Creative CLAT Meets Tax Concerns of the Ultra Affluent
– As published in the December 2013 issue of Estate Planning Magazine.
In addition to accomplishing charitable goals, charitable lead annuity trusts (CLATs) can be powerful income tax deduction tools for clients ranging from former executives receiving large onetime income payments from deferred compensation plans or nonqualified retirement plans to professional athletes receiving upfront contract or roster bonuses.
Hedge fund managers who hold offshore investments in their own funds are also looking at CLATs as a way to ease the tax burden incurred as they meet the Emergency Economic Stability Act of 2008 Provision to repatriate this money by 2017. (1)
CLATs provide a unique opportunity to ease the present income tax burden for ultra-high net worth individuals while enabling charitable giving and leaving individuals or trust beneficiaries with the remaining funds gift and estate-tax free.
What is a CLAT?
In its simplest form, a CLAT is the inverse of its brother, the charitable remainder trust (CRT). In a CRT, the primary beneficiary is the donor or a named individual, and then the charitable organization (often a private foundation) is the beneficiary of the remainder. With CLATs, however, additional estate planning benefits can be afforded through the use of creative structuring such as private placement insurance.
In a CLAT, the up-front income tax deduction is based on the total expected lead payments made to a qualifying charity. The calculated remainder interest for gift tax purposes is the initial contribution reduced by the present value of the lead payments. The IRS-prescribed discount or “hurdle” rate (“Section 7520 rate”) is a favorably low 1.40% (as of July 2013). The actual amount transferred to the remainder beneficiary is based on the underlying investment performance in excess of the lead payments and the 1.40% discount rate.
Example. A hedge fund manager is looking to repatriate $50 million of offshore assets, which would create a rather hefty income tax liability. The hedge fund manager could use a $50 million CLAT to generate a $50 million income tax deduction with any remainder passing gift and estate tax-free to an estate tax exempt trust. More specifically, assuming a 20-year zeroed-out CLAT, the hedge fund manager could achieve a $50 million income tax deduction (subject to adjusted gross income-related deduction limits (2)) and pass potentially $75.3 million estate and gift tax-free to an estate tax exempt trust. In addition, there would be an annual charitable contribution of $2.9 million per year.
Exhibit 1 summarizes the key components of the transaction. Key factors driving the economics are:
- Duration of the CLAT term
- Level or increasing charitable lead payments
- Maximizing charitable deduction
- Section 7520 rate (i.e., discount rate)
- Assumed/actual growth of underlying assets
In order to achieve the up-front charitable deduction, the CLAT must be established as a grantor CLAT for income tax purposes. This means that after the initial income tax deduction, all of the CLAT’s income and investment gains bypass the trust and will be recognized on the hedge fund manager’s individual income tax return. This can be a very expensive proposition considering the impact of the American Taxpayer Relief Act (ATRA) and the enactment of the new Medicare 3.8% tax on net investment income.
Staying with the example in Exhibit 1, the potential income taxes incurred could be as high as $22.9 million during the 20-year CLAT period on a present value basis, depending on the tax efficiency of the underlying investments (details of assumptions are discussed below). Shifting the parameters of this particular CLAT in various ways does not substantively mitigate the potential tax burden:
- Decreasing the CLAT term reduces the potential tax liability but increases the charitable lead payments and decreases the remainder interest.
- Liquidations of corpus to fund the charitable lead payment will trigger taxable gains, to the extent of appreciation, with no offsetting charitable deduction (because it was taken up-front).
- Payments in-kind also trigger taxable gain recognition and hence cannot be employed to avoid this result.
Assumptions. The example and illustration in Exhibit 1 are based on various assumptions:
1. CLAT duration is 20-years and solved to have a zero remainder value for gift and estate tax purposes.
2. Annual charitable lead payment is computed based on an assumed Section 7520 rate of 1.40% (as of July 2013) and level annual payments (simplifying assumption).
3. CLAT assets are assumed to appreciate at a net rate of 7% per year based on a hypothetical investment and do not represent any specific investment.
4. Taxes are not assessed to the CLAT balance, as all taxes are born by the grantor assuming the CLAT qualifies as a grantor CLAT for income tax purposes.
5. Investment returns are assumed to be taxed as earned, split 70/30 between income and short-term capital gains and long-term capital gains, with an assumed 43.8% and 23.8% federal tax rate, respectively.
6. Present value discount rate is 3.00% in all scenarios.
7. Hypothetical 20-year level term insurance policy has an annual premium $31,900 payable at the beginning of the year for $15 million of coverage. No assumption was made regarding term conversion or extending coverage beyond the 20-year level term period.
The private placement variable annuity (PPVA) assumptions are:
- Representative 50 basis point mortality and expense (M&E) fee reducing CLAT investment returns (actual M&E fees may be lower or higher)—net return is 6.50%.
- Annuity income, to the extent of gains, is taxed at a marginal federal income tax rate of 43.8%.
- Life expectancy for a 50-year-old male (non-smoker) in “preferred” health is 41 years. (3)
- Assumed marginal federal estate tax rate of 40% (does not include potential imposition of additional state estate taxes).
The private placement life insurance (PPLI) assumptions:
- Single carrier proxy used and may not be representative of all carriers and policies.
- Assumed 50-year-old male (non-smoker) issued at a preferred rate class.
- PPLI policy returns are assumed to be 7.00% per year net of investment management fees (hypothetical investment).
- PPLI end-of-year values include typical and customary insurance policy charges.
- Policy is funded using five equal premium payments and qualifies as a modified endowment contract (MEC).
- A MEC is created when the amount by which the contract death benefit exceeds the policy cash value or “amount at risk” is less than the minimum allowed by the IRS. A MEC does not receive the same beneficial tax treatment as a non-MEC life insurance contract in terms of policy distributions. Additional taxes may apply if a MEC life insurance policy is used as collateral. If a life insurance contract becomes a MEC while in force, adverse tax consequences may apply.
