Charitable Lead Trust

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1 APRIL 2015 Charitable Lead Trust A charitable lead trust is a trust with both charitable and noncharitable beneficiaries. It is called a lead trust because the charity is entitled to the lead (or first) interest in the trust assets, and the noncharitable beneficiary receives the remainder (or second-in-line) interest. The operation of a charitable lead trust is almost the opposite of a charitable remainder trust. Every year during the trust s term, the charity receives payment from the trust s assets. At the end of the trust s term, the remaining assets pass to the noncharitable beneficiaries, who are often children. There are several types of charitable lead trusts. The two most often used are: GRANTOR LEAD TRUST The grantor is treated as the owner of the trust assets for income tax purposes. The grantor receives an up-front income tax charitable deduction when the trust is funded, but the grantor must pay income tax on the trust s earnings annually, even though the grantor does not receive the income. NON-GRANTOR LEAD TRUST The grantor does not receive an income tax charitable deduction, and does not pay income tax on any income earned during the term of the trust (the trust pays the income tax, if any). The grantor will receive a federal gift tax deduction equal to the present value of the income interest going to charity. A charitable lead trust can be established to take effect either during life (an inter vivos trust) or at death (a testamentary trust). A charitable lead trust operates in an identical manner in either situation.

2 How Does a Charitable Lead Trust Work? With a charitable lead trust, the grantor does the following: Consults with a qualified estate planning attorney Chooses a qualified charity to receive income during the term of the trust Identifies a noncharitable beneficiary (usually children) to receive the remaining assets once the trust is terminated Decides on how much money the charity will be paid each year from the trust assets. This payment can be either an annuity amount (Charitable Lead Annuity Trust), which is a fixed amount of the initial fair market value of the trust assets, or a unitrust amount (Charitable Lead Unitrust), which is a specified percentage of the value of the trust assets based on an annual revaluation of the assets Determines how long the trust will last; it can be for a term of years or for the life of an individual who is then living Funds the trust with assets such as cash, securities, real property or tangible assets (though these would need to be sold to produce income) At the end of the stated period of time, any remaining trust assets pass to the noncharitable beneficiary. Assets Typically Used to Fund a Lead Trust Cash or other non-highly appreciated assets Income-producing assets with high appreciation potential this allows the transfer of the appreciation in those assets to beneficiaries at a very low cost Suitable Clients High Net Worth Individuals A client may want to consider establishing a charitable lead trust if the client: Has investable assets of $5,000,000 or more Is currently making significant contributions to a favorite charity Seeks to make future gifts to family at a significantly discounted gift tax cost Owns assets expected to appreciate substantially in value Wishes to reduce the value of his or her estate to help minimize future estate tax liabilities faced by his or her children Does not need the income from the assets being donated Seeks a large current-year charitable income tax deduction Choosing Your Trustee The trustee you select to handle your charitable lead trust will be responsible for administering the trust and investing the trust portfolio. Your trustee must also carry out the terms of the trust correctly for many years. Some of the responsibilities your trustee must handle include: Calculating and making trust income payments Meeting tax reporting and compliance requirements to ensure continued tax-exempt status of the trust Keeping records of the trust s assets Providing answers to questions you or your beneficiaries may have. 2 MORGAN STANLEY 2015

3 How a Charitable Lead Trust Works GRANTOR (YOU) 1 Trust is funded 2 CHARITY Income goes to charity first 3 Balance to grantor or grantor s family GRANTOR OR FAMILY ADVANTAGES Substantially reduces the gift/estate tax value of the gift to heirs because the gift is a discounted future interest Allows grantor to donate to charity but also to keep trust assets within the family Allows grantor to postpone the noncharitable beneficiary s receipt of the trust assets Allows grantor to control the payment method, term of the trust and beneficiaries DISADVANTAGES No income tax deduction unless grantor is also the owner of the charitable lead trust Irrevocable commitment Requires the charitable payment to be made each year, regardless of whether there is sufficient trust income available No guarantees of future appreciation for heirs Helps to minimize grantor s taxable estate, thus potentially reducing federal estate tax liabilities 3 MORGAN STANLEY 2015

