Wealth Transfer. Shark Fin CHARITABLE LEAD ANNUITY TRUST

Transcription

1 Wealth Transfer Shark Fin CHARITABLE LEAD ANNUITY TRUST

2 2 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

3 Shark Fin CLAT EXECUTIVE SUMMARY A Charitable Lead Annuity Trust (CLAT) pays a fixed amount of the trust s assets to a qualified charitable organization for a specific number of years or for the life of the donor. At the end of the term, the trust s principal is paid to the grantor, family members, or other non-charitable remainder persons. When a CLAT is created, it can be set up as a grantor trust or a non-grantor trust. The illustrations and examples set forth in this article assume that the donor established a grantor CLAT. With a grantor CLAT, the grantor receives an immediate income tax deduction for the present value of the annuity stream going to charity. The grantor then pays the income tax on all trust taxable income for the term of the trust (including the income used to pay the lead interest to the specified charity). The income tax deduction is limited to 30 percent of AGI, or 20 percent of AGI for gifts of appreciated property. If not fully used in the initial year, it can be carried over for an additional five years. The Shark Fin CLAT is considered to be the most aggressive type of CLAT structure. It derives its name from the graphical representation of small annuity payments over the term of the CLAT, which spike at the end of the term with a large balloon payment, resulting in a graphical line that resembles a shark s fin. On its surface, the CLAT instrument appears very straight forward. However, add in the Shark Fin component and some commentators feel like they have entered into unchartered waters with the IRS. This article focuses on examples, illustrations, and current research to show that the Shark Fin CLAT technique is worth a deep dive for high-net-worth clients that have an appetite for a unique PLANTE MORAN WEALTH MANAGEMENT 1

4 wealth transfer opportunity. Furthermore, it discusses what an advisor needs to know about this type of wealth transfer tool and ways to ensure the client is informed, empowered, and more protected should they pursue this technique which could come under IRS scrutiny. The Charitable Lead Annuity Trust (CLAT) has been a planning tool available since the 1970s, after being clarified by the Tax Reform Act of As a result of today s historically low interest rates, the CLAT has become an increasingly popular wealth transfer tool as its success is dependent on outperforming interest rates. Primary benefits: Fulfill charitable and non-charitable goals utilizing the same wealth transfer vehicle. Allow a charitable beneficiary to receive a benefit each year while shifting appreciation to heirs estate tax free. Any gift tax that is due would be based on the amount initially contributed less the present value of the payments to charity. Primary risks: CLAT could be disregarded for charitable purposes. If the assets in the CLAT underperform, then the CLAT will fail, and no remainder will be paid to the ultimate beneficiaries. IRS could challenge the transaction, which could lead to adverse income, gift, and estate tax consequences. 2 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

5 Shark Fin CLAT The Charitable Lead Annuity Trust (CLAT) has been a planning tool available since the 1970s, in response to the clarification in the Tax Reform Act of Despite its long-term history, the CLAT has become an increasingly popular tool to use in more recent history because its success is dependent on outperforming interest rates. As a result of today s historically low interest rates, the CLAT has become a more intriguing option for those who have a desire to fulfill charitable intentions while also providing a remainder interest that will pass to non-charitable beneficiaries. The overall concept of a CLAT is simple. The CLAT pays a fixed amount of the trust s assets to a qualified charitable organization for a specific number of years or for the life of the donor. At the end of the term, the trust s principal is paid to the grantor, family members, or other non-charitable remainder persons. The execution of a CLAT, however, requires a multitude of decisions such as whether the trust should be a grantor or non-grantor trust, which assets should be used to fund the trust, etc. Before contemplating how to structure the CLAT, a basic understanding of the CLAT technique and more importantly, the Shark Fin component must first be achieved. PART ONE: A BASIC UNDERSTANDING OF THE CHARITABLE LEAD ANNUITY TRUST STRUCTURE A CLAT is funded and designed to make payments to at least one qualified charitable organization either for a fixed term or on the measuring life of the donor, the donor s spouse, or a lineal ancestor to all non-charitable beneficiaries. At the end of such time, the balance is paid to the non-charitable beneficiaries named in the trust either directly to the heirs or to an irrevocable trust for the benefit of the heirs. For the philanthropic client, this planning strategy can be very appealing as it provides an opportunity to fulfill both charitable goals and wealth transfer to heirs all within the same transaction. Furthermore, it provides not only an annual benefit to charity via the income stream but also provides the ability to shift an appreciating asset to the donor s heirs estate tax free. Any gift tax that is due would be based on the amount initially contributed to the CLAT less the present value stream to the charity. The IRS requires utilization of specific rates depending on the type of CLAT that is created. Similar in nature to the Grantor Retained Annuity Trust (GRAT), this can allow a donor to zero out the gift to the CLAT by matching the present value of the income stream to the initial gift to the CLAT. The theory being that the asset, under today s interest rates, is expected to earn a rate set by the IRS, PLANTE MORAN WEALTH MANAGEMENT 3

