On-Demand: Estate Planning Opportunities & New Retirement Distribution Rules

January 28, 2021

Our panelists discussed a variety of estate planning opportunities, and recent changes to the new retirement plan distribution rules as a result of the SECURE Act.


Transcript

Good afternoon, everyone. I'm going to be discussing the SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement. We will be looking at how this affects estate planning for retirement benefits.

Patricia Green:This act was signed into law in December of 2019. For years, we have been planning to stretch out retirement benefits as long as possible. This act changes that for most beneficiaries. The act does not amend or replace with one exception, any of the existing regulations. It does, however, include a new section 401(a)(9)(H), which adds a new payout period for all designated beneficiaries. The definition of designated beneficiaries does not change, and I will be discussing see-through trust that qualify as designated beneficiaries in a little bit. So, categories of beneficiaries under the old law, there was two types of categories. One, a beneficiary who is not a designated beneficiary. And this falls under the distribution roles of five years of the participant's death. If the participant died before the required beginning date. Or the remaining life expectancy of the participant if the participant died on or after their required beginning date.

 The other category is a designated beneficiary, and they were entitled to take payout over their life expectancy. Now under the new law, we still have the beneficiary who is not a designated beneficiary, and there's no change on that. There is a change for all designated beneficiaries. There is now a new 10 year payout period. Bye bye to the stretch IRA. Then there is a third type of beneficiary, and this is an eligible designated beneficiary, and they are entitled to take the benefits over their life expectancy period.

As I said, the new code section has a new payout period of 10 years that applies to all designated beneficiaries with the exception of five categories. These five categories of eligible designated beneficiaries are excluded from the 10 year payout and can use life expectancy payout. The 10 year rule kicks in upon the death of the EDB or the age of maturity for a minor child. These categories are one, surviving spouse. Two, minor child. Three, disabled individual. Four, chronically ill individual. Five, a beneficiary less than 10 years younger than the owner.

Okay. That was a little tricky because I didn't mention it, but the answer is no. An estate is not a designated beneficiary under the definitions of the regulations. So there is no change to the payout period if the estate is the beneficiary of the retirement plan and the distributions would be required to be paid out under the five-year rule. It gets a little tricky if you want to leave your retirement benefits to a trust, and there are reasons that you may want to leave the benefits to a trust. You may want to keep it out of the assets of the beneficiary's estate, or you may want to provide increased protection against beneficiaries, creditors, predators and spouses.

There's two types of trusts that we're going to discuss, and they're both called see-through trusts, where the retirement plan looks to the beneficiary of the trust to determine the required minimum distribution rules that apply. The items to consider here are, one, are all the beneficiaries individuals. Two, which beneficiaries are counted? One of these see-through trust is what we call a conduit trust. In a conduit trust, the trustee has no power to accumulate the plan distributions. The trust document requires that all distributions that come out of the retirement plan into the trust be paid out to the income beneficiary. This type of trust automatically qualifies as a see-through trust and the remainder beneficiaries are not counted for the RMD purposes. If the beneficiary is a designated beneficiary, it falls under the 10-year payout period. Now this could cause a problem because if this is the only asset in this trust, this trust is going to be exhausted within that 10-year period. However, if the beneficiary is an EDB, then benefits can get paid out over their life expectancy.

The second type of see-through trust is known as an accumulation trust, where the trustee can accumulate the retirement plan distributions inside the trust during the lifetime of the initial income beneficiary for possible later distributions to remainder beneficiaries. In this case, all of the beneficiary who might be entitled to receive such accumulated are counted as beneficiaries for applying the minimum distribution rules. So all countable beneficiaries must be individuals. If they're not, then it would fail the see-through trust and distributions would be required under the five-year payout rule. If all the beneficiaries are individuals, then the retirement benefits must be paid out within 10 years. And under the old rules, we used to have to look to see who is the oldest beneficiary, and it would be paid out over that lifetime that no longer applies.

