Charitable Lead Annuity Trust (CLAT)

A charitable lead annuity trust, or “CLAT,” is an irrevocable trust which pays to charity a fixed dollar amount each year for a period of time. At the end of the trust, the remaining assets of the trust go to the beneficiaries (such as children or grandchildren of the grantor) that are specified in the trust document.

Why Use It?

The usual reason for creating a CLAT is that the grantor wants to make a gift to charity of a certain amount, but also wants to increase the amounts that can pass to children or grandchildren free of federal estate tax. A CLAT can be set up so that the present value of the remainder for federal gift tax purposes is very small, or even zero, which means that at the end of the term of the trust, the remaining trust assets (if any) that pass to the beneficiaries are free of federal gift tax and federal estate tax.

In this way, a CLAT operates like a grantor retained annuity trust ("GRAT"), which pays an annuity to the grantor during the term of the trust, which means that the present value of the annuity is not a gift. In a CLAT, the annuity is payable to charity instead of the grantor, so there is a gift, but there is no gift tax (or estate tax) because the annuity is payable to charity and qualifies for a charitable gift tax or estate tax deduction.

Because a CLAT can qualify for either a gift tax charitable deduction or an estate tax charitable deduction, a CLAT can be created during lifetime (an "inter vivos" trust) or at death through a will or revocable trust (a "testamentary" trust). In both cases, the goal would be the same, which is to crate a gift for charity while also seeking to increase the tax-free amounts ultimately going to children or grandchildren.

Another reason to create a CLAT is to be able to claim an immediate charitable income tax deduction for the payments to be made to charity in the future. However, that immediate charitable income tax deduction comes with a cost, because a CLAT will not result in an income tax deduction unless the CLAT is a "grantor trust" for federal income tax purposes, meaning that all of the income and gains of the trust must be taxed to the grantor of the trust and not the trust itself. However, the income of the trust will be paid to charity and not the grantor, and the grantor will not get any income tax deduction for the income paid to charity, so the grantor will have to pay income tax on income and gains that the grantor will not receive. As a result, the benefit of the immediate charitable deduction will be reduced or eliminated (and perhaps exceeded) by the income tax that the grantor will have to pay during the term of the trust.

For that reason, creating a CLAT to obtain an income tax deduction will usually be beneficial only if the grantor is now in the highest income tax bracket and expects to be in lower income tax brackets in future years.

How Does It Work?

The gift tax value of the remainder is the present value of that future payment, and the present value of the remainder can be zero even though valuable trust assets may actually go to the remainder beneficiaries at the end of the term of the trust. This is because of the way the Internal Revenue Code and its regulations say that the remainder should be valued for gift tax purposes.

The present value of the remainder is based on an assumption that the CLAT will earn a certain rate of interest, so the present value of the remainder can be zero if the CLAT pays an annuity that exceeds that assumed rate of interest, because in that case the trust has to distribute principal along with income in order to make the annuity payments. Using the assumed interest rate, it is possible to calculate an annuity amount that will result in the distribution of all of the principal over the term of the trust, so that there is nothing left to distribute at the end of the term. However, if the CLAT actually earns more than the assumed rate of interest, then there will be money left over at the end of the term of the trust, which is how the remainder beneficiaries can receive money without the grantor making a taxable gift.

Benefits

The benefit of a CLAT is the possibility (but not certainty) that the beneficiaries selected by the grantor of the CLAT will receive money or property at the end of the term of the trust, free of federal estate and gift tax, as explained above. This benefit is only a possibility, and not a certainty, because the remainder beneficiaries will receive money or property at the end of the trust only if the trust investments produce income and capital gains in excess of the interest rate that is used to value the remainder when the CLAT is created.

As explained below, this benefit comes with very few costs, aside from the charitable gift itself.

Costs

As explained above, a CLAT should have no (or insignificant) gift tax cost if the trust document is prepared to conform to the applicable tax rules, if the annuity amount is calculated properly, and if the trust is funded properly, so that the present value of the remainder is zero (or nearly zero).

Because the creation of a CLAT has little or no gift tax cost, there is no loss if the CLAT is not able to earn more than the assumed interest rate, so that all of the trust assets are distributed to charity in order to make the annuity payments and the remainder beneficiaries receive nothing. There is, from that point of view, no "downside" to the creation of a CLAT.