6 and if the asset grows at that rate while making payments to the charity, it will have no balance left for the remainder beneficiary. As mentioned earlier, with interest rates so low, the actual return doesn t need to be too high to generate a remainder balance at the conclusion of the trust. Pass assets to the trust, make payments to charity, and at the end of the trust term the remaining balance will be distributed to heirs; receive a charitable deduction and shift asset appreciation outside of the estate. For fixed term CLATs the IRS uses the 7520 rate. For lifetime CLATs the IRS uses Table S* (if one donor) or Table R* (if two donors). IRS Table S* and Table R* are nothing more than actuarially adjusted 7520 rates using Table 2000CM*. Both IRS Table S* and Table R* assume every donor will live to age 110. When structuring the CLAT, consideration should be given to whether the trust should be created as a grantor or non-grantor CLAT. With a grantor CLAT, the grantor receives an immediate income tax deduction for the present value of the annuity stream going to charity. The grantor then pays the income tax on all trust taxable income for the term of the trust (including the income used to pay the lead interest to the specified charity). The income tax deduction is limited to 30 percent of AGI, or 20 percent of AGI for gifts of appreciated property. If not fully used in the initial year, it can be carried over for an additional five years. With a non-grantor CLAT, there is no initial charitable income tax deduction to the grantor when the trust is established. Instead, the income generated by the trust is offset by a charitable deduction in each year for the amount that is paid to charity. The trust then pays income tax on any trust income it receives in excess of the lead interest it pays to the charity. Regardless of whether the donor decides to structure the CLAT as a grantor trust or non-grantor trust, it is important for the donor to remember that the CLAT is an irrevocable trust. Therefore, careful consideration and planning should be performed by the donor and his or her wealth management advisory team prior to implementing any wealth transfer strategy involving a CLAT. PART TWO: GUARANTEED ANNUITY PAYMENT The Tax Reform Act of 1969 defines the payment needed in the CLAT as a guaranteed annuity payment. It states that no deduction will be allowed for income, estate, or gift taxation for the current value of a charitable income interest unless such interest is in the form of a guaranteed annuity or a fixed percentage of the value of the trust property valued annually and distributed yearly. 4 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

