A CLAT / Grantor Trust provides the best of both worlds; an immediately income tax deductible charitable donation and tax-free income for children and a legacy for grandchildren.

Recently, the Heckerling Institute at the University of Miami, School of Law held its 49^th annual conference in Orlando, FL, attended by 3000 estate tax attorneys, accountants and advisors. Many of the Heckerling programs moderated by the leading estate tax attorneys in the country focused on the importance of income tax planning. As a consequence of the enactment of the American Taxpayer Relief Act of 2012 (ATRA) and the permanency of the relatively high federal estate, gift and GST tax exemptions, only a very small number of estates will be subject to these taxes.  For that reason, income tax planning has become more important for individual estate plans.

With respect to the federal income tax rates, ATRA increased the top individual, trust and estate tax rates from 35% to 39.6% and the top capital gain and dividend tax rates from 15% to 20%.  The Affordable Health Care and Patient Protection Act (commonly known as Obamacare) imposed an additional 3.8% surtax on net investment income (i.e., the threshold for married taxpayers filing jointly is AGI in excess of $250,000). This tax also applies to trusts with taxable income in excess of $12,300, increasing the highest trust federal income tax rate on interest to 43.4%.

Charitable Lead Annuity Trusts (CLATs)

Due to very low section 7520 and AFR rates, now is an ideal time to consider creating and funding a Charitable Lead Annuity Trust (CLAT) as a means of generating a large charitable income tax deduction while minimizing the gift tax value of the remainder interest left to the beneficiaries. In the following case study, designed by a Florida law firm, a husband and wife want to make a sizable income tax deductible contribution to charity while providing tax-free income to their children and a legacy for their grandchildren. They achieved this result by creating a CLAT with a grantor trust receiving the projected remainder interest income, gift and estate tax free.

Grantor Trust Funded with Life Insurance

In this scenario, a grantor trust (created by husband and wife), the beneficiary of the CLAT purchases two $2,000,000 individual 10 pay whole life policies.  (Mid-Term AFR of 1.70% for 9 years). These contracts are designed to create a “paid up policy” that is not treated as a modified endowment contract (MEC) as defined in Section 7702A. Once these contracts are “paid-up” and meet the DEFRA requirements, the future growth and income can be accessed income tax-free. 

A $400,000 loan from the grantors is used to fund the life insurance premiums for two years to avoid making additional gifts to the trust. The remainder interest of the CLAT is projected to be $2,353,269 (7.00% IRR), more than sufficient to pay the additional premiums to fund a “paid-up” policy as well as repay the grantors’ loan.. In year 11, when the CLAT terminates, the beneficiaries, son and daughter, will receive over $2,800,000 in projected dividends.  Subsequently, upon the death of their parents, the grandchildren will receive guaranteed life insurance proceeds of $4,600,000. (2015 Mass Mutual dividend rate – dividends are NOT guaranteed)

Grantor Trust Benefits

1. Guaranteed Tax-Free Income for Beneficiaries – DEFRA, TAMRA, Sec 7702A
2. Guaranteed Life Insurance – Income Tax-Free Life Insurance for Grandchildren
3. Asset Protection – Cash Value of Life Insurance Protected from Creditors in 43 states
4. Customized Plan Design – Min/Max Flexibility on Annual Contributions
5. No Roth IRA Income, Contribution or Withdrawal Limits
6. No Annual Fees or Surrender Charges

• 2015 Mass Mutual Dividend Rate – Dividends are NOT guaranteed                                  

Summary

CLATs provide the means to make tax deductible gifts to charities, universities and non-profit organizations while transferring assets to children at a significantly reduced gift tax liability. At the outset, the charitable organization receives a stream of income for the term of the trust.  At the end of the term, the remainder interest passes to the beneficiaries; income, gift and estate tax-free. However, due to the estate tax inclusion period (ETIP) rules, the allocation of the GST exemption must be made at the termination of the CLAT.

By creating a separate grantor trust to be the beneficiary of the CLAT funded with a guaranteed “paid-up” policy, the grantor can achieve the following goals:  (1) a sizable current year charitable donation deductible with amounts in excess of the deductibility ceiling potentially carried forward as a deduction for up to 5 years; (2) tax-free income to the grantor’s children; and (3) a legacy for grandchildren.  With the Section 7520 and AFR rates at historical lows, today is a particularly advantageous time to create CLATs.

In addition, real bond yields are much lower than historical averages. Treasury rates of return are below current and projected inflation rates and the nominal rate of return on 10-year treasuries is currently less than 2.00%. Historical data suggests that the current market price is the best estimate of future bond yields resulting in a low yield environment for years to come. Using 10 pay participating whole life contracts rather than fixed income portfolios in trusts will provide beneficiaries a much higher rate of return and a tax-free stream of income. A number of mutual insurance companies underwrite participating polices, combining contractual guarantees with tax-free distributions. Included in this number are four major mutual life insurance companies all licensed in New York State; Mass Mutual, Guardian, NY Life and Northwestern have excellent financial ratings, strong statutory surplus and long histories of paying dividends to its policy holders.  

Combining a CLAT with a Grantor Trust, funded with the most tax-advantaged vehicle in the tax code, life insurance, creates the best of both worlds.    

G. Dean Goodwin, CLU, AEP founded Granville Associates in 1987, an independent firm that provides insurance funding for tax-advantaged alternatives to traditional supplemental executive retirement plans (SERPs) and non-qualified deferred compensation (NQDC) programs. Granville Associates also works with a number of private banks, attorneys, accountants and family offices across the country to provide insurance solutions to maximize wealth transfer to future generations. Mr. Goodwin worked with Citizens Financial Group (CFG) and the Royal Bank of Scotland (RBS) in the initial development and implementation of premium financing arrangements, used to maximize wealth transfer by leveraging gift tax exemptions and creating tax-free liquidity for GST trusts (GST), grantor trusts and irrevocable life insurance trusts (ILIT).