The charitable lead trust has always been a powerful vehicle to balance philanthropic and estate planning objectives. The recent convergence of two factors that are critically important in the planning dynamic for charitable lead annuity trusts (CLATs) create a planning environment that is so favorable for CLATs, it is no exaggeration to suggest that the current period may be the golden age of CLATs, presenting a very interesting planning opportunity for wealthy families. But that opportunity is temporary, since the convergence of these factors is unlikely to continue for very long.
Historically low IRS interest rates
A CLAT is an irrevocable trust that each year over its term will distribute a pre-determined amount to a charitable beneficiary, with the remainder at the end of the trust term distributed to a child or other non-charitable beneficiary. The estate planning objective is to generate a current gift or estate tax charitable deduction that will partially, or even completely, offset the taxable transfer to the non-charitable beneficiary. Since we are talking about the unique planning opportunity that currently exists, we are talking about the charitable gift tax deduction CLATs established during life, as opposed to charitable estate tax deductions for testamentary CLATs.
The calculation of the charitable gift tax deduction is extremely sensitive to the section 7520 interest rate published every month. The lower the interest rate, the higher the deduction, and the rate has been dropping like a stone:
|Month||Section 7520 Rate|
For each month, the calculation of the charitable gift tax deduction may use the rate for the month the CLAT is funded, or either of the prior two months. This means that the historically low section 7520 rate for May, 2020 of 0.8% may be used to plan CLATs that are funded through the end of July, 2020. This is a crucial factor making this a unique period for CLAT planning.
Depressed Asset Values
The other factor making CLAT planning unusually attractive is the drop in asset values brought on by the coronavirus crisis. Dips in asset values have always presented opportunities for wealthy families to transfer family assets to younger generations. But those opportunities are multiplied due to the CLAT planning dynamic, which involves the arbitrage between the projected average rate of return of CLAT assets over the term of the CLAT and the rate that is assumed for purposes of calculating the gift tax deduction, i.e. the section 7520 rate. The greater the difference between these two percentages, the greater the potential tax-free wealth transfer to the younger generation.
When the value of a portfolio is depressed as a result of a crisis, investors typically expect a higher average total return over the following mid-term. For example, during the 10 year period following the Great Recession, from the trough of March, 2009, the average annual total return for the S&P 500 was about 14%. Many investors are looking for higher-than-normal returns once some normalcy returns to the current markets. So depressed asset values resulting from the coronavirus crisis not only presents the normal opportunity for wealthy families to transfer assets to their children at a lower transfer tax cost, they also increase the potential arbitrage between the current very low section 7520 rate and increased portfolio returns that are anticipated over the term of the CLAT.
Back-loading the CLAT
But the problem with average returns that might be projected over a term of, say, ten years is that the portfolio doesn’t have a total return equal to the average every year: some years the return is higher, some years lower. And when the CLAT is paying out a fixed amount every year, those swings can have a big impact on what is eventually left at the end of the trust term for the kids. This is where back-loading the CLAT makes a huge difference in the value of assets that may be transferred at lower transfer tax cost, since it allows more time for CLAT assets to be invested, thereby smoothing out the volatility of annual returns that are higher or lower than average.
To qualify as a CLAT, the transfers by the trust to charity do not need to be the same amount each year. The amounts must simply be specified in the trust instrument for each year with specificity, so that one may determine from the trust document precisely how much is to be distributed in a given year, and when during the year (quarterly? annually? beginning or end of the period? etc.). For example, for a ten year CLAT, the plan might be to distribute to the designated charity a de minimus amount annually, at the end of years one through nine, and to distribute to charity a much larger amount at the end of year ten, right before the trust terminates with the distribution of the remainder to the children.
Assume that wealthy parents wish to make a major commitment to their alma mater where they met and would also like to set aside funds in their donor advised fund (DAF) at the community foundation, from which a variety of charities might receive distributions as needs in the community, and their charitable interests, evolve over time (it hopefully will not always be Covid-19 all the time). They would like for their children, now in their early twenties, to benefit from the growth in the portfolio that the parents anticipate over the next ten years. They’re not assuming it will be 14% like it was in the recovery from the Great Recession, but think that 8% is a reasonable assumption, since that is less than the 9.8% average total return of the S&P over the last ninety years. They plan to fund the CLAT with $10 million in S&P 500 index funds with very low fees. The CLAT will distribute $100,000 at the end of each of the first nine years, one-half to the university and one half to the DAF, and $9.9 million at the end of the tenth year. Using the section 7520 rate of 0.8%, the charitable gift tax deduction is $10 million, meaning that the gift to the children of the remainder in the trust is completely free of gift tax. Assuming that the CLAT portfolio earned a total return of 8% on average over its ten year term, the distribution to the children would be over $10.3 million at the end of the CLAT term. The folks have provided $5.4 million to their alma mater and funded their DAF with an equal amount. Utilizing the CLAT has allowed the parents to transfer over $21 million worth of assets between charitable and non-charitable beneficiaries over the ten-year term of the trust, while reducing their taxable estate and without incurring any gift tax on the distribution to their children. Finally, to encourage the family tradition of philanthropy in the next generation, they name the children as the successor advisors to the DAF, so that the kids will be able to advise the community foundation regarding charitable uses of the approximately $5 million that will end up in the DAF at the end of the CLAT term.
 To put this table in perspective, keep in mind that just a year ago, the early months of 2019 saw the section 7520 rate at over 3.0%.
 Planners sometimes quote the line famously attributed to Rahm Emmanuel when he was White House Chief of Staff during the Great Recession, “Never let a crisis go to waste.”
 To give you a feel for how critically important the section 7520 rate is to this planning dynamic, using the 2.20% rate in effect just 3 months earlier, in February, 2020, the payment to charity in year ten would need to be over $11.4 million to make the gift of the remainder to the children tax-free.
 What if the average total return from the S&P 500 ends up being better than 8% over the next ten years? If it averages 9.5% average fees – about the 90 year average – the value of the tax-free remainder to the kids would be over $13.5 million!