Accumulation trust can not qualify for an EDB treatment, the payout over life expectancy, because the EDB is not the sole countable beneficiary. There are two exceptions to this though. If the beneficiary is disabled or chronically ill, they are considered the sole beneficiary and the benefits can be paid out over their lifetime. So trust that qualify for this life expectancy payout are trust for disabled and chronically ill, eligible designated beneficiaries. No one else during the income period can receive any benefits, and the remaining balance must be distributed within 10 years after the death of the last disabled or chronically ill beneficiary. Also, conduit trust for persons not more than 10 years younger will work for a stretch out over their life expectancy. Anyone may be a subsequent beneficiary and the 10-year rule applies upon that beneficiary's death. So this could be for a sibling, for a lifetime partner, anybody who is not more than 10 years younger than the owner.

Planning for a surviving spouse. You can always leave the benefits outright to the surviving spouse who can still roll over into their own IRA account and use the life expectancy rules. But there are reasons you might want to put the benefits inside a trust first for your surviving spouse. Suppose you have children from a first marriage and you want to make sure your surviving spouse is taken care of, but upon her death, you want it to go to your children and to ensure that that is the outcome, you may want to put it in a trust. So a conduit trust for a surviving spouse still works and the distributions are paid to the trust over the surviving spouse's lifetime. A common type of trust is a QTIP conduit trust, where the spouse receives the greater of the income or the required minimum distributions each year.

A see-through accumulation trust for a spouse will not be eligible for the life expectancy payout. In this case, you look at all the beneficiaries and you count all the beneficiaries. The spouse is not the only beneficiary, so let's get paid out within that 10 year anniversary assuming that all the beneficiaries are individuals. If there's a charity at the end of that, then it's under the five-year rule. I was thinking, there isn't an option that you might want to consider if you're to simulate a stretch IRA. Suppose you are the surviving spouse and you have a large retirement plan and you have children, but you have no grandchildren and you want to provide for your children during their lifetime, but upon their death, you would like the proceeds to go to charity.

One option is that you create a charitable remainder trust. The charitable remainder trust must annually distributed percentage of the trust assets, at least 5% to one or more individuals for life or up to 20 years and the remainder goes to charity. There are some rules with this. The charity interest at inception must be worth at least 10% of the value transferred to the trust. The trust is tax exempt. When the retirement plan benefits come out, they're not taxed to the trust. They are taxed as the benefits are distributed to the beneficiaries under the annuity. The annuity is taxed under a tiered system, taxing ordinary income first.

I have a couple other planning options that you might want to consider. The owner may want to start converting their retirement benefits to Roth so that it would fall under the 10-year period for the beneficiaries, but it would eliminate the tax burden. Another option is to make your charitable distributions directly from the IRA. If you are 70 and a half, you can do up to $100,000 per year. And this distribution under the 10-year period, you don't have to take it out evenly. You can leave it in for the 10 years to receive the maximum tax free growth, or you could take it out and spread it over the 10 years to even the tax burden.

Or you might want to consider leaving your retirement money to charity and leave your other assets to descendants. Or you have to also look if you have any eligible designated beneficiaries that you might want to set up the retirement funds and leave the assets to other individuals. You also might want to consider life insurance to cover the income tax burden on the accelerated payout. There's a lot of planning that has to go in when you're leaving your retirement benefits to a trust. So special care must be taken. I thank you for your time, and I now turn it over to Karen Goldberg.

Karen Goldberg:Thanks, Pat. Now we're going to change gears and I'm going to discuss ways of using the current gift and estate tax exclusion. Before that, let's run through the current exclusion and exemption amounts. The annual gift tax exclusion is $15,000, $30,000 for a married couple. The same as it was last year. The annual gift tax exclusion permitted for gifts to a non-US citizen spouse is $159,000. The gift and estate tax basic exclusion amount is $11.7 million per person or $23.4 million for a married couple. The generation-skipping transfer tax exemption has increased to match the gift and estate tax basic exclusion amount. It is now $11.7 million per person or $23.4 million for a married couple.

Now let's look at some state exclusion amounts. The New York estate tax exclusion is now 5.93 million. But is no longer available once an estate exceeds that amount by 5%. The Connecticut Gift and Estate Tax Exclusion has taken a big jump. Now it's $7.1 million. By the way, Connecticut is the only state that currently has a gift tax.

