If you are familiar with charitable remainder trusts, charitable lead annuity trusts, in many respects, are their mirror image. With a CRT, an income stream (in the form of an annuity or unitrust payment) is paid to a non-charitable beneficiary for a term of years or over a lifetime (or lifetimes). When the income term ends, assets remaining within the trust are distributed to charity. With a CLT, the term income stream (in the form of an annuity or unitrust payment) is paid to a charity, and when the term ends assets remaining in the CLT are distributed to non-charitable beneficiaries – the reverse of the CRT.
Charitable lead trusts’ primary use is to “stretch” an individual’s gift and estate tax exemption (how the “stretching” for gift and estate tax purposes works is the subject of a different post). This post concerns how a CLT can work for income tax planning. (Hat-tip for this goes to Jerry Hesch, Esq., one of my many brilliant tax professors).
Charitable Lead Trust Basics
While I started this article by stating CRTs and CLTs are essentially mirror-images of one-another, there are important differences. One is that a CRT is a tax-exempt entity. A CLT is not. A CLT must file a tax return every year and pay an income tax (the exception is grantor-type CLTs, which don’t file income tax returns; this post’s focus is on non-grantor CLTs).
That said, however, a CLT, unlike in the case of individuals, may take a charitable deduction for 100 percent of its charitable donations in the year the donations are made (in most cases, individual taxpayers are limited to a charitable deduction in any tax-year equal to 60 percent of their adjusted gross income).
Through deft management of a CLT’s investments, it is possible for a CLT to completely avoid income tax liability. This is the essence of the CLT income tax play, which really has two favorable income-tax outcomes for the donor.
The favorable outcomes arise because you remove an income-generating asset from your income tax base. The first favorable income-tax outcome resulting from a CLT is your ability to shift income to another entity that can deduct one-hundred percent of its annual charitable distributions (as opposed to the 60 percent AGI deduction limitation applicable to you as an individual taxpayer).
If you consistently make $10,000 of annual charitable contributions and have an asset you can comfortably part with that is invested to earn $10,000 annually (there are limitations on asset types – generally speaking, you can’t use an operating business or a business you own 35 percent or more of), by donating the asset to a CLT, you reduce your taxable income by the full $10,000 and shift that income to the CLT.
Unlike you personally, the CLT pays no tax on that income since it contributes the full $10,000 to charity annually and is allowed to deduct the full $10,000 annual charitable distribution – the AGI limitations applicable to individual taxpayers is not applicable to a CLT. Now your individual annual contributions are made by the CLT and, effectively, in combination with the CLT you receive a 100 percent charitable deduction for those donations.
CLTs and the Standard Deduction
The second income-tax advantage of the CLT comes about from its ability to leverage the standard deduction for some taxpayers. Assume you’re married and your adjusted gross income is usually $180,000. Your only itemized deductions are state and local taxes, and your annual $10,000 charitable contribution. Your deduction for state and local taxes (SALT) is limited to $10,000. Since the standard deduction is $24,000 for a married couple, you would claim the standard deduction. Your itemized deductions are $20,000 – $10,000 SALT deduction and your $10,000 charitable donation deduction – taking the standard deduction increases your tax deductions by $4,000.
However, consider the income-tax result with the CLT. Your annual AGI drops to $170,000 (since you shifted an asset producing annual income of $10,000 to the CLT), and your taxable income drops by the $10,000 shifted to the CLT. Your charitable giving is now through the CLT, so your total itemized deductions are $10,000, consisting of SALT deductions. You continue to take the standard deduction since the amount of your standard deduction exceeds the amount of your itemized deductions. In combination with the CLT, you have generated total income tax deductions of $34,000 (the $24,000 standard deduction you take plus the $10,000 charitable deduction taken by the charitable lead annuity trust). Your taxable income also drops by the $10,000 shifted to the CLT. You have effectively increased your annual income deductions by $10,000 using the CLAT. All-in-all, a great result.
A Strategy for the Start of a New Year
One last note – in most cases implementing this strategy at the beginning of the year makes most sense, since you can shift the 100 percent of the all income earned by the asset contributed to the CLT during a tax-year out of your income tax base. If you wait until the end of the year, chances are the contributed asset has already earned income (e.g., dividends, interest) paid to you that is reportable on your current year income tax return.
Charitable lead trusts are complex tax strategies that come in all types of flavors. There are charitable lead annuity trusts (CLATs), charitable lead unitrusts (CLUTs), and grantor and non-grantor type CLTs. Each flavor has unique income, gift, and estate tax impact, and each will have a different economic impact on any individual that implements a CLT. The preceding discussion was illustrative in nature, only, and was presented for educational purposes, concentrating in general terms on one specific type of CLT in a simplified manner.
We do not offer tax advice. Before taking any action, you should discuss your unique facts and circumstance with your tax advisor.