Source: https://www.twohawksconsulting.com/post/death-taxes-a-twist-on-the-testamentary-charitable-lead-annuity-trust
Timestamp: 2020-07-11 18:02:09
Document Index: 91416623

Matched Legal Cases: ['§1274', '§4941', '§1274', '§7520', '§7520', '§1']

Death & Taxes: A Twist on the Testamentary Charitable Lead Annuity Trust
by Randy A. Fox & Dan Rice
A constant theme in dealing with high net worth clients is the desire to fully eliminate estate taxes at the death of the last survivor. While this has become somewhat easier because of the higher exemption amount, it is still a challenge for those with “taxable” estates. This is especially true when clients insist on controlling as much of their wealth as possible while they’re still living.
One strategy that is often discussed and considered is the testamentary charitable lead annuity trust (TCLAT). Generally, the TCLAT receives whatever assets remain in the estate above the exemption amount and, by a formula computation, send an amount to charity for a period of years and bring the remainder back to the children at the end of the period and leaving a “zero” includable amount in the estate. The major issue with this strategy is that because of the way the trust must be computed to achieve a zero estate inclusion, the length of time for children to receive the remainder (if indeed any reminder is left), can be quite long.
One of the purposes of most inheritances is to allow heirs to benefit sooner rather than later. However, it is not unusual to see a TCLAT formula where the period of years is as long as twenty-five or even thirty. This can be a source of disappointment and unanticipated tension between parents and heirs.
The challenge, then, is to find a solution that satisfies the desire to totally eliminate estate taxes and to transfer the wealth to heirs in a more reasonable time frame.
Citations of authority for Charitable Lead Trusts begin on page 6.
Briefly, this philanthropic estate planning strategy is a testamentary method for transferring specific assets to the children tax free, while supporting charitable organizations or funding a family foundation (or Donor Advised Fund), through a testamentary Non-Grantor Charitable Lead Annuity Trust (T-CLAT). Typically, the plan becomes operative upon the death of the surviving spouse.
Not surprisingly, children are often adversaries of the T-CLAT. Imagine children as expectant heirs and think of their disappointment when they discover that their parent’s estate will be placed in a T-CLAT for a decade before the children finally get the trust assets. Is there a way to turn delayed CLATification into instant gratification and to allow the children to become advocates of their parents using the T-CLAT?
Step 1. Create a T-CLAT now. After the donor’s life, the Trust is funded. The Trustee can decide the Trust term and payout rate to the charitable organizations. Depending upon the Trust term and payout rate, estate taxes can be significantly reduced or eliminated. After the Trust term, the trust assets pass to the children. If the Trust income went to a Donor Advised Fund or Family Foundation to be used as Trust principal and additions to principal, the charity may continue to operate, using the T-CLAT annuity income it received.
Step 2. The parents grant an option for $2,500 to each child. Each child now owns an option to purchase an equal share of the selected assets (option assets) from the surviving parent’s estate. The options are usually exercisable for 9 months from the date of the death (the option period). The option can be exercised, during the option period, to purchase an option asset at its fair market value (see Private Letter Rulings 201448031, 201448028, 201448027, 201448025, 201448023, 201445017, 201129049, 200927041, 200722029, 200024052, 199930048, 199924069 and 9724018).
Step 3. Each child may exercise their option and purchase the option assets with cash (perhaps from insurance proceeds), or with an installment note (a collateralized balloon payment type), or a combination of these two. When promissory notes are used to purchase the option assets, they must bear interest at the applicable federal rate for such notes, determined under IRC §1274(d), and they should be secured by the option asset purchased or an amount acceptable to the seller (see Private Letter Rulings 201448031, 201448028, 201448027, 201448025, 201448023, 201445017, 201206019, 201129049, 200927041, 200722029, 200124029, 200232033, 200233031, 200635015, 200635016 and 200635017).
Comment. The options would bind the current and successor executors and trustees of the surviving parent’s estate, and if the option assets are distributed to the T-CLAT, the options will apply to the option assets of, and will bind the trustees of, the CLAT.
Step 4. The CLAT term will end before the Promissory Note balloon payment is due. The Note will pass to the children, who will then simply tear it up and no balloon payment will ever have to be made.
* Also, see page 6 below regarding the benefits of transferring a promissory note to an LLC and subsequently transferring non-voting LLC units to the T-CLAT, instead of transferring a promissory note directly to the T-CLAT.