Now let's look at the relevant provisions of Biden's tax plan. Well, it includes the reduction of the gift and estate tax basic exclusion amount to $3.5 million from its current high of $11.7 million per individual. A big drop. He also proposes an increase in the top estate tax rate to 45%. It's currently 40%. Finally, he wants to eliminate the basis step-up at death. In my opinion, the elimination of the basis adjustment at death would be an administrative nightmare because it would require the retention of cost basis records for potentially a lifetime. The looming question though, is whether a potential reduction in the gift and estate tax basic exclusion could be made retroactive to January 1st, 2021. I think this is highly unlikely since there isn't even a bill before Congress.

As you all likely know, the gift and estate tax basic exclusion amount and generation-skipping transfer tax exemption are at an all-time high, more than double what they were in 2017. However, if there are no law changes, these amounts will revert to $5 million plus some indexed amount in 2026. If Biden's tax plan is passed, these amounts will be significantly reduced before then.

So considering the likelihood, the highest estate and gift tax basic exclusion and  generation- skipping transfer tax exemption will likely be reduced sooner rather than later, this is the time to act. Simple ways of using the larger exclusion and exemption amounts include the following: (1) forgiving loans to family members, (2) forgiving notes with grantor trusts that were part of sale  transactions, (3)  topping off existing trusts, (4)  pre-funding life insurance trust with funds sufficient to pay future insurance premiums, and (5) making a late allocation of generation-skipping transfer tax exemption to existing trusts;  this permits the use of GST exemption without the need to make a gift.

Now let's discuss Spousal Lifetime Access Trusts, which are more commonly referred to as SLATs. This vehicle is very popular because it permits a married individual to make a gift to a trust and still retain indirect access to the trust assets. This is how it works. One spouse or both spouses set up a trust for the other spouse and their children and grandchildren. Because the spouse is a trust beneficiary, distributions can be made to that spouse who can then share them with the donor spouse, hence, indirect access. However, beware if spouses set up a SLAT for each other, the trust cannot be identical or too much alike; otherwise, the IRS could assert that the reciprocal trust doctrine applies whereby each spouse would be treated as creating a trust for himself or herself rather than the other spouse. If this happened, the trusts would be includible in the spouses’ respective estates.

If both spouses want to set up a trust for each other with the maximum gift tax exclusion amount, but only one spouse has enough funds to do so, the wealthier spouse can gift property to the less wealthy spouse, but there should be a “cooling off” period before the less wealthy spouse uses the funds to set up a SLAT for the wealthier spouse. The theory is that the IRS could assert that a step transaction took place if there isn't a “cooling off” period, or it isn't long enough. In such a case, the wealthier spouse would be deemed to set up the trust that the less wealthy spouse created and because the wealthier spouse is a trust beneficiary, the trust would be includable in the wealthier spouse's estate.  Not a good result.

A final point, SLATs are generally grantor trusts. This means that the donor spouse, rather than the trust, is responsible for the trust’s income tax. This permits the trust to grow undepleted by income tax, which is an additional benefit.

So if a couple wants to use some of the historically high basic exclusion amount, but isn't comfortable giving away $23.4 million, only one spouse should set up a SLAT to use their basic exclusion amount. This way, when and if the exclusion is reduced, the spouse who didn't fund a SLAT will still have basic exclusion amount available, regardless of what it is reduced to. Let me illustrate.

If both spouses set up a SLAT with, let's say $5 million for a total combined gift of $10 million, then they've each used $5 million of their current basic exclusion amount.  If the exclusion is ultimately reduced to $3.5 million, neither spouse will have any basic exclusion amount remaining. However, if one spouse sets up a SLAT with $10 million and the exclusion is reduced to 3.5 million, the spouse who set up the SLAT won't have any basic exclusion amount remaining, but the other spouse will have the entire 3.5 million exclusion available. Thus, allowing the couple to give away tax- free $13.5 million rather than just $10 million if they had both used $5 million of their current basic exclusion amount to fund a SLATs Thank you.

