What it means
The structure is the mirror image of a charitable remainder trust. Here the charity is paid first, for a fixed term of years or for a lifetime, and the family waits until that term ends before receiving anything.
The tax appeal lies in how the gift to the family is valued. Only the remainder interest, the projected value of what the heirs will eventually receive, counts as a taxable gift, and that figure is calculated at the outset using a prescribed discount rate.
Two payout styles are common. A charitable lead annuity trust pays a fixed dollar amount each year regardless of performance, while a charitable lead unitrust pays a fixed percentage of the trust's value as revalued annually.
Low prescribed discount rates make these trusts more attractive, because the charity's income stream is valued more highly and the taxable remainder shrinks accordingly. Any investment return the trust earns above that assumed rate passes to the family without further gift tax.
The trade off is control and risk. The assets are locked away for the whole term, the charity must be paid even in poor investment years, and if returns disappoint the family may end up with far less than the original projections suggested.
In practice
Real-world examples.
Example
A founder funds a $5,000,000 lead annuity trust paying a hospital foundation 5%, that is $250,000 a year for 20 years, a total of $5,000,000 to the charity. His children receive whatever the portfolio has grown to at the end, with only the small remainder value taxed as a gift today.
Example
A family expecting a company sale funds a lead trust with shares before the valuation rises. The gift is measured at today's depressed value, so the growth between funding and sale reaches the next generation without being taxed as a transfer.
Example
A donor sets up a lead unitrust paying 6% of the trust's annually revalued assets to an arts charity. Payments rise when markets are strong and fall when they are weak, which the charity accepts in exchange for a larger expected total over the term.
Formula
Calculation
Annuity factor = (1 - (1 + r)^-n) / r
Present value of the charitable payments = annual payment x annuity factor
Taxable gift to the remainder beneficiaries = amount funded - present value of the charitable payments
A donor funds a charitable lead annuity trust with $2,000,000. It pays a charity 5% of the initial value, that is $100,000, every year for 15 years, and the prescribed discount rate is 4%.
The annuity factor is (1 - 1.04^-15) / 0.04 = 11.1184. The present value of the charity's income stream is $100,000 x 11.1184 = $1,111,840, so the taxable gift to the children is $2,000,000 - $1,111,840 = $888,160 rather than the full $2,000,000.
Over the term the charity receives 15 x $100,000 = $1,500,000 in cash. If the trust's investments earn more than the 4% assumed rate, the family's remainder will exceed the $888,160 already reported as a gift, and that excess passes free of further gift tax.Case study
Seen in the real world.
The following case is illustrative and the family and figures are fictional. The Thornby family funded a charitable lead annuity trust with $3,000,000 of listed shares, paying a community foundation $180,000 a year, 6% of the starting value, for 12 years. The prescribed discount rate at the time was 3%.
The annuity factor was (1 - 1.03^-12) / 0.03 = 9.9540, so the present value of the charity's payments was $180,000 x 9.9540 = $1,791,720. The taxable gift to the children was therefore $3,000,000 - $1,791,720 = $1,208,280, less than half the amount actually put into the trust.
The portfolio went on to return about 7% a year. After twelve years of payments totalling 12 x $180,000 = $2,160,000 to the charity, the remainder passing to the children was roughly $3,537,000, well above the $1,208,280 that had been reported as a gift at the start. Had returns instead matched the 3% assumed rate, the children would have received close to the reported figure and nothing more.
Watch out
Common mistakes.
- Confusing a lead trust with a remainder trust, and assuming the donor or family receives income during the term.
- Expecting an immediate income tax deduction, which is generally available only in the less common grantor version of the structure.
- Funding the trust with an illiquid asset that cannot generate the required annual payment without being sold at a bad moment.
Questions
People also ask.
Who receives the money first in a charitable lead trust?
The charity does, through fixed annual payments for the agreed term, and the family receives only what remains afterwards.
Why do low interest rates make lead trusts more attractive?
A low prescribed discount rate raises the calculated value of the charity's income stream, which shrinks the taxable remainder passing to the family.
What happens if investment returns are poor?
The charity is still paid in full each year, so a weak portfolio is absorbed almost entirely by the family's remainder, which can shrink to very little.
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