Comments regarding the Self-Dealing Rules that Govern the T-CLAT
Like Private Foundations, the CLT is governed by the self-dealing rules under IRC §4941. Certain exceptions to the general rules can be found under Section 53.4941(d)-1(b)(3) of the Foundation and Similar Excise Taxes Regulations. This Section excepts certain transactions carried out during the administration of an estate (“the Estate Administration Exception”) from the definition of self-dealing. Specifically, Section 53.4941(d)1(b)(3) provides that the term “indirect self-dealing” shall not include a transaction with respect to a private foundation’s interest or expectancy in property (whether or not encumbered) held by an estate or revocable trust (including a trust which has become irrevocable on a grantor’s death), regardless of when title to the property vests under local law, if:
(i) The administrator or executor of an estate, or trustee of a revocable trust either — (a) Possesses a power of sale with respect to the property, (b) Has the power to reallocate the property to another beneficiary, or, (c) Is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust); (ii) Such transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate (or trust), or over the private foundation); (iii) Such transaction occurs before the estate is considered terminated for Federal income tax purposes pursuant to paragraph (a) of section 1.641(b)-3 of the regulations (or in the case of a revocable trust, before it is considered subject to section 4947 of the Code); (iv) The estate (or trust) receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust); and (v) With respect to transactions occurring after April 16, 1973, the transaction either — (a) Results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up, (b) Results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or (c) Is required under the terms of any option which is binding on the estate (or trust).
Typically, life insurance is a common component in many estate plans. Suppose your client previously bought life insurance years ago to pay future estate taxes. However, since the life insurance purchase, the client’s estate is much larger today and the insurance coverage now needed is unavailable because it’s too expensive or the client is uninsurable. The client’s estate can sell the children all of the assets, which will have a step up in basis, in exchange for an interest only promissory note. The children can pay the interest payments to the T-CLAT using the insurance proceeds and/or the investments earned on the insurance proceeds, rather than using the insurance to pay estate taxes.
Purchase a 9 year term life insurance policy.
Purchase a term life insurance policy for, say, a 20 year term that also has a convertible-to-permanent life insurance feature in the policy (which does not require a new medical exam prior to the conversion). After the first 9 years, the client can sell the policy under a Life Settlement arrangement that may enable him to not only recover all the prior 9 years of premiums but also a significant percentage of the face amount, making it compare quite favorable to other types of investments.
If the intentionally defective irrevocable trust (IDIT) promissory note drops into a T-CLAT, you may have to go to court to reissue the notes, to avoid self-dealing problems longer term. Why? Under the self-dealing rules, a promissory note with a disqualified person, that is transferred into a T-CLAT (or private foundation, or any trust governed by the private foundation rules), even though the promissory note pre-existed the T-CLAT, creates a self dealing problem, unless you go to court to swap the note out for a new, identical note.
Is a T-CLAT funded with a promissory note of any real benefit over simply using a private foundation, or an outright gift to a public charity, or a public charity’s Supporting Organization created for the donor? If the children purchase the estate assets from a private foundation with a promissory note, the interest payable on the note will be the applicable federal rate (AFR) under IRC §1274(d). However, the T-CLAT interest rate is the IRC §7520 rate, which is 120% of midterm AFR and is almost always higher than even the long-term AFR. The T-CLAT would be designed to only earn the AFR from the note, but the interest rate applicable to the charitable payout would be the IRC §7520 rate, which is higher. So most T-CLATs funded with such notes would actually run out of money before the end of the term. Therefore, in many cases, a private foundation, or an outright gift to a public charity, or a public charity’s Supporting Organization created for the donor, has the same economics for the family.
*Transfer Promissory Note to LLC Prior to Testamentary Funding of CLAT or Private Foundation and Transfer Non-Voting LLC Units to CLAT or Private Foundation
See PLRs 201446024, 201723005 and 201723006.
Treasury table citations for computing value of charity’s lead interests: Unitrusts — Reg. §§1.664-3(d) and -4; IRS Pub. 1458.
IRS Sample Forms for T-CLAT: Rev. Proc. 2007-46
Contact Two Hawks Consulting to determine if Testamentary Charitable Lead Annuity Trust (TCLAT) might be an option for you.
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