Which Planned Gift Gives Money To Charity Now?
Which planned gift gives money to charity now? And saves taxes for the donor? This is paraphrasing a question that planned giving professionals hear often.
The answer is that charitable lead trusts provide money to charity — now over a term of years and do offer the donor great tax savings. So why don’t we see a lot of lead trusts?
This article is dedicated to helping everyone (lawyers, fundraisers, non-profit executives, philanthropists, and journalists) understand these very often misunderstood vehicles. There are only around 6,000 lead trusts in existence today, according to the IRS — and this includes all existing trusts created over the past 20 years or so, not just ones created this year.
Why do I feel there is a need for greater understanding of these vehicles?
I notice that every single article, email or promotion piece on lead trusts includes some incorrect fact or misleading statement about them — often showing how the author doesn’t understand this giving vehicle and leading to further confusion.
This is my attempt to offer better understanding of the various details and concepts involved. Read this article, try to understand and please email me if you have questions. If I can positively impact one person, which might in turn even indirectly cause the establishment of one of these trusts, I would have accomplished something very worthwhile — namely hundreds of thousands, if not millions, of dollars to a worthy cause or causes.
What does a Charitable Lead Trust do for a charity?
These trusts commit to distributing an annual dollar amount to one or more charitable entities for the term of the trust. The term could be for a number of years or it could be for someone’s life. For example, a 10-year charitable lead “annuity” trust funded with $1 million dollars could be drafted to distribute $60,000 a year for 10 years to a particular charity. If you change the same lead trust to be a “unitrust”, then the trust in this example would distribute 6% of the fair market value of the trust assets every year to a particular charity approximately — $60,000 a year depending upon the investment of the trust assets. Generally, lead trusts involve a fixed stream of cash flow to a charity for 10 to 20 years.
What happens to the remaining assets in the trust after its term?
Typically, the assets remaining at the end of a lead trust term are transferred to children of the donor (grandchildren is a possibility but too complex to bediscussed in this article). There exists the possibility that the trust could revert its assets back to the donor — except that this might completely defeat the tax benefits (discussed later in this article) and is not really worth discussing. In fact, if you see an article or promotion piece talk about a Grantor Lead Trust that returns assets back to the donor, you should know that the author needs to read this article (please feel free to share this with anyone).
What are the benefits of a Lead Trust to the donor?
What is in it for the donor? Again, assuming we are talking about a Lead Trust that will distribute its remaining assets at the end of its term to children (referred to in legalese as a Non-Grantor Lead Trust), why is the donor doing this (besides wanting to support a particular charity)? The answer is that the remaining assets of a lead trust will often be distributed to the children at significantly reduced or eliminated gift tax rates (i.e. maybe no gift or estate tax at all!).
For example, a donor contributes $1 million in March 2008 to a Non-Grantor Lead Annuity Trust paying $70,000 a year to charity for 21 years, remainder to his children. The donor would report a “gift” to his children in the year the trust is set up of $0 (yes, zero dollars) to the IRS. If the trust investment returns 13% per year, the children will receive over $7 million at the end of the 21 years with no further estate or gift tax due. Note: this sample calculation assumed a gift in March 2008 since the federal rates for these calculations happens to at its best – lower federal rates make lead trusts more attractive (discussed later in this article).
Understanding the Tax Benefits
In the above example, we see that the donor avoided Federal and State Estate tax on the $1 million contributed to the trust. In New York, for example, the combined Federal and State estate tax rates are still well over 50%. In other words, the donor was able to convert $1 million today (worth only around $500,000 in his estate should he die) into total giving to charity of $1.47 million dollars over 21 years and over $7 million to his children after the 21 year period expires no more estate taxes. Even assuming that the same $1 million could have been invested and grown in a similar fashion, income and estate tax would still have bitten into that money enough that we can honestly say that the family might do better by giving to charity (I say that cautiously — rather, with the satisfaction of giving to charity coupled with avoiding estate, I can honestly say the family is much better off).
How did we stiff the government of its piece of the pie?
I always tell people to think of a lead trust as first and foremost a gift to your children. It is a gift to your children less the value of the income stream to charity. And, how the IRS lets you value the income stream is a crucial point to understand.
Ask yourself the following question for the above assumption of the lead cash flow to charity of $70,000 a year for 21 years: how much money do I need today to invest to cover the entire 21 year cash flow? Remember, $1.47 million is the total charity will receive but I don’t need that amount in the bank since I will be investing the money. To figure this out, I need to have an investment assumption. By the way, the investment assumption for lead trusts calculations is the AFR Midterm Rate — which for our example is 3.6%. The answer to the question is that I need $1,000,000 today, earning exactly 3.6% a year for the next 21 years, to produce the $70,000 a year cash flow for 21 years. If I did the same gift in February 2008 (with a 4.2% AFR investment assumption), I would need only $964,200 to produce the same 21 year cash stream. Since my investment assumption is higher in February, I need less funds today to produce the same cash flow.
