- Clients receiving offshore deferred compensation this year are facing a large income tax bill.
- A solution known as a Charitable Lead Annuity Trust (“CLAT”) can be used to limit the income tax paid on the received compensation.
- If you are interested in exploring this solution, please contact us as soon as possible.
Although many of our clients earn very large amounts of income each year, 2017 will present a unique income tax challenge for many of them. In 2009, a number of investment fund managers elected to defer the fees and incentive allocation they earned with respect to their offshore funds through 2017 (the last year that Congress permitted such deferral to continue). As a result, many billions of dollars are required to be brought onshore this year, and ordinary income tax (at a top marginal rate of 43.4%, not including State income taxes) must be paid on all of those amounts.
Understandably, our clients are searching for a way to avoid or limit the impact of the income taxes on their receipt of deferred income. Unfortunately, the Internal Revenue Code provides few opportunities these days for reducing ordinary income taxes. The most straightforward and effective remaining opportunity is the charitable deduction.
While the charitable deduction allows a full deduction against income for amounts given to charity (to the extent the donation doesn’t exceed 30% to 50% of the donor’s adjusted gross income, depending on the charitable recipient), as a general rule neither the donor nor the donor’s family can thereafter benefit from the donated funds. However, one type of arrangement, known as a Charitable Lead Annuity Trust (“CLAT”), and more specifically, a “Grantor CLAT”, does allow the donor to receive a charitable deduction while also potentially transferring significant wealth to the donor’s family.
The mechanics of a CLAT are simple. A Settlor contributes property to a trust and receives an up-front income tax charitable deduction for the full amount contributed, up to a ceiling of 30% of the donor’s adjusted gross income, with any contribution amount in excess of that ceiling generally available to be taken as a deduction in the following 5 years. The CLAT will continue for a fixed term of years (generally between 10 and 30). During each year of the trust term, the CLAT pays an annuity (a defined percentage of the initial value of the property contributed to the trust) to named or designated charitable institutions (which can be the Settlor’s private foundation or another charity or charities).
The aggregate amount paid to charity during the trust term is the initial amount contributed, plus interest at an IRS-defined rate, which is currently 2.4%. So long as the assets in the trust grow at a rate in excess of the IRS rate, there will be assets remaining in the trust at the expiration of the trust term to pass, free of income and gift tax, to the Settlor’s children or other individual beneficiaries, or to a trust for their benefit.
While a Grantor CLAT creates an opportunity to give both to charity and to the donor’s family, there are downsides. In a Grantor CLAT, in return for receiving the up-front charitable deduction for the amounts contributed to the CLAT, the Settlor is responsible for paying the income taxes on all income earned by the CLAT during the trust term, without any reimbursement from the CLAT. Although the benefit of the Settlor making these income tax payments inures to the CLAT remaindermen – usually the Settlor’s children, nevertheless this unfunded contingent liability is occasionally enough to dissuade a potential CLAT Settlor from utilizing a Grantor CLAT. Seward & Kissel, however, has pioneered several techniques for limiting the income taxes earned by the CLAT while still permitting the assets to grow substantially. These techniques include the purchase of Private Placement Life Insurance and the use of structured transactions with related family trusts. While neither of these solutions is free from all problems or risks, the overall result in tax savings and wealth transfer is nevertheless appealing.
As an example of the potential wealth transfer, assume an investment fund manager age 50, who is receiving $100,000,000 in offshore deferred income in 2017. The manager contributes $30,000,000 of that to a 20-year CLAT, and the CLAT uses most (but not all) of the contributed proceeds to purchase PPLI policies on the manager’s life (which avoids the accumulation of taxable income within the CLAT). Assuming 7% annual growth of the trust assets, and also assuming that the manager pays tax on the money not contributed to the CLAT and leaves the after-tax amount in a taxable investment account that also yields 7% annually pre-tax for the remainder of his life, then on the manager’s death, he would have transferred approximately $218 million to his children and $43 million to charity. By comparison, if the manager had received the offshore deferred income, paid tax on it and invested the after-tax amount in the same taxable account, on his death his heirs would inherit only $113 million, and nothing would pass to charity. So as a result of using a CLAT, the manager’s children will receive an extra $105 million, and charity will receive $43 million. That is an enormous difference, and makes the CLAT solution appealing even for someone who is not primarily motivated by charitable objectives.
Although a Grantor CLAT is ideal for someone receiving a large amount of offshore deferred compensation this year, it is also very effective for anyone who earns a large amount of income in any given year. Indeed, in some respects it is more effective, since the donor can give a larger percentage of his or her adjusted gross income to the CLAT in year 1, and then use the income earned in years 2-6 to absorb the excess charitable deduction.
If you are interested in using a Grantor CLAT to reduce your income tax bill for 2017, please contact us as soon as possible.