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Improved Tax Efficiency in Your Estate Plan – Henry & Associates

Year

Total

Estate

Assets*

($)

Pension

Assets in

Estate

($)

Total Tax

Attributed

To Pension**

Total

Transfer

Taxes ***

($)

2002

4,298,873

2,116,030

1,478,666

2,003,259

2003

4,618,258

2,235,631

1,532,920

2,155,407

2004

4,959,333

2,358,408

1,582,281

2,095,725

2005

5,323,313

2,483,855

1,628,167

2,247,712

2006

5,711,647

2,611,877

1,695,109

2,201,003

2007

6,125,467

2,741,273

1,761,268

2,384,155

2008

6,566,085

2,871,123

1,844,696

2,607,429

2009

7,035,126

3,001,109

1,928,213

2,168,521

2010

7,533,713

3,129,281

1,095,248

1,095,248

2011

8,063,583

3,255,132

2,447,101

4,386,750

 

* Net of cash flow and pension withdrawals based on minimum required distributions.

** Total tax = Federal Estate Tax attributable to pension and income tax on inherited pension and state death tax attributable to pension

*** Tax schedule based on EGTRRA 2001 and combined income tax rates (state and federal) of 35%, the hypothetical case assumes both deaths occur in 2003 with a $1 million applicable exclusion amount for illustration purposes

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Dr. and Mrs. George Olsen (both 70) have lived below their means for most of their lives and have accumulated a tidy nest egg.  As a dentist, most of George’s wealth is tied up in his $2 million IRA while his wife Angela has set aside the money she inherited in her own $2 million stock portfolio. 

 

George plans to continue part time in his dental practice and slowly phase out to make more use of his time in retirement.  When he sold his practice to a junior partner, he opted for a salary continuation plan and that will provide a steady, but finite source of retirement income.  With his salary, social security, the few stock dividends, and required distributions from his IRA, the Olsens will live comfortably.  George and Angela both have their IRA and stock portfolio assets invested with allocations that have averaged 10% over the last 25 years, and they expect their investments to continue to grow steadily.

 

While they have split their estates to take advantage of each spouse’s applicable exclusion amount, their estate planning has been haphazard at best.  Unfortunately, they have also incorrectly willed everything back to each other, effectively recombining their divided estates.  Based on their goals, they want to provide for financial security, but they do not want to enrich their children or provide any disincentive to work or succeed.  As such, they intend to leave each of their two children $1 million as their financial legacy, but the balance of their estate is destined for charitable causes important to the Olsen family. 

 

Their stockbroker has suggested a stretch IRA as a way to minimize taxes, but their accountant has recommended a different course of action if they really want to benefit philanthropic causes.  The accountant’s plan is to change their IRA beneficiary designations from their children instead to the charities.  By doing do, they will avoid the double taxation inherent in receiving “income in respect of a decedent” (IRD) and pass their income tax liability on to a tax-exempt charity.  By doing so, not only can the Olsens be tax efficient, but their children actually wind up with more tax-free assets too.

Q. – “I’ve just been given 10 minutes with the attorneys attending a “fundamentals of estate planning” state bar institute teleconference.  If you were me and had just two days to prepare, what would you want them to know about how I can help them meet their clients’ needs.”  – Planned Giving Officer

 

A. – Here’s my quick advice to the Planned Giving Officer

 

“1. Give away IRD Assets.

 

 2. Help clients ascertain their charitable interests through values-based questions (i.e., just because the client didn’t ask about a charitable gift in their estate plan doesn’t mean they’re not charitably inclined, they probably didn’t ask about a defective unfunded ILIT using Crummey gifts either, but you drafted them one).

 

 3. New legislation will continue to move the goal posts, especially with retirement assets, so you’re always willing to run sample illustrations or refer them to your stable of planning experts to help them solve client problems.”

The Olsen family plan evolved from a traditional plan (option 1) where children inherit assets after paying income and estate taxes.  Option 2 is the broker’s charitable plan.  He uses a stretch IRA, with named beneficiaries, passing the heirs the IRD assets but the charity receives its bequest by liquidating Angela’s stock portfolio.  The accountant’s more tax-efficient plan (option 3) calls for passing the heirs their same $2 million legacy.  Angela’s portfolio steps up in basis, and the charitable bequests come first from the IRD assets; as a result, no tax is due.

 

Navigating the Estate Planning Maze

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Investment Hypotheticals Within a CRT – Henry & Associates

Investment Hypotheticals Within a CRT – Henry & Associates

Are You Tax Efficient Inside Your CRT?



