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CLAT Redux: A Deep Dive

When and why might a grantor Charitable Lead Annuity Trusts (CLAT) work? A CLAT can be a great tool for people who have had a big income event this year, like a crypto sale, a big exercise of appreciated options or just a big bonus.

In this post, we’ll take a deeper dive into this common tooland. f you haven’t read the basics, here is a good overview and a comparison to Charitable Remainder Trusts.

charitable lead annuity trust
CLATs

What are the common scenarios that make sense for a CLAT?

Grantor CLATs often make sense when (1) you have enough income that you’re in an inherently high tax bracket (as in the scenarios we discuss below), (2) we are in a low interest rate environment (as we ware today), and (3) you have a long time to let your money grow untouched (because the returns really start to skyrocket around the 20-year mark).

  • You sold crypto or equity that qualified as short term capital gains
  • Exercised highly appreciated startup equity, which triggers an ordinary income tax on the difference between the current fair-market value of the stock and your strike price
  • Receiving RSUs that are taxed as ordinary income when received
  • Paying significant taxes on crypto farming or staking yields
  • Receiving an unusually large bonus or salary in a given year

The tax benefits of a CLAT

There are two key tax benefits of a CLAT: 1) Shifting current income to long-term capital gains and 2) the ability to generate a “return arbitrage.” We spent some time describing these benefits in the context of a case study, but we’ll explain in more detail how this all works.

Case study refresher

Jeff lives in New York and started trading crypto a few years ago. Like many folks in crypto, he has had a really good 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 now looking at a surprise 49.25% tax bill — about 37% from the federal government and another 12% from New York (city and state).

The numbers

  • Cost basis: $50,000
  • Current value: $350,000
  • Expected Taxes: $148,000
  • Gift to Trust: $300,000

The returns

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)
clat example
CLAT Example

Where do these benefits come from?

  1. Shifting income to long-term gains: $109,000. Jeff is able to lower his tax rate by shifting his income from short-term capital gains (which are taxed at a very high rate, the same as ordinary income) to long-term capital gains (which are taxed at a much lower rate). As a result, his top marginal rate drops from 49.25% to 35%.
  2. He is able to 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 have been taxed at 50%, and when he receives that money in the future he’ll only be paying 35%.
  3. Additional return arbitrage: $101,000. In addition to that basic tax arbitrage, Jeff is able to 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), and that deduction is calculated by taking the value of all of 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.
  4. Whatever you earn above and beyond that expected growth is yours to keep, and that can be a huge amount, 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 very attractive in today’s environment.
  5. In short, the deal you’re making is that you get to write off income (and taxes) now in exchange for future charitable deductions, reinvest that money, and keep the excess returns over the governments expected growth rate.
  6. Additional soft benefits: Significant charitable giving. A separate benefit 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. As a default, we set you up with a Donor Advised Fund (at no cost), which enables you, your family, or whoever you appoint to decide which charitable causes these assets are directed to. (If you are looking for worthy causes, we suggest GiveWell — a group that directs funds to charities with the highest return per dollar donated).

What is the downside of a grantor CLAT?

The primary downside of a grantor CLAT 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. This means that you’ll have to pay taxes on that income each year, which creates negative cash flow until the end of the term.

With that said, this shouldn’t be a huge concern. 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. This works because we work with you to reduce your tax liability during those years by (1) limiting income realization in the trust (dividends, sales of appreciated assets) and (2) designing the CLAT to make small charitable payments until the last year of the trust, when you receive all of the remaining assets in the trust and are cash flow positive again.

Next Steps

Follow up with our comparative article, try our innovative calculator to evaluate your potential return on investmeent, or schedule a call to meet our team and share your experience!

About Valur

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 make take care of it and make it easy.