CLATs: Maximizing Philanthropy And Wealth Transfer For Clients

Advising high-net-worth clients requires a working knowledge of various wealth transfer strategies. One strategy that has been garnering a lot of attention from wealthy families over the past few years is the charitable lead annuity trust (CLAT). Looking at the current tax structure and economic environment, it's easy to see why.

Current estate tax laws allow a married couple to effectively shelter $10.86 million ($5.43 million per individual in 2015) from estate tax with relatively little planning. But what about clients whose estates exceed this threshold? For them, historically low interest rates have made the CLAT an effective strategy for potentially maximizing their wealth transfer goals while also benefiting charity.

What Is a CLAT?

A CLAT is an irrevocable split-interest trust with two beneficiaries. The lead beneficiary is a charitable organization that receives a fixed annual payment throughout the term of the trust. The remainder beneficiary, commonly the children of the couple or individual establishing the trust, receives the assets left at the end of the trust term.

A CLAT can be established as a grantor trust or as a nongrantor trust, which is a separate tax-paying entity. For our purposes, this post will refer to the nongrantor version, as our focus is on gift and estate planning, not income tax planning.

The CLAT in Action

To understand the benefits of the CLAT, let's look at a hypothetical scenario. Your best clients, the Smiths, have a net worth of close to $20 million. The Smiths are concerned about the impact of estate taxes on the legacy they wish to leave to their children and the charitable organizations they wish to support.

You recommend that they establish a 5% 10-year CLAT and fund it with $2 million from their portfolio. The CLAT will pay $100,000 each year (i.e., 5%) to a charitable organization(s) over the 10-year term. At the completion of the trust term, the remaining assets will pass to the children.

Simple, right? So what's the big deal?The benefit lies in the gift tax leverage the clients can gain when implementing the trust. The assets used to fund the CLAT are considered a gift and thus carry tax liability. Because a portion of the assets is the vested interest of a charitable organization, however, clients escape paying gift tax on the entire $2 million. Still, the portion that passes to the remainder beneficiary will be taxable; to arrive at that figure, we first need to determine the present value of the annuity interest to be paid to the charitable organization.

In our example, that amount would be $907,731. (Try this calculator, using 1.8 [more on this later], 10, and 100000.00 as the inputs.) When we subtract this amount from the $2 million investment, we are left with $1,092,269, which represents the remainder interest to pass to the children. This is the taxable gift, so the client will either need to use a portion of the lifetime gift exemption or pay out-of-pocket gift tax.

Why Bother With a CLAT for the Smiths?

What I haven't mentioned is that the annuity and remainder interest is calculated today using the Applicable Federal Rate (AFR), which, at 1.8% (as of March 2015), is near a historic low. This factor provides an opportunity to take advantage of the low interest rate environment in return for gift tax savings.

If, in our example, the trust assets grow at a rate above 1.8%–say, 7%–the appreciation will pass to the children free of any gift or estate tax. The charitable organization will still receive a cumulative annuity total of $1 million; however, the remainder interest will be just over $2.5 million. This is certainly an agreeable result for both the charity and the children.

This is a simple example, but it provides a framework for understanding how a CLAT could be the right strategy for some of your high-net-worth clients. Remember, though, to seek the expertise of an estate planning attorney for help in implementing this strategy.