       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.

 

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     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.

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©2002 — Vaughn W. Henry

Gift and Estate Planning Services —SpringfieldIL 62703-5314

217.529.1958 — 217.529.1959 fax — [email protected]

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.

 

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PhilanthroCalc for the WebCONTACT 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.

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Making Tax Efficient Choices in Your Planning

Making Tax Efficient Choices in Your Planning

Children, Charity or Congress?

choices www.gift-estate.com“Give my stuff to charity!  What kind of crazy estate plan is that?”  is a typical client response.  When they ask about ways to eliminate unnecessary estate taxes and are told to make gifts during lifetime that’s an understandable reaction.  It’s not intuitively obvious how giving away something the client may need can be a good thing, especially if the potential donor was raised during the Depression.  The epiphany comes when the client looks at the choices they have for assets not consumed to support their lifestyle; those remaining assets can only go to children, charity or Congress.  Once the options are explored, many people make a decision to pass some property to heirs and other things to charities that either had or will have some impact on their family’s life.  How can they be smarter making that decision?

As it turns out, giving heirs assets that can be legally excluded from tax and leaving the rest of the estate to charity works if (and it’s a big if) tax avoidance and philanthropy are the only goals.  It’s a simple, easy to understand process with no need for expensive tax planning or specialized legal advice.  While this technique might shortchange family heirs, it is an ideal solution for charitably motivated families.  However, even if the family has an altruistic desire to make a charitable gift, there’s no reason it can’t be done in a tax efficient manner.  How so?  Make those charitable bequests with assets that otherwise would be taxed twice.  For example, in 2002 anything in excess of $700,000 is subject to a federal estate tax.  A simple estate plan would be to sweep anything above that level to charity.  A better plan would be to give away those assets on which an added income tax is owed.  What qualifies? “income in respect of a decedent” (IRD) assets.  Start with an IRA, a retirement plan account, a deferred annuity, and savings bonds; and don’t forget earned, but uncollected professional fees.  This means a charity receiving $100,000 from that donated IRA collects the whole value without paying any tax.  In the traditional estate plan, children might lose 75 percent if they inherited those IRD and tax-deferred dollars.  Better to let family heirs inherit assets that “step up” in basis, so if they’re sold later, there won’t be much of an income tax due.  The second plan is more tax efficient, as the charity receives more, the heirs get to keep more and the IRS gets zilch.

The problem is that without changes in beneficiary designations or specific language in the Will, the estate can’t make charitable gifts of income.  Bequests are normally made from principal unless there has been a proactive decision to give away tax liabilities.  Seek guidance from competent professional advisors to make sure these gifts are properly implemented, and do it now.

“If you don’t watch out, you can set up a situation where a child never has the pleasure of bringing home a paycheck.”

— T. Boone Pickens, Jr.

A good plan deals with concerns beyond tax efficiency; it must also meet the needs of the family.  For instance, will the plan provide for proper management by underage or unprepared heirs?  Has it been decided if there’s an upper limit on what heirs could or should receive?  What does the concept of money mean to the client?  How much is too much?  Could an inheritance provide a disincentive to work and succeed?  Does the plan try to pass assets to all heirs equally, or have past gifts and interactions been considered in an effort to be equitable?  Since there’s more to a legacy than just money, the estate plan should include passing down a family’s value system and influence.  How have the family’s core values been addressed in the master plan?

The problem is that few professional advisors like to deal with such intimate and personal questions.  Most tax and estate planners spend years honing their analytical skills only to find that clients don’t create and implement estate plans for purely logical reasons.  Instead, there’s an overriding emotional motivation that’s often unsolicited in discussions with client.  The problem is that even an elegant estate plan that does everything it’s supposed to accomplish won’t be well received if the family doesn’t understand and agree with its goals.  As a result, there’s paralysis by analysis, and nothing gets accomplished until both the logical and emotional needs for family continuity planning occur.  Rather than try to plan an estate on an asset-by-asset basis, take a big picture view of the family’s goals and values and see how the planning can be made to meet those needs.

© 2000 — Vaughn W. Henry

PhilanthroCalc for the WebCONTACT US FOR A FREE PRELIMINARY CASE STUDY

FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s more to estate and charitable planning than simply running calculations, but it does give you a chance to see how the calculations affect some of the design considerations. Which tools work best in which planning scenarios? Check with our office for solutions.

