In the rush to outrun the expiration of the federal estate and gift exemption at the end of 2025, many charitable lead trusts (CLTs) will be considered and some funded. The non-grantor CLT offers meaningful transfer tax savings for donors and heirs in the perpetually low Internal Revenue Code Section 7520 interest rate environment. The grantor CLT offers meaningful income tax savings in the year of contribution albeit at the future cost of being taxed on the income from the CLT net of the charitable deduction.
Prepayments
Is it possible to accelerate the benefits to both income and remainder beneficiaries of CLTs that have already been established? Let’s examine the pitfalls to navigate in successfully ending the trust. At first blush, it might seem surprising that there are even any pitfalls in paying charities earlier than required under the trust. If the charity receives the present value of all future payments, it certainly hasn’t been economically harmed. But on deeper reflection, the difference in the interest rate environment at time of funding and termination could result in the charity receiving something less than the full present value calculated at the time of funding.
Initially, the Internal Revenue Service took a position against prepayment. The CLT couldn’t have a provision allowing for the prepayment to the charitable and non-charitable beneficiaries.1 The consequence would be the loss of the gift tax charitable deduction as well as the penalties associated with failing to comply with the terms of the trust and impermissible self-dealing.2
Even if the trustee only has the discretion to commute and prepay the charitable lead annuity interest prior to the expiration of the specified term of the annuity, the interest doesn’t qualify as a guaranteed annuity interest under IRC Sections 2522(c)(2)(B) and 2522(a).
Would the result change if there wasn’t a possibility of interest rate arbitrage though the agreement permitted commutation—specifically, if the Section 7520 rate at commutation was identical to that at funding, then the charity receives the promised present value? The IRS found that kind of provision also unacceptable, as it prevented the exact amount payable to the charity to be undeterminable at the time of the gift.3 A court also held that permitting commutation would be inconsistent with an annuity interest being fixed and guaranteed.4
Could a CLT meet the regulation’s requirement of a periodic amount over a specified period in an amount determinable at the time of gift if the remaining undiscounted amount was paid? A trio of private letter rulings provides a path of how to do so.5 The IRS approved a court of competent jurisdiction deciding whether the unpaid balance could be paid to the state’s Office of Attorney General, a party to the proceedings. So long as the funds are being used by the charity for their purposes, then no disqualified party within the meaning of IRC Section 4946 would be benefiting. Nor would there be a taxable termination under IRC Section 507(c) or self-dealing under IRC Section 4941.6
Closeout
Two reasons for prepayment are apparent while others are less obvious but very valuable. Many charities are experiencing declining revenue from philanthropy and income from their programs. The long-running bull markets have left remainder values much greater than a donor could have anticipated at funding. The remainder beneficiaries might be ready or even need their “deferred inheritance” now.
Those who established a grantor CLT and now seek to eliminate the risk of recapture of the charitable deduction from a premature death can terminate the CLT to eliminate such risk.7 In the age of over
200,000 deaths from the COVID-19 pandemic, one’s mortality seems much clearer.
Those CLTs funded with assets that have increased by 100% or more likely have fiduciary income greater than the required annuity amount.8 The trust is in a position of being denied a distribution deduction for the amounts going to charity greater than the annuity trust amount.9
Paying the unpaid nominal amount to charity eliminates the income taxation of the fiduciary income at the trust level.
For those funders comfortable with accelerating the charitable interest but not the remaindermen, PLR 9844027 (Aug. 5, 1998) shows how the trust’s terms may still continue after payout only to the charity.
In this era of unprecedented economic distress for both charities and non-charitable beneficiaries, the time has never been better to examine whether accelerating the charitable good from a CLT makes sense.
Endnotes
1. Revenue Ruling 88-27.
2. See Internal Revenue Code Section 2522(a).
3. See supra note 1.
4. Rebecca K. Crown Income Charitable Fund v. Commissioner, 98 T.C. 327 (1992).
5. Private Letter Rulings 200226045 (May 26, 2002), 199952093 (Jan. 3, 2000) and 9844027 (Aug. 5, 1998).
6. Ibid.
7. See Treasury Regulations Section 1.170A-6(c)(4) for how recapture works.
8. In PLR 199952093, supra note 5, the assets had increased by a factor of five!
9. See Crown, supra note 4, aff’d 8 F.3d 571 (7th Cir. 1993), in which the court denied a distribution deduction to charitable amounts greater than the annuity trust amount.