lead trusts

Chariable Lead Trust Revolution!

Apparently I missed an unbelievable revolution in the charitable lead trust arena, by about 10 years! (and so did most of the rest of the planning community)

At yesterday’s PPGGNY’s planned giving day, I heard Paul S. Lee, JD, LLM, National Managing Director of Bernstein Global Wealth Management, talk about the so-called Shark-Fin Lead Trusts.

There is no way I can do justice Lee’s presentation.  Myself, a self-proclaimed lead trust guru (having worked heavily on three lead trusts that actually came to fruition), didn’t think there was much new under the sun with these planned giving vehicles – but I was very wrong.  I am going to try and summerize in shortest form the innovations he talked about (at least the ones I grasped) and give you a link to a recent paper Paul wrote on the topic (for the die-hard planners out there).

Firstly, if you are not sure about lead trusts in general, read this piece:  Understanding Charitable Lead Trusts (this is my own primer on the topic).  If you don’t have patience for my comments, here is Paul Lee’s article on the so-called Shark-Fin Lead Trust:  BNA_TM_SharkFinClats_1210  Here is another more recent outline:  PSL CLAT Outline (Jun 2011)

So, what did I learn new?

Number 1:  It is totally fine and standard to create a lead trust with laddered payments to charity.  In other words, you can create a lead trust in which payments start at $100K in the first year, jump to $120K in year 2, and keep jumping (any pattern should work even though using 20% incremental jumps has a greater history and is a bit more “standard” than more extreme patterns – as you will see).

Why is this important?  Paul showed us a very important chart regarding lead trust investments.  Guys like me always make projections with flat returns during the term of a trust (I know it is unrealistic but it is the simplest way for me to see generally what might happen with a trust).  In truth, investments in the stock market fluxuate (and yes, over time, you will get that nice average 9% return so says every decent investment presenter I have seen). With lead trusts, typical market fluxations could help or destroy your lead trust. If you start off your lead annuity trust with one or more of the bad investment years (that do happen), your trust might lose too much principal in its early years to catch up during the good investment years (which also happen but maybe too late).  Laddering payments to charity (smaller payments in early years) gives the lead trust much greater chances to succeed by giving your lead trust investments time to catch good investment years in the early years of the trust, which then can carry the trust through good and bad years until the end.

Paul used an amazing example of how this concept works.  He took the last 10 years of returns from the S & P 500 and used them as the investment results of an imaginary lead trust.  The average return over the time period was over 9% – great for lead trust success, right?  Not necessarily.   One column used the S & P 500 returns as they actually occurred and the result was good – money to charity and left overs for children.  The next column, he inverted the annual returns using the most recent years as the early years of the lead trust and guess what?  The trust failed – exhausted its assets.

And, this technique is not bad for charities.  Even if the charity gets less upfront, the present valuing of the income stream of a laddered lead trust requires more money to actually to go to the charity (albeit delayed).

Number 2: Paul humorously recounted how he ignored an email in 2007 announcing that the IRS had issued template Charitable Lead Trust forms.  I also ignored that piece of news – why would an attorney use the IRS’s typical not so great forms.  Well, contained within that 2007 lead trust Rev. Proc. (Revenue Procedure announcement) was a clear statement from the IRS that the income stream to charities under lead trusts needed only to be ascertainable.  In other words, lawyers had been using the GRAT model of 20% increases in annuity payments – not even 100% sure the GRAT rules applied to lead trusts.  Now, this Rev. Proc. says that there is no maximum annual increases like GRATs, rather, just as long as you can calculate the present value of the income stream to charity.  In other words, the Shark-Fin Lead Trust.

The Shark-Fin – I have no idea why that silly name.  How about naming it the Push-The-Envelope Lead Trust.  What is it?  Example: $1,000 a year for 19 years to charity and a balloon payment of $20 million in the last year.

Ok, Paul described some wild reasons why this might work.  But, also described why it didn’t work.  I wish I could write for hours on the whys – I just don’t have the time and Paul himself wrote the article if you want details.  Here is the link again:  BNA_TM_SharkFinClats_1210

Third big piece of news:  under Paul’s illustrations, he made a very strong argument that a lead trust is actually a better estate planning vehicle (especially the charitably minded but not necessarily) today than the other standards (GRATs, etc..).  A very bold statement since I always start with the premise that you will be better off, dollar for dollar (if your goal is strictly money in your hands and that of your heirs), with non-charitable vehicles.  He had a point and that makes his article worth reading if you are a non-charitable planner.

Last thing I learned (or at least confirmed):  Harldly anyone does these things (but for some super wealthy who trust guys like Paul).  Why?  Other options can be done without losing, just try it, and failure only means you start again.  Failure with a lead trust means that the trust ran out of money, charity doesn’t get everything promised, family gets nothing, and donor may have used up some of his precious lifetime giving exemption on a technique that failed to pass anything to the kids.

This leads to the one point I would have raised with Paul had I not glazed over in the last part of his presentation about insurance schemes built into lead trusts and stuff about private equity (no clue where he was going on that):

Paul noted that lead trusts were considered a risky wealth transfer option since no one wanted to do it with a reportable gift against their lifetime exemptions (therefore the investment rates needed for success are very high to offset a “gift” – called the zero’ed out lead trusts).  I wanted to ask him about this year and next being great years for individuals to max out their lifetime giving of $5 million each spouse.

Why not create a lower payout lead trust? That would require the filing of a gift against your lifetime exemption but would be much easier to guarantee good results for both the charity and the family.  Instead of a 7% payout to charity, make it a 3% payout to charity and report a gift to children of up to $5 million.  Then pick a conservative enough investment so that everyone can sleep well at night.

