by Ken Hoffman

A new twist on a popular planning tool that can increase your value to clients by impacting their own bottom line while maximizing their philanthropy.

The Charitable Lead Annuity Trust (CLAT) is a trust that promotes legacy planning for both philanthropic interests as well as family, passing assets to the next generation gift and estate tax free without using your lifetime exclusions. This vehicle is particularly helpful to wealthy individuals who are charitably inclined and are subject to gift or estate taxes, and it works especially well in a period of low interest rates.  The objective of the CLAT is to make an ongoing annual payment to charity, and when the trust unwinds, after charity receives their final payment, any principal remaining in the trust is passed to the heirs estate tax free.  Since the lower the interest rate the higher the proportion that is passed to the grantor’s heirs, today’s low interest rates are helpful in passing assets to the next generation.

CLATs have been used for decades and may be funded with all types of assets; bonds, equities, etc.  After the trust commitment to charity is fulfilled the balance of the assets flow to the heirs.  When funded, for example, with equities, the value of the CLAT is dependent on financial market performance, and the final payments to heirs can vary significantly.  A very useful strategy is to create a lifetime CLAT funded primarily with insurance policies which pre-determines the payments to both charity and his heirs, and to name a Donor Advised Fund as the charitable beneficiary to provide maximum flexibility with charitable giving. Hoffman commented that “The idea of a donor advised fund has always appealed to me—it acts like a bank account for charitable giving and it cuts down on the administrative work.” The allocation between the two is a function of the grantor’s age and interest rates, and a big advantage of this method is that you know exactly what the annual and future payments will be. Since this is a lifetime trust what you do not know is when they will occur since the final payment is made upon the trust maturity, the grantor’s passing.

Here’s how it works using actual numbers on a CLAT recently executed by Mr. Hoffman for a client; the husband is 67, and the wife is 61. Since the wife is younger and women statistically live longer than men, it is more cost effective to insure the wife.  The CLAT is funded with an insurance policy, an annuity and cash; in this case for a total of $3 million. The entire value of the contribution to the CLAT is tax-deductible—up to 30 percent of their adjusted gross income (AGI).  If they cannot use the entire deduction in the first year, they can carry it forward for another five years.

Assuming they are in the top tax bracket and paying the Obamacare surcharge, every dollar they put into the CLAT only costs them 50 cents; their $3 million contribution to the CLAT costs them approximately $1.5 million.  Viewed another way, the guaranteed return from the insurance policy to life expectancy, is a pre-tax calculation.  Since the CLAT is tax deductible, the post-tax return is significantly higher.  The payouts at the end of the CLAT are estate tax free, they are guaranteed and do not use up any lifetime exclusions.  What is not known is when it will pay off since that is dependent on when the insurance policy’s death benefit pays out.

In the example above, the DAF receives an annual annuity payment of $5,000, and when the wife passes away, the DAF receives $4.265 million, and the heirs receive $8.880 million. If she passes away in the first six years, the heirs will receive an even larger amount to offset the inclusion of the family benefit in the taxable estate.

Had the clients kept the $3 million invested in an instrument that returned 4.5% after tax, they would have earned $11.2 million during a 30-year period – in this case it assumes that the insured lives to age 91.  Those assets would be subject to estate taxes, reducing the inheritance to their heirs to less than $5.6 million.  The CLAT leaves the family with almost 60% more in assets net of taxes, at a significantly lower investment risk – even after the family’s DAF receives a very generous charitable gift.  This strategy is very effective for couples with an estate above $11 million who will be taxed on transfer of their assets at a rate that’s up to 50%.”

In using the Charitable Lead Annuity Trust and a donor advised fund, the value of charity is conveyed to the children, there is immediate income tax relief, a charitable legacy is created, and heirs receive a tax free inheritance at a significantly lower cost than could otherwise have been provided.

Ken Hoffman, Managing Director and Partner at HSW Advisors / HighTower LLC, and JCF fund holder since 1985. Recently, he and his wife opened a second donor advised fund using this strategy with the goal of providing additional cash for the charities they care about, while also ensuring that their children will one day inherit without incurring additional estate taxes.