A charitable lead annuity trust gives you a way to make a large gift to charity, get a tax break, and eventually leave assets to family members. These trusts are complicated, and they’re most often used by rich people who want to donate to charity and avoid the federal gift and estate tax (which only the very largest estates pay). In recent years, changes in the federal gift and estate tax laws, as well as market conditions, have made charitable lead trusts more attractive to wealthy donors.
You can establish a charitable lead trust during your life or at your death, but it’s most common to create one at death. You direct that certain assets (usually cash or securities) be held in the trust for a particular charity. The charity receives payments from the trust each year for a certain number of years. When that period is up, the trust ends, and whatever assets are left in the trust go to beneficiaries you named—your children or grandchildren, perhaps.
Advantages of a Charitable Lead Annuity Trust
The charity benefits by receiving a reliable stream of income for as long as the trust lasts. The financial benefit to you is that any leftover assets going to your non-charitable beneficiaries can be transferred free of federal gift and estate tax. For example, you could put $1 million in a charitable lead trust and end up with several hundred thousand dollars for your eventual beneficiaries—and get the same gift and estate tax benefit as if you had simply written a $1 million check to the charity.
The non-financial benefit, of course, is that you further the work of a tax-exempt entity that you believe in—a university, research institution, arts group, hospital, human rights or animal welfare organization, to name just a few possibilities.
Other kinds of charitable trusts also let you save on taxes while making large charitable donations. For more information, see the articles on Charitable Remainder Trusts and Pooled Charitable Trusts.
How the Trust Works
Here’s a more detailed look at the mechanics of the trust and some factors you should think about if you’re considering this kind of trust as part of your estate planning.
The trust is irrevocable. Once you put assets into a charitable lead trust, they’re locked up; you can’t change your mind and get them back. Given that it usually doesn’t make sense, financially, to create one of these trusts unless you can put $1 million or more in it, it’s a big commitment.
How long does it last? Many of these trusts are written to last 10 to 20 years. You can, however, specify that the trust is to last for a certain person’s lifetime—for example, you might want the trust to last as long as your spouse lives. (There are restrictions on whose life you can use for this purpose—only your own, your spouse’s, or certain lineal descendants.)
How much will the trust—and family members—inherit? With an annuity trust, each year the trust pays the charity a percentage of the initial value of the assets. You set the percentage. The charity is guaranteed to get this amount—or all of the trust assets, if the money runs out before all of the promised payments can be made. Your non-charitable beneficiaries don’t have any guarantees; how much, if anything will be left for them depends on the return on investment of the trust assets. If returns are greater than payments, there will be something left.
How the tax benefit works. When you set up a charitable lead trust, the IRS determines the present value of your total gift to the charity over the life of the trust. The present value of your charitable gift isn’t subject to the gift and estate tax.
To make the present value determination, the IRS takes into account the amount that will be paid to the charity each year, the length of the trust, and the expected return on investment of trust assets. The IRS assumes the return on investment of the trust assets will be at the applicable interest rate, also called the hurdle rate. The IRS sets the hurdle rate each month. It is based on U.S. Treasury rates, which means that for the last few years, the hurdle rate has been very low—around 1.5% for much of 2012.
The amount the trust assets are expected to be worth at the end of the trust term, less the present value of your gift, leaves the amount your non-charitable beneficiary is expected to receive. Only that amount is subject to gift and estate tax—and will likely be covered by using a small part of your gift and estate tax exemption ($5.43 million per person, and twice that for married couples, in 2015).
Example: Say you put $1 million in a 20-year charitable lead trust for your alma mater and direct that the university is to receive $50,000 each year. At the end of 20 years, whatever is left is to go to your daughter. The IRS, using the hurdle rate in effect when you establish the trust, estimates that after 20 years, there will be about $116,000 left for her. That amount is subject to gift and estate tax—but because it’s well below the exempt amount, no tax will be due. If after 20 years there’s actually much more money left for your daughter (because the trust assets grew at a greater than predicted rate), it won’t be subject to estate tax (the trust assets are out of your estate). On the other hand, if investment performance is unexpectedly bad, there may be less—or nothing—for your daughter.
Financial and Legal Planning for a Charitable Lead Trust
Obviously, you need very good legal and financial advice to set up a charitable lead trust. They’re very complicated devices, with lots of possible variations. A trust needs to be drawn up by a lawyer who’s got a lot of experience with estate tax planning and who understands your financial and personal situation. The trusts’ desirability also depends on outside factors that change, it seems, constantly: interest rates and federal tax laws. Get reliable, up-to-date advice from an expert before you decide to go down this road.