Charitable Lead Annuity Trust BasicsAlready Sold Your Assets? It's Not Too Late For Tax Deferral With A CLAT
A Charitable Lead Annuity Trust can help if you've had a big income event this year — if you've sold crypto, exercised options, received a big bonus, or just earned a lot.
❗Key Takeaway: Sometimes it's tough to plan for taxable events in advance. Maybe you recently sold your cryptocurrency, minted some popular NFTs, had a surprise opportunity to sell some start-up equity, or just had a really high-income year. If you've already sold your assets for a big gain, 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. Maybe you had a good run minting NFTs. Or maybe you exercised your company options anticipating an IPO in the near future. Whatever the reason, you’re now sitting on a pile of cash. That’s great!
At the same time, though, you know you’re also about to be hit with a massive tax bill – as much as 55% if you live in a high-tax state like California or New York. A Charitable Remainder Trust (CRT) isn't a good fit because CRTs only work for deferring taxes on future capital gains. 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 gains you've already realized?
Good news: There's another tool — the Charitable Lead Annuity Trust (CLAT) — that offers many of the same tax benefits of the CRT but works specifically for already-realized gains. Long-term tax deferral can be a huge boon, and that makes the Charitable Lead Trust attractive for people aiming to offset unusually high taxable income in a given year.
In this article, we’ll explain how Charitable Lead Trusts work and in what sorts of situations they might prove valuable.
What Are the Benefits of a CLAT?At a basic level, a CLAT is simple: (1) You put cash into the trust, (2) you receive an immediate tax deduction for as much as 100% of the value of that cash, and (3) your trust makes a donation to your chosen charity every year, (4) you receive what’s leftover 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.
Why is that all a big deal?In a sense, the answer is simple: A big tax deduction means you’re going to pay less in taxes this year. If you have $1 million of gains from the sale of an asset this year, 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 large returns via compound growth.
At the same time, you’re going to have to make those charitable donations and pay taxes on your money eventually. Are the immediate tax savings really worth it?
The Magic of Compound GrowthIn many cases, the answer is a resounding yes. That’s because of the magic of compound growth. If you did no tax planning, let’s say you’d be on the hook for about $450,000 in taxes on a $1 million windfall. You’d be left with about $550,000 to invest (or spend) going forward. If you put your earnings into a Charitable Lead Annuity Trust, by contrast, 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 investing the full $1 million.
You will have to pay a very small tax bill every year, and then 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 obvious 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 gains 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.
How, exactly, does a CLAT work?Mo the NYC artist. A simple example will be helpful. Take Mo, a young artist from New York City who has made a killing minting NFTs this year. He’s earned about $300,000, and it’s all going to be taxed as ordinary income—that’ll be something like $150,000 in federal, state, and local taxes.
Year 1: An immediate and large deduction. Mo works with us to put his cash into a 25-year CLAT today. He’ll get an immediate $300,000 deduction (which he can use today or spread out over the next five years). Let’s say he takes the whole deduction over the first two years. His taxable income on his NFT sales will be offset entirely by that deduction, so instead of sending $150,000 to New York and the federal government, he’ll pay $0, and he’ll get to re-invest the full $300,000 and let it grow.
The middle years: Donations and big investment growth. What happens in the following years? Two things. First, Mo’s trust will make a small donation to the charity of his choice – starting around $750, and growing by about 20% every year. Given the relative size of that donation, though, the far bigger deal is that Mo will get to re-invest his full $300,000. (Do note that the rules of CLATs dictate that Mo can’t withdraw the money until the end of the trust’s term – much like the age-related withdrawal restrictions of an IRA.)
Let’s say Mo’s money grows at around 8% per year. After the CLAT’s 25-year term, the trust will have donated about $360,000, and the trust’s assets will be worth about $1.7 million.
The final year: A massive payout. So Mo’s trust has about $1.5 million in the last year. What then? In the final year of the term, Mo will get all of the trust’s assets that have not been donated to charity (about $1.7 million), and he’ll pay taxes on those gains at that point (about $560,000). So, after the accounting, Mo ends up with about $1.1 million in his pocket.
The Impact. Due to the magic of compound growth, Mo grows his initial tax savings into a sizable nest egg. Taking the numbers we gave you above, the gains from a Charitable Lead Trust are striking: Mo would keep about $1.1 million (after taxes) at the end of the trust, versus about $700,000 if he had paid his taxes in year 1 and reinvested what was left. That’s about an additional 60% return! Plus, Mo would be giving about $360,000 to his chosen charity.
The Tradeoffs. CLATs are an amazing tax-deferral tool, and, as we’ve demonstrated, the benefits can be substantial. But there are tradeoffs to be made. Most notably, if you put your money into a CLAT, the money is locked away for the entirety of the trust’s term.
With that said, there are a couple of factors that minimize the costs of that inflexibility: First, you can direct the trust’s investments during that time, so it’s not like you have no control over your outcomes; and second, you can choose the length of your trust. Typically people set up CLATs for a minimum of 15- or 20-years to take advantage of the compounding tax mitigation benefits (depending, of course, on your assets, how quickly you expect your money to grow, and other details).
ConclusionNo doubt CLATs do 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.
Charitable Lead Annuity Trust Redux:A Deep Dive A Charitable Lead Annuity Trust can help if you've had a big income event this year. We'll take you through the details of this powerful strategy.
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 tool.
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
Case study refresherJeff 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).
- Cost basis: $50,000
- Current value: $350,000
- Expected Taxes: $148,000
- Gift to Trust: $300,000
- Baseline (that is, not using a trust): $761,000
- CLAT: $971,000 (27% additional return)
- 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%.
- 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%.
- 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.
- 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.
- 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.
- 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).
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.