Karen Goldberg:Most of you got the answer correct. The false answer is Biden's tax plan provides for a five million dollar estate tax exclusion. No, it provides for three and a half million dollar estate tax exclusion. Thank you. Now we're going to move on to Kurt's presentation.

Kurt Peterson:Hello, everybody. Thank you for allowing us to make the presentation to you today. I'm going to be speaking today about GRATs and Sales to Intentionally Defective Grantor Trusts. You've worked a lifetime accumulating assets and building wealth, and now you would like to plan to pass a significant portion of that wealth to your children, grandchildren and future generations. Those assets may be in the form of interest in closely held businesses, a portfolio of stocks, bonds, and perhaps even alternative investments and your personal residences and rental property. There are a couple of tried and true estate planning transactions that have been around for quite a while, referred to as the Grantor Retained Annuity Trust or GRAT for short, and the Sale to an Intentionally Defective Grantor Trust, which I will refer to sometimes as a Sale to an IDGT. You can attempt to create and implement a GRAT for virtually no gift tax cost with what is known as a zeroed-out GRAT, which by the way, used to be formerly known as a Walton GRAT.

The cost of implementing a zeroed-out GRAT would be the legal fees to draft the trust agreement and perhaps some administration costs. The sale to an intentionally defective grantor trust can be utilized to leverage your unified credit in order to create a trust as an economically credit worthy borrower, or perhaps you might even have an existing grantor type trust that you've previously funded with your gift tax credit, then those trusts can purchase the business, investment and personal assets. As a general accepted rule of thumb by commentators on this subject, the trust can purchase as much as 10 times the amount of assets with what was initially gifted in order to seed the trust. The time to think about these estate planning tools is now as the interest rate environment is incredibly low, which makes both of these techniques that much more effective as they freeze the value of your assets at their current levels and take advantage of the historically low IRC section 7872 AFR interest rate and the IRC section 7520 rate utilized by GRATs.

In order to jumpstart your estate plan through the use of these estate planning techniques, valuation discounts for lack of marketability and minority interests can be utilized to reduce the current value of your assets. Currently, these deductions are still available, whether they are applied to operating businesses, as well as entities that hold passive investment portfolios, rental activities, or personal assets. However, please know that there was an attempt during the Obama administration to eliminate the eligibility of non-operating businesses, such as family limited partnerships, to take these discounts. The IRS previously issued proposed regulations that were later withdrawn when the political environment changed. Let's stay tuned to see what happens during the new Biden administration.

In order to achieve the minority interest discounts, you may need to reorganize your business into voting and non-voting shares or managing and non-managing LLC interests. You can also structure the estate planning techniques to pass down your business interests to your children that want to be involved in your family business and utilize other non-business assets to equalize the inheritance of the children who you don't want involved in the family business.

Both the GRAT and the Sale to the IDGT may be utilized by taxpayers who previously used all or a portion of their unified credits.  As previously mentioned, the GRAT can be effectively zeroed out with no gift tax cost if the present value of the annual annuity stream that gets paid back to the grantor equals approximately the value of the assets transferred to the trust. Taxpayers that have previously created trusts for their children and grandchildren may be good candidates for the sale to the grantor trust technique. If hard to value assets are transferred that require an appraisal to document the fair market value of the assets for federal gift tax return purposes, then an initial and possibly an updated appraisal may be required each year, which will be an additional administrative cost if the GRAT needs to return some or all the units in a closely held business in order to make its annual annuity payments back to the grantor. The incentive for the IRS to audit the gift tax return and challenge an appraisal can be mitigated if a formula clause is used that defines the portion or percentage of the assets to be sold or retained by the grantor.

Additionally, a provision can be included in the trust agreement that will distribute the amount above a defined value to be transferrable to a charity or the donor's spouse who will be both non-taxable beneficiaries. Therefore, the service will ultimately receive no additional tax if they are successful, challenging the valuation of the hard to value assets. Both the GRAT and the Sale to the IDGT work well when the trusts are funded with assets that generate cashflow or income earned on the assets that can be used to pay either a portion or all the annual annuity payments owed back to the grantor during the GRAT or the interest payments due on the promissory note associated with the Sale to the IDGT technique. Both transactions maximize their benefits if the assets that are transferred to the trust are expected to appreciate far above the amount of the interest due back to the donor on the promissory note, or the 7520 rate utilized in the present value calculation of the GRAT.