There should be minimal federal income tax costs for a CLAT that is not a grantor trust (and so does not result in a charitable income tax deduction):

• The distributions of trust income (and gains) to charities in order to make the annuity payments should qualify for a charitable income tax deduction for the trust (but not the grantor), so the trust will pay income tax on trust income only if the income exceeds the annuity amounts payable.
• The distribution to the remainder beneficiaries of whatever is left in the CLAT at the end of the term of the trust should not result in any gain or loss, or any taxable income to the remainder beneficiaries.

Because there should be little tax cost for creating a trust, the only costs for the CLAT should be transactional:

• The legal fees or other costs in preparing the CLAT trust document. As explained above, the trust might be created during lifetime, or might be part of the grantor's estate plan for the disposition of his or her estate at death.
• For a CLAT created during lifetime, the costs of preparing any gift tax returns that will be needed to report the creation of the trust. The gift tax return would need to report the value of the assets transferred to the trust, the present value of the charitable gift of the annuity amount, and the resulting taxable remainder interests in the CLAT, so there may be costs of valuing the assets being transferred to the CLAT and costs of calculating the value of the annuity based on the federal interest rates that apply when the CLAT is created. If real property, closely held business interests, or other properties with no readily ascertainable market values are transferred to the CLAT, appraisals might be needed for those properties.
• For a CLAT created at death, the only additional costs would be the valuation of the charitable annuity interest and the funding of the trust from the grantor's estate, because the valuation of estate assets and the preparation and filing of an estate tax return would be required (or not required) whether or not the CLAT is created.
• The costs (if any) of administering the trust. The investment costs of the CLAT should be the same as what the grantor would have paid for investment advisors if the CLAT had not been created, so the creation of the CLAT should not cause additional administrative costs beyond what might be required for accounting for the receipts and disbursements of the CLAT and the preparation and filing of income tax returns for the trust.

The only other cost of a CLAT is what might be described as an "opportunity cost," because the assets of the grantor that are used for a CLAT cannot be used for other estate planning steps, such as taxable gifts directly to children or grandchildren or trusts for their benefit. The benefit of a CLAT must therefore be weighed against the benefit of other steps that might have greater estate planning benefits.

Who Should Use It?

A CLAT is usually best suited to a person who has an estate that is more than his or her applicable exclusion amount (which can include both the base exclusion amount, which is $12,920,000 in 2023, as well as the unused exclusion amount of a deceased spouse) and who also wishes to make a large gift to charity.

Decisions

Before a CLAT is created, there are some decisions to be made:

• Who are the remaindermen (the noncharitable beneficiaries)?
• What charity (or charities) should receive the annuity payments? This should be decided in advance, and the grantor should not have the power to change the charitable beneficiaries. If the grantor has retained the power to change the charitable beneficiary (or beneficiaries) receiving the annuity, either directly through a power retained in the trust document or indirectly because the grantor is serving as trustee and the trustee has that power, the gift to charity is considered incomplete and the value of the annuity will be included in the grantor's gross estate at death, so that the trust will become subject to federal estate tax.
• What should be the term of the CLAT? Although a CLAT can be created for the lives of grantor, the grantor's spouse, or ancestors (or spouses of ancestors) of the remaindermen, it is better to use a term of years if the goal is to minimize the present value of the taxable gift to the remaindermen. The usual decision is to make the CLAT for a relatively long term, usually twenty years or more. This is because a longer term will produce a larger discount for the value of the remainder, which means that annuity can be smaller while still producing a remainder with a present value of zero, which increased the likelihood that the investments of the CLAT will be able outperform the assumed discount rate and produce a positive value of the remainder at the end of the term of the trust.
• Should payments increase over time? The annuity payments must be "determinable" in amount, which means that it must be possible to calculate the future amounts to be paid when the trust is created. The payments can therefore increase over the term of the trust if the increases can be calculated in advance. Having payments increase by each year (or remain low and then increase sharply in the end, something often called a "shark fin" CLAT) is usually considered desirable, because it increases the time that money will be held in the trust before it is paid out, which increases the discount and the likelihood of a positive value of the remainder at the end of the term of the trust.

Webcalculators can produce economic projections of CLATs so that the results of different payouts and investments assumptions can be illustrated.