As the pandemic continues to hinder nonprofits’ ability to fundraise effectively and connect with supportive donors, a charitable lead annuity trust can be a vehicle to provide immediate and ongoing funding to charities, as well as estate or gift tax benefits to donors. This opportunity arises as a result of the historically low rates used to value the interests in these split-interest trusts.
The statutorily prescribed Section 7520 rate used to value the charitable lead interest and the remainder interest in a charitable lead trust is and has been at an all-time low. Consequently, donors have an opportunity to create trusts that provide for annual payments to one or more charities for a specified term, with a distribution of the remainder interest to the donor’s children at the end of the term, with no taxable transfer to the children.
With the Section 7520 rate of 0.6 percent for February 2021 (as well as the prior two months), the so-called zeroed-out charitable lead annuity trust (described below) offers donors the opportunity to transfer significant amounts to charity during the term of the trust and then the potential to transfer significant assets to children at the end of the trust term free from transfer tax. The exact amount the children receive, of course, will depend upon the investment performance of the trust during the term.
For example, if a donor wishes to contribute $100,000 annually to her favorite charities for 20 years, she can transfer $1,879,360 to the trust by April 30, 2021, and direct annual charitable payments of $100,000 (or 5.321 percent of the value of the initial assets contributed to the trust). At the end of the 20-year term, the trust can provide that the remaining assets are to be distributed to her children. Using these terms for the trust, the donor is entitled to a gift tax charitable deduction equal to the amount transferred to the trust, and there is no gift to her children for gift tax purposes. During the 20-year trust term, assuming the trust assets earn an annual return of 5 percent, the trustee will be able to distribute the trust’s remaining assets, worth $1,679,906, to the donor’s children, free of transfer tax at the end of the charitable term. If the trust earns an annual return of 6 percent, the distribution to the donor’s children will be $2,348,803.
For charitable lead annuity trusts (CLATs), lower Section 7520 rates generally increase the value of the charitable lead interest. Until recently, the Section 7520 rate had never fallen below 1.0 percent. While the rate hovered around 1.0 percent between June 2012 and July 2013, it has generally remained well above 1.0 percent during this time period and well below its peak at 11.6 percent in 1989. However, starting in May 2020, the Section 7250 rate fell below 1.0 percent, was 0.4 percent for August through November 2020, and was 0.6 percent in December 2020 and in January and February 2021.
The Section 7520 rate is used to value the charitable lead interest. The goal with a zeroed-out CLAT is to provide for a term and payout that result in a charitable lead interest valued at 100 percent of the amount contributed to the trust. This has the effect of resulting in a remainder value of zero and no taxable transfer to the donor’s children. The following table shows payout rates and trust terms that “zero out” the remainder value in a CLAT using the February 2021 Section 7520 rate of 0.6 percent if annual payments are made at the end of each year to charity.
Payout Rates to Zero Out or Produce Nominal Remainder Value.
| Terms of Years | Annuity Payout Rate |
|---|---|
| 15 | 6.991% |
| 20 | 5.321% |
| 25 | 4.319% |
| 30 | 3.652% |
Because it is uncertain when increases to the Section 7520 rate will occur, a donor whose estate planning includes a philanthropic component should consider whether a CLAT will assist in the accomplishment of the donor’s philanthropic and estate planning objectives, while also enabling the donor to provide much-needed support to nonprofits during the pandemic and associated economic uncertainty. The CLAT is also attractive for donors who no longer have any available gift tax exclusion.
Income Tax Considerations. The donor is not entitled to an income tax charitable deduction upon the establishment of the CLAT trust (unless it is structured as a grantor trust for federal income tax purposes). The CLAT is subject to income taxes but is entitled to an income tax charitable deduction each year for amounts of its gross income paid to charity under the terms of the trust agreement. Careful planning during the administration of the trust can minimize the trust’s income tax liability.
Conclusion. Given the potential for tax benefits to wealthy donors who also have a desire to support philanthropic causes, nonprofits should ensure that their fundraising teams are aware of these potential benefits when speaking with prospective supporters. Also, philanthropically minded individuals should consider this planning technique while the Section 7520 rates remain low as another method to support the charities they support and to obtain estate or gift tax benefits.
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