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Control of Social Capital

Control of Social Capital

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It’s All About Choices

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  • Disinherit the IRS
  • Why Allow the Government’s Default System to Work Against Your Family
  • Regain Control of Family and Business Assets
  • Preserve Personal Wealth and the Benefits of Community Influence
  • Pass More to Heirs and Charity/Community by Giving Away the IRS’s Money

A Note to Professional Gift/Estate Planners and Advisors

One of the most helpful tools in cultivating planned gifts is understanding the problems your client/donors face as they work to shelter assets accumulated over a lifetime of work. Until you can show client/donors how planned giving can be incorporated into their estate and financial plans, you will be an outsider looking in. When you can insert your organization into the planning process, you help donors realize how to become more efficient in conserving their social capital. Instead of asking for resources, as planned giving specialists you need to understand that the tools of financial and estate planning can be made to benefit both the donor’s family and your own nonprofit organization. Surveys indicate donors would be more supportive if they only realized how to give without creating hardship on their families or adversely affecting their lifestyle and security. Successful planned gifts can only be made after these issues are fully addressed by the planner. You must show them how their gifts can be made by simply rearranging their assets while addressing the problems of transition.

Would You Expend Your Assets This Way? 

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In the course of speaking to audiences across the United States, I often refer to farm families I work with in the Midwest. Farm families don’t have a lock on estate and continuity problems, but it’s useful to look at a basic estate planning opportunity for ideas. As a rule in central Illinois, it takes at least 800 acres of ground to support a family farm operation today. With productive farmland selling for $3,000 or more per acre, that quickly translates into $2.4 million just for the value of their “dirt”. But few farmers own just “dirt” today; they also have a tractor, a combine, a residence, a truck, a car, a little savings, maybe a small retirement plan, plus grain in their bins. Add it up, and these family farmers can easily have $3 million in their taxable estate. With estate taxes hitting $1 million on just this farmer’s assets, imagine how the heirs feel about writing that check to the IRS. If the family has done some transition planning, maybe they will have adequate liquidity to pay the taxes, but how many of those tax dollars came back to help their community? How much control does the family exert on how those tax dollars are actually spent? Finding ways to manage and control a family’s “social capital” is one of the responsibilities of an effective estate planning team and it separates real planners from those who try to solve problems in a traditional and one dimensional approach.

These concepts aren’t limited just to farm families. Instead, they apply to anyone who has managed to create personal wealth in a family business or an investment account. When I ask clients how they feel about sending a check off to the IRS and having $150,000 of their $1 million earmarked just to pay interest on the federal debt, a lot of clients say “if it was my money, I wouldn’t spend it that way”. It’s my contention that it is their money, and they should take control of it. Who better to recognize the needs in their local community? Is there a social program, a church or educational mission that should be supported? Would local influence and interest promote more solutions to community problems? If so, why not take the opportunity to redirect tax dollars back to the community and let the family have some influence on the direction those dollars should take?

These are powerful concepts, and in these changing economic times, there is significant value in voting your “social capital” and providing better stewardship of your family’s assets. For more information or a sample “zero estate tax plan”, contact our office for a courtesy evaluation.

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Vaughn W. Henry

Henry & Associates

Gift and Estate Planning Services

22 Hyde Park

Springfield, IL 62703 USA

Phone: (217) 529-1958 Fax: (217) 529-1959

E-mail:[email protected]

Last Updated: Jan 4 , 1998

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Hidden Treasures – Vaughn Henry & Associates

Hidden Treasures – Vaughn Henry & Associates

Hidden Treasures

Tucked away in dusty lockboxes and file cabinets are old life insurance contracts that have not seen the light of day for years. Why pull them out and review their provisions now? Tax circumstances change; and while life insurance is usually free of income tax, it often creates an estate tax liability. To be safe, eliminate the insurance from the estate’s inventory of taxable assets. In another classic oversight, too often the policy designates beneficiaries who may no longer be part of the family or who have predeceased the insured or the contract’s owner. Take that inventory and use a little proactive planning to avoid costly mistakes.

Once unearthed, make a decision about these policies. Besides updating ownership and beneficiary designations, consider a donation to charity. Does family financial security still require the policy? If so, adding a charity to the beneficiary designation would be an easily modified and revocable way to set aside something as a philanthropic legacy. Even naming a charity to receive just 10% or 20% of the policy’s proceeds is a great way to create a meaningful gift without adversely affecting the family’s interests. After a few more years pass, a donor can reassess needs and later adjust the beneficiary designations or choose to donate the entire policy.

