Tax Strategy

How to Reduce Ordinary Income Tax With a CLAT | Savvy

How to Reduce Ordinary Income Tax With a CLAT | Savvy
March 9, 2023

What Is a Charitable Lead Annuity Trust (CLAT)?

CLATs are trusts that allow you to donate assets in exchange for an immediate tax deduction.

How It Works: 

  1. You gift some of your income to the trust and get a charitable deduction up to the entire value you donated.
  2. You reinvest the cash in other assets during the term of the trust.
  3. Every year, the trust donates a predetermined amount to a recognized charity.
  4. At the end of the trust’s term, you or your beneficiary receive the remaining trust assets.

Why It Works

The tax mitigation arbitrage comes from two areas:

  • The difference in the government’s assumed growth rate of assets - 3% as of May 2022 - and the
    returns generated by the investments in the trust. The government is discounting your charitable
    deductions assuming a 3% growth rate, and as a result you receive a large charitable deduction
    and also capture the growth above that rate minus your charitable donation.
  • Writing off ordinary income or short-term capital gains now and then paying a lower tax rate as
    long-term capital gains when you pay taxes in the future.

What happens while the trust is operating?

Every year, the trust will make a small donation to the charity of your choice. Following the IRS’s prescribed procedure, that small donation to charity will start in the low four figures and grow 20%per year (ie. a $1m CLAT will donate $1,824,000 over 25 years). The key is that, by taking the deduction on day 1 and deferring the majority of the donation, you get to reinvest and grow your money for 25 years. Thus in this $1m example, in the final year, you will receive all of the assets remaining in the trust  — about $4.7 million on a pre-tax basis. Moreover, you won’t necessarily have to pay taxes on that amount on the day the trust ends; the trust can distribute the assets in kind, and you can continue to let them grow in the market until you need the liquidity.

Quantifying the Savings

  • You could earn $1,200,000 more with a CLAT
  • Additional return: 34%
  • Money donated to charity: $1,800,000

Hypothetical or simulated performance is not indicative of future results, but an illustration of the benefits of these structures and do not represent the results achieved by all Savvy clients. Past performance is not indicative of future results.

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