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Comprehensive Guide To CLATs by Valur

You’ve had a good year. Maybe you exercised your company options anticipating an IPO, received a big bonus, sold your business, or liquidated crypto holdings for a significant gain.

At the same time, though, you know you’re also about to be hit with a massive tax bill. These situations will trigger an unusually large amount of tax because the profits or earnings will be taxed as ordinary income at the highest possible marginal tax bracket – as high as 55% if you live in a high-tax state like California or New York.

No doubt you would have preferred to take steps earlier to get long-term capital gains treatment on your income, but sometimes it’s tough to plan for taxable events in advance. Is there anything you can do to reduce what you’re going to owe on income you’ve already realized?

Good news: There is! The Charitable Lead Annuity Trust (CLAT) is built for optimizing the taxes on already-realized gains and ordinary income.

Valur’s goal is to help founders, employees, and crypto investors keep more of their hard-earned gains by taking the sophisticated tax mitigation and asset protection tools of the ultra-rich and making them seamless and accessible to everyone. In this article, we’ll explain how CLATs work, when they can make sense, and the tradeoffs associated with the strategy.

What are CLATs and how do they work?

A CLAT is a type of irrevocable trust designed to reduce a beneficiary’s potential tax liability. CLATs are best suited for those looking to mitigate a major tax exposure AFTER income is received, either via salary, a bonus, or a major liquidity event.

The CLAT strategy is relatively simple: The trust´s creator – the grantor or donor – receives an immediate income tax charitable deduction for the present value of future donations to charity. Let’s talk about why, and how.

In many ways, the CLAT can be understood In direct contrast to Charitable Remainder Trusts (CRTs). With a CRT, the grantor places assets into a trust, invests tax free, receives distributions during the term of the trust, and then distributes what’s left at the end to charity. With a CLAT, by contrast, the grantor places money into the trust, receives an up-front tax deduction, makes a donation to charity every year of the trust’s term, and then the donor or another designated beneficiary receive the remainder of the assets after the final charitable contribution.

charitable lead annuity trust
Charitable Lead Annuity Trust

Here’s how that works in greater detail:

  1. You put assets into the trust. You can seed the trust with nearly any asset — cash, public and private equities, real estate, or crypto, for example — and reinvest the gains in other assets throughout the whole term of the trust.
  2. You receive an immediate tax deduction for as much as 100% of the value of the assets put into the trust. A big tax deduction means you’re going to pay less in taxes this year: If you have $1M of gains from the sale of an asset, you’re going to be on the hook for anywhere from $250k to $550k (depending on the character of the income and where you live). With a CLAT, you can reduce that tax bill to as low as $0 and reinvest the full $1M.
  3. You use the trust’s funds to make the same investments you would have made out of a regular taxable account, critically you are able to invest what would otherwise be tax dollars. This is almost like receiving a 0%-interest loan from the government.
  4. The trust makes a donation to your chosen charity every year. Critically, these donations are back loaded; you’ll give a very small amount in the early years – a fraction of a percent of the trust’s assets – and more toward the end.
  5. You or your beneficiaries receive what’s left over at the end of the trust’s term (which can last for as long as you want: a predetermined number of years or your lifetime).
  6. Taxes. You won’t pay taxes on the assets in the trust until income is realized. When you withdraw the trust’s funds at the end of the term, you can take the distributions in cash (in which case you’ll pay capital gains taxes) or in kind (in which case there’s no realization event and no tax bill).

The benefits of CLATs and when they make sense 

CLATs carry three key tax benefits:

  1. Up-front tax deduction. You can write off already realized income that would be taxed at a high rate, such as ordinary income or short-term capital gains and reinvest what would otherwise be taxes
  2. Lower your tax rate. You can take advantage of favorable tax treatment on both ends of a CLAT. On the front end, you can use your 100% deduction to write off high-tax income, like salary or short-term capital gains. On the back end, if and when you pay taxes on the trust’s gains, those gains will typically be taxed at the long-term capital gains rate, allowing you to write off high tax rate income, reinvest it and pay a lower tax rate in the future and reduce your effective tax rate by 20% or more.
  3. The ability to generate a “return arbitrage.” Although the math is complicated, the IRS is essentially discounting all the charitable deductions assuming a set percentage growth rate.  As a result, any appreciation in excess of the government’s interest rate and the charitable contributions is returned to the beneficiaries, so the lower the government’s interest rate, the higher the beneficiaries returns. As of May 2022, the current rate is 3.0% which is well below historical public market stock returns of 10%.