Those two amounts needed to produce the 21-year, $70,000 a year cash flow, under their respective AFRs, are in fact what is referred to as the present value of the income stream. The way we value the taxable gift to your children is we subtract the present value of the income stream (the charitable interest) from the initial funding amount. Back to our example, the donor put $1 million into the trust. If the gift was made in February, we would subtract $964,200 (present value of charitable income stream) from $1 million (gross value of gift to children) to determine the reportable gift of $35,800 (potentially subject to gift tax immediately or will go against your federal lifetime estate tax exemption). If the gift was made in March, we just subtract $1 million from $1 million and that’s how you get a zero gift to children or grandchildren!
Understanding What Just Happened
Assuming our lead trust example above was done in March 08 technically a zero gift to children let’s understand what really happened. First, the donor put $1 million into a lead trust entity that has its own tax ID number and presumably its own investment account. Based on the date of the transfer, the donor’s accountant or attorney needs to calculate what is the value of the gift to the children (see above paragraph). When the donor files his or her income tax return, a gift tax filing (attorneys and accountants recommend at least a very small gift so there can be something to report to the IRS) will be attached showing what was done.
When the trust ends, all remaining assets of the trust are transferred to the children — clear and free of gift and estate taxes (under normal circumstances).
The above example makes a few assumptions that are important to understand at this point. The example assumes that the donor is facing the highest estate tax brackets. Under current law, an individual would need to be leaving with roughly over $2.5 million dollars to non-charitable and non-spouse beneficiaries in his or her estate to be facing the highest estate tax brackets. Any money left to charity or a spouse is not subject to estate tax. In other words, your prospects for a lead trust are people who have exhausted standard methods of reducing one’s taxable estate and are in need of removing large amounts of assets for fear of a whopping estate tax.
Gift/Estate Taxes vs. Income Taxes vs. Capital Gains Taxes
If you noticed in this article, I have only referred to reducing gift and estate taxes. What about other taxes? This where I start finding problems in various promotions of lead trusts.
Fact: lead trusts are NOT a vehicle for avoiding income tax or capital gains tax. Please read that statement again and think about it. Lead trusts are a vehicle for avoiding estate and gift taxes, not income or capital gains taxes. Why?
Firstly, for the standard, non-grantor lead trust there is no income tax deduction for the donor. There goes your income tax incentive. Later, we will discuss the grantor lead trust which does provide an immediate income tax deduction but with a huge caveat.
Secondly, low basis property (stock or real estate) in a lead trust will not avoid capital gains — it may be delayed but definitely not avoided.
Technically, lead trusts are not charitable trusts. As I mentioned earlier, you are making a gift to your children first and foremost so the IRS has never granted these trusts status as tax-exempt entities. Therefore, all investment income (capital gains or otherwise) in the trust could be subject to income or capital gains tax. Under the standard, non-grantor lead trust, the trust is entitled to offset its taxable income with the distributions to charity. When things go smoothly, the charitable distributions offset the gains of the trust. If the non-grantor trust earns more than the amounts distributed to charity, the trust pays taxes on its excess gains (reducing anything left for children).
If a non-grantor lead trust is funded with low basis property and the trust sells that property to be reinvested, the trust could incur a gain much greater than its annual distribution to charity and be liable to pay taxes (at higher trust rates not — low individual capital gains rates) on the gain. And, if the trust holds the low basis asset until it passes to children, the children receive the property with the original basis, even if their parents are deceased.
As a side point, usually when property is inherited, there is a so-called “step-up in basis” — which wipes out any pre-death capital gains. Not so with lead trust assets. Not such a terrible problem since you are avoiding a 50%+ estate tax in exchange for a 15% capital gains tax (which is only incurred when the asset is sold). The results are still favorable for the family but definitely not geared for avoiding capital gains taxes as are charitable remainder trusts.
Aren’t There Lead Trusts That Do Involve Income Tax Charitable Deductions?
Yes, they are known as grantor lead trusts. Why the term “grantor”? Because it means that the donor/trustor as the grantor to the trust is keeping ownership of the trust. A plain vanilla grantor lead trust means that the donor puts property in the trust, it pays charity for the term, and then the assets revert back to THE DONOR! No estate/gift tax benefits here but it does allow the donor/grantor to take an immediate charitable income tax deduction for the present value of the income stream to charity for the term. Sounds good — why not for campaigns, multi-year commitments? Didn’t our father’s accountant always say cash in your pocket today is better than tomorrow? (i.e. why not take the tax saving of a multi-year commitment this year — invest it, etc..) And, you get your principal back at the end of the trust! Keep reading:
As a grantor trust, the grantor is responsible for paying the taxes on all investment income and incurred capital gains on the assets in the grantor lead trust. And, there are no offsetting charitable distributions. Yes, you get to eat your cake up front but you get it smashed in your face during the term of the trust. In other words, in year 1, donor is happy. In years 2+, donor is very unhappy paying taxes — unless the donor doesn’t mind paying phantom taxes (tax on earnings not received).