7 Meeting the above requirement is clearly paramount to allowing a CLAT to work. Treasury regulation 1.170A-6(c)(2)(i)(A) defines a guaranteed annuity payment as an arrangement under which a determinable amount is paid periodically, but not less often than annually, for a specified term of years or for the life or lives of certain individuals, each of whom must be living at the date of transfer and can be ascertained at such date. Only one or more of the following individuals may be used as measuring lives: the donor, the donor s spouse, and an individual who, with respect to all remainder beneficiaries (other than charitable organizations described in Section 170, 2055, or 2522), is either a lineal ancestor or the spouse of a lineal ancestor of those beneficiaries. A trust will satisfy the requirement that all non-charitable remainder beneficiaries are lineal descendants of the individual who is the measuring life, or that individual s spouse, if there is less than a 15 percent probability that individuals who are not lineal descendants will receive any trust corpus. An amount is determinable if the exact amount that must be paid under the conditions specified in the governing instrument of the trust can be ascertained as of the date of transfer. For example, the amount to be paid may be a stated sum for a term of years or for the life of the donor, at the expiration of which it may be changed by a specified amount, but it may not be redetermined by reference to a fluctuating index such as the cost of living index. In further illustration, the amount to be paid may be expressed in terms of a fraction or percentage of the cost of living index on the date of transfer. Furthermore, in PLR , the IRS allowed a testamentary CLAT specified for a 10-year duration to use increasing payments designed at 20 percent increases over the prior year s payment. The probate court noted that the payments were actuarially equivalent and the IRS let stand the charitable deduction stating the graduated payments were determinable as required by the language above. Grantor Retained Annuity Trusts (GRATs) also allow for graduated payments over the term of the trust and are specifically limited to 20 percent increases over the prior year s payment. As long as the two cash flow streams are actuarially equivalent, they are treated with the same present value. Because GRATs operate very similar to CLATs, it is often assumed that a 20 percent increase is the highest a CLAT would allow. There is no language in the definition above that would require that conclusion. PLANTE MORAN WEALTH MANAGEMENT 5

8 PART THREE: SHARK FIN CLAT The most aggressive form of payment structure that can be accomplished in a CLAT is known as a Shark Fin CLAT. This structure keeps the lead payments low and offers a balloon payment at the end of the CLAT. As defined in Treasury Regulation 1.170A-6(c)(2)(i)(A),a guaranteed annuity payment is a stated sum for a term of years or life. At the expiration, it is changed by a specified amount. The term Shark Fin is derived from graphing out both the lead payments and the final payment which symbolically resembles a shark s fin. The chart below is a visual comparison of the payments made by a level CLAT, an increasing CLAT, and a Shark Fin CLAT. Shark Fin CLAT Shark Fin CLAT Level CLAT 20 percent increasing CLAT PART FOUR: FIXED TERM VS. LIFETIME CLATS CLATs can allow for lifetime terms on either a single life basis or a joint life basis. It is more advantageous in a fixed term scenario to delay payments, either through a graduated payment schedule or a Shark Fin payment schedule. Delaying payments in a lifetime term scenario could generate some level of mortality risk that the portfolio may not be able to handle. IRS Table S* and Table R* are used to calculate lifetime term CLATs for both the annuity payment and any remainder payment due upon death. The IRS has calculated annuity, life estate, and remainder factors based on the 7520 rate and the age of the donor(s). Table S* is used with single life terms and Table R* for joint life. Breaking down how these rates are calculated is necessary in order to abide by the same ruling in the PLR and make two scenarios actuarially equivalent. 6 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

9 Table S* and Table R* provide enough data to calculate a lifetime level payment CLAT and a lifetime Shark Fin CLAT, but it does not calculate the data needed for a graduated payment schedule. In order to evaluate and compare payment schedules, we must first understand and prove how these rates are calculated. The factors in Table S* and Table R* both assume everyone has the probability to live to age 110 and is predicated on the mortality table set in Table 2000CM*. The factors presented are the equivalent of discounting the payment similar to a fixed term, but each future payment is then multiplied by the probability it will actually be made, which is the probability that one or both of the measuring lives are still alive. This can be found by using Table 2000CM* and building a table that calculates the probability of survival from the starting age to the age in the given year of the payment. Knowing this and the numbers in Table 2000CM*, we can validate the rates in Table S*, and at the same time validate the year-by-year discount rates which will be needed to compare increasing payment lifetime CLATs. The Table S* annuity factor for a 70-year-old with a 2.2 percent 7520 rate is The annual lead annuity payment to charity is determined by dividing the $1,000,000 of contributed funds by the Table S* annuity factor of As you can see in Example 1 on the next page, a $1,000,000 contribution to a level payment CLAT requires an annual payment of $85, in order to zero out the transaction for gift tax purposes. The present value of the payment is multiplied by the probability of survival each year to determine mortality adjusted present value, resulting in a total present value sum of $1,000,000 over the term of the CLAT. In summary, Example 1 provides the year by year data for a level payment CLAT, which can be used to prove actuarial equivalence of the use of an increasing payment CLAT and Shark Fin CLAT. PLANTE MORAN WEALTH MANAGEMENT 7

