Validity of Shark-Fin CLATs Remains in Doubt Despite IRS Guidance

Validity of Shark-Fin CLATs Remains in Doubt Despite IRS Guidance

Article posted in Charitable Lead Trust on 19 November 2010| comments
audience: National Publication | last updated: 27 April 2017
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Summary

Writing in the October 2010 issue of Estate Planning Journal, attorneys Richard Fox and Mark Teitelbaum caution that although language in Revenue Procedures indicates that charitable lead annuity trust payments may increase during the annuity period, until the IRS clarifies its position, the validity of the highly touted

By Richard L. Fox and Mark A. Teitelbaum, Attorneys

With the Section 7520 interest rate at a historically low level,1 the charitable lead annuity trust (CLAT) has become an increasingly powerful and popular estate planning tool to transfer wealth effectively to the next generation, while also furthering philanthropic goals by providing annuity payments to charity. Unlike a charitable lead unitrust (CLUT), a CLAT can be structured so that the present value of the annuity payments to charity is equal to the amount actually transferred to the CLAT, thereby resulting in what is known as a “zeroed-out” CLAT because the value considered transferred to the remainder beneficiaries for estate and gift tax purposes is equal to zero.

Rev. Procs. 2007-452 and 2007-463 contain sample CLAT forms,4 and the accompanying annotations state that the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar amount “but increases during the annuity period.” This language has spurred the promotion of what has become known as the “variable CLAT” or “VCLAT,” and particularly the highly touted “shark-fin” CLAT where fixed nominal annuity payments are made to charity each year followed by a substantial back-loaded balloon payment to charity at the termination of the trust. By back-loading the payment to charity, the shark-fin CLAT is intended to allow for a significant build-up of funds within the CLAT,5 so as to maximize the amount ultimately passing to family members on the termination of the CLAT, although the nominal annual annuity payments and the back-loaded balloon payment can be structured to result in a zeroed-out CLAT.

One version of the shark-fin CLAT being promoted uses substantially all of the funds initially transferred to the CLAT to purchase a single-premium life insurance policy on the settlor. Then, when the settlor dies (at which time the CLAT term also ends), a portion of the life insurance proceeds is used to fund the substantial back-loaded balloon payment to charity. The remainder of the insurance proceeds, plus any other funds remaining in the CLAT, passes to family members.6 Although the annotations accompanying the sample CLAT forms indicate that there may be “increases” in the annuity amount, the IRS has not provided any specific guidance or details regarding the permissibility of such increases and has never approved the shark-fin CLAT strategy, including those funding the balloon payment to charity with life insurance.

Interestingly, notwithstanding the annotations accompanying the IRS sample CLAT forms, it is not clear that increases in annuity payments under a CLAT should be permissible in the first instance. Moreover, even assuming the permissibility of such increases, there is authority suggesting that any such increases should be limited on a year-to-year basis and that nominal annuity payments should be considered de minimis and therefore disregarded, thereby raising questions as to whether the back-loaded approach of the shark-fin CLAT would actually pass IRS muster.7 Making a final balloon payment to charity funded by life insurance proceeds raises a further issue as to whether that final payment, triggered solely by the settlor's death, would in and of itself cause the shark-fin CLAT to be invalid because it would not be considered an annuity payment.

In addition, because a CLAT, as a Section 4947(a)(2) split-interest trust, is subject to the self-dealing rules of Section 4941, there is a further issue as to whether structuring a CLAT so that only nominal payments are made to charity prior to one substantial balloon payment on its termination could potentially be viewed as an act of self-dealing, given that the purpose of such a structure is to maximize the amount of assets in the CLAT passing to family members of the settlor and the fact that the charitable beneficiaries run a higher risk of not receiving any substantial payment because the trust assets may substantially depreciate before the final scheduled balloon payment is due. A discussion of this issue, however, is beyond the scope of this article.

This article explores the validity of the shark-fin CLAT, including those making a final balloon payment to charity funded with life insurance. In light of the risks associated with the use of a shark-fin CLAT, as discussed hereinafter, and particularly those funding back-loaded balloon payments with life insurance, an alternative CLAT structure using life insurance is also discussed.

Planning Tip

Low interest rates facilitate the creation of a “zeroed-out” CLAT. With a zeroed-out CLAT, the charitable deduction fully offsets the amount transferred to the CLAT, resulting in no gross estate tax inclusion (for testamentary CLATs) or taxable gift (for inter vivos CLATs) on funding the CLAT. An aggressive strategy used in connection with zeroing out a CLAT is to back-load payments going to the charitable beneficiary of a CLAT.

In a variable CLAT (VCLAT), the lead annuity payments to charity increase during the term of the CLAT. This type of CLAT is also sometimes referred to as an “increasing payment CLAT,” or “IPCLAT.” “Shark-fin” CLATs are a type of VCLAT. For purposes of this article, a “shark-fin” CLAT is one structured to make nominal annual fixed annuity payments to charity until a substantial balloon payment is made to charity in the final year of the CLAT. The “shark-fin” name is attached to this structure because if the payment pattern to the charity is plotted on a line graph, the final payment resembles a shark's dorsal fin slicing through the water.

Note that a CLAT may not always be structured as a “zeroed-out” CLAT, particularly if the settlor has not fully used the $1 million current lifetime gift tax exemption in Section 2505(a). In this case, the payments to charity otherwise required to zero out the CLAT can be reduced, leaving more funds within the CLAT and thereby likely resulting in more assets being transferred to family members on the termination of the CLAT, a key to the planning strategy of a CLAT.

