Farm Property and the CRT

Farm Property and the CRT – A Better Way to Preserve Family Wealth

Although there has been a lot of press about the reduction of the capital gains tax this year, the tendency for most owners of significantly appreciated assets is to hold them, rather than sell and accept any tax liability. Most of us in the estate planning community recognize that anIRC § 664Charitable Remainder Trust offers clients several creative, legal and ethical ways to minimize these tax burdens. Although many financial service professionals promote the CRT as a “capital gains bypass trust”; in reality, the trust offers more than the opportunity to reduce just the capital gains tax. Properly integrated into an estate plan, a CRT can be used to assist family business transition planning and control “social capital” by deciding on a voluntary – self directed gift instead of an involuntary tax overseen by others. Add to those advantages the ability to create a family controlled philanthropy preserving influence benefits of family wealth and you have a dynamic plan. The problem is that we typically approach estate planning processes piecemeal and don’t put together a complete package, one that goes beyond estate planning and actually encompasses wealth preservation planning. A classic case study follows. This IRC§664 Trust deals with creeping suburban sprawl and the conversion of farmland into shopping center parking lots.

John and Betsy Moore, ages 62 and 59, have an 80 acre parcel of ground that has been used primarily for corn and soybean production for their family farm. Recently, they have been offered a price based on a square footage figure for their land, acreage that they bought years ago for $500/acre. Since the Moore’s children are no longer active on the farm, the questions about preserving value and using assets to provide for a retirement have popped up. The Moore’s view this as an opportunity to create retirement security, since neither managed to set aside much in their IRAs. As they reviewed the tax liability with their accountant, he suggested that they call me to run a sample scenario*. Compare what would happen if they kept the land and continued to farm it, or sold it and paid the tax, reinvesting the balance, or transferred it to a CRT. The following chart seems self-explanatory, and they decided it made more sense to utilize the CRT as a retirement and tax planning tool and keep their assets in the community. In this case, they chose to fund a local hospital, a nursing home and a college in a nearby town, rather than let the IRS collect unnecessary tax and have the funds redirected to other non-local causes.

Hypothetical evaluations are provided as a professional courtesy to members of the estate planning community. Feel free to call for suggestions.

** Insurance premium of $25,028 for duration of joint life expectancy was used so there would be no difference between options B and C in the net cash flow ($775,867 was removed from option C cash flow to fund WRT). Policy used was a variable universal type survivor life policy with investment options at 10% like alternative investment assumptions. Funded with Crummey gifts to ILIT. All investment returns are hypothetical with no guarantee of future performance.

*** Value to family does not include the appreciated value of the charitable gift to family philanthropic interests.

© 1997, Henry & Associates, Springfield, Illinois

Henry & Associates

Gift & Estate Planning Services

Charitable Education Trusts for Grandkids – Henry & Associates

Charitable Education Trusts for Grandkids

Vaughn W. Henry © 1999

“There are two systems of taxation in our country:

one for the informed and one for the uninformed.”

Honorable Learned Hand (1872-1961)

Many planners believe a CRT only works for older income beneficiaries. However, there is a way for a family to fund both philanthropic goals and meet educational needs. How and why does it work? It takes the tax-free compounding of assets and uses an IRS §664 “spigot trust” to precisely control income. In the Watson family, Richard and Pam have several preteen grandchildren to help through college. However, they didn’t want to use the traditional gifting via the UTMA/UGMA approach. Instead, a CRT lets them ensure their own philanthropic legacy and still provide funds for educational expenses. In the simplest terms, Richard created individual trusts to benefit each of his grandchildren by transferring $50,000 of appreciated telephone company stock to each charitable remainder trust. By naming his granddaughter, Hannah, as the sole income beneficiary of the first “term of years” trust, he started the college funding plan last year. While most charitable trusts are intended to last over a life expectancy, this trust is designed to terminate after just 10 years and pass the remainder to the family’s charity, a donor advised fund at the local community foundation. By creating a 6% payout NIMCRUT, Richard will receive an income tax deduction of $27,858 for his $50,000 gift to the trust. Since the trust only operates for a limited time, it allows Richard and Pam to jointly make an “income interest” gift to Hannah valued at just $22,142, allocated to lifetime and generation skipping exempt gifts. Since Hannah is only 11 years old, she’s not expected to need college funding for 7 more years, so the investment will be structured to produce only growth and no “distributable” income for the first six years, allowing the CRT to grow. When Hannah turns 18, the “spigot trust” modifies the investment and pays out income for tuition at her lower marginal income tax rate.

