By now, you've likely read our short primer on Charitable Lead Annuity Trusts (CLATs) — a tool our startup and crypto customers choose to reduce their taxes on gains they've already realized — and you're probably comfortable with the basics. (If not, take your time, and we're always happy to help jumpstart your learning with a quick phone call.) In this post, we'll use a few examples, drawn from our real-world experience, to help illustrate the benefits (and, of course, the tradeoffs) of CLATs.
As we dig in, you'll see pretty quickly that there are 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.) And how much of your income (and, therefore, your taxes) do you want to offset? Here, we'll focus on a New York customer example in which they are offsetting $300,000 of short-term crypto gains being taxed at 49.25%. (Let us know if you'd like access to a customizable model that can show you different scenarios.)
A refresher on how CLATs work:
- You gift assets or cash to the trust and get a charitable deduction up to the entire value you donated (enabling you to write off all or nearly all of your taxes).
- You can seed the trust with nearly any asset — public equities, real estate, crypto, or even cash — and reinvest the gains in other assets throughout the term of the trust.
- Every year, the trust donates a predetermined amount to a recognized charity, such as the American Cancer Society, or your own Donor Advised Fund (DAF). You are liable for the taxes on the income generated inside the trust (though we do our best to minimize this tax exposure).
- At the end of the trust's term (a predetermined number of years), the trust gives its largest donation to charity and you receive the majority of the trust assets.
- 🥳 Celebrate — You successfully deferred your taxes and were able to reinvest what would be taxed to keep those assets compounding and working for you!
How can you benefit from a CLAT?
By putting your assets or cash into a CLAT and setting it up to pay out to charity very slowly, you can back-load your tax obligation — enabling you to zero out your current tax bill — pay a very small amount (in the three or low four figures) every year, and defer your big tax bill until the final year of the trust, 20+ years from now.
Why does this work? In exchange for these promised donations, the government allows you to take a large up-front deduction — as much as 100% of the amount you put into the trust. Although the math is complicated, the IRS is essentially calculating the value, in today's dollars, of all of the money you pledge to give to charity over the term of the trust; by back-loading those payments, you can reinvest the money and earn much more than what the IRS is requiring you to donate. (For those interested in the math: The tax mitigation arbitrage comes from the difference in the government's assumed growth rate of assets — 1% as of October 2021 — and the returns generated by the investments in the trust. The government is discounting your charitable deductions assuming a 1% growth rate, and as a result, you receive a large charitable deduction and also capture the growth above that rate.)
We know this is complicated so let's dive into a real-life example!
Jeff, Product Manager at Google who trades crypto on the side
Our first example is Jeff, who 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!). That's a big hit.
There's good news, though: 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 far in the future. (A quick aside: If we had had a chance to talk to Jeff before he sold off, he might have done even better by selling inside a Charitable Remainder Trust. C'est la vie, but the lesson is to start planning for these events well before you think you'll want to sell.)
If he does nothing, Jeff will owe the federal government about $115,000 in taxes on his capital gains, New York State will get another $20,000, and New York City will take $12,000, for a total tax bill of $148,000. That number is painful to stomach, and he would like to do some tax deferral planning so he can keep investing and growing his assets instead of sending just about half of them out the door.
Let's walk through how he can do that.
Setting the stage
Cost basis: $50,000
Current value: $350,000
Expected Taxes: $148,000
Gift to Trust: $300,000
Expected Post-Tax Returns after 25 years (assuming an 8% annual growth rate over the term of the trust):
Baseline (that is, not using a trust): $761,000
The big picture
We'll show you how Jeff can earn an additional $210,000, or about 27% additional returns, using a CLAT.
Immediate charitable deduction
The primary benefit Jeff will receive from putting his shares into a CLAT is an immediate tax deduction. He will get to deduct about 100% of the current value of the assets he puts into the trust, spread over two years. In this case, that's a $300,000 deduction that translates into a cash savings of about $150,000 on his taxes. Critically, Jeff gets to reinvest that money instead of paying it to the government.
What happens while the trust is operating?
Every year, the trust will make a small donation to the charity of Jeff's choice. (Recall that these promised donations are why the government allows you to take a large up-front deduction; although the math is complicated, the IRS is essentially calculating the value, in today's dollars, of all of the money you pledge to give to charity over the term of the trust.)
Every year, when the trust makes that small donation to charity — starting in the high three figures and growing 20% per year — Jeff will pay taxes on that money. That'll amount to a small tax liability of around $60,000 over 25 years.
But if Jeff is going to have to donate more than $360,000 to charity and pay taxes on those amounts, where's the benefit of this strategy? The key is that, by deferring the majority of the donation and therefore the taxes, 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 gets to benefit from the magic of compounding in the meantime. He eliminates about $150,000 in taxes at the beginning, reinvests that money for 25 years, and gets to reap most of the gains in the end.
Indeed, in the final year, after making his annual donations, Jeff will receive all of the assets remaining in the trust — about $1.6 million on a pre-tax basis. He will pay the taxes on that amount, but, even so, he'll end up with about $1 million — much more than he would have if he had just paid his taxes in year 1.
How does Jeff plan to use his money?
One of the first questions our customers ask us about CLATs is the following: "These gains are great, but my money will be locked up for the entire term of the trust. So what's the use case?" It's true that, unlike a Charitable Remainder Trust, a Charitable Lead Trust does hold your money for the trust's entire term. For that reason, most people think of a 15-, 20-, or 30-year CLAT like a retirement savings account or IRA.
What would all of these tax savings, investment gains, and donations mean for Jeff's bottom line? After 25 years of 8% growth, Jeff expects to end up with about $1.95 million in total payouts. About $360,000 will go to the charity of his choice — that's the bargain he struck when he chose a Charitable Lead Annuity Trust — so he ends up with about $1.6 million in his pocket or $970,000 after taxes.
If, instead, Jeff had paid his taxes upfront and reinvested the remainder — about $150,000 — in a regular, taxable investment account, he would have ended up with about $760,000 after taxes.
In other words, even after making what can only be described as a very generous donation to charity, Jeff still pockets an extra $210,000, all because he used a Charitable Lead Annuity Trust.