A wealthy friend meets with you and shows you a letter from his alma mater announcing its fund raising campaign to build new dormitory wings named after alumni donors. In a letter sent by the president of the university and the chief development officer, various philanthropic techniques are described. Featured in the menu are Charitable Lead Trusts and Charitable Remainder Trusts. The letter states, "Please consult with an attorney or accountant."

"What Do You Think?"

Your friend turns to you and says, "I've never asked your advice about this before, but you know my financial condition, what do you think?"

Not having previously tested the waters, what you think depends upon what you have found and will find in your library. You look for articles that link these trusts to your friend's estate plan. You skim through your CCH, Prentice Hall, and BNA volumes for specific references. Then you run through your journals of taxation and estate planning for articles on estate and income tax aspects of philanthropy.

You learn that the Charitable Remainder Trust (CRT) and the Charitable Lead Trust (CLT) are both creations of the Tax Reform Act of 1969. By definition, both trusts are required to provide a guaranteed annuity or unitrust. According to IRC Sec. 7520 enacted in 1990, the valuations of the interests of both the CLT (income to charity, remainder to heirs) and the CRT (income to donor, remainder to charity) are measured by 120% of the Federal Midterm Interest Rate (AFR), published monthly.

Then you read an article promising a zero transfer tax if the CLT is properly structured. You have always searched for the better estate and income tax planning device, and since interest rates are being drastically reduced to stimulate the economy, your research has brought you to the window of opportunity with the lowest AFR interest rate (7.43%) since publication started.

In 1983, IRS interest and valuation tables rose from 6% to 10%, making the annuity required for zero basis unachievable. Throughout 1990 and until October 1991, the AFR interest rate was never under 9%.

An annuity of only 9.75% for the maximum period of 20 years (including amortization of 2.32%) payable quarterly, would give the income interest a value of 100%, leaving the remainder interest valued at zero. As a result, your friend could transfer 100% of his principal to his heirs, after payment of 20 years of income to the charity, free of estate and gift tax.

With such an outcome, why does the literature make the CRT such a popular device for estate and income tax planners while the lesser used CLT is regarded as great for the charity but not so great for the donor?

The Benefits of a CRT

Your research reveals compelling reasons for the CRT's popularity:

1. The donor can create income tax deductions for a charitable gift without surrendering any money and while retaining income for life.

2. The donor can make a gift of a low basis asset and realize its current value without a capital gains tax through the CRT, which is tax exempt.

3. The cash from the tax deductions and retained income can enable the donor to buy life insurance that can be owned by the donor's heirs either directly or by irrevocable trust to compensate them for the assets which will pass to the charity at death.

4. The IRS has encouraged use of the CRT by issuing Rev. Rul. 88-81, which actually sets forth acceptable forms and provisions.

The Limitations of a CLT

In addition, there are limitations on the use of the CLT:

1. In providing an annuity to charity with remainder to the heirs, the CLT donor has to irrevocably part with funds without any short-term cash flow benefits. The CLT is not tax exempt and its creation does not give income tax deductions to the donor unless it becomes a "Grantor Trust," at the impractical cost of having all of its income attributed to the donor.

2. The ability to receive a zero basis will require an income commitment of 20 years before the remainder interest passes to the heirs. Few donors will surrender their funds on that basis.

3. Unless interest rates are low enough to achieve zero basis, the remainder interest will be subject to gift tax.

The CLT Window is Opened

When 120% of the AFR interest rates dropped to 7.43% in February 1992, an annuity of 9.75% became a feasible objective. However, the same climate that reduced interest rates also reduced the investment income necessary to fund the annuity payment. In light of this new opportunity, you make a preliminary comparison of the after tax results of the CLT and CRT, which reveals some surprising advantages for the CLT:

1. There is a complete reversal in income tax roles; the tax-exempt CRT pays an annuity to the donor for life, of which the income component is taxable. The CLT, which is a taxable entity, pays its income commitment to the tax exempt charity, and is taxed only to the extent that its income exceeds the annuity.