Background on charitable lead trusts

A charitable lead trust (CLT)8 is a “split-interest trust” that allows an individual to provide benefits to both charitable and noncharitable beneficiaries. Generally, a CLT is an irrevocable trust that provides a current benefit to charity, either in the form of a guaranteed annual annuity payment (the CLAT structure) or unitrust (a CLUT structure), for a period known as the “lead term,” which can be a specified number of years or the life or lives of designated individuals, including the settlor. On the termination of the lead term, the remaining assets in the CLT pass to noncharitable beneficiaries, typically family members of the settlor or a trust for their benefit. Thus, at the creation of a CLT, two gifts are made by the settlor:

(1) A gift of the annuity or unitrust interest to charity.
(2) A gift of the remainder interest to noncharitable beneficiaries.

A CLT is basically the opposite of a charitable remainder trust (CRT), which provides payments to noncharitable beneficiaries during an initial term, followed by a payment to charity at the end of such term. Unlike a CRT, however, there are no minimum or maximum payout requirements with respect to the annuity or unitrust payments, no requirement regarding the present value of the remainder interest, and no term limitation for a CLT that is not measured by the life expectancy of an individual. If the CLT conforms to the requirements of the Code, a charitable gift or estate tax deduction is available for the present value (determined using the Section 7520 rate) of the annuity or unitrust payments payable to the charity over the lead term.

Computation choice for deduction. Where an income, estate, or gift tax charitable deduction is allowed, the taxpayer may elect to use the Section 7520 rate for the month of the transfer or either of the two months preceding the month of the transfer.9 Section 7520 requires the use of an interest rate assumption equal to 120% (rounded to the nearest two tenths of 1%) of the applicable federal mid-term rate in effect under Section 1274(d) for the month in which the valuation date falls. This rate is sometimes referred to as the “charitable federal mid-term rate.” The applicable federal mid-term interest rate changes monthly and is published by the IRS in a revenue procedure, along with the Section 7520 rate, generally on the 20th day of the month preceding the month in which the rate applies.

The settlor of a CLT may use the applicable Section 7520 rate in effect for the month in which the gift is made or, pursuant to an available election, the rate in effect for either of the two months preceding the month of the gift. Because the Section 7520 rate for a particular month is announced on approximately the 20th day of the month preceding the month in which the rate applies, once the Section 7520 rate is announced for the following month, donors have the flexibility to choose an interest rate over a four-month period consisting of:

(1) The current month.
(2) The month immediately preceding the current month.
(3) The second month preceding the current month.
(4) The month following the current month, but only if the transfer to the CLT is actually deferred until that month.

This gift or estate tax charitable deduction offers a significant benefit, as the taxable amount of the gift or amount subject to estate tax is equal to the amount transferred to the CLT less the available charitable deduction,10 thereby potentially resulting in significant wealth being transferred to family members on the termination of the lead term at little or no gift or estate tax cost.

Planning Tip

The charitable lead trust (CLT) is one of several types of split-interest vehicles that split the benefits between charitable and noncharitable beneficiaries. Other such vehicles include:

  • Charitable remainder trust (CLT).
  • Pooled income fund.
  • Charitable gift annuity.

All of these are basically structured to provide payments to the noncharitable beneficiaries during an initial period. In contrast, a CLT is structured to make payments to the charitable beneficiaries during an initial period.

Unlike a CRT, a CLT is not a tax-exempt entity. Rather, during its lead term, the taxability of a CLT depends on whether it is treated as a grantor or nongrantor trust. In the grantor trust situation, the settlor is taxed on all of the income of the CLT, whereas in the nongrantor trust situation, the CLT is taxed on all of the income, subject to an income tax charitable deduction under Section 642(c)(1).

Grantor versus nongrantor CLT. In addition to offering a gift or estate tax charitable deduction, a CLT created during life can be structured to provide an income tax charitable deduction to the settlor of the trust. This is possible, however, only if the CLT is a “grantor trust” for income tax purposes, which can be accomplished where a provision in the trust document triggers the grantor trust rules.11 Although an upfront income tax charitable deduction is available, there is a price to pay for this benefit. The same grantor trust status of the CLT that results in an income tax charitable deduction to the settlor of the CLT also causes the settlor to recognize all of the taxable income of the trust during the lead term, without any further charitable income tax deduction for the annual payments from the trust to charity.

In effect, therefore, the upfront income tax charitable deduction is recaptured over time through the recognition of the taxable income earned by the CLT. Furthermore, if the settlor dies during the lead term of a grantor CLT, the grantor will be taxed on a recaptured amount.12 For this reason, most inter vivos CLTs are structured as nongrantor trusts, in which case it is imperative that the CLT trust form not inadvertently contain any grantor trust provision.13 In a nongrantor trust situation, the CLT is treated as a complex trust that is taxable as a separate entity under the provisions of Subchapter J of the Code under its own tax identification number.

The settlor of a nongrantor CLT neither obtains an income tax charitable deduction (either on the funding of the trust or at any time thereafter) nor recognizes any taxable income earned by the trust. Instead, each year, the CLT recognizes the taxable income earned by the trust and is also entitled to an income tax charitable deduction under Section 642(c)(1) (in lieu of the charitable income tax deduction otherwise available under Section 170(a)) for the annuity or unitrust amount paid to charity each year.
Thus, although a nongrantor CLT is not exempt from income tax,14 it may ultimately be the equivalent of a tax-exempt entity by virtue of the income tax charitable deduction available during the lead term under Section 642(c)(1). Moreover, the class of permissible charitable recipients for obtaining a deduction under Section 642(c)(1) is broader than the class of such recipients under Section 170(a). For example, an income tax charitable deduction is available for a contribution to a foreign charity under Section 642(c)(1) by a nongrantor CLT, whereas no such deduction is available to an individual under Section 170(a) for a contribution to a foreign charity.15

Effect of interest rates when using CLTs. A CLAT offers the potential for passing more assets to the noncharitable remainder beneficiaries if it is established in a low Section 7520 interest rate environment. This is because the lower the Section 7520 interest rate in effect on the date the CLAT is funded, the higher the present value of the annuity or unitrust interest passing to charity and, therefore, the greater the charitable estate or gift tax deduction.

