ELITE ADVISOR BEST PRACTICES

Validity of Shark-Fin CLATs Remains in Doubt Despite IRS Guidance

This unique charitable lead annuity trust can provide certain clients with powerful tax and giving advantages. But not all the issues have been ironed out. Advisors should proceed with caution.

By Richard L. Fox and Mark A. Teitelbaum

Key Takeaways:

  • A “shark fin” CLAT provides fixed nominal annuity payments to charity each year followed by a substantial back-loaded balloon payment at the termination of the trust.
  • The “shark fin” comes from the shape of its payment pattern to charity when plotted on a graph.
  • A shark-fin CLAT using life insurance involves the contribution of cash to an inter vivos CLAT, which is structured as a “grantor trust” for income tax purposes.


This article is adapted from a longer version that was published in the October 2010 issue of Estate Planning, © 2010 Thomson Reuters.

With the Section 7520 interest rate at a historically low level, the charitable lead annuity trust (CLAT) has become an increasingly powerful and popular estate planning tool to transfer wealth effectively to the next generation. This trust also furthers philanthropic goals by providing annuity payments to charity. Unlike a charitable lead unitrust (CLUT), a CLAT can be structured so that the present value of the annuity payments to charity is equal to the amount actually transferred to the CLAT. This results in what is known as a “zeroed out” CLAT because the value considered transferred to the remainder beneficiaries for estate and gift tax purposes is equal to zero.

Background on charitable lead trusts

As many advisors know, a charitable lead trust (CLT) is a split-interest trust that allows an individual to provide benefits to both charitable and noncharitable beneficiaries. Generally, a CLT is an irrevocable trust that provides a current benefit to charity, either in the form of a guaranteed annual annuity payment (the CLAT structure) or a unitrust (a CLUT structure), for a period known as the “lead term,” which can be a specified number of years or the life or lives of designated individuals, including the settlor. On the termination of the lead term, the remaining assets in the CLT pass to noncharitable beneficiaries, typically family members of the settlor or a trust for their benefit. Thus, at the creation of a CLT, two gifts are made by the settlor:

  1. A gift of the annuity or unitrust interest to charity.
  2. A gift of the remainder interest to noncharitable beneficiaries.

A CLT is basically the opposite of a charitable remainder trust (CRT), which provides payments to noncharitable beneficiaries during an initial term followed by a payment to charity at the end of such term. Unlike a CRT, however, there are no minimum or maximum payout requirements with respect to the annuity or unitrust payments, no requirement regarding the present value of the remainder interest and no term limitation for a CLT that is not measured by the life expectancy of an individual. If the CLT conforms to the requirements of the Code, a charitable gift or estate tax deduction is available for the present value (determined using the Section 7520 rate) of the annuity or unitrust payments payable to the charity over the lead term.

Enter the shark fin

The governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar amount “but increases during the annuity period.” This language has spurred the promotion of what has become known as the “variable CLAT,” or “VCLAT,” and particularly the highly touted “shark fin” CLAT in which fixed nominal annuity payments are made to charity each year followed by a substantial back-loaded balloon payment to charity at the termination of the trust. By back-loading the payment to charity, the shark-fin CLAT is intended to allow for a significant buildup of funds within the CLAT, in order to maximize the amount ultimately passing to family members on the termination of the CLAT, although the nominal annual annuity payments and the back-loaded balloon payment can be structured to result in a zeroed-out CLAT.

The shark-fin name is attached to this structure because if the payment pattern to the charity is plotted on a line graph, the final payment resembles a shark’s dorsal fin slicing through the water.

Shark-fin CLAT using life insurance

The basic strategy of the shark-fin CLAT using life insurance involves the contribution of cash to an inter vivos CLAT, which is structured as a “grantor trust” for income tax purposes. The CLAT uses most of the cash contribution to purchase a single-premium life insurance policy on the life of the settlor, the proceeds of which are payable to the CLAT on the death of the settlor, which also triggers the termination of the CLAT. A portion of the life insurance proceeds is used to make a final substantial balloon payment to charity, with the remaining insurance proceeds distributed to the noncharitable remainder beneficiaries. The portion of the cash contribution that is not used by the trust to purchase life insurance is used to purchase a tax-exempt municipal bond, which is used to make fixed nominal annual payments to a designated charity. Because the trust is a grantor trust, the settlor obtains an upfront income tax deduction. Furthermore, because the only income earned by the CLAT is tax-exempt municipal bond income, the settlor is not subject to tax on that income.

Example. A 60-year-old settlor contributes $1 million in cash to a CLAT. The CLAT immediately purchases a life insurance policy on the settlor with a $900,000 single-premium payment. The remaining $100,000 of the $1 million in cash contributed to the CLAT is used to purchase a $100,000 municipal bond that pays 4 percent interest. The arrangement produces the following results:

  • The life insurance policy has a death benefit of $3,801,000. When the settlor dies, the CLAT receives the $3,801,000 in life insurance proceeds, and $2,275,000 is paid to a designated charity. The remaining $1,526,000 passes to the noncharitable remainder beneficiaries designated in the CLAT.

  • The municipal bond earns interest of $4,000 each year, which the CLAT uses to make annual annuity payments of $4,000 to the designated charity. Consequently, even though the CLAT is structured as a grantor trust, thereby subjecting the settlor to income tax on the income earned by the CLAT, the settlor does not recognize taxable income because the CLAT income is tax-free municipal bond income. When the CLAT terminates on the settlor’s death, the remaining balance of the municipal bond is paid to the noncharitable remainder beneficiaries.

  • Based on an assumed Section 7520 rate of 3.4 percent, the present value of the $4,000 annual annuity payments to charity for the donor’s life and the balloon payment to charity at the donor's death of $2,275,000 equals $950,000. Thus, the grantor is entitled to a charitable income and gift tax deduction of $950,000. Because of the gift tax charitable deduction, the taxable gift at the time the CLAT is funded equals the excess of $1 million over $950,000, or $50,000 (which can be sheltered by the current $1 million lifetime gift tax exclusion).

Therefore, although the taxable gift is only $50,000, the noncharitable remainder beneficiaries ultimately receive a total of $1,526,000 and the municipal bond held in the CLAT,a clearly favorable outcome, assuming this strategy passes IRS muster.

Conclusion

Until the IRS clarifies its position, there would appear to be a question as to the validity of the shark-fin CLAT as a qualified charitable lead trust, particularly one funding a back-loaded balloon payment to charity using life insurance proceeds. Because of the risk of the disallowance of the income, gift or estate tax charitable deduction—a potentially disastrous result—planners should exercise caution in using such a CLAT and should consider alternative structures. These alternatives include those leveraging the benefits of life insurance for the noncharitable remainder beneficiaries rather than the charity.

About the Authors

Richard L. Fox is an attorney and partner in the Philadelphia office of the law firm of Dilworth Paxson LLP (www.dilworthlaw.com) where he heads the Philanthropic and Nonprofit practice. Mr. Fox is the author of the treatise “Charitable Giving: Taxation, Planning and Strategies,” a Thomson Reuters/Warren, Gorham and Lamont publication. He is also a member of the editorial board of Estate Planning and a member of the Board of Advisors of the American College Chartered Advisor in Philanthropy program (www.theamericancollege.edu).

Mark A. Teitelbaum, LL.M., CLU, ChFC, has worked in a senior advanced markets capacity for major life insurance carriers for over 20 years. He is also an assistant editor of the Journal of the American Society of Financial Service Professionals and was the previous editor of the American Society’s Business & Compensation Planning Section Newsletter.

The opinions expressed in this article are those of the authors and do not necessarily reflect those of their employers.