4 Examples and Considerations (Examples are for hypothetical use only.) Example 1. Grantor Lead Trust Mike and his wife Carol have a net worth of approximately $8,000,000. They enjoy the fact that they can make substantial annual donations to the local hospital. They have had an income windfall during the year and would like to have an offsetting tax deduction. After meeting with their financial advisor and estate-planning attorney, they decide to establish and fund a grantor lead trust with $2,000,000. The trust will last for 20 years and names their children as the noncharitable beneficiaries. Mike and Carol specify that the payout rate to the charity will be a fixed 5% annuity amount. The result is that every year for 20 years, the charity will receive a payment of $100,000, which is 5% of $2,000,000. After 20 years, any remaining assets in the trust will pass to their children. Mike and Carol s charitable contribution will net them an income tax deduction of approximately $1,635,140 based on an assumed IRS discount rate of 2%. This rate is provided by the IRS on a monthly basis and affects the computation of income, gift and estate tax charitable deductions for transfers to most charitable trusts. The value of the noncharitable beneficiaries interest (Mike and Carol s children) is determined by first calculating the value of the charity s interest. This is done using special IRS tax tables. The charity s interest is then subtracted from the total trust assets to arrive at the noncharitable beneficiaries interest for gift tax purposes. The present value of all payments to their charity equals $1,635,140, based on an assumed IRS discount rate of 2%. The present value of the remainder interest ($364,860) is a taxable gift to Mike and Carol s children; potentially giving rise to gift tax. However, assuming the trust s assets appreciate more than the IRS discount rate, Mike and Carol s children will receive an amount in excess of the present value of remainder interest without any additional gift or estate tax ramifications. Caution: The charitable income tax deduction is subject to rules that may limit or reduce the amount that can actually be claimed on an income tax return. Example 2. Non-Grantor Lead Trust Your Financial Advisor Your Advocate By utilizing our corporate trustee platform for your charitable lead trust, a unique, interactive relationship begins in terms of putting your planning efforts into motion. As a local contact, your Financial Advisor is someone to turn to for financial advice. He or she not only works closely with you and your attorney, but also with the trust professionals at Morgan Stanley. Your main contact, however, is your Financial Advisor. He or she knows you best and is your advocate in helping to achieve your specific goals. Mary is committed to her school s new Arts Center and wants to be a major contributor during her lifetime. She also has a significant taxable estate and wants to leave some of her wealth to her children. After meeting with her professional advisors, she establishes and funds a non-grantor lead annuity trust with $2,000,000 for 20 years. Using a 5% annual payout rate for the charitable contributions, Mary s college will receive $100,000 each year for the term of the trust. The present value of all payments to her college equals $1,635,140, based on an assumed IRS discount rate of 2%. The present value of the remainder interest ($364,860) is a taxable gift to Mary s children; potentially giving rise to gift tax. However, assuming the trust s assets appreciate more than the IRS discount rate, Mary s children will receive an amount in excess of the present value of remainder interest without any additional gift or estate tax ramifications. Caution: If grandchildren are named as the noncharitable beneficiaries of a charitable lead trust, generation-skipping transfer tax (GSTT) issues may arise when the trust term ends. Example 3. Testamentary Lead Trust John established a 10-year charitable lead trust in his will, with the remainder to his friend Dave. Assume that the present value of the charity s lead interest is determined to be $1,000,000. The result is that John s executor will be entitled to subtract $1,000,000 from the value of the gross estate. This amount would otherwise have been included in John s taxable estate. 4 MORGAN STANLEY 2015

5 Morgan Stanley s Open Architecture Trustee Platform Morgan Stanley s approach for trusts may differ from that of other financial institutions. We recognize that trusts are a vital part of your overall financial picture one that warrants a strong commitment to you. Our trustee platform is open architecture, meaning that we provide you with access to an appropriate third-party corporate trustee for your trust account. Trust Specialists within Morgan Stanley analyze client trust documents and situations and then suggest a fiduciary solution for your needs and goals. Your Financial Advisor may provide investment management services for the trust account using the investment management resources and strategies available through Morgan Stanley. We will help to identify a trustee partner who is the best fit for your charitable lead trust and your particular planning needs. Throughout the process, you maintain your relationship with your Morgan Stanley Financial Advisor. What Your Corporate Trustee Provides Our third-party corporate trustee partners all have experience managing charitable trusts. As trustee, some of the administrative and fiduciary services they will provide include: Assigning a professional Trust Officer to administer the trust Recordkeeping for all trust transactions and activity Calculating initial and ongoing annuity or unitrust payments Assuring the disbursements from the trust are made in accordance with the trust agreement and state and federal tax laws Issuing monthly/quarterly statements that reflect trust assets, transactions and receipts/disbursements Sweeping uninvested cash balances of $0.01 or more into a money-market mutual fund on a daily basis Maintaining securities tax data such as tax cost basis, acquisition dates and tax lots Exercising proxies and conversions as well as process calls, maturities and stock dividends Preparing and filing annual federal and state trust tax returns and providing an income summary and classification to beneficiaries for tax filing. IMPORTANT DISCLOSURES This paper has been prepared for informational purposes only. The case studies presented are for illustrative purposes only and there can be no guarantee that the strategies discussed would be achieved. Morgan Stanley Smith Barney LLC ( Morgan Stanley ) does not accept appointments nor will it act as a trustee but it will provide access to trust services through an appropriate third-party corporate trustee. Morgan Stanley and its affiliates, Financial Advisors and employees do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters Morgan Stanley Smith Barney LLC. Member SIPC. CRC (4/15) CS /15