Sometimes it’s tough to plan for taxable events in advance. For example, maybe you recently sold your cryptocurrency, minted some popular NFTs, had a surprise opportunity to sell some start-up equity, or just had a high-income year. If you’ve already sold your assets for a significant gain, a tax deferral with a Charitable Lead Annuity Trust (CLAT) can help you defer the taxes on that income even after you’ve received the bill.
You’ve had a good year. Maybe you sold your crypto holdings for a significant gain. Or you exercised your company options anticipating an IPO. Whatever the reason, you’re sitting on a pile of cash.
You know you’ll hit a massive tax bill. A Charitable Remainder Trust (CRT) isn’t a good fit because it only defers on future capital gains. But sometimes, it’s hard to plan for taxable events. Is there anything you can do to reduce what you owe?
Good news: Another tool — the Charitable Lead Annuity Trust (CLAT) — offers many of the same tax benefits as the CRT but works specifically for already-realized gains. In addition, long-term tax deferral can be a huge boon, making the Charitable Lead Trust attractive for people aiming to offset unusually high taxable income in a given year.
This article will explain how Charitable Lead Trusts work and what situations might prove valuable.
Why Are CLATs Helpful?
At a basic level, a CLAT is simple: (1) You put cash or other assets into the trust, (2) you receive an immediate tax deduction for as much as 100% of the value of that cash, (3) your trust makes a donation to your chosen charity every year, (4) you or your beneficiary receive what’s left over at the end of the trust’s term (which can last for as long as you want), and (5) you pay most of your taxes at the end.
But why is that a big deal?
In a sense, the answer is simple: A significant tax deduction means you’re going to pay less in taxes this year. For example, suppose you have $1 million of gains from selling an asset this year. In that case, you’re going to be on the hook for anywhere from $250,000 (if you have long-term capital gains and live in a no-tax state like Florida) to $550,000 (if you have short-term capital gains or ordinary income and live in a high-tax state like California or New York). With a CLAT, you can reduce that tax bill to $0. It’s an immediate win that can create significant returns via compound growth.
At the same time, you will have to make those charitable donations and pay taxes on your money eventually. So are the immediate tax savings worth it?
The Magic of Compound Growth
In many cases, the answer is a resounding yes. That’s because of the magic of compound growth. If you did not have tax planning, let’s say you’d be on the hook for about $450,000 in taxes on a $1 million windfall. But, as we advance, you’d be left with about $550,000 to invest (or spend). If you put your earnings into a Charitable Lead Annuity Trust, you would get to deduct as much as 100% of the value (spread out over a couple of years for technical reasons – the IRS doesn’t make anything simple!). So instead of owing $450,000 in taxes on that windfall, you’d owe $0. And instead of investing $550,000, you’d be financing the total $1 million.
You will have to pay a tiny tax bill every year and a bigger one when you withdraw your money at the end of the CLAT’s term. But you get to invest those savings in the meantime. It’s almost like receiving a 0% interest loan from the government.
And think about what happens when you put those savings into the stock market, crypto, or angel investments. Your tax savings continue to grow. While it seems evident that you would rather have $1 million in the market working for you than $550,000, most people don’t appreciate how big of a difference that will make over time. Assuming just an ~8% annual return—the average historical return from relatively conservative index investing—will turn into more than $3.6 million in additional gains over 25 years.
Even after you pay the taxes you owe on your profits and donate the required amount to the charity of your choice (more on that in a minute), you could come out more than $1.1 million ahead on an initial $1 million exit in that same timeframe. That’s the magic of the one-two punch of federal-tax-advantaged trusts and compounding.
When Do Grantor CLATs Make Sense?
Grantor CLATs often makes sense when:
- You have enough income that you’re in an inherently high tax bracket
- We are in a low-interest-rate environment
- You have a long time to let your money grow untouched (because the returns start to skyrocket around the 20-year mark).
What is the Downside?
The primary downside of grantor CLATs is that you typically don’t have access to the capital for a while (20+ years), and you’re responsible for the income in the trust in the meantime. So, you’ll have to pay taxes on that income each year, which creates negative cash flow until the end of the term.
However, the amounts we’re talking about are small: In most cases, the trust’s income will be a few thousand dollars a year, and your tax bill will be a fraction of that. So we work with you to reduce your tax liability during those years by limiting income realization in the trust (dividends, sales of appreciated assets). Therefore, we design the CLAT to make small charitable payments until the last year of the trust, when you receive all of the remaining assets and are cash flow positive again.
Case study refresher
Jeff lived in New York and started trading crypto a few years ago. Like many folks in crypto, he has had an excellent year. Jeff decided to take some of his gains from Solana, Avalanche, and Shiba Inu off the table — about $300,000 — but he didn’t realize that they all qualify as short-term capital gains. (Crypto moves fast!) As a result, he’s looking at a 49.25% tax bill — 37% from the federal government and another 12% from New York (city and state).
- Cost basis: $50,000
- Current value: $350,000
- Expected Taxes: $148,000
- Gift to Trust: $300,000
Expected Post-Tax Returns after 30 years (assuming an 8% annual growth rate over the term of the trust):
- Baseline (that is, not using a trust): $761,000
- CLAT: $971,000 (27% additional return)
Where do these benefits come from?
- He is shifting income to long-term gains: $109,000. As a result, Jeff can lower his tax rate by going his income from short-term capital gains (taxed at a very high rate, the same as ordinary income) to long-term capital gains (taxed at a much lower rate). As a result, his top marginal rate drops from 49.25% to 35%.
- He can accomplish this by (1) using his future charitable donations to write off his very high (and very highly taxed) income this year and (2) investing those tax savings in assets that, when sold, will be taxed at lower rates. To put it more concretely, he is writing off income that would tax 50%, and when he receives that money in the future, he’ll only be paying 35%.
- Additional return arbitrage: $101,000. In addition to that basic tax arbitrage, Jeff can generate higher returns (between 8 and 10% by investing in the broader market) than the government’s expected growth rate (1.6% as of December 2021). Why does this help? With a CLAT, you get a charitable deduction (up to 100% of the money you put in the trust). You calculate that deduction by taking the value of all the donations you’ll give to charity in the future and coming up with the discounted present value (that is, the value in today’s dollars) of that money based on how much the government expects your assets to grow.
- Whatever you earn above and beyond that expected growth is yours to keep. That can be considerable, especially in periods of high asset growth and low-interest rates. (Today, you might expect 8% or 10% growth, or even more, and the government’s rate is only 1.6%, so you’ll capture the 6-8% difference). This is a big part of what you get to keep when your CLAT pays out and why the structure is beautiful in today’s environment.
- In short, you’re making a deal to write off income (and taxes) now in exchange for future charitable deductions, reinvest that money, and keep the excess returns over the government’s expected growth rate.
- Additional soft benefits: a significant charitable giving. A different use that we do not include in our ROI calculations — but one that is significant for many people — is that, with a CLAT, you will be directing your charitable donations to worthy causes you believe in.
No doubt CLATs require you to sacrifice some flexibility, but they can be a great tool if you don’t need your money immediately – much like an IRA. Read more about CLATs in our deep dive into CLATs, or analyze your potential return on investment with our CLAT calculator.
If you have any questions, reach out to our team of experts!
- CRUT vs. CLAT: A Charitable Trust For Every Situation
- A Charitable Lead Trust Example to Defer Taxes
- CLAT Option Exercise to Reduce Your Tax Bill
We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder), and others. Valur makes it simple and seamless for our customers to utilize the tax-advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we take care of it and make it easy.