2. There is a powerful estate planning advantage built into the CLT. If the annuity is sufficient to achieve 100% valuation and estate and gift tax deduction, the remainder interest gets a zero basis. When the annuity is earned and corpus is kept intact, it passes free of estate and gift tax to the non-charitable beneficiaries after the annuity period. Earnings in excess of the annuity can accumulate and also pass free of tax. In contrast, the annuity paid to the donor by the CRT, after income tax, is subject to further estate tax at the donor's death.

Compare the Benefits

The after tax differential of the combined benefits to donor, charity, and heirs can be seen for a donor, age 65, who gives $100,000 in trust, retaining an annuity for life (assumed to be 20 years), then to the CRT charity. Compare this with annuity payments for 20 years to the CLT charity, remainder to donor's heirs. Assume 9.75% is earned by each trust, and the $600,000 Unified Credit is not a factor.

* The CRT donor can get income tax deductions of $38,304, worth $11,874 maximum in cash. The CLT donor gets no deduction.

* The CRT donor can receive $9,750 annually, of which $7,430 is subject to income tax. In 20 years, he will receive $195,000 (not compounded) less 31% x $148,600 ($46,066) plus $11,874, equalling $160,808. After estate tax at 55%, $72,364 will pass to the heirs. The CLT heirs will receive $100,000 free of estate tax.

* The CRT charity can receive $100,000 after 20 years, while the CLT charity can receive $195,000 (uncompounded). Total CRT benefits are $172,364. Total CLT benefits are $295,000.

Now comes the acid test: Assuming .5% in administration costs, are there prudent investments such as "investment quality" bonds in the current market that can earn 10.25%? if not, and lower quality bonds can be found to provide 10.25%, would they be deemed "jeopardizing" and incur an IRS penalty tax?

Sec. 4944 lists commodity trading, oil and gas, options, venture capital, and land as types of "jeopardizing investments," with no reference to bonds. Although the IRS requires "prudent man" behavior and diversification in different investments, they are inclined to accept "less than investment quality" bonds sold on the exchanges, if they are not what the IRS information officer in Washington calls "junk bonds." A letter ruling from the IRS regarding valuations and jeopardizing investments for the initial trust portfolio should be obtained before any funds are committed, and should be neither difficult nor expensive to obtain.

It is time to consult your friend's investment advisor on the merits of investing in "less than investment quality" bonds.

The prospect now looms that the investment vehicle required to achieve the proper return may pass the IRS tests but fail to be a sound investment. When you discuss it with professional advisors, they will point out that the blessing of making a commitment to pay out the annuity at the present low AFR rate becomes a curse as interest rates rise in the future and the market value of the bonds diminishes. They will also refer you to Standard & Poor's Bond Default Study, which shows an 18.75% default rate for BB bonds over a 10 year period (and you are proposing a 20 year period).

Assuming the after tax advantages achieved by a zero basis, can you find a compromise in reducing the payout rate, giving up the concept of zeroing out, and still be effective? Here the CLT is at a decided disadvantage when compared with the CRT, since any diminution of payout rate or length of years of the trust increases the value of the remainder interest and leads to a taxable gift.

By now, the comparison has strongly swayed in the direction of the CRT. The creation of a trust by document only, before the first payment or receipt of money, will create an income tax advantage, (i.e., the deduction of the remainder value) to the CRT and a gift tax cost (to the extent of the remainder value) to the CLT.

After extensive meetings with your friend's lawyer, the university's development officer, and expert counsel to the university, and after all of the pros and cons have been discussed, the decision is made to proceed with the CRT, using life insurance as the replacement vehicle for the remainder interest. Since there is a choice of insurance products, an insurance service company should be found with its own menu of available policies and companies. In assisting in the choice, you will soon be made aware that survivorship policies are the best value and that a single payment policy can often be purchased by payment to a life insurance trust using the gift tax exclusions available between husband and wife and other beneficiaries.

When the joint planning decisions are on the verge of being finalized, there will come the moment when your friend will say, "Well, have we thought of everything?" It is at this point that your friend's lawyer, the specialist lawyer for the university, and the planning officer will turn to the accountant and say, "What do you think?"