My love for Brazilian music precedes my study of Brazilian- Portuguese as a cadet at West Point. It was a very friendly and small department within the oldest engineering school in the Nation. The professors were very friendly in a place that was otherwise unfriendly, and the instruction was literally one-on-one. By the time I graduated I had the highest level of proficiency for a non-native speaker. At the same I further developed a great love for Brazilian music. My classmate in Portuguese class went on to become a Rhodes Scholar with a degree in Portuguese literature and later a two star general in the Army.
I recall hearing Bossa Nova as a ten year old at my neighbor’s house in the Panama Canal Zone – Sergio Mendes and Brazil 66. The Waters of March is one of many great songs written by Antonio Carlos Jobim and sung by Elis Regina. It remains one of my Brazilian favorites. Of course, none of this has anything to do with Charitable Lead Annuity Trusts (CLATS), but the idea of creating a series of cascading CLATs conjures up images of the Falls of Iguacu.
In order for the taxpayer to receive a deduction for the contribution to a CLAT, the CLAT must be a grantor trust Since the CLAT is treated as a grantor trust, i.e. the income is taxed to the taxpayer, life insurance and its tax advantages make it an excellent investment vehicle within the CLAT.
This article explores the idea of creating a series of CLATS over several years to fund a permanent life insurance contract on a non-MEC basis.
Charitable Lead Annuity Trust Basics
In the case of a CLAT that is treated as a grantor trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed an income tax deduction in the year the trust is established for the actuarial value of the annuity or income stream to be paid to the charity.
A CLAT is a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT is designed to produce a tax deduction equal to the contribution. The deduction (including cash contributions) is limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.
Unlike a charitable remainder annuity which needs to pay out a minimum of five percent on the CRT’s value per year, up to a maximum of fifty percent per year, a CLAT, does not face these payout restrictions. The CLAT payout may as little as one percent or as high as 100 percent. The percentage used and the duration of the trust will merely produce a smaller or larger charitable deduction for income and gift or estate tax purposes.
Similarly, the CLAT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. The CLAT does not have a limit for a term of years. A CLAT may be created lead trusts for thirty or thirty five years, with the CLAT remainder to grandchildren at the expiration of that term.
The charitable incomededuction is calculated using the Applicable Federal Rate (IRC Sec 7520 rate- currently 2.2 percent in September 2014) from the current month, or one of the two prior months. Since the payout is fixed with an annuity lead trust, the lower the IRC Sec 7520 rate, the less assumed earnings will accrue to the remainder recipient, and the smaller the taxable gift. Since all split interest calculations use an assumed interest or earnings rate to determine the value of the income interest, and the value of the remainder interest, the most favorable result for a lead trust is to use a low IRC Sec 7520 rate. As a result, the low interest rate environment has favored the use of CLATs for the last several years.
A charitable lead annuity trust pays a guaranteed annuity amount to one or more qualified charities at least annually. The annuity must be paid in all events. It is not permissible to create a lead trust in which the payment to charity is determined by the income earned by the trust. This aspect of the CLAT has spawned the use of the so-called Shark Fin CLAT. The Shark Fin CLAT provides for a minimal fixed and guaranteed CLAT payment to a charity with a large balloon payment in the final year of the CLAT’s term of years.
Excellent attorneys speculate on the legal authority for the use of the Shark Fin CLAT. Some attorneys view the language of Rev. Proc. 2007-45 as justification that the Shark Fin CLAT is a viable strategy. The language of the revenue procedure provides for a need to have a “guaranteed” annuity for term of years or life contingency that is paid annually. The CLAT payments must be ascertained at the time of the transfer without any regard to a minimum or maximum amount or percentage of the contribution. The Shark Fin CLAT meets these requirements based upon the requirements of Rev. Proc. 2007-45.
In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the §7520 rate (currently 2.2 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.
Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year), varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies.
CLATs and the Impact of the Charitable Split Dollar Rules
Since the CLAT is a grantor trust for income tax purposes, the grantor is taxable on any CLAT income. Advisors have reasoned that life insurance might be a strategic investment within the CLAT due to the inherent tax-advantages of life insurance. The trouble with this planning scenario is the potential application of the so-called charitable split dollar rules of IRC Sec 170(f)(10).
The rules provide that no deduction is allowed if the charitable organization directly or indirectly pays a life insurance premium. Advisors reason that the rules don’t apply because the CLAT is not an organization, i.e. a public charity. Other advisors reason that the rules don’t apply because the CLAT’s ownership and beneficiary status of a life insurance policy is not a split dollar arrangement as defined the treasury regulations.