As a result, in a low interest rate environment, the annuity payments to charity can be set at a much lower amount than in a high interest rate environment. This increases the likelihood that more assets will pass to the noncharitable remainder beneficiaries. CLUTs have virtually no sensitivity to interest rates (other than nominally based on the frequency of the annual unitrust payments), so they are the preferred choice in a high Section 7520 interest rate environment.

Zeroed-out CLAT. A CLAT, but not a CLUT, can be structured so that the present value of the annuity payments payable to the charity is equal to the value of the property funding the CLAT. In a “zeroed-out” CLAT, the annuity payments are set to have a present value equal to the full value of the property transferred to the CLAT, making the value of the remainder interest zero. For example, assume that a donor establishes a 20-year term inter vivos CLAT, funded with $1 million, when the applicable Section 7520 rate is 2.8%. In this situation, an annual annuity payout at the end of each year equal to 6.6% of the $1 million contribution, or $66,000, has a present value of $1 million. Thus, no taxable gift results because the amount contributed to the trust and the present value of the annuity (for which a charitable gift tax deduction is available) are both $1 million, thereby resulting in the remainder interest having a value of zero for gift tax purposes.

If the CLAT were, instead, structured as a CLUT paying a unitrust amount of 6.6% each year, rather than a fixed payment of $66,000 per year, however, the present value of the unitrust payments would be only $744,767, thereby producing a taxable gift of $255,233. Even where a CLAT is not zeroed-out, it still can be structured so that the taxable gift, although not equal to zero, is substantially minimized or is not subject to gift tax because of the available $1 million current lifetime gift tax exemption.

Shark-fin CLAT using life insurance

The basic strategy of the shark-fin CLAT using life insurance involves the contribution of cash to an inter vivos CLAT, which is structured as a “grantor trust” for income tax purposes. The CLAT uses most of the cash contribution to purchase a single-premium life insurance policy on the life of the settlor, the proceeds of which are payable to the CLAT on the death of the settlor, which also triggers the termination of the CLAT. A portion of the life insurance proceeds are used to make a final substantial balloon payment to charity, with the remaining insurance proceeds distributed to the noncharitable remainder beneficiaries. The portion of the cash contribution that is not used by the trust to purchase life insurance is used to purchase a tax-exempt municipal bond, which is used to make fixed nominal annual payments to a designated charity. Because the trust is a grantor trust, the settlor obtains an upfront income tax deduction. Furthermore, because the only income earned by the CLAT is tax-exempt municipal bond income, the settlor is not subject to tax on that income.

Example. A 60-year-old settlor contributes $1 million in cash to a CLAT. The CLAT immediately purchases a life insurance policy on the settlor with a $900,000 single premium payment. The remaining $100,000 of the $1 million in cash contributed to the CLAT is used to purchase a $100,000 municipal bond that pays 4% interest. The arrangement produces the following results:

  • The life insurance policy has a death benefit of $3,800,001. When the settlor dies, the CLAT receives the $3,801,000 in life insurance proceeds, and $2,275,000 is paid to a designated charity. The remaining $1,526,000 passes to the noncharitable remainder beneficiaries designated in the CLAT.
  • The municipal bond earns interest of $4,000 each year, which the CLAT uses to make annual annuity payments to the designated charity of $4,000. Consequently, even though the CLAT is structured as a grantor trust, thereby subjecting the settlor to income tax on the income earned by the CLAT, the settlor does not recognize taxable income because the CLAT income is tax-free municipal bond income. When the CLAT terminates on the settlor's death, the remaining balance of the municipal bond is paid to the noncharitable remainder beneficiaries.
  • Based on an assumed Section 7520 rate of 3.4%, the present value of the $4,000 annual annuity payments to charity for the donor's life and the balloon payment to charity at the donor's death of $2,275,000 equals $950,000. Thus, the grantor is entitled to a charitable income and gift tax deduction of $950,000. Because of the gift tax charitable deduction, the taxable gift at the time the CLAT is funded equals the excess of $1 million over $950,000, or $50,000 (which can be sheltered by the current $1 million lifetime gift tax exclusion).

Therefore, although the taxable gift is only $50,000, the noncharitable remainder beneficiaries ultimately receive a total of $1,526,000 and the municipal bond held in the CLAT, a clearly a favorable outcome assuming this strategy passes IRS muster.

Permissibility of back-loading payments to charity
In order for an income, gift, or estate tax charitable deduction to be available on funding a CLAT, the charitable interest must be in the form of a “guaranteed annuity.” 16 Therefore, absent the payments to charity constituting a “guaranteed annuity,” potentially disastrous tax consequences can result:

  • For a testamentary CLAT, the entire amount transferred would be included in the taxable estate.
  • For an inter vivos CLAT, the entire amount transferred would be a taxable gift.

