Reversionary Grantor Charitable Lead Annuity Trust

Reversionary Grantor Charitable Lead Annuity Trust

Article posted in Charitable Lead Trust on 2 March 2016| 2 comments
audience: National Publication, Dan Rice, Philanthropy Architect | last updated: 9 March 2016
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Summary

New author, Dan Rice presents an interesting spin on the Charitable Lead Trusts.

Charitable Lead Trusts in a Nutshell

In a Charitable Lead Trust (CLT), the charity leads off by receiving an income interest for a certain period of time, and then the noncharitable beneficiaries receive the remaining trust principal. A qualified CLT will meet the various IRC requirements for deductibility of the lead interest for federal estate, gift and income tax purposes.
The charity may receive an annuity payment, through the Charitable Lead Annuity Trust, or a unitrust payment through the Charitable Lead Unitrust. An annuity payment is the right to receive a specified amount from the trust each year that does not change. A unitrust payment is the right to receive a specified percentage of the trust assets each year that will vary from year to year.
A CLT is not exempt from federal income tax. A grantor CLT treats the donor as the owner for federal income tax purposes and the donor is taxed on all of the income of a grantor CLT. A non-grantor CLT is taxed as a complex trust for income tax purposes. However, a non-grantor CLT receives an unlimited charitable income tax deduction for the annuity or unitrust payments made to charity each year.

Citations of authority for Charitable Lead Trusts are at the end of page.

Reversionary Grantor Charitable Lead Annuity Trust

At first glance, you might justifiably wonder why anyone would recommend using this type of Charitable Lead Trust to implement a family wealth transfer plan. So, let’s nickname this strategy the “Conundrum CLAT” because it enigmatically anchors itself to a REVERSIONARY GRANTOR Charitable Lead Annuity Trust (G-CLAT). Admittedly, it’s counterintuitive to suggest using a reversionary trust as a family wealth transfer device.

Overview

  1. Donor (Grantor) creates a Reversionary G-CLAT and funds the G-CLAT with assets, which have significant appreciation potential (i.e., real estate, partnership units, LLC interests, closely-held stock (C stock or S stock), etc.). The G-CLAT Trustee must be an independent Trustee. Neither the Grantor, nor related or subordinate persons may serve as Trustee. The Grantor may remove/replace the independent Trustee (Revenue Ruling 95-58). 
  2. The G-CLAT makes an annual payment to charity equal to a certain percentage of the initial fair market value of the G-CLAT assets for a term of years. 
  3. The G-CLAT is designed so that the Grantor’s reversionary interest is less than 5% of the fair market value of G-CLAT assets under IRC §7520(a). The G-CLAT is also designed so that the Grantor is treated as the owner for income tax purposes. In such a situation, the Grantor will receive an income tax charitable deduction, but the Grantor will also personally report the G-CLAT’s income during the G-CLAT term. (See, e.g., IRC §674(a) regarding a power of a independent third party to allocate income and/or principal among charitable beneficiaries, which would cause the Grantor to be taxed on the income of a G-CLAT, but would not cause the corpus of the G-CLAT to be included in the Grantor’s gross estate; see also, e.g., IRC §675(4), which would have the same effect.) 
  4. Contemporaneous with the Grantor’s transfer of assets to the G-CLAT, the Grantor will sell to his or her child his entire reversionary interest in the G-CLAT, for its fair market value. There is no gift tax or related “3 year rule” issues involved because the reversionary interest is sold to the child. 
  5. After the G-CLAT term of years expires, the G-CLAT assets are transferred to the child who owns the G-CLAT reversionary interest. The child’s cost basis in these assets is what he or she paid the Grantor for the reversionary interest (IRC §1.1014-8(c)).  See Private Letter Ruling 9512002.