Most advisors recognizing the issue recommend the purchase of life insurance outside of the CLAT on a single premium basis with the taxpayer contributing a the policy to the CLAT. The policy funded as a MEC allows the policy to accumulate on a tax-advantaged basis. The CLAT’s trustee may take loans to make the CLAT’s escalating payments.
The disadvantage of a life insurance policy that is a MEC within a CLAT is the tax treatment of policy loan or partial surrenders of cash value that are treated as ordinary income to the CLAT.
Some taxpayers may prefer a policy that is a non-MEC (modified endowment contract) which would allow the trustee of the CLAT or the trustee of a family trust in the future, to take tax-free withdrawals from the policy.
Tax Advantages of Permanent Life Insurance
Permanent life insurance provides strong tax advantages. The investment growth of the cash value accrues on a tax-free basis. In a non-MEC policy, the policyholder is able to distribute investment gains from within the policy through low cost policy loans and partial surrenders of the cash value. The investment gain is ultimately paid to the beneficiary as part of the death benefit on an income tax-free basis.
The trustee of the CLAT may take tax-free distributions from the policy each in order to make distributions to the CLAT’s trustee who in turn will use the proceeds to make payments to the Charity.
The range of policy choices include private placement variable life insurance, retail variable life insurance and equity indexed universal life insurance. The crediting rate of the traditional universal life insurance is likely not a good choice in the continuing low interest rate environment.
Cascading CLATs – A Workable Solution
The CLAT regulations and the charitable split dollar issues create a limitation for funding the policy over several years because neither the CLAT nor the charitable lead unitrust (CLUT) provide for ongoing contributions. Overlaying a LLC or limited partnership as part of the CLAT planning structure allows the taxpayer to contribute cash to the CLAT while the CLAT’s trustee makes a contribution to an investment LLC or LP.
The idea is to create a new CLAT for each year that a premium contribution is contemplated in to the policy owned within an investment LLC. The trustee of the CLAT contributes the cash to the LLC or LP in exchange for an interest in the LLC. The managing membership in his capacity as manager causes the LLC be the applicant, owner and beneficiary of the policy. Each subsequent cash contribution in exchange for additional LLC interests provides the LLC with the additional liquidity to complete the LLC funding.
From the perspective of IRC Sec 170(f)(10), the trustee of the CLAT has invested in a LLC that is treated as a security for state and federal law purposes that is not subject to registration.
Each CLAT is designed so that the CLAT payment scheme produces a charitable deduction equal to the amount of the contribution based upon the prevailing IRC Sec 7520 rates.
Joe BigSpender, age 55, is the owner of a closely held business in California which has substantial excess income each year. The company’s S corporation status results in the income being taxed at the highest marginal rates for federal and state tax purposes – 53 percent. The company has a large number of employees making a defined benefit plan an expensive solution. Joe has strong charitable inclinations and is willing to make a commitment that helps public charities while helping himself.
Joe forms a CLAT in Yr. 1 and contributes $1,000,000 in cash. The CLAT provides for a twenty year term. The 7520 rate is 2.2 percent. The CLAT trustee contributes cash to an investment LLC in exchange for an interest in the LLC. The manager of the LLC uses the cash to purchase a second-to-die equity index universal life insurance policy with a $25 million death benefit. The LLC is the applicant, owner, and beneficiary of the policy.
The CLAT provides for an income pattern that provides for an annuity stream that increases by twenty percent each year. The payment in Year is $7,480; Year 5 is $15,510; Year 10 is $38,595; Year 15 is 96,037. The payment in Year 20 is 238,970. The total payments to charity over the twenty years is $1,396,420. The amount of charitable deduction is equal to the contribution amount- $1 million. The deduction is limited to 30 percent of AGI.
In Year 2, Joe creates CLAT #2 and contributes $1 million to the CLAT. The payout design provides for an ascending annuity increasing by twenty percent per year. The amount of taxable deduction is equal to the amount of the contribution. The trustee of the CLAT contributes
In Years 3 and 4, Joe creates CLAT #3 and CLAT #4 respectively. The process outline above is repeated. The trustee accesses cash value using a partial surrender up to the amount of the policy basis in order to make the CLAT annuity payments to the public charity.
At the end of the CLAT term, the policy reverts to the BigSpender Family Trust along with all of the interests of the LLC that were owned by the CLAT. At that point, the policy and all of its future benefits should be received on an income and estate tax basis. The trustee may also make tax-free distributions to trust beneficiaries.
The cascading CLAT strategy can serve as a supplemental retirement plan while providing a significant charitable benefit over a term of years. The use of life insurance provides for tax-advantaged wealth accumulation and transfer within the CLAT. High income W-2 wage earners (think MDs, lawyers and corporate executives) should consider the CLAT using life insurance as a mechanism to reduce current taxation and provide for future supplemental income while supporting a favorite public charity(ies).