No income tax charitable deduction would be available.
The term “guaranteed annuity” is defined in the regulations as "an irrevocable right pursuant to the instrument of transfer to receive a guaranteed annuity," which is defined in turn as "an arrangement under which a determinable amount is paid periodically, but not less often than annually, for a specified term of years or for the life or lives of certain individuals.”17 An amount is considered “determinable” if the exact amount which must be paid to charity can be “ascertained as of the date of gift.” The regulations provide “[f]or example, the amount to be paid may be a stated sum for a term of years, or for the life of the donor.”18 The only guidance in the regulations addressing the permissibility of increasing the annuity amount paid to charity during the CLAT lead term is a statement that the annuity amount “may be changed by a specified amount” at the expiration of a term of years or at the death of an individual.19 The examples provided under the regulations regarding the valuation of CLAT annuities use only a stated dollar amount to be paid to charity over the term of the CLAT, not any payout scheme involving increasing payouts.20

The lack of explicit guidance under the CLAT regulations regarding the permissibility of year-to-year increases in the annuity payments to charity is contrary to the regulations under other provisions of the tax law involving “annuity trusts.” For example, the regulations governing charitable remainder annuity trusts (CRATs) specifically require the annuity to be the same “stated dollar amount” each year, thereby precluding the possibility of annual increases in the annuity amount.21 The regulations governing grantor retained annuity trusts (GRATs) similarly provide that an annuity is a “stated dollar amount,” but specifically allow an annual increase equal of 20% of the stated dollar amount payable in the preceding year.22

Ascertainable payment vs. guaranteed annuity. In the context of a CLAT, it has been suggested that so long as the payments to charity are “ascertainable” on the date of the initial transfer to a CLAT, there is no prohibition on increasing the annual payout amounts to charity.23 This is based on the theory that as long as the amount of the payments to charity is known, the available income, gift, or estate tax charitable deduction will be based on exactly what the charity will be receiving. This situation presents no potential for the charitable deduction to be taken based on payments that will never in fact be received by charity, a result that potentially could have occurred prior to the enactment of the present-day rules governing CLTs.24
Under the CLAT regulations, the requirement that a payment be “ascertainable” relates only to whether a payment is considered to be a “determinable amount,” not whether the payment is a guaranteed annuity. To constitute a “guaranteed annuity” under the CLAT regulations, however, there must be "an arrangement under which a determinable amount is paid periodically but not less than annually.” Thus, qualification as a “guaranteed annuity” does not rest solely on the payments to charity being ascertainable, as absent a determinable amount being paid periodically, there can be no “guaranteed annuity.” Moreover, based on the use of the phrase “a determinable amount” in the CLAT regulations, rather than “determinable amounts,” and the indication in the CLAT regulations that increases in annuity payments may be permissible on the expiration of a term of years or at the death of an individual, the language of the CLAT regulations could very well be interpreted to require the payment of the same stated dollar amount during a specific term of years or for a measuring life. 25
Indeed, the conclusion that a guaranteed annuity requires the payment of a fixed stated sum is consistent with the courts defining the term “annuity” under Section 7520, the very statute that is used to value CLAT annuity payments for estate and gift tax purposes, as an “obligation to pay a stated sum, usually monthly or annually.”26 It is also consistent with the language in the Preamble to the proposed regulations amending the CLAT regulations in response to Estate of Boeshore,27 where the IRS stated that a “guaranteed annuity is defined in the regulations under section 170, 2522, and 2055 as an arrangement pursuant to which a specified sum is paid not less often than annually.” On the other hand, the absence in the regulations of an explicit prohibition or limitation on increases in CLAT annuity payments, coupled with the fact that there are no required minimum or maximum CLAT payout amounts, lends support to the position that annual increases may be permitted as long as the exact amounts to be paid periodically to charity are ascertainable and payable at least annually.28

Increasing amount? Given the lack of clear guidance in this area, however, commentators had long questioned whether payments to charity during the lead term of the CLAT could indeed be structured as an increasing amount and, if they could, the extent of the allowable increases from year-to-year.29 The only authority discovered in the context of a CLAT where the IRS appears to condone the use of varying payments being made to a charity under a charitable lead trust is Ltr. Rul. 9112009, where the minimum amount payable to the charity during the lead term “varies each year.” Note that although a private letter ruling is a written statement issued by the National Office of the IRS "which interprets and applies tax laws to a specific set of facts," a letter ruling may not be relied on by taxpayers other than the one to whom it is issued.30 Moreover, Ltr. Rul. 9112009 did not set forth with any degree of specificity the nature of increases in the annual annuity payments, and there is nothing to indicate that the ruling involved a series of fixed annuity payments followed by a lump-sum payment on the death of the grantor.

In the absence of clear authority on this issue and the attendant risk of not being eligible for a charitable deduction if payments to charity are not a “guaranteed annuity,” CLATs have traditionally been structured to provide for a payment of a fixed stated dollar amount to charity during the lead term of the trust, without any annual increases in the payment amount.

The annotations in the 2007 Revenue Procedures containing the sample CLAT forms state, without more, that “the governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar amount ... but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded.”31 They do not, however, address the amount of the permissible “increases during the annuity period,” provide any examples involving increases in annuity payments, or cite any authority or provide any analysis for the underlying proposition that increases in annuity payments to charity are, in fact, permissible in the first instance.

Also, nothing in the annotations specifically permit the governing instrument of a CLAT to provide for the payment to charity of fixed nominal annual annuity payments followed by a substantial lump-sum balloon payment at the death of the settlor (i.e., the termination of the trust), the key to the structure of a shark-fin CLAT. It is on the basis of language in the IRS Revenue Procedures that there may be “increases” in the annuity payment to charity “during the annuity period,” however, that the use of a shark-fin CLAT has been promoted as being approved by the IRS.32 This is not the case; the Revenue Procedures merely indicate that the annuity may start out as a “fixed dollar amount,” which may increase during the annuity period. Nothing in the Revenue Procedures addresses, let alone approves, the permissibility of nominal payments followed by a substantial lump-sum balloon payment in the final year of the CLAT.