10 Example 1: Level payment CLAT structure assuming a 70-year-old single life with $1,000,000 of contributed funds and a 2.2 percent 7520 rate. Year Age Lead Annuity to Charity Probability of Survival Present Value of Payment Mortality Adjusted PV 1 71 ($85,720.76) $83, $82, ($85,720.76) $82, $79, ($85,720.76) $80, $75, ($85,720.76) $78, $71, ($85,720.76) $76, $67, ($85,720.76) $75, $63, ($85,720.76) $73, $59, ($85,720.76) $72, $55, ($85,720.76) $70, $52, ($85,720.76) $68, $48, ($85,720.76) $67, $44, ($85,720.76) $66, $40, ($85,720.76) $64, $36, ($85,720.76) $63, $33, ($85,720.76) $61, $29, ($85,720.76) $60, $26, ($85,720.76) $59, $23, ($85,720.76) $57, $20, ($85,720.76) $56, $17, ($85,720.76) $55, $14, ($85,720.76) $54, $12, ($85,720.76) $53, $10, ($85,720.76) $51, $8, ($85,720.76) $50, $6, ($85,720.76) $49, $5, ($85,720.76) $48, $3, ($85,720.76) $47, $2, ($85,720.76) $46, $2, ($85,720.76) $45, $1, ($85,720.76) $44, $1, ($85,720.76) $43, $ ($85,720.76) $42, $ ($85,720.76) $41, $ ($85,720.76) $40, $ ($85,720.76) $40, $ ($85,720.76) $39, $ ($85,720.76) $38, $ ($85,720.76) $37, $ ($85,720.76) $36, $ ($85,720.76) $35, $2.64 $1,000, SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

11 PART FIVE: EXHAUSTION TEST While Example 1 can be utilized to prove actuarial equivalence, there is still a need to explore the application of the exhaustion test imposed upon lifetime annuity interests. The exhaustion test makes it impossible to zero out a lifetime level or graduated payment CLAT. There is industry-wide speculation as to whether the exhaustion test should be used. Treasury Regulation example 5 clearly indicates the need for utilizing an exhaustion test, and therefore not utilizing an exhaustion test would be considered aggressive. The exhaustion test simply states that the above annuity factors cannot be utilized if the trust will exhaust itself of all money prior to the donor(s) reaching age 110, assuming assets grow at the 7520 rate. In Example 1 on the previous page, a 70-year-old with $1,000,000 of contributed funds results in annual payments of $85, Assuming a 2.2 percent return, the money will exhaust itself fully by year 14, and the 70-year-old will only be able to make a partial payment of $54, in the 14th year. Because the trust is expected to exhaust itself, it must be treated similarly to a term CLAT and only utilize the present value of payments that are expected to be made. Therefore, since only 13 payments of $85, are expected to be paid in full with a partial payment of $54,125 in year 14, the payment streams will be broken into two separate annuities for purposes of the calculation. The first annuity will be calculated using 13 annual payments of $31, ($85, $54,125.00). The second annuity will be calculated using 14 annual payments of $54, The annuity factor used to determine the net present value of each annuity is derived from IRS Table H*. As you can see in Example 2 below, the total net present value is $799, Example 2: Calculation of net present value of split annuity streams. $31, x = $286, $54, x = $512, Annuity 1 (Years 1-13) Annuity 2 (Years 1-14) Net present value $799, Value of remainder interest (gift) $200, Performing the above calculations in order to determine the present value of an increasing payment CLAT could prove to be very difficult. However, Table H* is nothing more than a mortality-based table, one that was used to figure out the numbers for the mortality-based present value calculation in Example 1. PLANTE MORAN WEALTH MANAGEMENT 9

