“Zeroed-Out” Testamentary Charitable Lead Trusts

Q:  I want to build in a zeroed-out charitable lead annuity trust (CLAT) in my client’s living trust.  I am not seeing that the insertion of a charitable lead trust is part of the living trust dialogue, but I may be missing something.  I am also not sure of the term I need on the CLAT to eliminate the estate tax.  Can you assist me here or point me toward some resources?

A:  My book, Charitable Gift Planning: A Practical Guide for the Estate Planner (ABA 2^nd ed. 2007), discusses lead trusts generally in chapters 8, 9 and partly in chapter 10.  It discusses this specific strategy on pages 488-491.  But let’s review the concept here, and then show how to draft a zeroed-out testamentary CLAT (TCLAT) using WealthDocx7™.

The concept:  A good description of the charitable lead trust comes from Howard Zaritzky:

“A charitable lead trust is the opposite of a charitable remainder trust.  It is a charitable gift of an annuity or unitrust interest followed by a noncharitable remainder interest.  Charitable lead trusts are a useful way to make a lifetime or testamentary gift at a reduced (or zero) gift or estate tax cost.

“The annuity or unitrust interest of a charitable lead trust is almost identical with the noncharitable interest used in a charitable remainder trust, except that there is no minimum 5 percent payout requirement on a charitable lead trust.

“The donor receives no income tax deduction for a gift to a charitable lead trust, but does receive a gift tax charitable deduction based on the actuarial value of the charitable lead interest.  This value is based on actuarial tables, which change monthly to incorporate the prevailing interest rates, pursuant to Section 7520 [of the Code].  Like the valuation of the interest in a charitable remainder trust, a donor may value the interests in a charitable lead trust using the assumed interest rate applicable on the date of the transfer for during either of the two immediately preceding months.  Generally, a lower assumed interest rate will produce a larger charitable deduction for a charitable lead interest.”

-- H. Zaritsky, Tax Planning for Family Wealth Transfers -- Analysis with Forms, ¶5.04[1] (WG&L)

A testamentary charitable lead trust is a lead trust that the client creates as a sub-trust of his or her revocable living trust or Last Will, funded at his or her death.  It can produce significant tax savings to his or her estate.  The present value of the charitable lead trust’s income interest qualifies for the estate tax charitable contribution deduction.  Only the remainder interest is subject to estate tax.  However, it is possible to use a formula clause that creates a lead trust with the present value of the income interest equal to the amount used to fund the trust, and, thus “zero-out” the estate tax.

What’s Best?  A Charitable Lead Unitrust or Charitable Lead Annuity Trust?  As Zaritsky notes, charitable lead trusts come in two varieties:  The charitable lead unitrust (CLUT) calculates the income interest to charity as an amount equal to a fixed percentage of the net fair market value of the trust assets as determined annually.  Treas. Reg. §§ 1.170A-6(c)(2)(ii)(A), 20.2055-2(e)(2)(vii), 25.2522(c)-3(c)(2)(vii).  A charitable lead annuity trust pays “a determinable amount” at least annually to the charitable beneficiary.  Treas. Reg. §§ 1.170A-6(c)(2)(i)(A), 20.2055-2(e)(2)(vi), 25.2522(c)-3(c)(2)(vii).  The traditional method for defining “determinable amount” is to simply state it as an amount equal to a stated fraction or percentage of the initial fair market value of the trust property.  Most drafters use a TCLAT to accomplish the “zero-out” because only with an annuity trust can one draft the present value of the charitable interest to equal the fair market value of the assets transferred into the trust; thus, the full value of the assets transferred to the lead annuity trust equals the estate tax charitable deduction amount.  One finds it difficult – if not impossible – to accomplish this same result with a lead unitrust.  Like a lead annuity trust, the Code defines the charitable deduction for a lead unitrust as the present value of the income interest.  But unlike the lead annuity trust, the unitrust interest changes from year-to-year with the fair market value of the assets.  If the market value of the assets grows at the Section 7520 rate, the value of the assets can never reach zero.  Consider these results for a charitable lead annuity trust and unitrust, both funded with $100,000, each with a 15-year term, and with the annuity and unitrust percentages at 9.38 percent.  The Section 7520 rate is 4.6 percent:

                                                                         Annuity Trust                                  Unitrust

Value of Asset                                                          $100,000                                 $100,000

Charitable Deduction                                               $100,000                                   $75,565           

Taxable Amount                                                              $ -0-                                   $24,435

Under this scenario, one must increase the lead unitrust percentage to 40 percent before the present value of the unitrust interest comes close ($99,927) to the value of the assets used to fund the trust.