Furthermore, a close examination of various relevant authority, as discussed below, sheds doubt as to the validity of a shark-fin CLAT. Indeed, commentators have specifically noted that the 2007 Revenue Procedures do not sanction the back-loaded shark-fin CLAT and have cautioned that it may be considered abusive.33

Value of relevant authority. In Rev. Proc. 89-14,34 the IRS offered the following statements regarding taxpayer reliance on Revenue Rulings:

(1) "Revenue rulings published in the Bulletin do not have the force and effect of Treasury Department regulations (including Treasury Decisions), but are published to provide precedents to be used in the disposition of other cases, and may be cited and relied upon for that purpose.”
(2) "Taxpayers generally may rely upon revenue rulings and revenue procedures published in the Bulletin in determining the tax treatment of their own transactions and need not request specific rulings applying the principles of a published revenue ruling or revenue procedure to the facts of their particular cases.”
(3) "Each revenue ruling represents the conclusion of the Service as to the application of the law to the entire statement of facts involved. Therefore, taxpayers, Service personnel, and others concerned are cautioned against reaching the same conclusion in other cases unless the facts and circumstances are substantially the same."

Therefore, taxpayers may rely on a Revenue Ruling and presumably a Revenue Procedure addressing substantive law, except where the relevant facts are distinguishable. Of course, the Revenue Procedures containing the sample CLAT form provide only that there may be “increases” in the annuity payment to charity “during the annuity period,” without reference to any facts and circumstances, and particularly facts dealing with back-loaded payments to charity on the termination of the CLAT that are preceded by nominal payments.

Guidance under GRAT rules. A GRAT is an estate planning vehicle that is very similar to a CLAT, although unlike in the CLAT context, where the annuity payments are made to charity, the annuity payments in the context of a GRAT are made to the grantor. In both a GRAT and a CLAT, noncharitable remainder beneficiaries receive the amount remaining in the trust on termination, and the goal is to maximize the amount passing to such beneficiaries. For purposes of determining the estate and gift tax consequences on funding both a GRAT and a CLAT, the present value of the annuity payments reduces the taxable estate or the gift, and both a GRAT and a CLAT can be “zeroed-out.”

When proposed regulations were initially issued in the context of a GRAT on 4/9/1991, long after the CLAT rules had been in place, the GRAT annuity payment was required to be a fixed stated amount.35 Under the proposed regulations, therefore, any increases in the annuity amount over the term of a GRAT were not permitted, even if the increased annuity payments were ascertainable. When the final regulations were issued on 2/4/1992, the Preamble specifically indicated that the prohibition on increases in annuity payments contained in the proposed regulations was intended to prevent structuring a GRAT with a series of nominal annuity payments, followed by a balloon payment at the termination of the trust, stating as follows:

The proposed regulations prohibited increases [in the annual annuity payment] to prevent transferors from “zeroing out” a gift while still effectively transferring the appreciation on all of the property during the term to the remainder beneficiary (e.g., by providing a balloon payment in the final year of the term). The Treasury Department and the Service believe that such a result would be inconsistent with the principles of section 2702.” [Emphasis added.]36

Thus, where the IRS has actually considered a balloon payment being made in the final year of an “annuity trust,” it has determined that such a scheme is not appropriate because this would effectively result in all of the appreciation of the transferred property being passed to the remainder beneficiaries. This conclusion was reached notwithstanding that the exact amount of the lump-sum balloon payment to be made in the final year of the GRAT was ascertainable as of the creation of the trust. Because the goal of both a GRAT and a CLAT is ultimately to pass the maximum wealth to noncharitable remainder beneficiaries at the termination of the trust, this same position may similarly be adopted by the IRS in the context of a shark-fin CLAT, notwithstanding that a lump-sum balloon payment to charity is ascertainable at the creation of the trust.

In response to comments from taxpayers requesting that the GRAT proposed regulations be revised to allow for increases in the annuity amounts, the final regulations ultimately allowed for such increases, but only to the extent of an increase of 20% for each year.37 Thus, under the final regulations for GRATs, an annuity payment in any given year cannot exceed 120% of the stated dollar amount payable in the preceding year. As a result, under the GRAT rules, it is not permissible to make nominal annual annuity payments, followed by a lump-sum balloon payment when the trust terminates. In allowing for these annual increases in the context of a GRAT, the Preamble to the final regulations provided as follows:

In response to comments requesting that increases in the annuity ... amounts be permitted throughout the terms, the final regulations provide flexibility to taxpayers by permitting the annuity ... amount to be 120 percent of the annuity ... amount paid for the preceding year. ... The final regulations, with minimal complexity, strike a balance between the government's policy concerns and taxpayer's desire for planning flexibility.

The policy concerns expressed by the IRS regarding a lump-sum balloon payment at the termination of a GRAT, a vehicle similar in purpose and operation to a CLAT, and the lack of any guidance from the IRS regarding the extent to which CLAT annuity payments may be increased,38 clearly raise a question as to the validity of the shark-fin CLAT. Indeed, it is possible that the IRS might view the shark-fin strategy as abusive and, accordingly, seek to limit the CLAT's charitable payments that may be deferred or, consistent with the GRAT regulations, seek to impose a percentage limitation on year-to-year increases in the annual payments to charity.39 Until the IRS clarifies its position on this issue, it would appear prudent in the context of a CLAT for planners to adopt the 20% GRAT limitation on the year-to-year increases in the annual payments to charity.