While the trust’s performance depends on the underlying investments, it’s very important to select a tool that allows precise control of income recognition. The other common problem with a NIMCRUT is the inability to actually access the make-up account without compromising the total return portfolio of investments. “Spigot trusts” are inherently complex, so a careful review of all the options should be made. Of the many products available to the Watson’s financial advisor, a well-diversified portfolio of equities for growth may be found in a number of deferred annuities. Some advisors might question putting an ordinary income producing tax deferred product into a tax-exempt trust, but there are compelling reasons to do so, if the annuity has been especially designed to work within a CRT. The “garden variety annuity” will have too many design flaws to work properly inside a NIMCRUT, but if the document allows annuity use, it should be considered. Ordinary income tax treatment of distributions isn’t likely to be an issue for such young income beneficiaries with their already low tax rate. The other usual concerns about pre 591/2 restrictions and non-natural persons owning annuities aren’t an issue inside the exempt CRT; instead, understand why the “recognition” of annuity income works in favor of the “spigot trust”.

Given the time frame of the trust, a growth-oriented set of investments should be selected. If it performs better than expectations, Hannah will receive even more income for college expenses and the charity will benefit by having a larger remainder. As designed now, the charity should receive $104,761 while Hannah will have $42,491 of income, taxed at her lowest marginal rate, to help her pay tuition and board. The advantage to this technique for the Watson’s estate plan is that it:

• removes an appreciating low basis asset from the estate without incurring capital gains liabilities
• funds a significant growth asset without significant gift or generation skipping tax liabilities
• keeps control of assets that otherwise would be taxed and returns them to a family influenced charity
• creates an income tax deduction for a higher income older generation, with five more years of tax relief if the deductions can’t all be used in the first year

It’s not a technique for all clients or donors, but in the right situation, it works well. For a hypothetical evaluation, have our office run an illustration.

Tax Free Assets?

Tax Free Assets?

Unconventional Control of Family Assets

Vaughn W. Henry

 Unconventional maybe, but for sure this is an effective and powerful means to re-exert control over assets that would otherwise be lost to unnecessary taxation.

For those client/donors who already make significant donations and who may not be able to make full use of the charitable deductions, consider how the Lead Annuity Trust (CLAT) might be a useful alternative. If the purely philanthropical tools don’t motivate the client, consider this as an advanced estate and financial planning strategy designed to effectively pass assets down to heirs. An added benefit is that it maintains control of the social capital generated by the family when a family foundation is built into the final plan.

A reciprocal trust arrangement to the more popular Charitable Remainder Trust(§ 664 CRT), the Lead Trust is created under IRC §170 (f)(3). The major difference is the lead trust is a taxable trust providing periodic payments to a charity with the remainder either passing back to the donor or on to the donor’s heirs.

Why does this work well for some families intent on passing assets down more efficiently? Discounting and control. For example, a $3.03 million piece of farmland that generates 5.09% annual income but is expected to appreciate significantly because of location is already an estate tax liability just waiting to happen for many families. One possible scenario that employs efficient tools for conserving and passing value incorporates a Family Limited Partnership (FLP) and a non-grantor CLAT. The farmland is transferred into the FLP and the 99 limited partnership units are passed into the lead trust. The net effect, with a 30% discount typically attributable to unmarketable minority assets in a FLP, is the CLT receives income generating assets valued at $2.1 million. By passing out 7.25% of the initial value of the trust annually to the family’s charitable foundation or donor-advised fund in the local community foundation, the heirs will receive the discounted farmland valued in the trust at just $605,766 by deferring possession for 16 years. This value is less that the donor’s unified credit, and so the transfer avoids estate tax through a double discount strategy. At the same time, remember that the land is also appreciating at 6% inside the CLT and so it passes to the heirs without additional taxation at a value of $7.62 million. (There are some wrinkles if A FLP is used, generally a CLAT has to be rid of any ongoing business entity within 5 years or Excess Business Holdings may trigger unfavorable tax treatment. In this example a 2 trust CLAT, one holding FLP units and another holding land and securities, would be more likely to succeed.) What’s the cost? A deductible contribution to charity. In this case, $38,062.50 paid quarterly to the family’s foundation can be distributed to further advance the family’s values and charitable legacy while still passing assets to heirs efficiently. If the appreciating farm could be passed without paying any estate taxes, would a family give up the right to the income earnings on their farmland? Follow the math below. Questions? Check with our office for design options and suggestions.