GRATs are most likely better suited if the period of time prior to the sale or a liquidation event of your business is about to occur, as the regulations provide for the amount of the retained annuity to be determined relative to the value of the property transferred to the GRAT. This is not so much true for sales to IDGTs as the IRS could assert the step transaction doctrine and collapse the transaction. Additionally, if an offer by a potential buyer has already been made for the business, an appraiser will have to take that fact into consideration when valuing the business interest to be sold to the trust, which could significantly increase the purchase price of the business and therefore, will also increase the principal amount of the note that will have to be paid for the business.

Both techniques include the use of grantor type trusts, and the grantor is taxed on his or her personal tax returns on all the income and gain earned by those assets while they are held in the trust. By the grantor paying all the income tax and the NIIT Obamacare tax liability out of the other assets in his or her estate, the other assets included in the grantor’s gross estate are reduced. The assets held by the trust can therefore grow tax-free without the burden of the income taxes on the appreciation of the trust’s assets. The grantor's payment of the tax liability on the income and gain earned by the trust assets are not deemed to be an additional gift by the grantor, which is another perk of a grantor-type trust. The grantor can also swap his high basis assets held in his remaining taxable estate for the low basis assets held by the trust in order to attempt to get a step-up in basis of the low basis assets should the grantor die with those assets in his estate.

There is no gain recognition or interest income when a grantor sells assets to a grantor trust in exchange for an unsecured promissory note, as the grantor is, in effect, selling assets to him or herself. The exception is the Commonwealth of Pennsylvania, which happens to be where I currently practice, as it is the only state in the country that does not follow the federal grantor trust rules for irrevocable trusts. So therefore, there would be gain recognized on the sale and reportable interest income received by the grantor on the note for Pennsylvania individual income tax purposes.

On this slide, is an illustration of the steps associated with the GRAT technique. The grantor transfers assets to a trust in exchange for the right to receive annual annuity payments for a period of years. Please note that the number of years cannot be less than two. The amount of the taxable gift is equal to the difference between the fair market value of the assets transferred to the trust less the upfront present value of the annuity stream to be paid back to the donor. If the value of the annuity stream is engineered to approximately equal the value of the assets contributed to the trust, there is essentially no gift and no need to use any of the taxpayer’s unified credit. If the assets appreciate during the retained annuity term in excess of the IRC section 7520 rate, the GRAT will be successful and any additional appreciation or remainder will pass gift tax free to the children, or perhaps to a remainder trust for the benefit of the children.

If the assets decline in value during the annuity term, all the assets will be paid back to the donor during the annuity payments. If the donor passes away prior to the termination of the annuity payments, in the zeroed-out GRAT, all the assets will be includable in the gross estate and nothing would have been achieved by creating a GRAT term that the donor doesn't survive.

On this slide, this is an illustration associated with the Sale to an Intentionally Defective Grantor Trust. The grantor makes a gift utilizing his or her unified credit to a grantor type trust, creating a trust that is a credit worthy entity. If the donor does not already own an interest in a closely held business available for use in the technique, the grantor can create a family limited partnership and fund it with an investment portfolio or other non-business assets, which will then be managed on behalf of the grantor and his or her spouse.

After a period of time after the funding of the partnership, the limited partnership interest or non-managing LLC interests are valued and sold to the grantor trust in exchange for a promissory note, which also could be a balloon note with the entire amount of the principal being due only upon the maturity of the note. The annual interest payments on the note that are paid to the grantor are not reportable as taxable interest income. Upon the maturity date of the promissory note, the note is paid off and the appreciation of the assets,  including the original valuation discounts, if any, remain in the trust available for distribution to the trust beneficiaries, which can be the grantor's children and their descendants.