One last word.  Based on this speech, I might say that an attorney or financial advisor that is already guiding clients towards lead trusts, better offer some sort of laddered payment option or he or she might be guilty of malpractice (or at least giving poor advice).

Charitable Deduction for Donating Use of Space? Lead Trust solution?

Yesterday’s question of the day:  donor is letting charity use space rent free.  Can he take a charitable deduction?

Answer: no.  Partial interest rule problems here.  Generally, unless you give an undivided ownership interest in something, you aren’t entitled to a deduction.  Some exceptions to this rule but not here.

Of course, the nonprofit has a reliable source saying it is possible so they put me in touch.

Here is what we discussed.  What if the donor puts the property or a percentage of it (or shares of LLC) into a charitable lead trust (see prior posts on lead trusts or http://plannedgivingadvisors.com/wp-content/uploads/2011/03/understanding-charitable-lead-trusts.pdf for more info on these).  Let’s say it is a Grantor version, meaning that the property interest reverts back to the donor at the end of the term.  Assume the payout to the nonprofit from the lead trust is the same as the value of the rent the charity isn’t paying.  On paper, lead trust pays the charity the amount they should be paying in rent – sounds like a wash.

What’s wrong with this scenario?  (putting aside the fact that I don’t even know how it is owned or anything about it so the discussion could be a nonstarter anyway)

Well, the donor could take as a charitable deduction the present value of the payment stream to the charity – there is your deduction! Mission accomplished? No.

What I told this reliable source is that this is a Grantor trust.  That means that the Grantor owns it, pays taxes on it (and there is no offsetting of the trust’s income from the lead trust payments to charity because the donor takes credit upfront for those charitable payments).

In more simple terms, what this Grantor trust will do is create is phantom taxable income to the donor for the value of the phantom rent payments from the charity.

So, the trade off would be:  donor gets upfront deduction but has to pay tax in rest of the years of the trust on rental income (that he isn’t seeing).

I don’t think the donor want’s his tax deduction so badly that he’s willing to pay income tax on the “rent” payments that he isn’t receiving from the charity.

We’ll see about this one.  There are about 1 million and 1 reasons why this will never happen but maybe it will lead to a more sane gift proposal like a percentage interest in the property!  That is a deductible gift that will not cause phantom income and in fact, could lower the donor’s annual tax bills by the assignment of a percentage of income to the charity (which by the way he doesn’t actually has send as cash since charity’s payment is the free rent!).



New Lead Trust Opportunities Created by Tax Relief Act?

Among all of the variables created by the Tax Relief Act of 2010, one yet to be addressed in this blog is a much improved environment for Charitable Lead Trusts.

Normally, I cringe at hearing anyone tout Lead Trusts.  Not that I don’t love them – who wouldn’t in the nonprofit world since they are the planned gift that pays the charity now and has the family wait for their share after the term of the trust.

My problem with Lead Trusts has been their promotion by people completely ignorant of how they work.  Also, they are rare.  The IRS reports only around 6,000 of them currently in operation – most of which have been around for a while.  A few hundred new ones a year, maybe, across the country?  Low discount rates or not, they just don’t happen very often.

Rather than go into a full discussion of how they work, I will link here an article written two years  ago (a little dated but still applicable concept-wise) that gives you all of the details and why they are so challenging: Understanding Charitable Lead Trusts (click on it to download!).

The point of raising this issue again came from Robert Sharpe. He mentioned the use of lower rate Lead Trusts.  This is brilliant and I will explain why.

In the past, wealthy individuals were leery of using any of their Federal lifetime gifting exemption on Lead Trusts because the exemption wasn’t so high and if the Lead Trust failed to produce a gift to the family, you would have used the exemption for naught.

So, planners were forced to create what we call “zero’ed out” Lead Trust illustrations for Lead Trusts that would produce little or no gift tax reporting.  In other words, the trust has to pay higher and/or over a long period so that the value of the “gift to family” is essentially zero.  Problem with this is that it required Lead Trust payments of 10% or higher and/or 20 year or longer terms, or a combo of high payout and long term trusts.

When it came down to making a decision, there just seemed to be too much risk that the trusts could not produce enough guaranteed returns to guarantee the family any benefit.  In many cases, the family was bettor off making a multi-year pledge, taking the income tax deductions (which, by the way were lost if they did a Lead Trust), and passing assets to heir with other means.

What changed?  With a $5 million gifting window (to children and even grandchildren), and a chance that it will go down in two years (to as low as $1 million if there is gridlock in Congress – not so far fetched), now might be a time to structure a Lead Trust using some or all of the lifetime exemption amounts.

In other words, it is suddenly good advice to use that $5 million gifting opportunity NOW, instead of waiting for the ShangriLa of permanent estate tax repeal (i.e. not happening in our lifetime).  Financial advisers should be counseling their clients on methods to use the exemption while it is high and Lead Trusts are a prime method (because they combine discounting of the gifts, time delay, and philanthropic goals).

Here is an example that should drive this point home.  I just ran numbers this week on a $5 million Lead Trust, paying 3% ($150,000 a year) for 20 years.  The reportable gift is around $2.8 million.  Not a bad use of one’s lifetime exemption since with 3% payouts, there is a much greater likelihood of success for the family.  You could even invest in conservative,  long-term fixed income investments and see a nice remainder for the family.  And, the donor gets credit for a $3 million gift.

The point is that this type of planning (more conservatively structured Lead Trusts) is new with the Tax Relief Act and something nonprofits need to understand and introduce to their top prospects.