Turning off the Ordinary Income Pump

Employer Stock in Selected 401(k) Plans

Employer ^1	%	Employer ^1	%
Procter & Gamble	94.7	Williams	75.0
Sherwin-Williams	91.6	McDonald's	74.3
Abbott Laboratories	90.2	Home Depot	72.0
Pfizer	85.5	McKesson HBOC	72.0
BB&T	81.7	Marsh & McLennan	72.0
Anheuser-Busch	81.6	Duke Energy	71.3
Coca-Cola	81.5	Textron	70.0
General Electric	77.4	Kroger	65.3
Texas Instruments	75.7	Target	64.0
William Wrigley, Jr.	75.6	Household International	63.7
^1 Company stock as a percentage of total 401(k) plan assets		11/01 DC Plan Investing, Institute of Management and Administration, NY.

Despite the clamor for pension reform resulting from the Enron debacle, many of the nation’s best companies still have plenty of their own stock in their profit-sharing and 401(k) retirement plans. While there are no taxes when assets are sold and reinvested inside these plans, lifetime withdrawals typically produce all ordinary income, taxed at the owner’s highest marginal tax rate. In addition, such assets can be hit at death with both the income tax and the estate tax, consuming up to 80% of their value as IRD assets (income in respect of a decedent). These IRD assets are more frequently found and many people don’t recognize the tax traps associated with a lifetime of tax deferred savings.

Many people nearing retirement or after leaving an employer irrevocably roll these assets into an IRA, wait until the mandatory withdrawal age (April 1 after the year the owner turns 70 ½), and then begin withdrawals under the required minimum distribution rules. From an IRA, withdrawals are 100% taxable ordinary income. There is another, more tax-efficient way.

What Works?

Under retirement plan distribution rules ⁽³⁾, if you meet certain requirements, you can convert the appreciation from ordinary income to long-term capital gain by taking an “in-kind distribution” of the employer securities inside your 40l(k) or profit-sharing plan. There is no capital gain tax until you sell, but you report as ordinary income only the cost basis of the stock. This forces most people to sell stock to raise cash in order to pay the tax, but this sale would also trigger the 20% capital gain tax on the appreciation. What to do?

You can structure a win-win situation for you and for your favorite charity. The ordinary income tax to which you are subject when you receive an in-kind distribution can be offset by the charitable deduction generated by funding a CRT.

Example: $2.5 million market value with $300,000 cost basis. Income tax is due on $300,000 cost basis. Owner sells the stock triggering 20% capital gain tax on the appreciation. Total income tax and capital gain tax is $555,800.

Solution: Part Sale/Part Gift. Sell $500,000 worth of shares. Contribute $2 million worth of shares to a CRT.

Sale Portion: Ordinary income tax on $300,000 basis; 20% capital gain tax on gain from the sale of $500,000.

CRT Portion: Charitable income tax deduction on remainder value of CRT. No immediate capital gain tax when CRT sells the shares. Lifetime income to owner/spouse; preferential tax treatment under the 4-tier system. On death, CRT assets go to donor’s charity. (For age M65/F65, 5% CRT, 5.4% discount rate, deduction is $705,540 to be claimed up to IRS contribution ceilings)

Who is Eligible?

Employee must have been a participant for five years, and attained age 59 1/2; or have terminated service with the employer; or be significantly disabled ⁽²⁾.

Summary of Advantages of an In-kind ⁽³⁾ Distribution via CRT Planning

• Ordinary income from pension distributions can be converted to long-term capital gains.
• Avoids double taxation as IRD asset at death.
• Avoids the confusing minimum distribution requirements.
• Property can be transferred without triggering income tax on amount exceeding cost basis.
• Lifetime income to donor and spouse.
• Charitable deduction for CRT offsets income tax from in-kind distribution.
• Donor’s favorite charity receives substantial gift on death of CRT beneficiaries.

⁽¹⁾ DC Plan Investing, Institute of Management and Administration, New York

⁽²⁾ IRC Sec. 72(m)(7)

⁽³⁾ IRC 402(e)(4)(D)

© 2002, Henry & Associates – Ashton Associates

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Vaughn W. Henry
Henry & Associates
Gift and Estate Planning Services
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Last Updated: November 11, 2002

Gift & Estate Planning Services © 2002

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note -- there's much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not "do it yourself brain surgery". When is a CRUT superior to a CRAT? Which type of CRT is best used with which assets? Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When to use a CLUT vs. CLAT and the traps in each lead trust. Which tools work best in which planning scenarios? Check with our office for solutions to this alphabet soup of planned giving tools.