The GRAT technique is specifically permitted as a viable estate planning transaction within the internal revenue code. Therefore, GRATs are much less prone to IRS scrutiny than the Sale to the IDGT technique. The taxpayers’ generation-skipping tax exemption can be allocated at the time of the funding of the trust, in the Sale to the IDGT technique, allowing the trust assets to be fully exempt from the generation-skipping tax if the trust will be for the benefit of grandchildren and future generations. The GRAT is not an effective generation-skipping transfer tool as the GST exemption cannot be allocated until the termination of the grantor’s retained annuity stream or what is also known as the ETIP, the Estate Tax Inclusion Period. As you can see by this slide, the current minimum IRS mandated AFR interest rates and the GRAT’s 7520 rate are extremely low. Therefore, almost all of the appreciation of the trust assets can be transferred gift tax free to younger generations with either technique.

With respect to the sale to the IDGT which uses the AFR, please note that the short-term period is for a note that has a maturity of zero to two years, mid-term is three to nine years and the long-term is anything above nine years. The grantor of the Sale to the IDGT does not need to survive through to the repayment of the promissory note in order for the assets included in the trust to avoid inclusion in the grantor's taxable estate. Only the remaining outstanding principal on the note and the accrued interest will be includable in the grantor's gross estate if the grantor should die prior to the repayment of the promissory note. The grantor could also bequeath the outstanding note to the spouse and the estate would then be eligible for a marital deduction. The spouse could then use the remaining principal and interest payments on the note during his or her lifetime to go ahead and live on. Now it's time for another polling question.

Kurt Peterson:Thank you for paying attention. Most of you got it correct. The grantor retained annuity trust at 72 and a half percent is in fact the correct question, even though item three is a very quick way of reducing your taxable state, but that's not the correct answer. Now I will leave, the next speaker is Scott Testa. Thanks again for listening.

Scott Testa:Thanks, Kurt. So far so good. Excellent job, everyone. Next, we're going to talk about Charitable Lead Trust, which I think is a great planning move, especially for those who want to incorporate charitable giving into their estate plan. CLTs are an effective way to give money to charity, leave assets to heirs, but maybe not right away and receive potentially substantial savings in estate and gift taxes and possibly income taxes. These work even better when interest rates are low or really low, like they are now, just like the GRAT or the Sale to Intentionally Defective Grantor Trust.

A CLT works the same way as a GRAT, except that the annual annuity payment is given to charity instead of retained by the grantor. During the trust term, the payments from the trust are disbursed to a selected charity or charities as either a fixed annuity payment or percentage of the trust, depending on how the trust has been structured. At the end of the term, the remaining assets are distributed to non-charitable beneficiaries, often family members. Because there's no retained annuity interest, there's no exposure to estate tax exclusion if the grantor dies during the CLAT term. It does require a charitable intent because it does require substantial amounts - the annual annuity stream - going to charity.

The key is that if the trust can outperform the 7520 rate, which right now that's an incredibly low rate of 0.6%, then more assets will pass the heirs. If you use a zeroed out CLAT, this will be a estate or gift tax free.

Basically, there are two main types of Charitable Lead Trust, grantor or non-grantor, which I'll discuss a little further in the next slide. There's also a non-qualifying non-grantor CLT, but I won't get into that. Then the other terms you need to consider, should it be an annuity trust or CLAT or unitrust CLAT?

In a CLAT, the charity receives an annuity that is either fixed percentage of the initial fair market value of the trust assets or a fixed sum. You can even vary the annuity payments. You can structure the payment amount so it increases every year. I remember years ago, we talked about the concept of the shark fin CLAT that provides for extremely low payments upfront and the balloon payment in the last year. I haven't heard those talked about lately. Many, including me, consider this to be an aggressive approach. The best bet is to use the same rule that applies to GRATs, which allows for a 20% increase each year.  CLT with lower distributions to charity upfront early years allows for more upfront growth and accumulation of assets over the terms of the trust, especially in a down or volatile market.