Nominal annual CLAT payments preceding balloon payment may be disregarded. In the context of a series of nominal payments to charity followed by a substantial lump-sum balloon payment to charity when the CLAT terminates, there is an issue as to whether the nominal payments will be disregarded as de minimis. If this were the case, the payments made to charity under a shark-fin CLAT would not be considered a “guaranteed annuity” and, therefore, there would be no estate, gift, or income tax charitable deduction available on funding the CLAT. A similar issue has arisen in the context of a charitable remainder trust (CRT) requirement that the annual annuity or unitrust amount must be “payable to or for the use of a named person or persons, at least one of whom is not an organization described in Section 170(c).”40

Thus, so long as there is at least one noncharitable beneficiary of a CRT, a portion of the annuity or unitrust payment may be paid to a charitable beneficiary as well.41 In this context, the IRS has issued private letter rulings stating that the allocation of the annual payments between noncharitable and charitable beneficiaries is permissible only if the amount paid to the noncharitable beneficiaries each year “is not de minimis under the facts and circumstances.” If the payments to the noncharitable beneficiaries are considered de minimis, the payments are disregarded, such that the trust would not qualify as a CRT under Section 664 because of its failure to make annual payments to noncharitable beneficiaries.
The same approach could be applied in the context of a shark-fin CLAT where the lead payments to the charity preceding the year of termination are considered to be de minimis when compared to the balloon payment payable to charity in the year of termination. The private letter rulings in the context of CRTs do not address the meaning of “de minimis,” although de minimis has been defined as “trifling; minimal” and of a fact or thing “so insignificant that a court may overlook it in deciding an issue or case.”42 In the context of a CLAT making annual payments of $4,000 to charity and a final “balloon payment” in the year of the termination of $2,275,000, as described above, the $4,000 annual payment represents .176% of the $2,275,000 final balloon payment, which clearly is susceptible to falling within the meaning of de minimis.

Lump-sum payment at death may not be part of an annuity. As discussed above, qualification as a “guaranteed annuity” under a CLAT does not rest solely on the payments to charity being ascertainable, as absent an ascertainable amount being paid periodically, there can be no “guaranteed annuity.” For an amount to be payable periodically as part of an annuity, the courts have indicated that the amount must be paid at regular intervals. In Estate of Gribauskas,43 for example, the court stated that an annuity is “an amount payable yearly or at other regular intervals (as quarterly) for a certain or uncertain period.” Although a CLAT can certainly have a term measured by the life of the settlor, it would appear questionable whether a lump-sum balloon payment to charity triggered only on the death of the settlor, an event clearly not known when the CLAT is established, would be considered a payment made at a regular interval or periodically. Thus, the shark-fin CLAT paying a back-loaded balloon payment funded with life insurance, triggered only on the death of the settlor, would appear to be even more susceptible to an IRS challenge than a shark-fin CLAT that pays a back-loaded balloon payment to be made on a specified date (which is not funded by life insurance).

Alternative structure of CLAT using life insurance
Although life insurance certainly has a useful place within a CLAT,44 the above analysis indicates that there are questions regarding the validity of a shark-fin CLAT, particularly one funding a substantial back-loaded balloon payment to charity with life insurance. Until further guidance on this issue is provided by the IRS, one alternative structure leveraging the benefits of life insurance is to use the life insurance proceeds for the benefit of the noncharitable remainder beneficiaries, rather than the charity. In this structure, the CLAT purchases a life insurance policy, not with an upfront single premium, but rather with annual premium payments by the CLAT, preferably funded from the CLAT's income in excess of the annual annuity payment to charity.

Thus, each year the CLAT makes an annuity payment to charity and a premium payment on the life insurance policy. When the settlor dies, the insurance proceeds are not paid to the charity, but remain in the CLAT for the benefit of the noncharitable remainder beneficiaries. This is an excellent alternative to the use of life insurance within a shark-fin CLAT, is not subject to the potential IRS challenges faced by the shark-fin CLAT, and—depending on its structure—can produce many of the same benefits.

Conclusion

Until the IRS clarifies its position, there would appear to be a question as to the validity of the shark-fin CLAT as a qualified charitable lead trust, particularly one funding a back-loaded balloon payment to charity using life insurance proceeds. Because of the risk of the disallowance of the income, gift, or estate tax charitable deduction, a potentially disastrous result, planners should exercise caution in using such a CLAT and should consider alternative structures. These alternatives include those leveraging the benefits of life insurance for the noncharitable remainder beneficiaries, rather than the charity.


1 Section 7520 prescribes the interest rate for valuation of any annuity, interest for life or a term of years, or remainder or reversionary interest, including for a CLAT. As discussed below, a CLAT works best in a low Section 7520 interest rate environment.

2 2007-29 IRB 89 (sample inter vivos CLATs).

3 2007-29 IRB 102 (sample testamentary CLATs).

4 For a discussion of these forms, see Fox, “A Guide to the IRS Sample Charitable Lead Trust Forms—Part 1,” 36 EPTL 7 (April 2009); and Fox, “A Guide to the IRS Sample Charitable Lead Trust Forms—Part 2, 36 EPTL 13 (May 2009).

5 This build-up is accomplished because by making only nominal annual annuity payments to charity prior to the termination of the CLAT, the entire initial contribution is effectively allowed to remain in the CLAT and continue to grow until the trust terminates.