Example

  1. Grantor creates a Reversionary G-CLAT and funds the G-CLAT with $5 million of S stock. The G-CLAT will make annual payments of $500,000 (10% of $5 million) to a charity for 14 years. 
  2. The reversionary interest (based on the November 2006 Discount Rate of 5.6% under IRC §7520(a)) is $136,100 (or 2.7% of $5 million).
  3. Grantor sells the $136,100 reversionary interest to his or her child.
  4. After 14 years, the G-CLAT will terminate and the G-CLAT assets will transfer to the child. Assuming the G-CLAT assets have grown in value during the 14 year period, the child will receive these assets tax free, since he or she previously purchased the reversionary interest for $136,100.

Comments

Care should be taken when establishing the G-CLAT term of years and payout percentage to the charity. If the G-CLAT assets do not produce enough income to meet the required annual payments to the charity, then the G-CLAT assets must be distributed to the charity to make up any annual shortfall. Prior to creating the G-CLAT, asset valuation adjustment planning may be accomplished to make certain that enough income will be produced. 

The child may work for the S corporation or otherwise manage the G-CLAT assets during the G-CLAT term and be compensated.

Planning Opportunities

The Grantor Reversionary CLAT might be especially attractive for significant wealth transfers, in cases where the parents own rapidly appreciating assets and are facing substantial gift taxes and have previously used up their Federal gift tax credits on prior gifts.

Another practical application is for situations involving transfers of closely-held stock or other interests in privately owned businesses.  When a non-reversionary CLAT is funded with closely-held stock, the excess business holdings rules of IRC §4943 can present special challenges. The Code provides that a charitable lead trust is not subject to the excess business holdings rules unless the present value of the charitable income interest exceeds 60% of the aggregate fair market value of all trust assets on the date of creation. For non-grantor lead trusts, the cost of avoiding the excess business holdings rules requires subjecting at least 40% of the trust assets to gift or estate tax. However, see Private Letter Ruling 200747001 for an interesting solution to this problem.


Planning Considerations for Reversionary G-CLAT funded with S stock 

Will the Grantor status of the G-CLAT change to a Non-Grantor status if the reversionary interest is less than 5%, because of IRC §673(a)?  Also, will the S corporation's S election be lost if its shares are transferred to a G-CLAT in which the grantor has less than a 5% reversionary interest? 

There are numerous ways for a CLAT to qualify as a grantor trust, and the grantor's retention of a greater than 5% reversionary interest is only one of them. Assuming one or all of the following methods are used to qualify the CLAT as a grantor trust, the fact that the grantor's reversionary interest is less than 5% should not make a difference:

1 - Power of independent Trustee to add charity as a beneficiary;
2 - Power to substitute assets in a non-fiduciary capacity; and
3 - Requiring consent by non-Trustee for distributions.

Power #3 can be problematic and depends on the wishes of the Grantor, which is why powers #1 and #2 are relied upon more often. Power # 2 is questionable, since it is always a facts and circumstances test, and the IRS will not rule. Power #1 is considered the most reliable. Some attorneys recommend adding a fourth power, allowing the CLAT to buy life insurance (even cheap joint and survivor term) on the life of the Grantor and/or his or her spouse.

Private Letter Ruling 199908002 directly addressed the issue concerning whether a G-CLAT qualified for the grantor trust provision in the S corporation rules, that conditionally permitted grantor trusts to be qualified S corporation shareholders. In this ruling, the IRS held that if the grantor is considered the sole beneficial owner of the G-CLAT under the grantor trust rules, than the G-CLAT can hold the S stock without terminating the S election. The IRS refused to rule directly on whether the G-CLAT does in fact qualify as the sole beneficial owner for purposes of the grantor trust provision in the S corporation shareholder eligibility rules.

This leaves open the possibility that the charitable lead beneficiary might also be deemed to have a beneficial interest in the trust, causing it to have more than one beneficial owner for grantor trust purposes. A literal reading of the S corporation provision permitting grantor trusts to be qualified shareholders indicates that there can be only one beneficial owner who must be a U.S. citizen, so this issue remains open. However, see Private Letter Ruling 200747001.