With the CLUT or unitrust, the charity receives a fixed percentage of the net fair market value of the trust assets valued at least annually, usually the first business day of each calendar year. Also, you might want to consider using a testamentary Charitable Lead Annuity Trust. If your client has a taxable estate and is considering leaving a lump sum to charity, you can even use the zeroed out testamentary CLAT, to zero out the estate tax. With such a trust, the charity would receive a significant amount, but over time instead of a lump sum, plus the leverage from a lower 7520 rate would result in amounts passing estate tax free to the client's children.  The zeroed out CLAT: like a GRAT, a CLAT can be zeroed out if the present value of the charity's annuity stream equals the fair market value of the property transfer the trust. Therefore, there's no taxable gift.

Here are the key points in the diagram of a Charitable Lead Trust. In the Charitable Lead Annuity Trust, the grantor makes a contribution to fund the trust. It can be cash, publicly traded securities, real estate, you could even do private business or closely held stock, but you have to worry about unrelated business taxable income. You can even do a family limited partnership. If the donor can get a low valuation on the asset, such as discounts on the family limited partnership on the date of the gift and the asset does experience exponential growth and sold at the later date, more assets will be going to heirs at a lower gift tax cost since the annuity is based on the initial value of the trust of the assets going into the trust. But make sure there's sufficient cash flow to make the annuity payments or you have to sell assets or other otherwise use the same discounts to transfer assets out to the charity.

Next, the payments are sent to the charity. It can be one qualified organization, or you could use a donor advised fund or private foundation. After the specified term, the remaining trust assets are to distributed non-charitable beneficiaries, it could be the donor or spouse, but typically it is family members.

Tax planning and other goals of the client should be considered when deciding between a grantor or a non-grantor CLT. A grantor CLT like charitable remainder trust is designed to give the donor an upfront charitable income tax deduction. However, to receive the charitable income tax deduction, donor must be willing to be taxed on all the trust income. After all, it is a grantor trust.

In addition to paying the tax each year, the donor must be willing to give up the cash flow during the trust term.  That applies to a non-grantor trust as well. But some donors, some clients just want the instant gratification of the upfront charitable income tax deduction. There are reasons to use, again, it depends on the client, to use a grantor versus a non-grantor trust. For non-grantor CLT, you don't get the upfront deduction, but instead the trust claims the charitable deductions from amount paid to charity, and that typically offsets any income that might be due on the trust.

Here are some other Charitable Lead Trust considerations. A Charitable Lead Trust is good way to fund multi-year campaign pledges, but I think it even better ideas to pair of CLT with a donor advised fund or private foundation. This way it gives you greater flexibility to make distributions to charity. Again, you don't have to name them in the document. If you use a private foundation as a charitable beneficiary, you can include family members as officers or employees of the foundation and can even pay them a reasonable salary. There is a caveat, however, that the donor should not participate in grant making decisions, otherwise, there's a risk of including the trust in the grantor's estate if he dies during the trust term.

If you do a grantor Charitable Lead Trust, note that the income tax deduction is limited to 30% of your adjusted gross income even for gifts of cash since the gift is "for the use of" rather than “to” the charitable donation. Furthermore, the 20% limitation applies if the trust is funded with long-term capital gain property and the donee is not a public charity.  Unused deductions in one year can be carried over to next five succeeding years.

Keep in mind, when setting up the trust term for grantor or Charitable Lead Trusts, that the donor must recapture some of the income tax charitable deduction if he or she dies during the trust term. This special recapture rule requires that the donor of a grantor CLT who ceases to own the trust for income tax purposes, mostly because of death, include in income, a portion equal to original charitable deduction minus the discounted value of all the amounts paid to the charitable lead prior to the grantor's death.

Filing requirements. First, the donor should file a gift tax return in the year he sets up and makes a transfer to the trust. Unlike the income tax charitable deduction, which is subject to the percentage limitations, donors are entitled to an unlimited gift tax charitable deduction, but the deduction is not automatic. That's why gift tax return must be filed. The gift tax deduction applies whether it's grantor or non-grantor. In addition, Charitable Lead Trusts are subject to annual filing requirements. You need to file a federal form 5227 and if it's a non-grantor trust form 1041. You also need to provide information to the grantor if it's a grantor trust. For all Charitable Lead Trusts, they need to be registered with a state body that administers charitable requests and charitable organizations. If it's a grantor trust, you might also file the 1041 as a way of providing the information to the grantor to issue a grant or letter.