Advanced Tools for Optimizing CLATs
Private placement insurance products could provide a practical solution for ultra-high net worth individuals and their families looking to resolve the CLAT conundrum. Private placement insurance and annuity products are institutionally priced insurance products made available exclusively to accredited investors and qualified purchasers. As these are non-registered products, there is more latitude in permissible investments than their retail product cousins (and may have additional investment risks). Ultimately, the high net worth individual is trading tax friction for the insurance charge friction, which is the cost of the tax savings.
How does private placement insurance fit into and benefit the CLAT equation? The two scenarios are to employ either private placement variable annuities (PPVA) or private placement life insurance (PPLI). Incorporating these solutions into a trust demands sophisticated estate planning, but done right, the impact can be significant.
Staying with our hypothetical hedge fund manager scenario, private placement products provide an 18% to 60% reduction in the grantor income tax liability during the initial 20-year CLAT period. The tax savings are further magnified when measured against the cumulative income tax liability to the grantor over his or her lifetime (assuming a grantor trust is the remainder beneficiary). The frictional trade-off is a reduction in the present value of the residual trust value; however, when we account for the long-term impact of the additional tax friction, the holistic net benefit to heirs is increased by 18% to potentially over 80%.
The least complex private placement solution is to incorporate a PPVA, which provides low-cost tax deferral. Our hedge fund manager could realize income tax savings of $6.1 million by having the 20-year CLAT invest the proceeds inside of a PPVA on a nominal basis. The remainder value to the non-charitable beneficiary is nominally lower due to the additional charge friction of the PPVA. Accounting for the differential in taxes, PPVAs provide a superior long-term total return to heirs with the ultimate tax obligation back-loaded until the surrender of the annuity or eventual death of the grantor.
Greatly simplified, a PPVA provides tax-deferral but is not a mechanism for tax avoidance. In more detail, the tax exposures with the PPVA in this scenario are:
- Annuity withdrawals are taxed under LIFO accounting treatment. Therefore, withdrawals to fund charitable lead payments are taxed at ordinary income tax rates to the extent of gains, and an additional 10% tax penalty may apply for distributions prior to age 59 1/2.
- Annuities provide income tax deferral only as long as they are owned by a natural person or as an agent of a natural person such as a grantor trust.
- A mandatory distribution would occur at the grantor’s death which would be a taxable event.
- If the grantor dies during the CLAT term, there would be both a recapture of the CLAT income tax deduction plus taxes due on the mandatory annuity distribution— a double negative.
- An intermediate surrender of the annuity is subject to ordinary income tax to the extent of gains.
PPLI provides a more complete tax solution at the expense of additional complexity and some cost. PPLI is a true life insurance policy providing both a tax-free death benefit and tax-favorable access to policy cash values (assuming non-modified endowment contract status). Hence, unlike the annuity, the PPLI policy may be retained until the death of the grantor at which time a tax-free death benefit is paid to the remainder beneficiary. It is worth noting that as a true life insurance policy, full medical underwriting is part of the process.
Exhibit 2 illustrates this arrangement.
The projected policy values are hypothetical for illustration purposes only and may not be used to project or predict investment results. Policy value will vary based on the actual performance of the sub-account investments selected, actual insurance charges over the life of the plan, and the timing of premium payments. (4)
Tax exposures of PPLI are different than those of PPVA. The use of life insurance inside of a CLAT requires consideration of the charitable split-dollar rules. (5) These rules preclude a charity from engaging in a life insurance transaction where a benefit inures to a non-charitable beneficiary. Strategies exist to avoid the implication of these rules. In practice, they are the domain of the most erudite estate planners and tax attorneys. From a very top-level perspective, one strategy could be to use a power of substitution to “swap” assets between the grantor and the grantor CLAT after the PPLI policy has been fully funded.
A second strategy is to have the CLAT invest the corpus in a limited liability company (LLC) which subsequently invests the funds into a PPLI policy. Further, the CLAT LLC structure can be integrated into additional estate planning mechanics. For example, the CLAT and another estate-exempt trust could co-invest in the LLC. Instead of using a traditional pro-rata share of investment distribution, a preferred return or reverse freeze LLC could be used. In this scenario, a fixed preferred payment rate is paid to the CLAT with any growth in excess of the income preference paid to the common unit holders, i.e. the second trust. Since generation-skipping transfer tax (GSTT) exemption cannot be allocated toward a grantor CLAT remainder trust (due to the potential income tax recapture if the grantor does not outlive the CLAT term), a combination approach as just described could be a means to weight the ultimate remainder benefit between both an estate-exempt trust and more favorably towards a GSTT exempt trust.
Given the current tax rules and favorable market dynamics, advisors to ultra-high net worth individuals should consider reviewing grantor CLATs and their potential advantages when implemented with private placement insurance. The impetus for immediate income tax deductions may potentially be magnified by the required repatriation of offshore funds by 2017; however, the benefits of a CLAT should be counter-balanced against the increase in both personal and investment tax exposure of the grantor in light of the American Taxpayer Relief Act (ATRA). An effective grantor CLAT needs to be analyzed and implemented with a deft hand, especially when taking advantage of the additional low-cost tax efficiency solutions provided by private placement insurance.
- Section 457A
- Section 170(b)
- Society of Actuaries’ 2008 VBT Select mortality table
- Due to FINRA regulations, a hypothetical term insurance policy must be illustrated in conjunction with the CLAT in order to compare the benefits of owning a PPLI policy inside of the CLAT. The author concedes that in reality, a term insurance policy would most likely not be purchased inside of a CLAT.
- Section 170(f)(10)
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