What works? Is there a veteran’s policy or an old whole or universal life insurance contract in that pile of paperwork? A policy acquired to reduce risk when there was a mortgage on the house and worries about getting kids through college may be an ideal gift now. Classic giving opportunities for insurance exist when the mortgage is paid, the kids are grown, and those risks that the insurance originally covered no longer apply. Even employer sponsored term contracts can work if the donor chooses a charitable beneficiary, and while there may not be an income tax deduction, significant support with a tool that ultimately endows your charity on a limited budget still works for almost anyone. These are painless gifts. Giving an obsolete life insurance contract does not negatively affect the donor’s cash flow; instead, it offers the charity an opportunity to receive needed funds that bypass delays in probate and family turmoil.

Outright gifts of a cash value type life insurance policy to a tax-exempt organization may generate an income tax deduction. While deduction calculations and rules can be complex, in order to qualify, the donor gives up legal ownership and allows the charity to become the irrevocable beneficiary. However, be careful if the policy has outstanding loans or if the cash value will not sustain the policy after the charity accepts it, as the gift may prematurely collapse. As with the gift of any asset, seek qualified guidance to be sure that it works properly.

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Investment and Management Decisions Within a CRT – Henry & Associates

CRAT or CRUT?

Selecting the RightTrust for Your Needs

 

One would think a simple “either – or” decision would be the easiest to make, but as it turns out it is not always so straightforward.  Take the choice of charitable remainder trust.  Which works better for the client – the annuity or one of the unitrust variations?  Well, many prospective trust makers throw the choice back to their advisors, assuming that because there is a legal, financial planning, or accounting professional designation or degree that their advisors know what is best.  As it turns out, that’s not necessarily so since so many professionals now specialize and can’t be expected to know all the problems associated with every tax planning situation, and few know anything about §664 split interest trusts.  It is not reasonable to expect litigators and general practitioners to know about obscure tax rules any more than a psychiatrist would be competent to perform a kidney transplant.  The possession of an MD, CFP, CPA, or JD designation only provides a framework for future knowledge and experience.  What is most important is the practical application of that knowledge, and with charitable remainder trusts, there are precious few professionals who have ever seen one, much less understand them.  As an example of the compartmentalization found among professionals, examine the planning that went into former President and Mrs. Clinton’s 1997 tax returns.  Arguably, while theClintonshave access to lots of qualified counsel and even possess law degrees themselves, they still made serious blunders in their charitable and estate planning.  If the first family cannot get it right, it should come as no shock that the majority of clients will not get it right either.

 

TheClintonspaid $291,755 in federal income taxes over the two years.  But they could have paid $167,532 less by having royalties from “It Takes a Village,” Mrs. Clinton’s book about child rearing, sent directly from the publisher to a charitable fund instead of taking the money as income, paying taxes and giving away the difference.  The charities would have come out ahead, too, collecting 22 percent more than the $840,000 they received. 

“It Takes a President to Overpay the IRS”, New York Times,April 19, 1998

 

For most planners who don’t specialize in charitable planning, their assumption that a CRAT is best for old folks and a CRUT is best for younger donors isn’t necessarily the best way to make a decision about a trust that’s irrevocable.  This is especially true when the timeline of the CRT, something with which a donor must deal for years, is considered.  Disagreements among advisors often pop up over investments inside a CRT since few financial advisors really understand the fiduciary accounting peculiarities of investing for a tax-exempt CRT.  Because a charitable trust invests over a long time horizon, and the trust does not usually pay income tax on its growth or income, chasing returns and reacting day to day is not the style of investing that works best for the CRT.  Add to the long term view the very real concern about avoiding unrelated business income that may be unintentionally created when a broker uses a margin account, acquires partnerships or other working interests that expose the trust to “toxic income” that loses the CRT its tax-exempt status.

 

A well drafted CRUT allows, even encourages, additional contributions; however, it is not an option in the annuity trust.  Trustees need to properly fund the CRAT and be extra cautious to ensure that it is just one straightforward transaction and not in bits and pieces over a period of days.  With a charitable remainder annuity trust (CRAT), the payout is irrevocably set in a fixed dollar amount at the inception of the trust, and this rigidity creates several potential problems for trustees managing the trust and its investments.

 

Which trusts work best?  Sometimes knowing which trust will not work is a good place to start.  For example, if a donor contributes cash or publicly traded stock, that is a workable solution, but if undeveloped land goes into to a CRAT, the downside risks are numerous.