12 Example 3: Proof of IRS Table H* exhaustion test for a level payment CLAT structure. Assumes a 70-year-old single life with $1,000,000 of contributed funds and a 2.2 percent rate of return. BOY Lead Annuity EOY Actual Probability Mortality Adjusted Year Balance Growth to Charity Balance Payment of Survival Present Value 1 $1,000, $22, ($85,720.76) $936, ($85,720.76) $82, $936, $20, ($85,720.76) $871, ($85,720.76) $79, $871, $19, ($85,720.76) $804, ($85,720.76) $75, $804, $17, ($85,720.76) $736, ($85,720.76) $71, $736, $16, ($85,720.76) $667, ($85,720.76) $67, $667, $14, ($85,720.76) $596, ($85,720.76) $63, $596, $13, ($85,720.76) $523, ($85,720.76) $59, $523, $11, ($85,720.76) $449, ($85,720.76) $55, $449, $9, ($85,720.76) $373, ($85,720.76) $52, $373, $8, ($85,720.76) $295, ($85,720.76) $48, $295, $6, ($85,720.76) $216, ($85,720.76) $44, $216, $4, ($85,720.76) $135, ($85,720.76) $40, $135, $2, ($85,720.76) $52, ($85,720.76) $36, $52, $1, ($85,720.76) $0.00 ($54,124.98) $21, $799, Example 3 above reflects the output of an exhaustion test utilizing the same facts as Example 1. By using the exhaustion test, we have determined the mortality adjusted net present value of payments that are expected to be made if the fund only grows at the 7520 rate. Not surprisingly, if the exhaustion test doesn t apply because the payments are low enough to not exhaust the trust, the net present value will still be identical to the exhaustion test if it were to apply. The IRS is using a gender-neutral mortality table (Table 2000CM*) that is seven years old. It would be practical to assume that the next time the IRS updates Table 2000CM*, the probability of survival will increase, therefore increasing the net present value of the annuity and, in turn, reducing the amount of the gift that is made. Because future payments are discounted by both the 7520 rate and the probability of surviving to make that payment, it disproportionately affects increasing payment CLATs. Increasing future payments may have little effect on 10 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

13 present value as a) they could occur after the assumed exhaustion of the trust, and b) the probability of the donor surviving to that payment is low. Example 4 below outlines an exhaustion test and net present value of a 20 percent increasing payment CLAT. Example 4: Exhaustion test for a 20 percent increasing payment CLAT structure. Assumes a 70-year-old single life with $1,000,000 of contributed funds. BOY Lead Annuity EOY Actual Probability Mortality Adjusted Year Balance Growth to Charity Balance Payment of Survival Present Value 1 $1,000,000 $22, ($8,757.78) $1,013, ($8,757.78) ($8,466.54) 2 $1,013, $22, ($10,509.33) $1,025, ($10,509.33) ($9,692.13) 3 $1,025, $22, ($12,611.20) $1,034, ($12,611.20) ($11,068.63) 4 $1,034, $22, ($15,133.44) $1,042, ($15,133.44) ($12,606.02) 5 $1,042, $22, ($18,160.12) $1,047, ($18,160.12) ($14,312.15) 6 $1,047, $23, ($21,792.15) $1,048, ($21,792.15) ($16,192.35) 7 $1,048, $23, ($26,150.58) $1,045, ($26,150.58) ($18,249.20) 8 $1,045, $23, ($31,380.69) $1,037, ($31,380.69) ($20,481.11) 9 $1,037, $22, ($37,656.83) $1,022, ($37,656.83) ($22,880.39) 10 $1,022, $22, ($45,188.20) $999, ($45,188.20) ($25,431.20) 11 $999, $21, ($54,225.84) $967, ($54,225.84) ($28,108.86) 12 $967, $21, ($65,071.00) $923, ($65,071.00) ($30,879.12) 13 $923, $20, ($78,085.20) $865, ($78,085.20) ($33,695.21) 14 $865, $19, ($93,702.24) $791, ($93,702.24) ($36,497.80) 15 $791, $17, ($112,442.69) $696, ($112,442.69) ($39,215.47) 16 $696, $15, ($134,931.23) $576, ($134,931.23) ($41,764.37) 17 $576, $12, ($161,917.48) $427, ($161,917.48) ($44,049.69) 18 $427, $9, ($194,300.97) $242, ($194,300.97) ($45,971.28) 19 $242, $5, ($233,161.17) $14, ($233,161.17) ($47,425.99) 20 $14, $ ($279,793.40) $0.00 ($14,895.11) ($2,571.97) $509, Even though the funds in Example 4 are expected to last six years longer than the funds in Example 3, the net present value has diminished by about $290,000 ($799, $509,559.48). Assuming that the donor has fully exhausted their PLANTE MORAN WEALTH MANAGEMENT 11

