Note: This article was posted prior to the Trust's current strategy.
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The persistently low interest rate environment often stirs conversations around the challenges to investors seeking yield and returns.
But for philanthropists, and the advisors who counsel them, the continuation of low interest rates may be a great opportunity to talk about potential charitable planning techniques that are available when rates are low.
Charitable Lead Annuity Trusts
Do you have a client who is interested in supporting charities during her life and interested in making gifts to children or other family members in the future? Maybe that client is even interested in maintaining flexibility as to which charitable organizations receive support during her life.
For this client, a charitable lead annuity trust (CLAT) may be a great solution, and one that has particular appeal in a low interest rate environment.
How They Work
The mechanics of a CLAT are straightforward. The grantor establishes the CLAT, and the CLAT makes distributions of a predetermined amount—often a set percentage of the initial trust assets—to one or more charities for the life of the donor or a specific term of years. At the end of the trust term any remaining assets in the trust pass to individuals selected by the grantor, such as children or grandchildren.
A CLAT is a wealth transfer vehicle known as a “split-interest trust” because the trust assets are used to support both charitable organizations and individual beneficiaries.
If the grantor established the CLAT during life, the amount eventually passing to individuals—such as children or grandchildren—will likely be subject to federal gift tax. The grantor may have to pay gift tax on the estimated transfer to the individual beneficiaries, or use some of the grantor’s lifetime exemption from federal gift and estate tax.
However, in a low interest rate environment, the grantor who sets up a CLAT may be able to leverage their lifetime exemption from federal gift and estate tax by paying less tax than they would when rates are high.
The reason for this centers on the Internal Revenue Code Section 7520 rate at the time the trust is created and funded. The 7520 rate is used by the IRS to assume a reasonable rate of return on investments, as well as to value annuities and remainder interests for split interest trusts, like CLATs. If a CLAT is created and funded when the 7520 rate is low, and the trust investment returns exceed the 7520 rate, the excess appreciation passes to beneficiaries free of gift tax.
In some instances, a CLAT may be set up so that all of the appreciation passes to beneficiaries free of gift tax (known as a “zeroed-out CLAT”).
If a CLAT is created and funded when the 7520 rate is low, and the trust investment returns exceed the 7520 rate, the excess appreciation passes to beneficiaries free of gift tax.
Why Choose a Donor Advised Fund as the Charitable Beneficiary?
Suppose your client is interested in a CLAT, but the client isn’t sure what charitable organizations she wants to support. She indicates that she may want to change charitable beneficiaries from year to year. How do you advise the client?
You could suggest the client set up a private foundation, but there are challenges with that option.
First, the client will need to pay an attorney to set up the foundation, and then wait for approval from the IRS to verify the foundation’s tax-exempt status.
Additionally, once the private foundation is established, there will be ongoing costs and administrative burdens, such as filing an annual tax return, registering with state and federal authorities and meeting the annual distribution requirement.
However, the most significant challenge may be the client’s ability to participate in the grantmaking activities of the foundation. IRS rules may make it difficult for a grantor of a CLAT to meaningfully participate in a family foundation funded by the CLAT and still take advantage of the estate planning benefits that the vehicle has to offer.
For these reasons, a donor advised fund (DAF) may be a terrific alternative to a private foundation as the recipient of the charitable lead payments from the CLAT. The grantor can name The Chicago Community Trust as the charitable beneficiary of the CLAT and establish a DAF with The Chicago Community Trust.
As an advisor to the fund, the grantor who sets up the CLAT can recommend other charitable organizations to receive grants from the DAF. Much like a private foundation, the grantor can also name family members or friends to be advisors to the DAF and participate in recommending grants out of the fund.
A further benefit is that The Chicago Community Trust will take care of all of the administrative requirements—such as tax returns and filing with the appropriate state and federal authorities— so that the grantor and her family can focus on the fun part of philanthropy: supporting their favorite charities.
A Case Study
Maria retired ten years ago after selling her industrial lighting company. Maria spends much of her retirement volunteering and supporting her favorite charitable organizations. Maria’s two adult sons, James and Oliver, are successful in their own rights as a high school math teacher and a social worker, respectively.