6 See Markuson, “IRA Rescue—The ECLAT Solution” where the “ECLAT” acronym stands for “Enhanced Charitable Lead Annuity Trust.” This paper is an undated Power Point presentation available on the Internet that was presented at the “2nd Annual TKS Companies Sales Summit.” See also Bernstein, “Create a Legacy That Lives on For Generations,” Palm Beach Society (December 4-10, 2009) (“we have been encouraging individuals recently to consider what is known as an ECLAT (Enhanced Charitable Lead Annuity Trust)”).

7 Note that discussions with the Branch of the IRS National Office that issued Rev. Procs. 2007-45 and 2007-46, supra notes 2 and 3, reveal that the IRS National Office has not even considered the validity of the shark-fin CLAT.

8 Although CLTs, in their current form, were first sanctioned under the Tax Reform Act of 1969, they became increasingly popular after Jackie Kennedy Onassis created a highly publicized testamentary CLT for the benefit of her grandchildren under the residuary clause of her will dated 3/22/1994. For various reasons, including a provision that death taxes were to be paid from the residuary of her estate, the CLT was never, in fact, funded. Nonetheless various publications cited the CLT feature in Mrs. Onassis's will as a shrewd way to avoid estate taxes.

9 Section 7520(a).

10 The taxable gift of the remainder interest must be reported on Form 709, U.S. Gift Tax Return. Such a gift is not subject to the Section 2503(b) annual exclusion because it is a gift of a future interest. Section 2503(b); Reg. 25.2503-3(a).

11 Section 170(f)(2)(B). The annotations for the introductory paragraph and paragraph 1 of Rev. Procs. 2007-45 and 2007-46, supra notes 2 and 3, specifically provide that such trusts “may be established as either a grantor charitable lead trust or a nongrantor charitable lead trust.” For an article addressing this issue, see Bieber and Hodgman, “Planning With Grantor Charitable Lead Annuity Trusts,” 33 ETPL 36 (August 2006), under the heading “Making the CLAT a grantor trust.” See also Madsen, “Obtaining a Better Benefit by Using a Grantor Charitable Lead Trust,” 31 ETPL 579 (December 2004).

12 Section 170(f)(2)(B); Reg. 1.170A-6(c)(4).

13 Although most CLTs are nongrantor trusts, a grantor trust can be a valuable tool under the appropriate circumstances and, indeed, the IRS revenue procedures contain sample grantor CLT forms. See, e.g., Madsen, supra note 11.

14 This is in contrast to a CRT which, under Section 664, is exempt from tax, except with respect to unrelated trade or business income which is subject to a 100% excise tax. Section 664(c)(2).

15 Section 170(c)(2)(A) imposes a requirement that a qualified recipient be created or organized in the U.S. In the context of a grantor CLT, no income tax deduction is available where the lead beneficiaries are foreign charities.

16 Sections 170(f)(2)(B) (income tax), 2522(c)(2)(B) (gift tax), and 2055(e)(2)(B) (estate tax).

17 Regs. 1.170A-6(c)(2)(i)(A) (income tax), 25.2522(c)-3(c)(2)(vi) (gift tax), and 20.2055(e)(2)(vi)(a) (estate tax).

18 Id.

19 Id.

20 Regs. 25.2522(c)-3(d)(iv), Examples 1 through 4 (gift tax), and 20.2055-2(f)(2)(iv), Examples 1 through 3.

21 Reg. 1.664-2(a)(1)(ii).

22 Reg. 25.2702-3(b)(1)(ii)(A).

23 Indeed, the annotations to the 2007 revenue procedures adopt the approach that the CLAT annuity payments may increase “provided that the value of the annuity is ascertainable at the time the trust is funded.”

24 Prior to the 1969 Tax Reform Act (“1969 Act”), a charitable deduction was allowable where the interest of the charity in a CLT was a traditional “income interest.” Congress was concerned that giving charitable deductions for traditional income interests would reward inappropriate low-income investment strategies that would deprive the charity of a value commensurate with the deduction allowed. The 1969 Act enacted rules so that a charitable deduction would not be allowed unless the interest given to charity was in the form of a guaranteed annuity or a unitrust. The purpose of this change was to “assure that the amount received by the charity, in fact, bears a reasonable correlation to the amount of the charitable contribution deduction allowed the taxpayer.” H. Rep't. No. 91-413, 91st Cong., 1st Sess. (1969), 1969-3 CB 200, 239.

25 Indeed, certain commentators have asserted that CLAT annuity payments must be the same fixed stated dollar amount payable over the term of the CLAT. See, e.g., Ackerman, “Harnessing the Power of Charitable Lead Trusts,” 2006 National Conference on Planned Giving (in the context of a CLAT, the “annuity amount will be fixed on the date of creation and not change”); Robinson, “Using Charitable Lead Trusts Funded With Real Estate,” 21 ETPL 228 (July/August 1994) (with respect to the lead payments to charity under a CLAT, the “amount is established upon the creation of the lead trust and does not change during the lead term”).

26 See, e.g., Cook, 92 AFTR 2d 2003-7027, 349 F3d 850, 2003-2 USTC ¶60471 (CA-5, 2003), where in determining the meaning of an “annuity” under Section 7520, the court acknowledged that Section 7520 does not define “annuity,” but cited Estate of Gribauskas, 116 TC 142 (2001), rev'd on other grounds 92 AFTR 2d 2003-5914, 342 F3d 85, 2003-2 USTC ¶60466 (CA-2, 2003), for the proposition that the definition of an annuity under Section 7520 should be based on its customary meaning: “An obligation to pay a stated sum, usually monthly or annually, to a stated recipient.”