Planning Considerations for “Term of Years” Reversionary G-CLAT funded with S Corporation Stock 

What happens if the G-CLAT is designed to run for a term of years, instead of for the grantor’s life, and the grantor dies before the term of years expire? Will the Grantor status of the G-CLAT change to a Non-Grantor status and will the S corporation's S election be lost because the CLAT is no longer a qualifying S stock owner?

The grantor trust status expires after a 2 year grace period following the Grantor’s death, during which the CLAT can still own the S stock (IRC §1361(c)(2)(A)(ii)). Incorporating an Electing Small Business Trust (ESBT) provision, to be eligible to elect ESBT status, may be an effective defensive measure. See Private Letter Rulings 199908002 and 200747001

Citations of Authority

Income tax charitable deduction — Only allowed if all the income earned by the trust, including the income paid to the charity is taxable to the donor; and, the charity’s interest is a guaranteed annuity or unitrust interest. IRC §170(f)(2)(B); Reg. §1.170A-6(c)(2).  The charitable deduction substantiation rules do not apply to charitable lead trusts. Reg. §1.170A-13(f)(13).

Ceiling on deduction — 30% of adjusted gross income, with a 5-year carryover for any excess. IRC §170(b)(1)(B). Different rules may apply when the lead interest beneficiary is a non-operating private foundation.  IRC §170(b)(1)(D).

If the donor ceases to be treated as the owner before the trust terminates, the deduction is recaptured. IRC §170(f)(2)(B).

Capital gain:
Reversionary interest — Donor is taxed on the gain in year realized by the trust.

Non-reversionary interest — Trust is taxed on the gain in year realized by the trust.

Gift and estate tax — To avoid gift and estate tax on the charity’s income interest, the interest should be a guaranteed annuity or unitrust interest.  IRC §§2522(c)(2)(B) and 2055(e)(2)(B); Reg. §§25.2522(c)-3(c)(2) and                20.2055-2(e)(2); Rev. Rul. 77-300, 1977-2 CB 352. Also, some commentators state that Rev. Rul. 82-128, 1982-2 CB 71, dealing with charitable remainder trusts, could also apply to charitable lead trusts.

Generation-skipping tax — There is no generation-skipping tax on the remainder to a grandchild whose parents are not living on the trust’s creation; nor for the remainder to a grandnephew or grandniece if the parents are not alive at the trust’s creation and the trust grantor has no lineal descendants.  IRC §2651(e).    

Treasury table citations for computing value of charity’s lead interests:
Unitrusts — Reg. §§1.664-3(d) and -4; IRS Pub. 1458.
Annuity Trusts — Reg. §§1.664-2(c) and 20.2031-7; IRS Pub. 1457.
Federal midterm rates — IRC §7520; Reg. §§1.7520-2, -3.
When Treasury-issued actuarial tables are disregarded — Reg. §§1.7520-3(b); 20.7520-3(b) and 25.7520-3(b).   


IRS Sample Forms for Inter Vivos CLAT: Rev. Proc. 2007-45
Issued: Friday, June 22, 2007

IRS Sample Forms for Testamentary CLAT: Rev. Proc. 2007-46
Issued: Friday, June 22, 2007

IRS Sample Forms for Inter Vivos CLUT: Rev. Proc. 2008-45
Issued: Friday, July 28, 2008

IRS Sample Forms for Testamentary CLUT: Rev. Proc. 2008-46
Issued: Friday, July 28, 2008

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Comments

Re: Reversionary Grantor Charitable Lead Annuity Trust

First, I'm talking about a REVERSIONARY interest.

Secondly, I agree that in all cases any interest should be sold for its fair market value. My article talks about the sale of the Reversionary Interest in this manner too.

Re: Reversionary Grantor Charitable Lead Annuity Trust

Very interesting article and thanks for posting. Question: some years ago, I seem to recall the IRS coming out with some pronouncement or other level of authority that it was basically against selling the remainder interest in a CLT for less than the full amount of the CLT value. In other words, it did not want to enable the full and adequate consideration for a remainder interest to equal its true FMV. Are you familiar with these rulings and if yes, what is your take on their impact on the CLAT strategy you discussed in the article? Thanks!

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