The Formula.  In a testamentary format, it is impossible to achieve a zero-out if the donor’s last will or living trust sets out all of the annuity variables (annuity amount, trust term) for the testamentary lead annuity trust.  The reason:  one cannot accurately predict the Section 7520 rate at the donor’s death.  Therefore, the donor’s estate plan must use a formula to ‘zero-out’ federal estate tax.  The Service has approved the use of formula clauses in lead annuity trusts for zeroing-out estate taxes.  See Priv. Ltr. Ruls. 199927031, 9631021, 9128051, and 8946022.  These clauses qualify for the federal estate tax deduction because they create a determinable amount, ascertainable as of the donor’s date of death.  Typically, the formula will state all of the lead trust variables, except the annuity interest.  Priv. Ltr. Ruls. 9128051 and 8946022.  So, the formula would define the annuity interest as an amount, which, after taking into account the Section 7520 rate for the donor’s date of death, will create an income interest, the present value of which equals the amount contributed to the trust.  Or, the formulas could leave the term of years as the formula variable.  Priv. Ltr. Rul. 9631021.  We offer both drafting options in WealthDocx7™. 

Does it really work?  A question we frequently see is whether the lead trust creates a remainder amount for the client’s family that is worth the wait necessary to zero-out the taxes.  Wouldn’t it be better just to pay the taxes, and leave the remainder immediately to the family members?  These are valid questions, and the answers turns on both a philosophical and practical basis:

1.      For some people, the idea of giving any estate taxes to the government is anthemia.  So, for these people, directing money to charity through a lead trust makes more sense philosophically than sending a check to the government, even if the family may have to wait a while for the remainder, and even if the transaction doesn’t make perfect sense considering the time value of money.

2.       As a practical matter, the answer depends on two factors: the Section 7520 rate at the time of the client’s death, and the internal rate of return for the trust.  Let’s assume that pre-Bush estate tax limits return in 2011 ($1,000,000 exemption amount / 55% maximum tax rate).  The client has a taxable estate of $5,000,000, and has his full $1 million exemption available at his death.  His estate tax at death is $2,045,000, leaving a $2,950,000 inheritance for his family, and nothing to charity.

Example No. 1:  At the time of his death, the Section 7520 is 1.8%.  The CLAT can achieve an internal investment rate of return equal to 7.5%.  Client left the term of years as the “zero-out” formula variable for the lead trust, and drafted the trust as a 7% annuity payout.  Under the WealthDocx7™ formula, the trustee will allocate $1 million immediately to the non-charitable share and $4 million to the lead trust.  The formula will result in a 16.8-year term.  At the end of this term, the trust will provide a remainder of $4,654,161 to the family, and payments over the trust term totaling $4,358,000 to charity.  A client with charitable motivations may find this an excellent result.

Example No. 2:  Same facts as No. 1, except the Section 7520 rate is 4.4% and the trust can only maintain a 6.5% rate of return.  The formula will result in a 23.1-year term, but a remainder of $2,998,031 for the family with payments over the trust term totaling $6,440,000 for charity.  This result might be less satisfactory for the family, considering the time value of money.

Because of this uncertainty, one might best describe the “zeroed-out” T-CLAT as a clean-up strategy to avoid federal taxes and use up any remaining exemption amount for family.  One probably should not view it as the primary strategy for getting wealth to family members, unless the client has very strong philanthropic inclinations or, perhaps, the client’s relatives are only collaterals and the client would prefer a large amount to charity but without completely disinheriting these relatives.  In most instances, a client uses the TCLAT when he or she has already transferred wealth to family members using some other tool – like a family limited partnership or irrevocable life insurance trust.

Using WealthDocx7 to draft the Zeroed-Out CLAT:  Like the user who asked the question, some users have found it difficult to locate the “zeroed-out” TCLAT input selection screens in the RLT dialogue.  Rest assured, we’d love to make it easier to find and use these screens, but the logic of the platform HotDocs™ program makes this impossible; we simply cannot program HotDocs in any other way.  By following these steps, however, we believe it’s easy for any user to draft a zeroed-out TCLAT for his or her clients:

1.      At the “Residuary Beneficiaries” dialogue box make the following selections:

2.      At the “Distribution of the Charitable Share,” dialogue, enter the name you want for your client’s TCLAT as the name of the First Charitable Beneficiary, enter 100% as the share amount, and select “Testamentary Charitable Lead Trust” as the type of charitable beneficiary:

3.      You now have the option of stating either the term of years of the trust, in which case the formula calculates the payout percentage.  Or stating the payout percentage, in which case the formula calculates the term of years.  The Trustee will determine the calculated amount or term of years (as the case may be) at the time the Trustee funds the TCLAT, depending on the 7520 rate in effect at that time.

4.      You have an option of creating layered TCLATs by stating shares at different year terms or different payout rates.  The formula will solve for the unstated term of years or payout rate.

a.      For Term of Years:

b.      For Percentage Payouts:

And that’s how you draft for a “zeroed-out” TCLAT!  We hope this helps.

Yours for better drafting,

Thomas Ray

Executive Editor

Acknowledgments:  I took portions of this blog from my book, Charitable Gift Planning: A Practical Guide for the Estate Planner (ABA 2^nd ed. 2007) – used with the permission of the publisher.  The book is available at the WealthCounsel MarketPlace.

I also acknowledge Lew Dymond’s efforts in creating the screen captures.