John Anderson, a 72 year-old confirmed bachelor, has $1 million worth of low basis real estate at the edge of town.  While it has been steadily appreciating, he has a desire to relocate to warmer climes, so John has decided to sell and move to a golfing community and enjoy his retirement.  As an electrical engineer, John is very comfortable evaluating ledgers and exploring his options in minute detail, so he has decided to make use of a charitable remainder trust to minimize the $225,000 tax on his capital gains liabilities and retake control of his social capital.  While he understands the philosophical and mechanical concepts behind the CRT, his broker has limited experience with investing inside a tax-exempt §664 trust and has proposed a series of products for the CRT when the property sells.  When comparing options for a 5% quarterly payout, John assumed an average 9% annual return, but wanted to know how much spendable income he could expect from his trust if he used different asset allocations from the all-ordinary to the all-appreciation models.

      How important is it to invest tax efficiently? 

       In John Anderson’s case, a CRUT funded with $1 million of appreciated assets, the difference in net spendable income is significant.  John is a conservative investor and his broker proposed a series of income type securities.  However, his broker initially chose an investment model with an annuity and bond portfolio under the mistaken notion that he needed a guaranteed income stream to meet the unitrust payment.  Nevertheless, by doing so, the broker will have turned a capital asset into a highly taxed ordinary income pump.  Over John’s life expectancy, a unitrust producing all tier one distributions from fixed income investments will shortchange him by $170,000.  Instead, if he moves the selected investment allocation model from the 100% ordinary income portfolio with $1,050,564 of income up towards the 100% capital appreciation portfolio, he produces $1,222,910 over the life of the trust.  By doing so, the broker puts more money into John’s pocket without negatively affecting the charity’s interest.

© 2002 -- Vaughn W. Henry

Gift and Estate Planning Services -- Springfield, IL  62703-5314

217.529.1958 -- 217.529.1959 fax -- VWHenry@aol.com

on the web at gift-estate.com

       When John suggested a tax efficient, equity driven portfolio, the broker’s next reaction was to suggest a more aggressively managed brokerage account.  The problem with investment accounts, if a lot of trading occurs, is that short-term gains taxed at ordinary income rates in an active account may not perform as well as one with a “buy and hold” philosophy, or one with tax managed sales and purchases.  Another problem occurs if portfolio managers make use of margined stock until trades clear or buy partnership investments.  While these wire house actions are generally legitimate inside an individual’s account, they poison the CRT with unrelated business income and debt-financed assets, and that loses the CRT its exempt status.  If that happens in the first year of the trust’s existence, then the sale of the contributed asset becomes a taxable event.  Since John funded his CRT with the expectation that it would minimize his capital gains liability, this creates serious problems.  If a broker is willing to gamble on his or her E&O or malpractice coverage, this mistake might slip by, but it would be better to avoid the problems in the first place by understanding the limitations of investing inside a charitable trust.  Even if investment advisors are used to working with retirement or endowment accounts, they may not truly understand how different a CRT is.  Seek competent and experienced advisors for best results.