Important Information about Potential Tax and Economic Effects of Your Charitable Lead Trust, Funding It, and for a Grantor CLT, Deducting such Funding
Please review the following important general information and share with your legal counsel. Note that neither the PCA Foundation nor any of its employees or agents may or will provide to you legal or other professional advice, or legal or other particular information for your reliance, and neither may or will represent you or your interests. We urge you to engage your own legal and other professional counsel to assist you in the consideration and making of any charitable gift, especially a gift to a charitable lead trust.
Grantor CLT or Non-Grantor CLT: Understanding the following communication requires that you understand and keep in mind the basic difference between the two basic types of charitable lead trust, the grantor CLT, and the non-grantor CLT.
The grantor CLT pays the remaining assets of the trust back to the grantor. The grantor CLT is disregarded for tax purposes as a taxable entity separate from the donor. That is, for tax purposes the grantor CLT is treated as simply the grantor, and the grantor recognizes as his own taxable income the taxable income of the grantor CLT. The grantor CLT is an income tax saving device. It enables the donor to deduct against his taxable income in the year of forming the CLT the present value of the annual distributions the CLT will make to charity over the term of the trust (not the value of the initial contribution to the CLT). The deduction for contributions to a grantor CLT is limited to 30% of the grantor’s adjusted gross income (AGI), or 20% if the contribution is of an appreciated non-cash asset.
The non-grantor CLT pays the remaining assets of the trust to the grantor’s heirs and other beneficiaries other than the grantor. The non-grantor CLT is an entity separate from the donor for tax purposes. The non-grantor CLT recognizes its own taxable income, and pays income taxes, but can deduct against up to 100% of its income the income payments it makes to charity. The non-grantor CLT is primarily an estate and gift tax saving device. It enables the donor with a very large estate to give out of his estate to his heirs and other beneficiaries while paying reduced estate/gift tax. (It can also be used to save income taxes by enabling the donor effectively to deduct all his charitable giving when he is giving in excess of the 50% or 60% AGI limitation.)
Grantor CLT Potential Recapture of Deducted Amounts. If the grantor of a grantor CLT dies before expiration of the trust term, the estate will have to recapture on the grantor’s final income tax return the amount of the grantor’s original deduction less the value of the amounts paid to charity before the grantor’s death (discounted back to the year of deduction).
Annuity Trust or Unitrust (CLAT or CLUT): A charitable lead annuity trust (whether grantor or non-grantor) pays out a fixed sum to charity each year of the trust. A charitable lead unitrust pays out a percentage of whatever the trust value is each year. Typically, a grantor/donor who creates a non-grantor CLT will choose to make it an annuity trust rather than a unitrust because the point of a non-grantor CLT normally is to increase the amount that goes estate-and-gift-tax-free to the donor’s beneficiaries, rather than charity. That is, any actual earnings in excess of the interest rate that is assumed in calculating the value of the income payments to charity go to the remainder beneficiaries free of estate and gift tax. With a unitrust, to the contrary, the actual earnings in excess of the interest rate effectively are split between the charitable income beneficiary and the remainder beneficiaries. However, a donor who has determined how much he wants his beneficiaries to receive (rather than as much as they possibly can receive without estate or gift tax), and is confident that the CLT can achieve that amount at a particular income payout rate, may choose to share any increase in earnings with charity and therefore choose a unitrust rather than an annuity trust.
Increasing CLT Annuity Payments. The grantor of a non-grantor charitable lead annuity trust (non-grantor CLAT) may create the trust to distribute annuity payments to charity each year that start quite low and then rise every year. The reason for doing so is to better assure that his remainder heirs and beneficiaries receive the intended estate-and-gift-tax-free amount, and even substantially increase the amount they receive, by leaving in the trust for longer periods of time larger amounts invested for greater returns. Typically the increase each year is a uniform rate not exceeding 20%.
Remainder Beneficiaries. The grantor may identify any person as the remainder beneficiary of a non-grantor CLT. However, if the grantor identifies a grandchild as the remainder beneficiary of a non-grantor charitable lead annuity trust, the ability to increase the amount going to the grandchild free of generation skipping transfer tax by realizing growth higher than the assumed interest rate is barred. A grantor who desires to benefit grandchildren may want to create a non-grantor charitable lead unitrust instead.
Term of CLT. The term of your CLT may be for any number of years, for your life, the life of any ancestor of a remainder beneficiary, or the life of a spouse of either. The grantor’s decision on term may be informed more by how long the grantor wants to benefit charity, or how long the trust term must be in order to reduce estate and gift tax to the desired level.