For these reasons, a CLAT often makes sense as a way to write off income that would be taxed at an especially high rate, like a high salary, a large bonus, an option exercise, or short-term capital gains.

The downsides of CLATs

CLATs are an amazing tax-deferral tool and, as we’ve demonstrated, the benefits can be substantial. But there are tradeoffs to be made.

An important one is that the money is locked away for the entirety of the trust’s term, much like a retirement savings account or IRA.

At the same time, there are a couple of factors that minimize the costs of that inflexibility:

  1. You can direct the trust’s investments during that time, so it’s not like you have no control over your outcomes.
  2. You can choose the length of your trust. Typically, people set up these structures for a minimum of 15- or 20-years as the benefits compound and significantly increase beyond this length.

If a CLAT sounds like a good fit for your situation, there will be a couple of key decisions to be made: How long do you want to set up the trust for? (The longer the time frame, the higher the ROI, but the longer the period of illiquidity.) And how much of your income (and your taxes) do you want to write-off (and tie up)?

Next, we’ll take a look at a real-life case study: An investor who is aiming to offset $300k of short-term crypto gains that would be taxed at 49.25%.

Case study

Like a lot of our clients, Jeff, who lives in Manhattan, started trading crypto a few years ago and has had a good couple of years. He decided to take some of his gains off the table – about $300k – but he didn’t realize that they would all qualify as short-term capital gains. 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).

But there’s good news: Jeff can work with Valur to set up a CLAT to eliminate his short-term-gains taxes this year, reinvest that money now, and pay most of his taxes at a lower tax rate in the future. By pursuing that strategy:

  1. He will get to reinvest that money instead of paying it directly to the government. Jeff will get to deduct 100% of the current value of the assets he puts into the trust and reinvest the tax savings. In this case, that’s a $300k deduction that translates into immediate tax savings this year of about $150k, and that can be reinvested to create more wealth for Jeff!
  2. He´ll be able to lower his tax rate by shifting his tax rate from short-term capital gains to long-term capital gains. He´ll accomplish this by using his promised charitable donations to write off his very high (and very highly taxed) income this year and convert them to long term capital gains when they are realized in the future. To put it more concretely, he is writing off income that would have been taxed at 50% now, and when he receives that money in the future he’ll likely be paying around a 35% tax rate.

What happens while the trust is operating?

In short, the deal Jeff is making is that he gets 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.

Every year, Jeff will make a small donation to the charity of his choice – starting around $750, and growing by about 20% (after the CLAT’s 25-year term, the trust will have donated about $360k).

But if Jeff is going to have to donate a lot to charity and pay taxes on those amounts, where’s the benefit of this strategy? The key is that, by deferring what would have been tax dollars, Jeff gets to reinvest and grow his money for 25 years. Yes, he’ll end up donating more than the initial amount he put into the trust, but he still gets to benefit from the magic of compounding those saved tax dollars.

Total Returns

What would all of these tax savings, investment gains, and donations mean for Jeff’s bottom line? After 25 years of approximately 8% growth, Jeff expects to end up with about $1.95M in total payouts. About $360k will go to the charity of his choice — that’s the bargain he struck when he chose a Charitable Lead Annuity Trust — so he will end up with about $1.6M in his pocket, or $970k after taxes.

If, instead, Jeff had paid his taxes up front and reinvested the remainder — about $150k — in a regular, taxable investment account, he would have ended up with about $760k after taxes.

CLAT example
CLAT Example

Next Steps

CLATs help to deal with the problem of having too much taxable income in a specific year. A person who has significant taxable income can establish a CLAT and use the charitable income tax deduction to mitigate the impact of taxes in his or her situation.

There are, of course, other reasons to establish a CLAT besides the significant up-front deduction. The most important one is the motivation on the part of the donor to make significant gifts to charity.

Having said that, the characteristics of CLATs will appeal only to donors who are in a position to direct at least several hundred thousand dollars of cash or other assets into a trust for the long term.

Follow up with our next post on how to design a CRT to grow your IRA. Try our CLAT calculator to evaluate your potential return on investmeent, or schedule a meeting for a free consultation!

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.