Lead trusts provide wonderful leveraged gifts. The gift and estate tax deduction, of course, is equal to the present value of the income to charity. When the Applicable Federal Rate approaches 4% or lower, lead trusts paying 6% to 8% provide a very significant gift or estate tax deduction. Depending on the trust term, the deduction can range from 60% to 100% of the lead annuity trust value.

But can a donor double his or her benefit? Is it possible through creative planning to receive a double discount? If the plan is structured correctly, it may be possible to obtain a double discount and move assets through to children in a few short years with zero gift or estate taxation.

Family Limited Partnership

The double discount lead trust concept involves both a family limited partnership (FLP) and a charitable annuity lead trust. The family limited partnership is created with 99% limited partnership interests and 1% or less general partnership interests. Under IRS guidelines, there must be a business purpose for the limited partnership.

A limited partnership interest is typically not easily sold. The family member with the general partnership interest controls the operation and liquidation of the partnership. Thus, the limited partner might hold his or her interest for many years with very minimal benefits. Under this circumstance, the willing buyer/willing seller test results in a significant discount from fair market value.

While there have been cases with higher discounts, the discount levels for FLPs with liquid securities are typically 15% to 20% and for those that hold real estate are approximately 30% to 40%. These discounts reflect both the lack of marketability and the lack of liquidity of the FLP interests.

Charitable Lead Trust

Charitable lead trusts are usually funded with a portfolio of securities. While real estate and other assets are permissible, securities are relatively easy to manage and thus are favored by trustees. However, in some circumstances it may be possible to fund a charitable lead trust with limited partnership interests. There are three primary requirements for this arrangement. First, there should not be debt in the partnership. Second, there should not be an active business in the partnership that would cause the charitable trust to recognize unrelated business taxable income (UBTI). Under Sec. 512(c)(1), even a limited charitable partner may recognize active income and be subject to UBTI. Third, there must be a friendly general partner who will not violate rule one or rule two during the term of the trust.

Several tax rules require these three conditions. If there were debt in the partnership, then under Sec. 512 and Sec. 514, the presence of debt could give rise to unrelated business income. Similarly, if the business is not engaged solely in producing passive income, but is involved in an active business, there also could be UBTI. The problem with a charitable lead trust that has UBTI is that under Sec. 681 the trust no longer receives a full deduction for all distributions to charity. While lead trusts normally are able to earn and deduct 100% of income under Sec. 642(c) when the income is transferred to charity, lead trusts with UBTI are subject to the 30% appreciated and 50% cash limits of Sec. 170. Thus, it is essential to avoid the creation of UBTI in a lead trust.

Planning Considerations

Clearly, the double discount lead trust has enormous tax advantages. It is possible in family business planning to move a multimillion-dollar block of C corporate stock from one shareholder to another in just under five years with minimal taxation. Alternatively, families might use the plan to transfer a major inheritance value to children within a relatively short period of time.

However, the combination FLP and lead trust does require a fairly knowledgeable attorney and an experienced appraiser. The valuation of the discount on the FLP must be very well supported, or it may be subject to attack by the IRS.

Other planning factors include considering the possibility of sale of assets during the term of the lead trust. Since a lead trust is a taxable trust, there would be very significantly negative consequences with a sale of trust assets and payment of capital gains tax out of the lead trust. Indeed it is possible that a major portion of the lead trust principal could then be required to make the distributions to charity, thus reducing the inheritance for family.

In some circumstances, the limited partnership will make distributions to the lead trust and those distributions may then be transferred to the charity. However, it may in other circumstances be necessary or appropriate to transfer limited partnership interests to the charity. At a future time, a plan would necessarily contemplate repurchase of those interests by the family from the charity. Fortunately, a public charity is not subject to the Sec. 4941 self-dealing rules. Therefore, the children or an entity owned by the children may be permitted to repurchase limited partnership shares at fair market value.

The FLP/lead trust plan provides a very effective means for wealth transfer. Assets may be transferred to family members in a relatively short period of time with little or no gift taxation. Truly, the double discount lead trust is a double benefit to all concerned.

Example – Living Lead Trust

Harold Wilson has a very substantial estate and desires to move significant assets through to family members. However, he would like to leverage his exemption by a factor of five. That is, for each dollar of exemption used, he would like to move five dollars through to family members.

Harold transfers assets valued at $10 million to a family limited partnership. He selects a mix of liquid property and real estate with a fixed-payment lease. Under appropriate Treasury and Tax Court guidelines, the appraiser determines a 35% discount for lack of marketability and lack of control. Harold then transfers the limited partnership interests with their discounted value of $6.5 million into a lead trust. Based upon an assumed $601,250 payout on the $10 million in value, the lead trust is written to pay out 9.25% of the discounted $6.5 million value for a term of eight years. The charitable interest is valued at $4,220,595. Harold's CPA files a Form 709 gift tax return and shows a transfer of $6.5 million with a charitable gift deduction of $4,220,595 reducing the taxable gift to $2,279,405.

The lead trust pays $4,810,000 to Harold's favorite charity over the next eight years. At the end of eight years, the family limited partnership is transferred to family members. The assets have a discounted value of $7,158,551, but the underlying value is $11,013,155.

Has Harold leveraged his exemption? For the use of approximately $2.3 million of gift exemption, Harold has transferred in just eight years nearly five times as much value to family. This factor achieves Harold's leveraged transfer goal.

Example – Testamentary Lead Trust

Clara Williams has a $15 million estate. She is recovering from cancer, and the treatment two years ago was apparently successful. She is concerned that with the current estate tax exemption of $5 million, her estate will be taxable in the future. Therefore, Clara seeks opportunities to protect her estate from estate taxation.

Her attorney observes that a substantial proportion of her estate could be transferred to a family limited partnership. If she were to pass away, the FLP could be distributed to a lead trust. She would receive a discount first for the FLP and then for the lead trust.

Clara followed her attorney's advice and created a FLP with $13 million in assets. She retained her home and sufficient assets outside the FLP to provide for her support and care. Clara's attorney drafted a lead trust to receive the limited partnership interests when she passes away. Unfortunately, she did have a recurrence of the cancer and passed away quite suddenly.

At that time the $13 million lead trust was discounted by 28%, since the majority of the trust was composed of liquid assets. The discounted value of $9.36 million was used when setting the 7.64% payout of the lead trust annuity. For 10 years, the trust will pay an annuity of $715,104 to charity. At the end of this time, the trust will be distributed to family. It will have grown to $11,298,795 of discounted value. However, the underlying assets will then be valued at $15,692,771. Best of all, after both the FLP and the lead trust discounts, the plan produced a trust that changed the potential estate tax from $2,121,000 to zero. With no estate taxation, Clara will have transferred over $17 million in present and future value to family. (Note: This example assumes a $5 million estate exemption. Future estate exemptions may differ.)

Planning Opportunity with $5 Million Exemption

With the increase in the estate exemption to $5 million, many successful persons still face a major potential estate tax. For those with charitable receptivity, a living or testamentary lead trust combined with a family limited partnership may facilitate an inheritance of ten to twenty million dollars with zero estate tax.