Getting More Assets to Family Members Under a CLAT

A Charitable Lead Annuity Trust (CLAT) is an estate planning tool, whereby a taxpayer transfers assets to a trust. The trust provides that a fixed annual amount will be paid to a charitable organization for some period of time, and then anything left in the trust at the end of the charitable term gets paid to the remainder beneficiaries, which are often members of the taxpayer’s family.

These trusts are typically structured as "nongrantor" trusts, so that the funding taxpayer does not have to pay the income taxes on the income of the trust during the trust term. However, by being a nongrantor trust, the funding taxpayer does not get an income tax charitable deduction for funding.

These trusts are also often structured to be "zeroed-out." This means that the amount to be paid to the charity during its lead interest is high enough, so that on an actuarial basis nothing is expected to be transferred to the remainder beneficiaries because it will have all been previously transferred to the charity. This is done to avoid an up-front taxable gift to the remainder beneficiaries. However, by structuring in this manner, there is a good possibility that if the investments of the trust do not outperform the applicable IRS interest rates, there will in fact be nothing left for the family members at the end of the charitable term.

In a recently published article, Glenn Kurlander discusses a method for getting more assets to the family remaindermen method without increasing the tax cost. His proposed structure is that the trust will be a grantor trust, so that the funding taxpayer receives an income tax deduction on funding. To the extent of the taxes saved on funding, he would structure the trust to not zero-out the remainder interest, but to allow a taxable gift that generates an amount in gift taxes equal to the income tax savings. Since the gift taxes and the income tax savings net each other out, there is no net cost to having a greater amount going to the family remaindermen. This enhanced gift to the family remaindermen occurs by lowering the amount paid to charity and thus increasing the actuarial value of the remainder interest, and thus also the amount that which will eventually pass to the remainder beneficiaries. While Mr. Kurlander indicates this technique is only useful to those who have already used up their gift tax unified credit so that the gift generates a gift tax, it should likewise provide the same net benefits even if the gift tax portion of the transaction is covered by some or all of the gift tax unified credit - in this situation, the income tax savings compensates the funding taxpayer’s estate for the loss of the unified credit and thus future increased estate or gift taxes.

What about the funding taxpayer now being taxed on the income of the trust? This tax is avoided by having the trust invest in municipal bonds, which are not taxable. A laddered portfolio would be used to maximize interest and reduce risk. While not discussed in the article, such investments may need to be specifically mandated in the trust instrument to avoid issues of allowable investments under the Prudent Investor Rule and similar state law concepts of fiduciary investment.

Kurlander, Glenn, The Family Centric CLAT Can Provide More for Remainder Beneficiaries, WGL Estate Planning Journal, January 2006

You Be the Judge - Litigation Settlement Proceeds

Facts: Taxpayer-employee sued his employee for various damages. The employee and the employer settle the lawsuit, and taxpayer-employee is paid $40,000, less tax withholdings. The taxpayer claims the payment was to compensate him for a physical injury so that it was not taxable to him. The settlement agreement between the employer and the employee does not indicate the proceeds were paid to compensate the employee for physical injury.

The Law: Code Section 104(a)(2) provides an exclusion for "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness."

The Issue: Can the employee deduct the payment if the settlement agreement doesn’t say it was for physical injury?

The Holding: No deduction allowed. The Court noted that a taxpayer seeking to exclude money damages from income bears the burden of proving that the exclusion applies. The fact that the settlement agreement did not indicate the payment was for physical injury meant the taxpayer did not bear his burden of proof.

The Lessons:

a. Make sure your settlement agreement describes what the settlement payment is for, if you are trying to claim that the proceeds received are of a type that are not subject to income tax.

b. Where the settlement agreement is silent, a court may look to the original complaint and pleadings to see what damages the claimant was originally seeking. Make sure your complaint has the description of the claim that you want the settlement proceeds (or indeed, an ultimate court judgment recovery) to be characterized as.

Rivera V. Baker West, Inc., 96 AFTR 2d 2005-XXXX, (CA9), 12/13/2005.

It's Not to Late for a 2005 Charitable Deduction!

For all procrastinators out there, it is not too late to make a charitable deduction in 2005 and receive an income tax deduction. If you put a charitable deduction on your credit card in 2005, you can deduct it in 2005, even though you do not pay your credit card bill until 2006. (Rev.Rul. 78-38)

For assistance in finding charities that accept credit card donations, check out the website of Network for Good.