14 federal lifetime gift and estate exemption ($5,450,000 for 2016), Example 4 would result in a gift tax exposure of approximately $100,000. The exhaustion test applied to Shark Fin CLATs produces some interesting results. Under the exhaustion test, it must be assumed that all measuring lives survive until age 110, and with a final payment that is increased upon death, this in effect delays the balloon payment many years into the future. Consideration should be given to the lead payment prior to implementing the CLAT. With the appropriate lead payment, the trust can pass the exhaustion test, which in turn allows the use of Table S* or Table R*. With a lead payment too high it will exhaust the fund at or before age 110, causing the discount of the final payment to be so high that the present value is extremely small in comparison to the initial contribution amount. If a 70-year-old single donor had a lead payment set at 2 percent of the initial contribution of $1,000,000, then assuming the assets grew at 2.2 percent, the donor would have over $94,000 left after making $20,000 lead payments and the final balloon payment of $1,031,387. This works for payments all the way up to the exact rate equivalent to the 7520 rate. At a payout rate exactly that of the 7520 rate it will have enough money to the penny but will technically exhaust itself at age 110. If it is interpreted that the final payment does cause the trust to exhaust itself with a 2.2 percent lead payment then the exhaustion test present value would be capped at $256,000, while a percent payout would allow it to pass and have a present value of the full $1,000,000 which would be the only way to zero out a lifetime CLAT. PART SIX: DE MINIMIS PAYMENTS It is often argued that a Shark Fin CLAT could be challenged based on the idea that the lead payments are too small to be considered measurable. This argument is supported by the idea that a de minimis requirement is applied to Charitable Remainder Trusts (CRTs). A CRT is essentially a CLAT in which the recipients of the lead payment and remainder interest are switched. Since the inception of CRTs, it has been subject to a 5 percent de minimis payout requirement. In a CRT, the payment is stated as a fixed percentage of the initial fair market value or as a fixed sum. The annuity percentage or fixed amount cannot change regardless of the fluctuations in the portfolio value. Unlike CLATs and GRATs, a CRT is a tax-exempt trust and does not allow for graduated payments. CLATs, just like GRATs, never directly impose a de minimis requirement. 12 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

15 GRATs do however impose a 20 percent limit on increasing payments. If the donor desires to zero out the gift, utilizing the 20 percent limit on increasing payments will cause the first payment to be high enough that over the term of the GRAT the present value of the annuity payments zeros out the present value of the remainder interest for gift tax purposes (thus resulting in a zeroed out GRAT). If the initial payment is too small, it will end up creating a gift for the difference. A CLAT has neither a defined de minimis payment like the CRT nor an implied de minimis payment like the GRAT. In PLR , the IRS approved the use of 20 percent increasing payments for a 10-year testamentary CLAT. The 20 percent increasing payments were deemed acceptable because they were actuarially equivalent and determinable. Utilizing similar methodology as PLR , a 20-year term zeroed out CLAT with 20 percent increasing payments would result in an initial payment of $7,476, or just under.75 percent of the initial contribution amount. This would be the same initial payment for a GRAT with a 20-year term. A longer term CLAT or GRAT would require a significantly smaller initial payment than the one calculated above. Example 5 below charts the difference in remainder balances at Life Expectancy (LE) to heirs for various lead payments from a Shark Fin CLAT expressed as basis points (bps) of the initial contribution amount. Note that Example 5 utilizes the 2008 VBT mortality table. The remainder balance for a 70-year-old single taxpayer with a life expectancy of 88, assuming a 5 percent asset growth and a 2.2 percent 7520 rate, could be as high as $1,048,000 at a 10-basis point payout or as low as $789,000 at a 219-basis point payout. Example 5: Remainder Balance at Life Expectancy. $1,200, $1,000, $800, $600, $400, $200, $ bps 40 bps 60 bps 80 bps 100 bps 120 bps 140 bps 160 bps 180 bps 200 bps 219 bps PLANTE MORAN WEALTH MANAGEMENT 13

