learned here, academically or not has forever molded the person I am today."

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