Charitable Lead Annuity Trust (CLAT): How to Pay $0 Tax in a High-Income Year
Charitable Lead Annuity Trust (CLAT): How to Pay $0 Tax in a High-Income Year
EXECUTIVE SUMMARY
- The Opportunity: You sold a business or exercised stock options, generating $1M in taxable income. You face a $370k+ federal tax bill.
- The Mechanism: A Grantor CLAT allows you to deposit that $1M into a trust. You get an immediate income tax deduction for the present value of the future charity payments. If structured correctly (“Zeroed-Out”), the deduction can equal 100% of the deposit.
- The Payoff: You wipe out your current tax bill. The trust pays charity annually for a set term (e.g., 20 years). Whatever is left at the end (the “Remainder”) comes back to you or your heirs tax-free.
- Authority Baseline: This strategy leverages the statutory deduction rules for “Split-Interest Trusts” under IRC § 642(c), allowing taxpayers to front-load charitable deductions.
Most people give to charity and get a small tax break. The CLAT is for people who want to give to charity instead of paying the IRS. It is a mathematical arbitrage: You trade a tax payment today for a charitable donation paid over 20 years. Meanwhile, the principal stays invested and growing. According to Team BMT Analysis, this is the most powerful “Rescue Strategy” for unexpected windfall years. Source: American College of Trust and Estate Counsel (ACTEC)
Scenario: You want to convert $1M Traditional IRA to Roth IRA. Tax Cost: $370,000.
- Step 1 (Create Tax): You convert $1M to Roth. Taxable Income +$1M.
- Step 2 (Erase Tax): You fund a $1M Grantor CLAT. Tax Deduction -$1M.
Net Taxable Income: $0. - Step 3 (The Flow): The CLAT pays charity $50k/year for 20 years.
Investment Growth: If the CLAT earns 8% and pays charity 5%, the excess stays in the trust. - Step 4 (The Return): After 20 years, you get the remaining principal back (approx $1M+). Plus, you have $1M in a tax-free Roth IRA.
BMT Verdict: If you are paying 37% federal tax on a windfall, you are volunteering to lose wealth. The CLAT effectively redirects your tax dollars into a private investment account that services your philanthropic goals. It is the only vehicle that can legally generate a 100% offset against Adjusted Gross Income (AGI).
Wealth Impact Simulation
| Action | Immediate Tax Bill | Total Given to Charity (Over 20 Years) |
|---|---|---|
| Pay Taxes (No Strategy) | 370000 | 0 |
| Execute CLAT | 0 | 1000000 |
*Chart Note: By using a CLAT, you deprive the IRS of $370k and give $1M to charity instead. The “cost” to you is liquidity (the money is locked up), but the “benefit” is directing social capital while preserving the principal for later.
“But I lose access to the money for 20 years.” Yes, that is the trade-off. However, paying taxes loses the money forever. The CLAT is a “temporary loss of access” to save a “permanent loss of capital.” If you have other liquidity, the choice is obvious.
CRITICAL SCENARIO: The “Phantom Income” Risk
The Grantor Trust trap.
| Trust Type | Pros | Cons |
|---|---|---|
| Non-Grantor CLAT | Trust pays its own tax. No liability for you. | No upfront deduction. Not useful for wiping out a windfall tax bill. |
| Grantor CLAT | Huge upfront deduction. Wipes out personal tax. | You pay tax on Trust’s income. Every year, the CLAT’s investment gains are taxed on your personal return, even though you don’t get the cash. You must have outside cash to pay this. |
Execution Protocol
The IRS assumes your money grows at the “Section 7520 Rate” (e.g., 5%). If your CLAT investments earn 8%, the 3% spread (“The Arbitrage”) accumulates inside the trust for your benefit.
Timing: Execute when 7520 rates are low to maximize the arbitrage.
Don’t do a flat payout. Use a “Shark Fin” or “Back-Loaded” payout schedule. Pay the charity very little in the early years (allowing principal to compound) and balloon payments in the end. This maximizes the amount left over for you.
You can name your own Donor Advised Fund (DAF) as the beneficiary. This keeps the money under your control even after it leaves the CLAT.
Decision Order: Calculate Tax Bill → Determine CLAT Amount → Fund DAF → Invest for Growth.
This strategy requires a minimum funding of $500k to justify legal fees ($5k-$10k). If your tax bill is under $100k, stick to a simple DAF contribution.
WEALTH STRATEGY DIRECTIVE
- Do This: Pair a CLAT with a massive Roth Conversion. The deduction from the CLAT neutralizes the income from the conversion, effectively moving millions into Roth for free.
- Avoid This: Funding a CLAT with low-yield bonds. The math only works if the investment return beats the IRS hurdle rate. You must invest aggressively (Equities/Alts) inside the CLAT.
Frequently Asked Questions
Can I get the money back sooner?
No. It is an irrevocable term. If you need liquidity, you cannot break the trust. This is “Permanent Capital” committed for the term (10-20 years).
What if the investments drop?
If the CLAT portfolio performs poorly (below the hurdle rate), the trust might run out of money paying the charity. In that case, you (the remainderman) get nothing back. The charity got everything. You still kept the initial tax deduction.
Is this a listed transaction?
No. CLATs are standard, statutory vehicles codified in the IRC. They are not aggressive tax shelters; they are government-incentivized philanthropy.