16 There is clearly an economic advantage to keeping the lead payment low. The smaller the lead payment, the more aggressive the planning. The additional return to heirs at a 10-basis point lead payment is very small compared to the 75-basis point lead payment. The most conservative setup would use a lead payment that is just one basis point less than the 7520 rate. A Shark Fin CLAT offers significant benefits to any high-net-worth client who has used most or all of their unified credit and is looking for additional philanthropic ways to transfer wealth. PART SEVEN: THE USE OF LIFE INSURANCE AND THE APPLICATION OF SECTION 170(F)(10) Shark Fin CLATs often use life insurance to coincide with the final payment needed to cover the balloon payment at death. This technique also covers the initial mortality risk if the donor(s) pass away early in the CLAT term and the balloon payment needs to be made before the assets have had time to grow to the appropriate level. The final hurdle to overcome in this strategy is the application of Section 170(f) (10)(A)(ii), which states that nothing in this section or in Sections 545(b)(2), 642(c), 2055, 2106(a)(2), or 2522 shall be construed to allow a deduction, and no deduction shall be allowed, for any transfer to or for the use of an organization described in Subsection (c) if in connection with such transfer. (i) The organization directly or indirectly pays or has previously paid, any premium on any personal benefit contract with respect to the transferor, or (ii) There is an understanding or expectation that any person will directly or indirectly pay any premium on any personal benefit contract with respect to the transferor. The term personal benefit contract means, with respect to the transferor, any life insurance, annuity, or endowment contract. If any direct or indirect beneficiary under such contract is the transferor, any member of the transferor s family, or any other person (other than an organization described in subsection (c) designated by the transferor). Section 170(f) was originally enacted to eliminate the practice where a donor would make a deductible contribution to a charity, which in turn would use the funds to purchase a life insurance contract on the donor, and then assign the death benefit above the cash value to the donor s family. In essence, a charitable deduction for life insurance premiums paid. It is debated as to whether Section 170(f) also applies to a CLAT that has purchased life insurance. Whether it does or doesn t will be decided by future challenges by the IRS, but assuming it is challenged and the charitable deduction is lost, the consequences could be significant. 14 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

