Planning professionals need to master the skill of communicating the tax savings from a planning technique in a manner that a potential client can quickly and easily understand. This is particularly true when dealing with charitable giving strategies. Here are some tips on communicating the current benefits of a charitable lead annuity trust (CLAT) to a client.
A CLAT works the same way as a grantor retained annuity trust (GRAT), except the annual annuity is given to charity instead of retained by the trust creator. Because there’s no retained annuity interest (and assuming the remainder interest is gifted away at formation), there’s no exposure to estate tax inclusion if the creator of the CLAT dies during the CLAT term, as there is with a GRAT.
Use Introductory Statements
When charitable giving is involved, a simple introductory statement to use when you first meet a potential client can be something like this:
“With a properly structured charitable giving technique, what you end up giving to charity need not cost you anything. Instead, what you give to charity is the money you would have otherwise paid in federal and state income taxes and estate taxes.”
Before starting to describe the possible planning technique, you can expand on this introductory statement by mentioning some key benefits:
1. Pass assets to the next generation without any transfer taxes. By using a lifetime CLAT, especially in today’s low interest rate environment, you can pass an income-producing investment asset on to the next generation without any gift or estate taxes.
2. Assign income to another taxpayer. There are income tax advantages to using a CLAT by assigning taxable income to another taxpayer, especially if that individual is in a lower-income tax bracket.
Three Scenarios to Present to Clients
Assume that your client, Senior, a resident of California, a state with a 13.3 percent top income tax on individuals, with little or no charitable intentions, owns a $1 million portfolio of corporate bonds, paying $38,500 of annual interest (a 3.85 percent return). The current gift tax rate is 40 percent. The September 2016 IRC Section 7520 rate (basically the income number your CLAT has to beat to be effective) is 1.4 percent. You can present Senior with the following three simple scenarios (in order of increasing tax savings) to help her understand and reach the right conclusion.
Scenario 1: Senior retains the $1 million investment portfolio earning 3.85 percent annually, pays the federal and state income taxes on the $38,500 of ordinary income each year and allows all earnings, after the payment of the income taxes, to accumulate as part of this investment portfolio. Assume that the accumulated income also earns the same 3.85 percent rate of return. At the end of 28 years, the investment fund will grow to $1,711,722. Senior gifts the entire $1,711,722 of accumulated funds directly to her children. After the payment of $684,689 in gift taxes (computed at the 40 percent gift tax rate), the children effectively net $1,027,033.
Scenario 2: Each year, Senior gifts the entire $38,500 of annual investment income to charity, creating a charitable deduction that offsets the interest income. Senior gifts the $1 million investment portfolio to her children at the end of 28 years. The children effectively net $600,000 after gift taxes, and the charity receives a total of $1,078,000 over the 28-year period.
Scenario 3: Senior contributes the $1 million investment portfolio to a lifetime CLAT, which in turn is required to distribute a fixed annuity of $38,500 to charity each year over a 28-year period. Because the value of the remainder interest to Senior’s children is zero (hence, the term a “zeroed-out CLAT”), there’s no taxable gift at the time the trust was created. At the end of 28 years, the CLAT terminates and distributes all $1 million to the children without incurring any gift taxes. The children net $1 million, and the charity receives the same $1,078,000 over the 28-year period.
A client who’s already giving substantial amounts to charity each year in her individual capacity can’t avail herself of the estate and gift tax savings from a lifetime CLAT. If this client will be continuing similar annual charitable donations, she should use a lifetime CLAT to also obtain the transfer tax savings.
Comparing the Scenarios
By having the CLAT make the annual charitable contributions under Scenario 3, a client can pass almost as much to her children than by doing no tax planning and still give over $1 million to charity.
Comparing Scenario 1 (no giving) with Scenario 3 (CLAT makes contributions), the total of $1.078 million in annual distributions to charity only costs the client $27,033. The client is giving to charity the practical equivalent of the gift taxes she would have otherwise paid if the CLAT hadn’t been used. Even though the client’s children would have been slightly better off under Scenario 1, the client may still be interested in the CLAT if you explain that the $27,033 reduction in the amount the children net is the practical equivalent of it only costing the family $27,033 to give $1,078,000 to charity over a 28-year period.
Comparisons Are Key
The use of simple illustrations that first show what the family would net with no tax planning and then compare the amount received by the next generation with the implementation of a tax plan is often the most effective way to communicate complex concepts. And, examples comparing the scenarios illustrated above can communicate the tax savings within the first 10 to 15 minutes of the client meeting. Remember, what the client really wants to know during the first meeting isn’t how the planning technique works, but how much in taxes she can save!
This is an adapted and abbreviated version of the author's original article in the September issue of Trusts & Estates.