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Practice Management

The charitable lead annuity trust has become a more attractive estate planning tool in the wake of a recent U.S. Tax Court ruling.

This Practice Management article is intended for financial advisors only (registered representatives of broker dealers or associated persons of Registered Investment Advisors).

A recent ruling by the U.S. Tax Court has blunted the effectiveness of one popular estate-planning tool. But in the process, tax lawyers say, another device, the charitable lead annuity trust, has become even more attractive.

In a March decision, the court rejected one use of a tax-reduction technique called discounting. The ruling is viewed by some attorneys as a red flag, and they are warning clients and their financial advisors to stop using discounting altogether.

To use valuation discounts, an estate-planning attorney would create an entity, usually a limited partnership, and restrict the transfer or marketability of the assets inside the entity. These assets might be traditional ones like stocks and bonds, or other less liquid valuables. The restrictions would be so severe that the assets are worth significantly less—that's the discount—and get taxed at a lower rate than they would have been.

Many clients loved the method because it allowed them to pay a lower tax and leave more to their heirs. But in its decision, the Washington, D.C.-based Tax Court disallowed valuation discounts.

The decision was not totally unexpected. "This follows an unrelenting pattern of the Obama administration and the IRS attacking the concept of discounting, and people should just abandon it," says Matthew Erskine, an estate lawyer in Worcester, Massachusetts. "Let's do something safer and more reliable."

An Alternative
One effective alternative is the charitable lead annuity trust. In such a trust, a fixed amount goes to a charity for a set period of time, and if there's any money left at the end, it goes to the client's heirs. This works especially well now because it is pegged to interest rates—the lower the rate, the greater the likelihood that money will be left over. And rates are historically low.

Here's an example: An estate attorney creates a trust and an advisor funds it with $1 million. The advisor invests the money to finance an annuity to the client's alma mater of $50,000 a year for 10 years, or $500,000 over the term of the trust. But the investment also seeks to produce a healthy payment for the client's heirs at the end of the trust.

Here's where the tax savings come in. Although set up for a charitable purpose, the trust is not tax-free. The taxes are due when the trust is funded. The IRS uses the applicable federal rate to calculate the value of the charitable gift of the annuity. (The applicable federal rate is also called 7520 rate, for the section of the tax code it comes from.)

Last month, the rate was 1.2%—essentially, what the IRS believes an investor ought to be able to earn in the current investing environment. Based on the hypothetical, the IRS would determine the value of the gift to be $475,320 and use that amount to arrive at the gift-tax bill. The tax is calculated on $1 million minus the charitable deduction, or $524,680.

Continuing the example, the $1 million is invested to produce a total annual return of 4%. The actual net payout from the trust is the annuity payment minus any income generated. For the first year, when the income on the $1 million was $40,000, you subtract that from the $50,000 the trust pays to the alma mater to get a net payout from the trust of just $10,000, leaving the other $990,000 for the heirs. Repeat for another nine years.

At the end of 10 years, the actual value of the trust going to the heirs is likely to be much higher than the IRS figured it would be. In the example, the value of the trust assets would be close to $800,000 at the end of 10 years, not the $524,680 that the IRS tables calculated. The difference—about $275,000—goes to the heirs tax-free.

Of course, this example assumes 4% steady income over the decade. But, Erskine says, if an advisor funds the trust with something paying a fixed rate, like a mortgage on a commercial property, it's entirely possible.

These tax savings seem alluring and the investment hurdle seems low—who can't beat 1.2% these days? But remind clients not to put the cart in front of the horse. "Charitable lead trusts must first be motivated by a charitable inclination—these are not tax-saving devices," says Michael Puzo, partner at Hemenway & Barnes in Boston and chairman of the firm's private client group. "If there's something left, that's wonderful."

Puzo, who has overseen many charitable lead trusts and their variants over the years, says the current environment is about the best he's ever seen. "You're arbitraging the difference between expected investment rates of return over the long term and today's discount rate," he says. "It's completely legit—you're just respectfully disagreeing with the [IRS], in effect, over the kind of return you can achieve. If you play your cards right and invest successfully—well enough to cover the payout to the charity—then at the end you wind up with a pot of money that the IRS predicted wouldn't exist."

But what if the IRS is right? What if the trust does earn only 1.2% annually? It still must pay the charity its $50,000 annuity. First, it pays whatever it can from the investment returns—in this case, $12,000. The other $38,000 must come from the principal, the part of the trust earmarked for the heirs.

Even if the trust fails to perform as well as an advisor projected, the client cannot stop it. Remember, the trust's primary aim is to pay the promised amount to the charity each year. Advisors should note that charitable lead trusts are appropriate only for clients who can afford not to see the money again, and particularly for those who are planning on giving a big charitable gift anyway—because, as Puzo says, "What the heck, there might be something left at the end."

What if the investments go bad and the trust runs out of money before the end of the period? Is the client on the hook to make good on the rest of the payments to the charity? In most cases, no.

If the commitment paperwork to the charity is done properly, it should be clear the gift is just that: a gift. It is not a pledge that must be honored over the entire time period.

"You don't want any confusion about extent of your charitable commitment," Puzo says. If the money runs out, the trust is ended prematurely—although, because it's a taxable entity, the trust must file paperwork with the IRS to say it is closing.

"No Pot of Gold"
Puzo experienced just such a situation. Years ago, his firm inherited a client with a charitable lead trust drafted by another law firm. At the time, with inflation rampant and interest rates soaring, it was easy to think high bond income was a sure thing. The previous advisors set the annuity at 10%, thinking bonds would pay that rate for years to come.

But the advisor did not match the duration of the bonds to the length of the trust. When high-rate bonds came up for reinvestment before the end of the trust, the advisors could not replace them with securities offering equally high yields. They "had to start paying out principal, and then it got into a death spiral," Puzo recalls. "The charity says, 'What happened to our payments?' And the kids find out there's no pot of gold."

If the charitable lead trust sounds vaguely familiar, that may be because it has a more famous sibling: the charitable remainder trust. In that trust, a fixed payment goes to an individual—the client's spouse or child—generally for however many years that person lives. At the end of that person's life, or the end of the term of the trust, any money that is left—the remainder—goes to charity.

Elizabeth Wine is a contributing writer for Financial Planning.


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