In 2012, the IRS finalized regulations that affect the way charitable lead trusts (CLTs) are taxed. As a result, CLTs may be less attractive than before.

A CLT makes annual payouts to a qualified charity for a specified period or for the grantor’s life. The remainder interest then passes to the grantor’s heirs or other noncharitable beneficiaries. Lifetime CLTs are usually designed as nongrantor trusts, which are subject to taxes on their net income. Testamentary CLTs (that is, CLTs funded at death) are also taxable trusts.

To minimize taxes, CLTs often contain “ordering rules,” which provide for the highest-taxed income classes to be distributed to charity first. Typically, distributions are made from ordinary income first, followed by capital gains, other types of income (including tax-exempt income) and finally trust principal. The objective is to remove from the trust, to the extent possible, the least desirable income types, leveraging the benefits of the trust’s charitable deduction. The income retained by the trust is either taxed at a lower rate or not taxable.

The IRS has never liked this strategy, and last year it finalized regulations that make it difficult to achieve. The regulations provide that ordering rules are disregarded for federal tax purposes unless they have “economic effect independent of income tax consequences.” Instead, distributions are deemed to consist of a pro rata portion of each type of trust income.

Some commentators argued that ordering rules have an independent economic effect because disregarding them would increase the CLT’s tax liability, reducing the trust’s value and, in turn, reducing charitable distributions and jeopardizing the noncharitable beneficiaries’ remainder interest. The IRS rejected this argument.

If your estate plan includes a CLT, be sure to evaluate the potential impact of the new regulations.