CLT Funding Assets. Appreciated non-cash assets do not produce the same increased tax savings when contributed to a CLT as when contributed outright or to a CRT (charitable remainder trust). The reason is that a CLT is not exempt from tax as a charity or a CRT is, so the CLT will realize capital gain when it sells an appreciated asset. That is, when a grantor CLT sells an appreciated funding asset, the grantor realizes the taxable capital gain, and when a non-grantor CLT sells such an asset, the trust itself realizes that taxable gain. This does not mean, however, that the grantor should not fund a CLT with appreciated non-cash assets since such assets still may serve the purposes of the CLT. For a grantor CLT, the funding assets must produce income sufficient to make the required payment to charity each year without the necessity of liquidating the assets sooner than the donor would want. Such assets could be investable cash, fixed income investments, or private business equity or rental real estate that throw off substantial annual income. The key is cash flow. For a non-grantor CLT, the funding assets must not only produce income sufficient for the required annual payments to charity, but ideally also be likely to appreciate substantially, thereby increasing the value that passes to the grantor’s beneficiaries at the end of the trust free of estate and gift tax. The keys are cash flow and appreciation. Appreciated non-cash assets may serve the foregoing goals whether the grantor plans to sell them or to keep them for return to himself (grantor CLT) or to his heirs or other beneficiaries (non-grantor CLT). Just keep in mind that they do not facilitate a double income-tax deduction as they do in the case of an outright gift or contribution to a CRT.
No Step-Up in Basis for Heirs or Beneficiaries. Note that appreciated assets contributed to fund a non-grantor CLT and then returned to heirs and other beneficiaries at the conclusion of the trust term do not receive a step-up in tax basis as do assets passed to them from the estate at death. This means that the beneficiaries will have to realize the amount of the appreciation as taxable capital gain when they eventually sell the assets. The loss of step-up in basis does not bar funding a CLT with appreciated non-cash assets if the donor plans to sell the assets before death anyway. If not, the estate and gift tax savings achieved with a non-grantor CLT funded with appreciated non-cash assets may significantly exceed the capital gains tax incurred due to not realizing the step-up in basis. However, if possible, a grantor may be well-served to leave highly appreciated non-cash assets equal in value to the grantor’s remaining estate tax exclusion amount in the estate to be distributed to heirs, and fund the CLT with less highly-appreciated (and appreciating) assets.
S Corporation Stock: Unfortunately, a non-grantor CLT created for estate and gift tax savings is not a permissible shareholder of an S corporation. Accordingly, you may not fund your non-grantor CLT with S corporation stock. However, you may fund your grantor CLT with S corporation stock.
Unrelated Business Taxable Income (UBTI) and Debt: The Internal Revenue Code does not impose a 100% punitive excise tax on a non-grantor CLT’s unrelated business taxable income as it does on a CRT’s UBTI. However, a non-grantor CLT may deduct its payments to charities of such income only to the extent of 50% of it, in contrast to the 100% deduction allowed for payments to charity of other income. This may mean that a non-grantor CLT should not be funded with an interest in a partnership or a limited liability company that has elected to be taxed as a partnership or a disregarded entity, at least if that partnership entity engages in active business rather than merely investment activity, since the CLT’s allocable portion of the partnership entity’s income is deemed to be UBTI. This deduction limitation also may mean that a non-grantor CLT should not be funded with any business interest or other asset that is subject to a lien for debt, since the income produced by debt-encumbered property is deemed to be UBTI (subject to certain exceptions). In addition to creating UBTI, contributing property to the CLT that is encumbered by debt that is less than 10 years old may constitute self-dealing, which is subject to punitive excise taxes imposed on both the CLT and the donor or related person who engaged in the self-dealing. So, before contributing any asset to a non-grantor CLT that the CLT might not sell for any significant period of time, the grantor should pay off all debt that encumbers the asset. (An exception is that the grantor need not pay off the debt if the encumbrance was placed on the asset more than 10 years before the funding, and the donor has held the asset for more than 5 years before the funding, and the CLT almost certainly will liquidate the asset within 10 years following the funding.) In addition, a non-grantor CLT grantor should consider carefully with his qualified tax counsel whether the allocable income of even a real-estate or other investment partnership that is indebted may produce UBTI. We will ask you to provide on the funding information form the debt that currently encumbers the asset to be given, and all debt of an interest to be given to the non-grantor CLT in an entity that is taxed as a partnership.
