Estate planning experts are torn. Some contend that a unique variation of the charitable lead annuity trust (CLAT) (referred to as a "shark-fin" CLAT) is safe to use, while others warn donors to stay out of the water until the IRS clarifies its position on the validity of this charitable giving device.
First, some CLAT basics
Taxpayers with charitable intentions often use a device known as a charitable lead annuity trust (CLAT). With this device, a donor creates and funds a trust that pays a fixed annuity to a qualified charity for either a specified term of years (e.g., 10 years) or for a term measured by the life of one or more individuals (e.g., upon the death of a surviving spouse). At the end of the term, assets in the trust pass to a remainder beneficiary. CLATs are typically used by wealthy individuals who have no current need of certain assets, and who want not only to benefit heirs, but also to make gifts to charity.
CLATs have become very popular recently because of the historically low monthly IRS discount rate, which has averaged 2.8% from January 2010 through July 2011. The donor is entitled to a charitable gift tax deduction for the value of the annuity interest. A lower discount rate results in a higher value for the annuity interest (and the corresponding charitable gift tax deduction), and also results in a lower value for the gift of the remainder interest. And, if the investment performance of the trust property exceeds the discount rate during the lead period, the excess passes free from gift tax to the remainder beneficiaries.
Lower interest rates also facilitate the "zeroed-out" CLAT. A zeroed-out CLAT is one that is structured so that the charitable deduction is equal to the amount transferred to the CLAT, resulting in no taxable gift (for inter vivos CLATs) or no inclusion in the donor's gross estate (for testamentary CLATs).
Enter the shark-fin CLAT
IRS Revenue Procedures 2007-452 and 2007-463 contain language that states that a CLAT may provide for an annuity amount that is initially stated as a fixed dollar amount "but increases during the annuity period." This language has resulted in the promotion by some of the "shark-fin" CLAT. With a shark-fin CLAT, a series of small payments is initially made to the charity, then one big (balloon) payment is made at the end of the CLAT term (this strategy is sometimes referred to as "back loading"). If you plotted these payments on a graph, they would look like a shark's dorsal fin (hence the name). Because of back loading, the shark-fin CLAT allows for a significant buildup of funds during the lead period (although there is no guarantee this will happen), maximizing the amount that passes to the remainder beneficiaries.
The debate
Supporters of the shark-fin CLAT contend that the IRS procedures issued in 2007 (referenced above) clearly allow CLATs to vary their annuity payments, and this is sufficient evidence that a balloon payment at the end of the lead period is valid.
Critics say that the IRS procedures are only guidance and explicit approval is lacking. They fear that the small annual payments (followed by the balloon payment) may be disregarded by the IRS because they would be considered de minimis. Additionally, the series of payments to charity in a shark-fin CLAT does not fit traditional concepts of what annuity payments are. While the value of such payments can be calculated, they cannot be calculated using just annuity formulas. Beyond the de minimis argument, there may be doubt as to whether the series of payments is an annuity. Critics also fear that the shark-fin may be seen by the IRS as abusive.
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