Why Last-Minute CLATs Can Cost Clients Dearly
It’s human nature to wait until the last minute, especially when it comes to unpleasant things like taxes and estate planning.
Early in my career, when I was new to the charitable giving world, I helped one of my largest clients fund a charitable remainder trust. I remember standing in the office of his Merrill Lynch broker on New Year’s Eve, waiting for the firm to transfer my client’s shares to the beneficiary’s new account. We’re talking about a $1.5 million transaction, which was a lot of money in the early 1990s.
I remember thinking to myself: “I’m never doing this again because if this doesn’t go right, my clients doesn’t get the deduction this year, and he’s going to be mad at me.” So, I waited most of the day until the funds finally cleared, and I had the grubby little transfer document in my hand right before the brokerage office closed.
It happens every year. There’s always a last-minute estate or charitable transaction that could get entirely canceled out if something goes awry. If it does, your client’s not happy with you, and they must wait another 12 months to get the deduction or risk losing it altogether.
What You Can Do Before Year-end
Sure, there’s still time to help clients set up a CRT, donate to a pooled income fund or make an outright gift of highly appreciated stock. But anything that requires drafting a trust document or transferring a complex asset from one financial institution to another at the last minute will always be problematic.
CLATs
One item that shouldn’t be rushed is the charitable lead annuity trust.
Year after year, as the calendar turns to November and December, panicked advisors call us to set up a charitable lead annuity trust before year-end to help a client offset a large liquidity event (such as a business sale, a large bonus or cashing out company stock).
In a basic CLAT, the trust pays a fixed amount of the trust’s assets to a qualified charitable organization for a specific number of years or for the life of the donor. At the end of the term, the trust’s principal is paid to the grantor, family members or other non-charitable remainder persons. This also gives the donor a charitable income tax deduction that may be as high as 100% of the contribution amount.
Waiting until the last minute to set up a CLAT is one of the most common and potentially expensive mistakes we see in high-net-worth tax and estate planning. Rushing the execution of this strategy can expose your client to several painful risks:
1. Transfer and funding bottlenecks. A trust doesn’t provide tax benefits simply because the paperwork is signed; it must be fully funded before midnight on Dec. 31 to claim a deduction for that tax year.
If publicly traded securities are involved, it typically takes several weeks to set up new institutional brokerage accounts in the name of the newly formed trust, to clear compliance/”know your customer” restrictions and to execute in-kind transfers.
2. Missing the Internal Revenue Service hurdle rate window. The efficiency of a CLAT depends on outperforming the IRC Section 7520 rate, a statutory hurdle rate set monthly by the IRS.
When you fund the trust, the current month’s Section 7520 rate locks in for the entire term of the CLAT. Waiting until the last minute means losing the flexibility to choose the optimal month. Even though there’s a three-month lookback to choose the best rate, if interest rates are projected to rise like they are today, waiting until the end of the year could significantly raise the hurdle that your client’s investments must clear to pass tax-free wealth to their heirs.
Don’t Become Shark Fin Bait
We’ve even had several calls about setting up more aggressive Shark Fin CLATs before year-end. Here, a donor funds the trust and receives an immediate deduction, but the trust pays the charity, and then the balance reverts to the donor or the donor’s heirs after a period of time or upon the donor’s death. A highly optimized CLAT often uses a “Shark-Fin” structure in which annual charitable payouts are heavily backloaded to keep capital compounding inside the trust for as long as possible. For lifetime Shark Fin CLATs, these structures are sometimes funded with life insurance policies to assure the balloon payment can be met at the end.
Here’s the problem: Precise financial models must be developed before these CLATs are implemented. And good luck trying to get a life insurance policy underwritten during the holiday-compressed final months of the year.
Other Strategies
In addition to CLATs, don’t try to rush any strategy that requires multi-step planning. We often get last-minute requests to set up various types of trusts or gifts of complex assets such as real estate, closely held business interests, artwork or collectibles. We have to turn the work down if the advisor insists on getting it done before year-end.
You don’t want clients giving assets away that they may never get back, especially if it’s going to create financial hardship or donor’s remorse. When you’re just trying to beat a tax deadline, you stop losing the ability to be objective and think and really consider everything in the context of an overall plan.
