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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.You know you’re also about to be hit with a massive tax bill. These situations will trigger an unusually large amount of tax. But what if a CLAT could save you?
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. Therefore, a Charitable Lead Annuity Trust (CLAT) is the best choice you can go for optimizing the taxes on already-realized gains and ordinary income.
So, let’s dive into these trusts!
CLAT is defined as 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 trust 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 receives the remainder of the assets after the final charitable contribution.
To strengthen CLATs definition, here’s how they works in greater detail:
CLATs carry three key tax benefits:
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.
CLATs include some 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:
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).
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 use 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:
Total Returns
What would 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. Nearly $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.
Are you having more questions about CLATs? Check out our case study on reducing your ordinary income with a CLAT.
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 investment, or schedule a meeting for a free consultation!
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.