Of course, we need to talk about generation skipping planning. And just a special note, where the grantor wants to have the remainder eventually passed to grandchildren, Charitable Lead Annuity Trusts do not work well because the determination of the amount of the transfer subject to GST tax is not ascertainable until the lead interest is terminated. If you want to get technical, GST exemption is allocated when the CLAT is created, but the applicable fraction is determined at the termination of the lead interest. If the CLAT appreciates greatly by the time the charitable lead terminates, that appreciation is all going to be part of the denominator and could cause an inclusion ratio greater than zero and cause a generation skipping tax. CLUTs do work with grandchildren as beneficiaries because this rule is not applicable to them because the inclusion ratio focus on the value of the trust when it was created.

To give you an example here to show how they might work, the example is if donor establishes a 10.333% fix payment, 10 year non-grantor CLT with five million dollars worth of low basis securities when the AFR is 0.6%. At the end of 10 years, the trust terminates in favor of his children and stock will be sold off as needed to fund the annuity payout of $516,650 per year. By the end of the 10 year lead term, the foundation will have received 5,166,500. If the after tax rate of return was 6% per year, $2,144,381 will be available to be distributed to his children. This will not be treated as a gift since this is a zeroed out CLAT. In this case, the annuity payment equals the fair market value of going in. Then I show an example where you vary the annuity payments by 20% each year. It comes out with a slightly better remainder interest and more going to charity.

It's a little unfair because if you look at the first couple of years in each example, with the fixed percentage, the fixed amount, the amount going to charity exceeds the income. So there's no tax.  But in the vary annuity example, in the first few years, the amount going to charity is less than the income. So there could be potentially a tax in those years, but this just gives you an idea.

For comparative purposes, back in 2010, almost exactly 10 years ago, I wrote a featured article in the July issue of the Journal of Accountancy on Charitable Planning. I ran the same exact examples of 10 year zeroed out CLAT but I used the May 2010 7520 rate, which was 3.4%. If you're using a fixed annuity, it would have been $598,200. The remainder to the beneficiary was $1,069,487. 5,982,000 went to charity and about a million going to children or the beneficiaries.  You can see, the difference in the 7520 rate makes a big difference. The difference is over a million dollars net to heirs in this case.

Scott Testa:All right. It seems like more than 57.5% of you got what I felt was the correct answer, that is CLT provides the annual annuity stream, the lead interest be paid to qualified charity and the remainder interest is typically paid the heirs. All CLTs do not offer the upfront charitable income tax deduction. That only applies to grantor charitable lead trusts. Just to conclude, this is really just the slide summarizing the Charitable Lead Trust. As always, if you're considering making charitable giving as part of your estate plan, you should consult with your tax and estate planning advisor to determine the best vehicle and strategy for your situation. Even considering various options, including outright gifts of cash or appreciated securities or naming a charity as beneficiary of your IRA. It's also important to communicate these charitable giving vehicles, not only with your financial professionals, but with also your family so that they're familiar with these issues and your goals and how you intend on passing assets to them. I think that wraps up the slides.

About Patricia Green

Patricia Green is a Tax Director with over 30 years of experience in providing services to small businesses, individuals and estates. She has expertise in tax compliance, estate and gift tax, wealth transfer, and succession planning.

About Karen L. Goldberg

Karen L. Goldberg Partner-in-Charge, Trusts and Estates practice, within the Personal Wealth Advisors Group. She specializes in estate planning for closely held business owners, senior corporate executives and other high net worth individuals.

About Kurt Peterson

Kurt Peterson Tax Director provides a wide range of tax services including financial planning, income tax planning, estate planning, complex estate plan structures, retirement planning, and risk management insurance.

About Scott E. Testa

Scott Testa is a Tax Partner and a leader in the Trusts and Estates practice within the Personal Wealth Advisors Group.

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