Maria is tremendously proud of her sons, but worries about their own financial future since neither son chose a high-paying career. Maria would like to help provide for James’ and Oliver’s retirement so that they can focus on doing what they love.
Maria recently met with her estate planning attorney to discuss ways she might be able to assist her sons financially. Given the size of her estate, her interest in philanthropy and her desire to help her sons when they reach retirement age, Maria’s estate planning attorney suggests a CLAT.
The CLAT will reduce the size of Maria’s estate now (and potentially help reduce or eliminate estate taxes upon her death), create a stream of payments to support her philanthropy, and provide for her sons in the future when they are approaching retirement age.
The estate planning attorney further recommends that Maria consider funding a donor advised fund with The Chicago Community Trust. Not only will the donor advised fund give Maria flexibility in deciding which charities to support from year to year, it will also allow Maria to include her sons in philanthropy, as she can name James and Oliver as advisors to the fund. As a bonus, the current low rate environment means that Maria can fund the CLAT and leverage her lifetime exemption from federal gift tax.
Maria can take comfort in knowing that her two primary goals—supporting philanthropy and ensuring that her sons are supported during their retirement years—can be achieved with the creation and funding of one vehicle: the CLAT.
Gift of a Retained Life Estate
Perhaps less known than the CLAT, a gift of a retained life estate is another charitable giving option that may be more desirable when the 7520 rate is low. While not suited for every potential donor, under the right circumstances the technique can be highly effective.
How They Work
A homeowner transfers ownership of his home to The Chicago Community Trust. However, the homeowner retains a life estate in the home, meaning he has the right to live in the home until his death or until both parties agree to sell the home.
The homeowner who makes the donation may receive an income tax deduction in the year the transfer is made that is equal to the actuarial value of the remainder interest in the home. For the duration of the life estate the donor is responsible for paying property taxes, insurance and costs associated with general upkeep of the home.
Upon the death of the donor, ownership of the home transfers outright to The Chicago Community Trust. The home may then be sold and the proceeds used in a variety of ways.
For example, the donor may arrange to have the proceeds applied to a fund that supports workforce development programs in economically disadvantaged Chicago neighborhoods.
As noted, the donor receives an income tax deduction in the year the transfer is made, and the deduction amount is based upon the actuarial value of remainder received by The Chicago Community Trust. The lower the 7520 rate, the greater the value of the charitable deduction received by the donor. Given the fact the 7520 rate was 1.6% in October 2016, now may be a great time to discuss this technique with your clients.
Who Should Consider a Gift of a Retained Life Estate?
Making a gift of a retained life estate may be suitable for many well-positioned donors looking to convert a primary home or vacation home into philanthropic dollars. This may be especially true for would-be donors with the following characteristics:
- Own multiple homes (such as a primary residence and a vacation home in another state)
- Do not have children or grandchildren who wish to inherit a primary or secondary home
- Wish to convert a home into charitable dollars for multiple organizations or causes
Individuals or couples who own a second home that they do not plan to gift to subsequent generations may be a particularly good fit for the gift of a retained life estate, as there may be less emotional attachment to a secondary home in comparison to a primary home.
For example, a couple may reside in Chicago but also own a vacation home on the shore of Lake Michigan. This particular couple may consider gifting the vacation home to The Chicago Community Trust and retaining a life estate in the vacation home so that both spouses can continue to use and enjoy the home for the duration of their lives.
After the death of the second spouse, the home can be sold and the proceeds used to set up an endowed fund in the name of the couple that supports environmental and conservation efforts in metropolitan Chicago.
If you have a client with one or more homes that might benefit from a making a gift of a retained life estate, please consider The Chicago Community Trust, and let us help you talk through the benefits with your client.
The end of the year can be a stressful and frenetic time for clients and financial advisors alike. Getting ahead of planning conversations is always a good idea, as it can make the final months of the year less hectic, more productive and more beneficial to clients and planners.
For more information, please contact Tim Bresnahan at 312.616.8000 ext. 158 or by email at firstname.lastname@example.org.