© Henry & Associates 1998, 2000

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The 10 Per Cent Solution — CRT Planning Traps

The 10 Per Cent Solution — CRT Planning Traps

Vaughn W. Henry

As a result of changes to tax law, be aware that there are a few wrinkles that crept into the creation of a charitable remainder trust (CRT). In an effort to force charitable intent and minimize abuses, the §1089 section of the Taxpayer’s Relief Act of 1997 now mandates a 10% remainder value for the charity’s portion of the split interest gift. What factors affect the charity’s remainder? Number and age of beneficiaries or length of trust term, per cent payout to the income beneficiary, type of CRT and contributed asset, the §7520 120% applicable federal rate (AFR) and initial contribution all affect the tax deduction. However, the remainder is also significantly affected by the investment returns inside the trust and the IRS has little control over that influence. For this reason, the trustee needs to be very aware of the long-term results of a diversified and well-structured portfolio.

TRAPS

When discussing a CRT as a planning option, pay close attention to the charitable remainder calculations. From a practical perspective, it just means taking more care to make sure the trust qualifies. Concerns about having a CRT eligible as a tax-exempt trust under §664 are made more difficult if there are either high payouts or young income beneficiaries. During the planning process, the problem often occurs if there is a large disparity between ages of the income beneficiaries, e.g., parent – child or with spouses of much different ages. It may also occur if several income beneficiaries are included, for example, if a grandparent attempted to set up a trust for his 4 grandchildren. The choice between per cent payout and per cent deductibility also needs to be examined over the time frame of the trust. Unfortunately, too many planners view income tax deductions as the primary motivation to establishing a CRT. In reality, the power of the trust is in conserving the capital gains and investing the entire sale proceeds of an appreciated asset inside a trust that compounds the investment performance tax-free. An added benefit is the control or influence over the trust’s social capital disposition that becomes an important component of the plan for many families.

OPTIONS

If the CRT does not qualify, then a term of years trust (not to exceed 20) or a CRT with a lower income payout might. In the example above, the 5% payout is already the least allowable, so it may make sense to try to include fewer income beneficiaries instead. How could this work? In the case of a married couple, consider offering the younger, healthier and probably female partner the income beneficiary designation. If she’s the last to die (a statistical probability), then the income stream would pass to the family unit as it would have if both spouses were each receiving 50% of the CRT. There is no difference. However, if she predeceased her spouse, then he loses all the future income benefits and there is an increased risk to consider. To reduce the risk of income loss to the non-income beneficiary, an insurance policy could be acquired for a term long enough to recover the value of the contribution.

RESULTS

A successful unitrust produces a steady stream of increasing revenue; if properly invested, it also delivers tax efficient income. Besides benefiting the income beneficiary, high quality investment returns also produce a larger corpus for the charity. In the example above, the IRS assumes that the trust won’t generate more than the AFR of 6.6% and that seems to be an unrealistically poor return for a trustee’s performance over the young income beneficiaries’ 50 year life expectancy. Moving the trust investments from an 8% return eventually producing $1.1 million to 10% means that $2.8 million goes to charity instead, and a 12% return generates $7.3 million to charity. The fiduciary obligation to manage for both current income and the deferred beneficiary should encourage the trustees to look long term and seek sophisticated investment counsel for best results.