THE 60/40 CLAT
Despite their impressive achievements, many successful business owners still experience a lack of accomplishment. This might have been best expressed recently by John Caudwell, a 58-year-old U.K. billionaire, as follows: "It's partly a question of what you want to see on your tombstone. Here Lies a Very Successful Businessman doesn't really do it, does it? FN1" Caudwell is giving much of his wealth away to help disabled children around the world. Business owners who, like Caudwell, would like to share their good fortune with others, but who also would like to pass on their businesses to their heirs estate tax free should consider a "60/40 CLAT". What that is, how it works, and how it helps closely-held business owners are all discussed below.
1. What is a CLAT?
A charitable lead annuity trust (CLAT) is an irrevocable trust that first pays an annuity to one or more charities for a term of years. Then it pays its remaining assets to the settlor's children (or other heirs). These are called the "remainder beneficiaries" or the "remainder interest." The payments to charity are called the "lead interest." The present value of the lead interest is deductible for gift tax purposes.
Al and Susan would like to make a $1,000,000 gift to their children. Susan sets up a $1,000,000 CLAT that pays $55,415 to charity for 20 years. In year 21, the trust pays what's left to the children. Assuming a 1% IRS discount rate, the lead interest is worth $1,000,000. Thus, on her gift tax return, Susan reports a $1,000,000 gift and a $1,000,000 charitable deduction. After subtracting, Susan reports a $0 taxable gift. This type of CLAT is called a "zeroed-out" CLAT because of the zero taxable gift that it produces.
2. Is the lead interest also income tax-deductible?
That depends on the trust's income tax classification. If a "grantor trust" (making the trust a "grantor CLAT"), the settlor can deduct the lead interest against his income. However, he must also include the trust's income on his own income tax return (and pay tax on the same). As discussed further below, paying tax on such "phantom income" is not necessarily a bad idea.
Assume the same facts as in Example 1 above and also that the CLAT is a grantor CLAT. In that case, Susan can also deduct $1,000,000 against her income in the year of the gift. If the $1,000,000 deduction exceeds 30% of her AGI for that year (20% if the charity is a private foundation and the gift asset is capital gain property), Susan can deduct the excess against her future income in up to 5 succeeding tax years. In addition, for each year of the 20-year CLAT term, Susan must pay income tax on all income earned by the trust. (She does not get to deduct the $55,415 that the CLAT pays to charity each year because that was already deducted when she set up the trust.)
3. What additional wealth transfer advantages does a grantor CLAT provide?
On top of the gift and income tax deductions for the lead interest, a grantor CLAT also provides the following advantages: (i) the settlor's payment of income tax on phantom income is effectively a tax-free gift to the remainder beneficiaries; and (ii) grantor trust status partially "opens the door" to using CLATs with closely-held business interests, such as S-corporations and LLCs.
4. What is a 60/40 CLAT?
A 60/40 CLAT is a grantor CLAT with a lead interest equal to 60% of the gift asset and with a remainder interest equal to 40% of the gift asset.
Assume the same facts as in Example 2 above, except that Susan opts for a 60/40 CLAT (with a 12 year term). On her gift tax return, Susan again reports a $1,000,000 gift, but now a $600,000 charitable deduction. After subtracting, she reports a taxable gift of $400,000. Susan pays no gift tax, however, because her $5,120,000 gift tax exemption (2012) is more than enough to cover the taxable gift.
5. What is the wealth transfer advantage of a 60/40 CLAT?
The 60/40 design "opens the door" to using grantor CLATs with closely-held business interests "the rest of the way." This is because the 60/40 design allows the trust to hold the business interest for longer than 5 years. This, in turn, allows a more reasonable annuity payment FN2. Increase the lead interest to 61% or more, and the trust must sell the business interest to non-family members (or back to the business itself) within 5 years of receiving it.
Assume the same facts as in Example 3 above except that the $1,000,000 gift asset is stock in an S-corporation. Because the trust's lead interest does not exceed 60%, the trustee can hold the stock for the full 12 year term, still paying $55,415 to charity each year.
6. Why is the 60/40 CLAT especially important now?
With interest rates at all-time lows and the gift tax exemption at an all-time high, one can hardly think of a better time than now for business owners to use 60/40 CLATs in their planning. Based on the 2012 exemption, Table 1 below shows the maximum value that can be transferred with a 60/40 CLAT gift tax free.
