Charitable Lead Trusts
For a single individual or a married couple of very high net worth, the creation of a non-grantor Testamentary Charitable Lead Annuity Trust (CLAT) is one of the most desirable and powerful ways to minimize estate taxes without complicating your life in any way. The way the testamentary CLAT works is that upon your death, or upon the death of the surviving spouse, assets are irrevocably transferred to a trustee of a CLAT established upon your death. A CLAT can also be created during your lifetime.
The trustee of the CLAT pays a fixed annuity payment (calculated as a fixed percentage of the initial value of the trust assets) to a qualified charity (which could be a Private Family Foundation that you establish while you’re alive or that is established upon your death pursuant to instructions in your trust) for either a set number of years or the lifetime of individuals. When the term of the trust has ended, the remaining trust assets are distributed to your children, grandchildren, or other individuals (called the remainder beneficiaries). A long-term lead trust with a sufficiently high payout rate can significantly reduce or possibly even eliminate a gift or estate tax on the assets transferred, meaning that a CLAT can zero-out your estate tax bill. This is sometimes called a “zeroed-out CLAT” because it zeroes out your estate taxes.
Most of our testamentary CLATs have 3 “tiers,” meaning 3 sub-trusts within one CLAT (similar to having 3 separate CLATs with 3 different payout terms). For example, the first tier typically lasts for only 5 or 10 years after your death (paying income to the charity during that time) and then pays the remainder amount to your children; this saves only a small amount of estate taxes but allows a tax-free gift to your children relatively soon after your death. The second tier typically lasts 20 to 30 years after your death (paying income to the charity during that time), and then pays the remainder interest to your children; this saves a much greater amount of estate taxes and allows a tax-free gift to your grandchildren. The third tier typically lasts 50 – 90 years after your death (paying income to the charity during that time), and then pays the remainder interest to your great grandchildren or other remote descendants; this saves the greatest amount of estate taxes and allows a tax-free gift to your remote descendants.
Example of a Testamentary CLAT in Action
A person with a $20 million estate creates a testamentary CLAT in their living trust:
- $5 million funds the CLAT at death.
- The trust pays $250,000 per year (5% annuity) to charity for 20 years.
- If the trust earns 7% annually, there may be substantial assets left over for heirs after 20 years.
- This reduces estate tax liability while benefiting both charity and family.
Who Should Consider a Testamentary CLAT?
- Individuals with a large taxable estate (above the federal estate tax exemption).
- Those who want to support a charitable cause but also provide for their heirs.
- People who want asset appreciation, making a CLAT an effective wealth transfer tool.
A testamentary CLAT is an excellent way to combine philanthropy and estate tax efficiency, ensuring both charitable impact and tax-advantaged wealth transfer to the next generation.
The federal estate tax (if any) upon your death or the death of the surviving spouse is based on the present value of the remainder interest — i.e., the beneficiaries’ right to receive the trust remainder at some future time. This calculation is based upon the term of the trust, the amount payable each year to the charity (the present value of which amount results in a charitable deduction to the estate), and the AFR (applicable federal rate) at the time of the transfer. Stated another way, the present value of the charity’s future stream of income is an immediate charitable deduction for estate tax purposes. Stated yet another way, the donor’s estate is entitled to an estate tax deduction equal to the actuarial value of the income interest payable to the charitable organization.
Because your estate doesn’t pay estate taxes on this charitable portion, the money that otherwise would have been paid in estate taxes can instead be held in the charitable lead trust and invested. During the term of the trust, increased investment income can help pay for the fixed annuity promised to the charity — and if there is any surplus, that extra income (plus any appreciation on the value of the assets) will be compounded for your children and grandchildren (or other remainder beneficiaries) and pass to them — free of gift and estate tax — when the trust ends, or when each tier ends.
Part of the significant advantage of the testamentary CLAT is that it allows discounted gifts to family members – i.e., gifts with substantial valuation discounts. Under present tax law, the value of a gift is determined at the time the gift is made (i.e., at your death or the death of the surviving spouse).
Because the family members who are the remainder beneficiaries must wait for the charity’s income term to expire, the present value of that remainder interest is discounted for the time cost of waiting. In other words, the tax value of the gift is reduced because the value of the gift is decreased by the value of the annual income interest donated to charity. If the term of the trust (or at least the 3rd tier of the trust) is long enough, the value of the remainder interest can sometimes be reduced to zero or close to zero.
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