17 For example purposes, let s assume some basic facts and then dive into two scenarios that further explore the use of life insurance and the application of Section 170(F)(10). Facts A 70-year-old single donor contributes $1,000,000 to a lifetime Shark Fin grantor CLAT. The trust requires $7,500 lead payments during the lifetime of the donor, with a final balloon payment of $1,227,000. At the end of the term, the remaining assets in the trust will be distributed to a trust for donor s children. Based on the application of the exhaustion test and Table S*, the donor would not utilize his lifetime exemption on the gift to this trust as the gift has been zeroed out. Furthermore, the donor would be able to utilize a current income tax deduction of $1,000,000 against his current income (subject to the general charitable deduction rules). The donor has a taxable estate and has not used any of his $5,450,000 federal lifetime exemption. The donor is not a resident of a state that imposes gift or estate tax. Below are two scenarios. Scenario A The Shark Fin CLAT uses $850,000 to buy a single premium paid-up guaranteed life insurance contract that will provide a death benefit of $1,950,000 (assumes 2015 rates). After purchasing the insurance contract, the CLAT will have $150,000 remaining which it will invest and receive a 5 percent annual fixed rate of return, resulting in $7,500 worth of annual income. The $7,500 of annual income will then be used to make the $7,500 annual lead payments. When the donor reaches age 88, the CLAT will have a remainder balance of $873,000 ($150,000 + $1,950,000 - $1,227,000). The $873,000 will be distributed to a trust for donor s children. The donor was able to take advantage of a charitable deduction of $1,000,000 against his current income (subject to the general charitable deduction rules), and also shift $873,000 worth of assets (including any future appreciation) to a trust for his children. Keep in mind that the donor also funded the Shark Fin CLAT with $1,000,000 that was previously inside his estate. Simply transferring the $1,000,000 into a Shark Fin CLAT and removing the $1,000,000 worth of assets outside of the donor s estate saved him $400,000 worth of estate tax right away (assuming he was in a taxable estate to begin with). Clearly, there are income, gift, and estate tax advantages to this strategy. However, as with any wealth transfer strategy, there are also risks. For example, the IRS could challenge the transaction and argue that the Shark Fin CLAT structure constituted a personal benefit contract that indirectly benefited the donor s children. If the IRS were successful in this challenge, the income, estate, and gift tax consequences could be significant. The donor would lose his charitable deduction, thereby increasing the donor s personal income tax liability for the year(s) that he claimed a charitable income tax deduction. The IRS could also assess penalties and interest on the underpayment of income tax. The value of the gift would change from $0 to $1,000,000. Assuming the donor already fully utilized his lifetime exemption the increase in gift value to $1,000,000 would result in a gift tax liability of $400,000. This clearly PLANTE MORAN WEALTH MANAGEMENT 15

18 is not the end result that the donor was hoping for, which is why it s important to understand each donor s risk/return appetite and couple that with an analysis that determines the income, gift, and estate tax consequences to the donor prior to implementing the strategy. Scenario B The Shark Fin CLAT only buys enough life insurance to cover the charitable balloon payment of $1,227,000. This scenario would exempt donor from the Section170(F)(10) rule because no incidents of benefits will be paid to anyone other than the charitable organization. Furthermore, this scenario relies on the compounding of returns on the growth of the trust principal to generate the future value which will ultimately be transferred to the remainder beneficiaries. A balloon payment of $1,227,000 will require a single premium of $536,340. At life expectancy of age 88, the remaining trust balance will be $904,000, if the assets are assumed to grow at 5 percent return. The full balloon payment of $1,227,000 will be covered by the paid-up life insurance policy. As you can see in the graph below, Scenario B results in a smaller remainder balance if the donor passes away prior to life expectancy, and a larger remainder balance if the donor exceeds life expectancy. In our opinion, if the IRS were to challenge Scenario B, they would have a much more difficult time classifying the insurance policy as a personal benefit as defined under Section 170(F)(10). Despite Scenario B holding more investment assets than Scenario A, Scenario B appears to make more sense to setup as a grantor trust due to the upfront charitable deduction (subject to the general charitable deduction rules). However, the decision to treat the trust as grantor or non-grantor is specific to each donor and should be evaluated on a case by case basis. Example 5: Remainder Balance Scenario A vs. Scenario B $2,500, $2,000, $1,500, $1,000, $500, $ Scenario A: Remainder Amount (at death) Scenario B: Remainder Amount (at death) 16 SHARK FIN: CHARITABLE LEAD ANNUITY TRUST

19 PART EIGHT: CONCLUSION While the Shark Fin CLAT is considered to be the most aggressive type of CLAT structure, it is still worth exploring and potentially implementing for the right client profile. This strategy may be particularly appealing to those clients who have a taxable estate, have already implemented other forms of wealth transfer, and are looking for a unique way to fulfill both philanthropic and family legacy goals. If you have any questions or would like to have a more detailed discussion regarding this wealth transfer opportunity, please contact: STEVE GIBSON, CFP Associate steve.gibson@plantemoran.com RACHELLE ROBERTS, CPA Associate rachelle.roberts@plantemoran.com All investment returns and assumptions used in this material are for illustration purposes only * Table S, Table R, Table 2000CM, and Table H reference IRS Actuarial Tables PLANTE MORAN WEALTH MANAGEMENT 17

20 wealth.plantemoran.com