27 78 TC 523 (1982), acq. in result 1987-2 CB 1. In response to this decision, proposed regulations were promulgated on 7/23/2002 (Fed. Reg. Vol. 67, No. 141) and final regulations were issued, effective 7/7/2003, pursuant to TD 9068, to provide that an otherwise available income, gift, or estate tax charitable deduction for a charitable unitrust or annuity interest will not be disallowed solely because it is preceded by a noncharitable unitrust or annuity interest in the same trust.

28 The permissibility of annual increases in the CLAT annuity payments is, indeed, the position embraced by certain commentators. See, e.g., Melcher, Zuengler, and Peters, “Splitting Assets Between Family and Charities at Death: Using CLATs to Improve the Opportunity Set,” 79 Taxes 35 (September 2001), wherein the authors state: “Several commentators have pointed out that so long as the amount to be paid are ascertainable on the date of the initial transfer to the trust, there appears to be no Code provision prohibiting increasing payouts to the charity”; Dunn and Cunningham, “Advantages to Back-Loading: An Analysis of Back-Loaded Annuity Payments from a CLAT or RPM Annuity Trust,” Tax Management Estates, Gifts and Trusts Journal annual CLAT distribution amount is not required to represent equal payments"); Markuson, supra note 6 ("The Treasury Regulations specifically allow non-linear payments").

29 See, e.g., Hester, “Charitable Lead Trusts: The Time Is Right,” 110 J. Tax'n 4 (January 2009); Goodman and Mielnicki, “Planning With Testamentary Charitable Lead Annuity Trusts,” 138 Trusts & Estates 34 (June 1999); Melcher, Zuengler and Peters, supra note 28; Dunn and Cunningham, supra note 28. These articles recognize the potential advantage of using an increasing annuity or back-loaded annuity in the context of a CLAT given that such structure allows for a build-up of funds within the CLAT so as to maximize the amount ultimately passing to family members.

30 Reg. 601.201(a)(2).

31 Rev. Procs. 2007-45 and 2007-46, supra notes 2 and 3.

32 See, e.g., Grote, “Shark-Fin CLATs vs. the Bears—Charitable Giving in Down Times,” Planned Giving Design Center (6/24/2009) (“The IRS issued Model CLAT forms in June 2007 allowing these trusts to vary their annuity payments, thus making the balloon payment alternative possible”).

33 See, e.g., Testa, “Charitable Planning: CRTs, CLTs and the Increasing Payment CLAT,” 210 J. Accountancy 18 (July 2010), where the author specifically notes that “although the IRS has stated in Revenue Procedure 2007-45 that CLTs can have increasing annuity payments, the Service has not specifically opined on a strategy like the balloon IPCLAT.” The author also questions whether such a strategy could be considered abusive.

34 1989-1 CB 814.

35 Prop. Reg. 25.2702-3(b)(1)(ii)(A) (requiring the GRAT annuity payment to be a “fixed amount,” defined as a “stated dollar amount, but only to the extent the amount is the same each year of the term”).

36 TD 8395, 2/4/1992.

37 Reg. 25.2702-3(b)(ii).

38 Commentators who have indicated that increases in CLAT annuity payments are permissible have specifically noted that the extent of the increases is unclear. See, e.g., Melcher, Zuengler, and Peters, supra note 28 (“It is not clear how much the payments could increase from one year to the next. The most extreme case would be simply to have one balloon payment at the end of the trust term, but this arrangement would presumably not work because it is not really an annuity. The IRS might also argue that a series of small payments (e.g., one dollar per year) with a balloon payment at the end of the term would also fail to qualify as an annuity.”).

39 These issues have been raised by commentators. See, e.g., Testa, supra note 33, where the author states in connection with a shark-fin CLAT: “Could it be considered abusive? Should the annual growth of the annuity be limited to 20%? In any case, some planners may think that the balloon IPCLAT is too aggressive and may advise their clients to limit the annuity payments to a 20% annual increase.”

40 Regs. 1.664-2(a)(3)(i) (annuity trust) and 1.664-3(a)(3)(i) (unitrust).

41 See, e.g., Rev. Proc. 2003-53, 2003-2 CB 230, section 5.02[1] (“An organization described in § 170(c) may receive part, but not all, of the annuity amount”). See also Ltr. Rul. 200832017, where the IRS ruled that a provision in a CRUT providing a special trustee power to allocate a portion of a unitrust among charitable and noncharitable beneficiaries will not preclude the trust from qualifying as a CRUT under Section 664(d)(2), and Ltr. Rul. 9423020.

42 Black's Law Dictionary (7th ed.)

43 Note 26, supra.

44 See, e.g., Leimberg and Gibbons, “Life Insurance as a Charitable Planning Tool: Part 2,” 29 ETPL 196 (April 2002).


RICHARD L. FOX is an attorney and partner in the Philadelphia office of the law firm of Buchanan Ingersoll & Rooney (www.bipc.com) where he heads the Philanthropic and Nonprofit practice. Mr. Fox is the author of the treatise, Charitable Giving: Taxation, Planning and Strategies, a Thomson Reuters/Warren, Gorham and Lamont publication. He is also a member of the editorial board of Estate Planning and a member of the Board of Advisors of the American College Chartered Advisor in Philanthropy program (www.theamericancollege.edu).

MARK A. TEITELBAUM, LL.M., CLU, ChFC, has worked in a senior advanced markets capacity for major life insurance carriers for over 20 years. He is also an assistant editor of the Journal of the American Society of Financial Service Professionals and was the previous editor of the American Society's Business & Compensation Planning Section Newsletter. The opinions expressed in this article are those of the authors and do not necessarily reflect those of their employers.
 

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