Marital Status Maximum Value
7. What about valuation discounts?
Valuation discounts add further leverage, allowing even more to be transferred gift tax free. Assuming a gift by a married couple in 2012, Table 2 below illustrates the maximum value that can be transferred with a 60/40 CLAT at various discount rates.
Discount Rate Maximum Value Annuity Payment(FN3) Term(FN4)
10% $28,444,444 $1,422,222 11
20% $32,000,000 $1,600,000 10
30% $36,571,429 $1,828,571 8
40% $42,666,667 $2,133,333 7
50% $51,200,000 $2,560,000 6
Instead of transferring just $1,000,000 of S-corporation stock, Al and Susan would like to transfer as much of their stock as possible to their children in 2012. They therefore recapitalize their corporation into voting and non-voting shares. The non-voting shares (99% of the equity) appraise for $36,571,429 (pre-discount) and for $25,600,000 after a 30% valuation discount is applied. After subtracting the 60% lead interest (60% x $25,600,000 = $15,360,000) the taxable gift is $10,240,000 ($25,600,000 - $15,360,000). Though only Susan is the settlor of the trust, the couple pays no gift tax because they elect to "split" the gift. This means that each spouse is treated as having made one-half of the gift, thereby using both of their $5,120,000 gift tax exemptions ($10,240,000 total).
8. What advantages does a 60/40 CLAT have over other business transfer techniques?
Table 3 below provides some points of comparison between the 60/40 CLAT, a GRAT, and sale to an IDGT.
GRAT IDGT 60/40 CLAT
Mortality Risk? Yes No No
Tax on "Phantom Income?" Yes Yes Yes
Income Tax Deduction? No No Yes
Estate Tax on GRAT Annuity/ Yes Yes n/a
Gift to Charity? No No Yes
9. What are some options on the charitable end?
Recipients of the 60/40 CLAT payments can be the settlor's favorite charities or a donor advised fund. The latter is generally preferable because it allows the settlor (and then later generations) to select which charities ultimately benefit.
10. What are some disadvantages of the 60/40 CLAT?
First, a 60/40 CLAT does not make efficient use of the generation skipping tax exemption. If such is desired, a 60/40 CLUT (charitable lead unitrust) could be used. Table 4 below is the same as Table 2 above, except that Table 4 applies to 60/40 CLUTs. Note that the only difference between the two tables is in the "Term" column (slightly longer for 60/40 CLUTs).
Valuation Discount Maximum Value Unitrust Payment(FN5) Term
10% $28,444,444 $1,422,222 16
20% $32,000,000 $1,600,000 14
30% $36,571,429 $1,828,571 12
40% $42,666,667 $2,133,333 10
50% $51,200,000 $2,560,000 8
Second, whether a 60/40 CLAT or CLUT, if the settlor dies before the term, the income tax deduction must be partially recaptured in the form of taxable income to the settlor's estate.
Zeroed-out grantor CLATs warrant serious consideration in all wealth transfer planning contexts FN6. But for owners of closely-held business interests, the 60/40 CLAT may be the best way yet to choose children and charity over Congress.
1 Jon Henley, The New Philanthropists, The Guardian, (March 7, 2012) http://www.guardian.co.uk/society/2012/mar/07/new-philanthropists-wealthy-people? INTCMP=SRCH.
2 For example, using a 5-year "zeroed-out" CLAT to transfer a $1,000,000 closely-held business interest would require a $206,040 annual payment to charity. In contrast, the 20-year zeroed-out CLAT in Example 1 above required only a $55,415 payment per year.
3 5% of Maximum Value shown at left. As expressed in the trust instrument, the payment rate would be "grossed up" to reflect the valuation discount.
4 Rounded down.
5 First year unitrust payment equal to 5% of Maximum Value shown at left. Subsequent years' payments will vary with trust growth or shrinkage.
6 In fact, a recent study by a leading financial firm demonstrated how a 20-year zeroed-out grantor CLAT funded with $10,000,000 delivers as much wealth to children as a GRAT and more wealth to children than a sale to an IDGT, without factoring in the $10,000,000 income tax deduction. See Paul S. Lee, J.D., LL.M., National Managing Director Bernstein Global Wealth Management, Innovative CLAT Structures: Providing Economic Efficiencies to a Wealth Transfer Workhorse, ALI-ABA Course of Study, Advanced Estate Planning Techniques, March 24-25, 2011, San Francisco, California, pp. 13-15.