One of my friends in planned giving just went through this scenario. One of the charity’s leaders sells a donor on a grantor lead trust for a short term. He tells the prospect what a great deal this is. Donor gets a deduction upfront. Donor gets his money back at the end of 5 years.
Without running any calculations, I can say with confidence that but for the costs and hassle of setting up the grantor lead trust or not using a lead trust at all, there is no difference at the end of the day for the donor either way. No extra benefit except that he gets a bigger deduction now but a bigger tax hit over the term of the trust. If the donor knew that this year, for some special reason, he needed and could use the deductions now and the extra income in future years was not a problem, then yes, a grantor lead trust could help. But, in this case, the donor was a professional athlete signing his first multi-year contract — the deductions now make no difference for him. So why bother?
By the way, I polled a few top planned giving attorneys from the around the country about whether anyone does grantor lead trusts. The answer was — unanimous almost no one does these because there is really very little benefit to it.
Advanced Planned Giving (only read if you are glutton for complex tax discussions)
There is a variation on the grantor lead trust — termed the “defective” grantor lead trust — that combines the benefits of both the non-grantor and grantor lead trusts. These don’t return the principal to the donor but rather pass the remainder to children (like the standard, non-grantor trust) at the same reduced or avoided gift and estate tax. And, the defective grantor lead trust gives the donor the upfront income tax deduction. The donor will still have to pay all income on the trust assets during the term — which under the regular grantor trust is a bad thing. But, with a defective grantor lead trust, paying the income tax is actually a good thing! If your goal is to pass on as much assets to your children without gift or estate tax, and you consider money in your hands worth only fifty cents on the dollar (due to potential estate tax), you should actually be happy paying the taxes from your pocket and not your children’s. This is one of those accountant ideas which the rest of the world has trouble with. Needless to say, I would still not sell the defective lead trust as a way to avoid income tax. Rather, the ultimate family benefit is the estate and gift avoidance plan. And, as mentioned earlier, the children may actually inherit the capital gains burden on the property of the trust — but it is still better than surrendering 50%-60% in estate taxes.
After reading this article, your brain is probably spinning a bit. And, all of the great tax breaks may not seem so attractive anymore. Well, if the complexity hasn’t turned you off, keep reading.
One factor I alluded to earlier in the article is the rate of return needed to make these work really well for everyone. In my example early on, I assumed a fixed annuity payout of 7% and total return on investment of 13%. What investments today will guarantee that kind of total return? And, if you earn much less, there won’t be anything left for the children — you would be better off making direct gifts to charity (at least you’ll avoid some income tax).
There are some tricks that attorneys use to alleviate the need for a 13% return but they are too complicated for this article (they usually involve funding the lead trust with a limited partnership interest). In any case, even if I convince a donor that this is a great device, that he or she needs to avoid some estate tax, I am always left with the problem of “what will we put in the trust?”
That question is really the biggest challenge of establishing lead trusts. The perfect funding asset is income producing real estate held in a limited partnership. And, the last lead trust I worked on was just that — and it was slam dunk. But, the last prospect I worked with who agreed that it was the way to go and even sent me to his accountant — we came away empty because of how his limited partnership interests were leveraged. See, I had the right donor, he understood the vehicle, he had the need, he had the desire to help the charity, and I thought he even had the perfect properties. Alas, I was off on the property issue and the gift went nowhere.
Finally, if you read about lead trusts enough, you will eventually hear that Jackie Onassis did one. Not true! Her will (these can be done during life or set up in your estate plan) called for setting up a lead trust to transfer assets after 20+ years of charitable distributions to her grandchildren. But, her children had the option to fund the trust or not, and decided not to fund it. I recall reading that making her grandchildren the ultimate beneficiaries caused a tax problem. A quirk in the generation skipping tax in lead trusts would have lead to a whopping tax when the trust was through — probably eating up most of the remainder to the grandkids (that is why I left grandchildren out of the article until now).
I wish lead trusts were the vogue — because I would be very busy with them if that were true. But, they are complicated, and they are not a planned giving vehicle in which charities can be overly involved. Charity should never serve as trustee and the donor’s estate planning attorney needs to draft and implement the trust as part of an overall estate plan.
Still, it is worthwhile for fundraisers and nonprofit executives to understand leads trust enough to spot real opportunities.