Charitable Lead Annuity Trusts—Planning for a One-Time Windfall

A charitable lead annuity trust can help clients who have a one-time windfall. For the following explanation, assume the clients (married couple with two children who will likely have a taxable estate) will have an adjusted gross income for the year of about $3.33 million—significantly more than they are used to making.

The charitable deduction that can be used in the current year is limited to 30% of adjusted gross income. The clients write a personal check for $1 million to themselves as trustees. We use a term of 15 years. There is no magic to this figure—it’s just that clients can see the end in the not-so-distant future.

There are two mandatory distributions:

• The first is the amount that must be written to charity each year. The clients are getting an immediate $1 million deduction, but that won’t go to a charity for 15 years. So each year for 15 years, they must pay what, in a sense, is interest on that promise. That interest is based on the effective rate in Section 7520 of the tax code when the annuity trust begins. If it begins in May 2023, that would be 4.4%, meaning the trustees will write a $44,000 check to a charity (see below) each year for 15 years.
• The second is that at the end of the annuity trust term, an amount equal to the amount of the first year’s deduction (in this case, $1 million). If the trustees’ investments don’t do well, they needn’t make up any shortfall. On the other hand, if the investments outperform the IRS interest rate, the extra amount can come back to the family.

As trustees, they will invest the funds to get the highest possible return, with limits. This has several benefits:

First, the clients get an immediate deduction equal to the check they write to themselves as trustees. Although the deduction for 2023 is limited to 30% of adjusted gross income, any excess can be carried forward for up to five additional years (subject to the 30% limit).

The clients also get to select the charity to benefit. They can choose any public charity, a family private foundation, or a donor advised fund at an investment firm (many public charities also offer such funds). They can change their mind each year as to the charity or charities to benefit, and the percentages for each charity. When the annuity trust term ends, they must make a final decision. (If their final choice is a donor advised fund, they continue to have discretion as to which public charities will benefit.)

Additionally, any amount the annuity trust earns beyond the IRS interest rate can go to a children’s trust free of estate, gift, and income tax. The excess could come back to the parents. However, the transfer tax benefit of going to a children’s trust is a wonderful estate and gift tax opportunity given the potential estate tax. The May 2023 interest rate is 4.4%. If their investments earn 8.1% and they contribute $1 million to the annuity trust, at the end of the term, after the charity gets the first $1 million, the children’s trust will receive $1 million.

There are also two disadvantages. The first is that the annuity trust is a grantor trust, meaning that it’s disregarded for income tax purposes. The clients must pay the tax on any of the trust’s taxable income. This is referred to as “phantom taxable income,” because the clients will have taxable income without the cash to pay the tax.

There are three ways to address this:

• The trust can buy a condominium in a nice neighborhood. Since it’s residential rental property, the depreciation will offset taxable income of 2%.
• The trust can buy stocks that pay low or no dividends but (hopefully) appreciate significantly in value. Each year the trustees sell a small amount of the stock, personally pay capital gains tax rates instead of ordinary income tax rates, and use the funds to make the required charitable distribution.
• The trust can pay $850,000 of the $1 million as a premium on a life insurance policy. For the first three years use the $150,000 of liquid assets to pay the required annual distribution. After that, the trustees borrow the increase in the policy’s cash value, meaning taxable income won’t be created

The second disadvantage is, if the clients die before the end of the trust’s term, the charitable income tax deduction is proportionately “clawed back.” There is no guaranteed way to avoid that.

A suggested approach is to have the clients form a limited partnership with a complex children’s trust as a small limited partner, make the $1 million intended contribution to the limited partnership, and have the partnership make the trust contribution. The argument is that, even if the clients don’t survive the 15-year term, the actual donor—the limited partnership—hasn’t “died” before the end of the 15-year term.

There are no legal and ethical structures for a one-time windfall that—using baseball as a metaphor—are a grand slam home run. However, this is a structure which, for the right family, is a good solid double. In other words, when the client hears the explanation, the client won’t say, “Wow! That’s the greatest thing I have ever heard.” The maximum positive reaction they will have is, “That’s nice.”

The final piece of good news is that the clients needn’t decide until near the end of the year. However, at least they know of one legal and ethical structure that may make sense given the family situation.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Bruce Givner is of counsel to KFB Rice, LLP in Los Angeles. He has been practicing law for 46 years.

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