Excess Business Holdings: The CLT essentially is prohibited from owning directly or indirectly for more than five years from the date of funding an interest in any investment partnership, C corporation, or other company that when added to the interests of the grantor and certain related persons equals more than 20% of the company. We will ask you to provide on the funding information form the holdings of you or any related individual or entity in the company or any other business entity downstream from the company in the chain of ownership. This business holdings section does not apply, and the associated part of the funding information form need not be completed, if neither the company nor any downstream entity engages in any active business (but note that active business includes real estate development).
Self-Dealing: Any self-dealing between a CLT and the grantor or a related person, regardless of whether the economic exchange is fair value or not, such as the grantor’s continued possession of real estate contributed to the CLT, with or without paying rent, is subject to punitive excise taxes imposed on both the CLT and the grantor or related person who engages in the self-dealing. Funding the CLT with an asset subject to debt that is less than 10 years old also constitutes self-dealing.
Process: PCAF will review and assess the information and documentation for the funding asset that you provide, and will try to assure that the value of the funding asset is substantial and unencumbered (or able to be unencumbered), that the asset may be transferred, and generally that receiving the asset is likely to advance the charitable purposes of the CLT.
Responsibility for Requirements for Charitable-Contribution Deduction: Please note, as critically important, that you are responsible to identify and comply with all requirements to secure a charitable-contribution deduction for your contribution to a grantor CLT. The IRS insists on strict compliance with all such requirements. We urge you to obtain the assistance of your own qualified professional counsel, and remind you that neither PCAF nor any of its staff may provide any legal or other professional advice or service to you, and this disclosure form may not include every requirement for securing a deduction for your particular gift under the circumstances.
Maintenance of Reliable Written Records: The applicable Treasury Regulations require you to maintain reliable written records of your funding contribution and the assets contributed, including records of how you acquired the asset and its cost basis, the date and location of the funding contribution, and the fair market value of the asset at the time of contribution.
Form 8283: You will need to complete and submit with your income tax return a Form 8283 if the deduction you will claim for your contribution to the CLT (of other than cash, marketable securities, or certain other kinds of property), or your contribution and other similar contributions you make to the CLT or any other donee in the year, is more than $500.
Appraisal: To claim a deduction of over $5,000 for a contribution to a grantor CLT of an asset other than cash or marketable securities (or certain other kinds of property), you must obtain and retain indefinitely in your records a “qualified appraisal” prepared, signed, and dated by a “qualified appraiser.” To qualify, both the appraisal and appraiser must meet certification and multiple other specific requirements laid out in the Internal Revenue Code and Treasury Regulations for purposes of the rules for deducting charitable contributions. You must obtain the appraisal (it must be signed and dated, and in your possession) no earlier than 60 days prior to the contribution date, and no later than the due date for your income tax return. The appraisal must value the funding asset as of a date no earlier than 60 days prior to the contribution date, and no later than the contribution date, if the appraisal is dated prior to the contribution date. The appraisal must value the asset as of the contribution date if it is dated on or after that date. You may want to review IRS Publications 526 and 561 to better and more comprehensively understand the rules, but again, we encourage you to engage professional counsel.
To claim a deduction of over $500,000 for a contribution to the grantor CLT of an asset other than cash or marketable securities (or certain other kinds of property), you must attach the qualified appraisal to your income tax return.
NOTE: THE IRS CONSIDERS CRYPTOCURRENCY TO BE PROPERTY OTHER THAN CASH AND OTHER THAN MARKETABLE SECURITIES. CRYPTOCURRENCY IS NOT CASH; IT IS NOT A MARKETABLE SECURITY. ACCORDINGLY, ALL OF THESE RULES FOR CONTRIBUTIONS OF PROPERTY APPLY TO YOUR CONTRIBUTION OF CRYPTOCURRENCY (EVEN WHEN GIVEN DIRECTLY RATHER THAN FIRST WRAPPING IN A BUSINESS ENTITY).
Form 8282: When the Foundation as trustee of the CLT liquidates or otherwise disposes of most assets contributed to it, other than cash or publicly traded securities, within 3 years of receiving the contribution, it must file a Form 8282 to report such disposition. We eventually will need your Social Security number to be able to complete this form.
PCAF System Use Agreement: The System Use and Gift Agreement (“Agreement”) to which we have asked or will ask you to agree when you enrolled or will enroll for your donor-advised fund here establishes your and PCAF’s respective rights and obligations with regard to our interaction in charitable ministry. The Agreement, as amended from time to time, is available on our website at https://pcafoundation.com/wp-content/uploads/2019/11/AGR-Form-System-Use-rev-191122-1.pdf