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Charitable Lead Annuity Trust (CLAT)

Current economic conditions have presented intriguing options for charitably oriented individuals looking to transfer wealth tax free. A Charitable Lead Annuity Trust (CLAT) is an alternative trust structure that transfers wealth free of gift tax to an heir and a charity. In a CLAT the donor creates a charitable trust that pays an annuity to the charity and at the end of the trust the principal often transfers to the heirs. The CLAT benefits from the historically low IRS discount rate (now hovering at around 1.4%) which makes it possible to avoid gift taxes when transferring assets remaining in the trust at its termination. For a CLAT to function properly it is important that the assets in the trust have an expected appreciation value greater than the hurdle of the IRS discount rate. Fortunately, the extremely low hurdle in place now vastly widens the pool of feasible favorable asset options.

The tax law on CLATs opens a window of opportunity that is particularly appealing in today’s economy. Tax law dictates that all payment amounts be known at the creation of the CLAT; however, the payment amounts do not need to be the same. A “Shark-Fin” CLAT takes advantage of this nuance of law by making minimal payments throughout the trust’s life and in the last year makes a balloon payment large enough to cover the amount necessary for the trust to earn a 100% gift tax deduction according to the IRS discount rate. By allowing the trust to grow rapidly through the small payments in the trust’s life, the large balloon payment is made possible as long as the trust achieves the discount rate. Anything made in excess of the low discount rate is passed to the heirs free of gift tax. The Shark-Fin strategy hedges against the possibility of poor investment results in the initial years of the trust and anticipates more favorable investment results in the long term. A Shark-Fin CLAT is particularly appealing when the economy is sluggish because it compounds the benefits of both the current low IRS discount rates and the long term prospect of economic recovery.

The negatives of a Shark-Fin CLAT are mostly shouldered by the charity. A charity is most likely going to want the steady flow of sizable payments rather than one large payment at the end of the trust, especially since the charity will be receiving the same amount whether a Shark-Fin CLAT or a normal CLAT is used. Also, time-value of money makes the wealth received from a Shark-Fin CLAT less valuable to the charity than an equal amount received through a normal CLAT. Another negative is the income tax under a Shark-Fin CLAT is likely to be greater. The trust is taxed on earned income in excess of the distributions and since the distributions to the charity are small in every year except the last, the deduction amount offsetting the tax is very small.

For more information on CLATs, please contact Hoffman & Associates at 404-255-7400