How a lead trust pays charity first, passes the remainder to family, and uses the IRS interest rate to move growth out of the estate
A charitable lead trust reverses the structure of a charitable remainder trust. Charity receives payments from the trust for a period of years, and when the payments end the remaining property passes to the donor’s children, grandchildren or a trust for them. Families use lead trusts to satisfy charitable commitments they would make anyway, while passing appreciation to the next generation at a reduced gift or estate tax cost.
How the gift is valued
When a donor funds a lead trust, the gift to family is only the value of the remainder. The value of the charity’s lead interest is deductible for gift tax purposes under section 2522 of the Internal Revenue Code, or for estate tax purposes under section 2055 when the trust is created at death, but only if the lead interest is a guaranteed annuity or a fixed percentage of the trust’s value determined each year, as sections 2522(c)(2)(B) and 2055(e)(2)(B) require.
The remainder is valued using the interest rate the IRS publishes each month under section 7520. If the trust’s investments earn more than that rate over the term, the excess passes to the family without further gift or estate tax. Unlike a charitable remainder trust, a lead trust has no minimum remainder requirement, so the annuity can be set high enough that the remainder is valued at or near zero. A lower section 7520 rate makes that easier. Because a charitable deduction is allowed, the donor may elect the rate for either of the two months before the month of funding.
The trust may run for a term of years or for one or more lives. Under Treasury Regulation section 25.2522(c)-3(c)(2)(vi)(a) and (vii)(a), the only permitted measuring lives are the donor, the donor’s spouse, and a lineal ancestor, or the spouse of a lineal ancestor, of all of the remainder beneficiaries. A trust meets the lineal descendant requirement if there is less than a 15 percent probability, computed at funding, that anyone other than a lineal descendant will receive trust property.
Annuity trusts and unitrusts
A charitable lead annuity trust, or CLAT, pays charity a fixed dollar amount each year. Because the payment does not grow, all of the growth above the payment accumulates for the family. A charitable lead unitrust, or CLUT, pays a fixed percentage of the trust’s value revalued each year, so charity shares in the growth. The choice matters most where grandchildren are remainder beneficiaries. For a CLAT, section 2642(e) measures the generation-skipping transfer tax exemption against the value of the trust at the end of the term, which makes a precise allocation at funding impossible. A CLUT does not have that rule, and it is the usual choice for a trust that will pass to grandchildren.
The IRS has published sample forms: Revenue Procedure 2007-45 for inter vivos annuity trusts, Revenue Procedure 2007-46 for testamentary annuity trusts, Revenue Procedure 2008-45 for inter vivos unitrusts, and Revenue Procedure 2008-46 for testamentary unitrusts.
Grantor and nongrantor lead trusts
Most lead trusts are nongrantor trusts. The donor receives no income tax deduction. The trust is its own taxpayer and deducts the amounts it pays to charity out of its gross income under section 642(c). The donor’s benefit is the reduced transfer tax cost of passing the remainder to family.
A grantor lead trust works differently. If the donor is treated as the owner of the trust under the grantor trust rules, section 170(f)(2)(B) allows an income tax deduction in the year the trust is funded for the present value of the charity’s interest. In exchange, the donor pays income tax on the trust’s income every year of the term, and the same section recaptures part of the deduction if the donor stops being treated as the owner before the term ends. The deduction is subject to the percentage of income limits in section 170(b) and, beginning in 2026, the 0.5 percent floor in section 170(b)(1)(I), so the donor’s CPA should confirm its value before the trust is signed. A grantor lead trust suits a donor with an unusually large income in one year, such as the year a business is sold.
Rules borrowed from private foundations
A lead trust is a split-interest trust under section 4947(a)(2), and the private foundation self dealing rules in section 4941 apply to it. The donor and family members may not buy from, sell to, borrow from or lease to the trust. The excess business holdings and jeopardizing investment rules are excused by section 4947(b)(3)(A) only if the charitable interest is worth no more than 60 percent of the trust at funding, which affects trusts that are to hold a family business.
California property tax
Under Property Tax Rule 462.160(a), a transfer of real property into a trust is a change in ownership unless an exception applies, and chapter 3 of Assessors’ Handbook section 401 treats the present beneficiary of an irrevocable trust as the owner of the trust property. In a lead trust the charity holds the present interest, so real property contributed to a lead trust is generally reassessed on funding. Under Rule 462.160(d)(1), a second change in ownership occurs when the remainder passes to family at the end of the term, unless an exclusion applies. For that reason, lead trusts are usually funded with securities or entity interests rather than directly with real estate, and entity interests carry their own change in control rules under Revenue and Taxation Code section 64.
Case study: charitable bequests made during life
A couple in their seventies had left fixed charitable gifts totaling several million dollars in their trust, payable at the second death. They also wanted their children to receive the family’s investment portfolio with as little estate tax as possible.
Rather than wait, they funded a nongrantor charitable lead annuity trust with marketable securities. The trust pays the same charities an annual amount for eighteen years. The annuity was set so that the value of the children’s remainder, computed at the section 7520 rate for the month of funding, was close to zero, and the gift tax return reported a small taxable gift. The charities now receive support during the couple’s lives rather than after them, and any return on the portfolio above the section 7520 rate over the eighteen years will pass to the children’s trust without estate tax. The couple’s trust was amended to reduce the charitable bequests by the amount now committed through the lead trust. Their CPA prepared the gift tax return and projected the trust’s own income tax under section 642(c).
How we can help
Worden Williams designs charitable lead and remainder trusts and coordinates them with the rest of the estate plan. We work with the family’s CPA on the valuation and the returns, with the financial advisor on the investment policy the term requires, and with the charities on their acceptance of the gift.
This article is general information about California and federal law as of its date. It is not legal or tax advice and does not create an attorney-client relationship. Case studies are composites drawn from the kinds of matters the firm handles; names, places, amounts and other details have been changed, and the result in any matter depends on its own facts. Tax results should be confirmed with your CPA. Responsible attorney: Tomer T. Gutman, Worden Williams LLP, 462 Stevens Avenue, Suite 100, Solana Beach, California 92075, (858) 755-6604.