If you face significant income tax obligations and charity is a part of your financial landscape, then you should be thinking about creating a CLAT. Certainly, if you already have charitable commitments, you could hardly find a more efficient way to fulfill these obligations than through a CLAT.
A CLAT allows you to set aside funds to be given to charity over a number of years and to receive an immediate tax deduction this year for the full amount of that donation. At the end of the term of the CLAT, you generally also realize a significant return on the money donated to the CLAT. This return can be structured to come back to you at the end of the term of the CLAT or to be transferred to your family members free of estate and gift taxes.
Notably, right now, when interest rates are at historic lows, it is an especially advantageous time to create a CLAT.
Ok, Sounds Good. So, What Is a CLAT?
CLAT is an acronym for Charitable Lead Annuity Trust. Charitable: the trust will benefit charity; Lead: charity benefits first, you benefit next; Annuity: there is an annual disbursement to charity; and Trust: well, because, it is a trust.
A CLAT is created by transferring cash or other assets to an irrevocable trust. The charity of your choice then receives a fixed annual payment (an annuity) from the trust for a specified number of years. After those years are up, all remaining assets return to your family.
How Do I Get Money Back if the Money is Going to Charity?
Even though the trust is designated for charity, there is also a significant personal return on investment to be made from the funds that you put into the CLAT. Because the money is gradually distributed from the CLAT to charity over a number of years, the remaining funds sitting in the trust in the interim are invested until they are donated, thereby generating a return on investment that is collected by you or your family when the term of the CLAT concludes.
Aside from the initial amount in the trust being distributed to charity over the term of the trust, the IRS requires that the trust additionally donate the “expected return on investment” each year. Now, this number is determined by current interest rates. Any profit that the trust gains from its investments above that amount remains in the trust for whomever you designated. This spread is where the return to you comes in. In almost every case, the difference between the IRS’s expected return and the actual return can be significant.
To illustrate: The current AFR (Annual Fixed Rate) is 4.4% (which is likely to drop even lower come December). However, it is reasonable to project an actual return of 8%. Any profit made on the investments of the trust between the assumed AFR of 4.4% and the 8% actual return remains in the trust at the end of the term. In effect, the trust is gaining 4% on the remaining principal each year, and that amount is distributed back to you or your family at the end of the trust term.
Illustration
Say you fund a CLAT today with $500,000 for a term of 20 years. The first and most immediate benefit is that you realize an immediate income-tax deduction for the full $500,000.
The trust then invests the funds and disburses an annual amount to charity (the amount given annually is determined upon the creation of the trust) until all the original principal as well as the expected return is paid.
Using today’s Annual Fixed Rate of 4.4% (which is likely to drop even lower in December), the trust would donate $38,105 annually to charity.
However, because the actual return on investment is much higher than 4.4%, there would be money left in the trust at the end of the 20 years. Assuming a return of 8%, at the end of the term of the trust, there would be a total of $586,000 remaining, to be returned to you or designated to your heirs without any gift or estate-tax liability.
In this same scenario, had you simply invested the initial principal yourself, you would have been liable for significant federal income taxes on the $500,000. By investing the remainder after taxes, you would have come out slightly ahead personally at the end of the 20 years, but without the opportunity to give charity and without the estate-tax benefits.
Setup
Creating and structuring a CLAT requires the services of an attorney. The attorney takes the details of both your personal and financial situation into account and structures the trust in the manner that brings the most benefit to you and your charitable causes.
To learn more, please contact our office.