  1. Will the asset produce enough income to meet the required income distributions?  A CRAT may not defer required distributions and being illiquid is not an excuse.
  2. If the asset is not an income-producing asset, is it readily marketable to make the required distributions?
  3. If the CRAT does not have enough liquidity to meet the obligations of the trust, is the asset easily partitioned in order that the income beneficiary can receive an in-kind distribution?  As an added insult, those in-kind distributions typically trigger capital gains tax liabilities, so the beneficiary receives his or her land back and has a tax bill to boot.  That is a recipe for an unhappy client – advisor relationship.
  4. Was the contribution of the asset matched with enough additional cash to pay insurance, property taxes, maintenance, marketing, and operating expenses?  Remember, there can only be one contribution in a CRAT, so any cash transfer has to occur simultaneously with the transfer of the real estate deed.
  5. Generally speaking, a CRAT is a better tool for a donor unconcerned with eroding purchasing power, and it is typically used for clients with little tolerance for volatility and short term needs, i.e., less than ten years, otherwise inflationary pressures diminish the value of the income distributions.
  6. The minimum annuity paid at least annually must be at 5%, but cannot exceed 50% of the initial fair market value of the assets contributed to the trust.  In most cases to prevent trust exhaustion, a CRAT paying out more than 6.5% is a concern.
  7. After the Taxpayer Relief Act of 1997 passed, the charity’s calculated remainder interest must be worth at least 10% of the value initially transferred to the trust.  This severely restricts young individuals from having a life income interest in any CRT, and restricts payouts to lower levels for many trusts, especially if there are more than two income beneficiaries.
  8. Because there is a very real possibility of a CRAT collapse in a poor investment environment, these trusts must also meet a 5% probability test [Rev Rul 77-374].  If the trust fund has a greater than 5% chance that it will exhaust before the trust terminates and passes to the charity, then the trust will not produce an income tax deduction or qualify as a CRT.

 

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CRAT vs. CRUT invested in a growth mutual fund

1/1/1990–1/1/2002

 

 

Too many trustees take an ultra- conservative and shortsighted investment approach to preserve principal.  However, prudent investment management is important if the income distributions are going to be tax efficient and the remainder value is to appreciate for the benefit of the charitable beneficiary.  As an example of a well balanced equity approach, an annuity trust (CRAT) established on January 1, 1990 and funded with $250,000 that purchased diversified GFAA shares (after fees) would produce significant gains, even with the fixed dollar annual income distributions of $12,500 (5% of the initial value) made through the end of the trust period.  While this specific trust is historically accurate in depicting annual returns even through several real market corrections, there is no guarantee of similar performance in the future; however, this particular fund has produced a trust remainder value of $928,488 as of12/31/2001

 

Using exactly the same investment vehicle and historical time horizon as the CRAT above, a 5% charitable remainder unitrust (CRUT) that pays a fixed percentage of the trust (annually revalued, so the payouts vary with the trust’s investment performance), yet it still produces a significant return of $765,884 for the remainder beneficiary and the income interest is enhanced to offset the effects of inflation.  A variable payout CRUT takes a percentage of a well-invested and diversified trust and increases in value. The CRUT in the example produced $273,444 of aggregated income over the twelve year period.  Compared to the CRAT’s income payments of just $150,000, it should be obvious that the variable payout unitrust offers more opportunity for growth if the investment performs properly.  Besides having a greater opportunity for an improved income stream, an equity based trust investment tends to produce more tier two (realized capital gains) income.  Remember, realized gain taxed at the more efficient 20% rate leaving the income beneficiary with more spendable income, rather than being penalized at the highest marginal ordinary federal rate of up to 38.6%.

 

 

Select Appropriate Charitable Remainder Trust

 

 

Which CRT Works Best?

 

§ 644 Trust Options

CRAT

SCRUT

FLIPCRUT

NIMCRUT

Is Current Income Needed?

 

 

Y**

Y***

Spigot Income or Deferral Strategy Allowed?

 

 

Y**

Y***

Contribution of Hard-to-value Illiquid Assets

 

N/Y

 

 

Multiple Contributions Allowed

 

 

 

 

Fixed and Secure Income Desired

 

N*

N*

N*

Easy to Understand

 

 

 

 

Preferred for Younger Income Beneficiary

 

 

 

 

Flexible

 

 

 

 

* Depends on payout rates that are lower than CRT investment portfolio’s performance

 

 

** Depends on FLIP triggering event

*** Depends on underlying assets inside CRT

 

 

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VWH www.gift-estate.com

PhilanthroCalc for the WebCONTACT 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”. Knowing when a CRUT is superior to a CRAT or which type of CRT is best used with which assets and what investments “poison the trust” is critical. Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When should you use a CLUT vs. CLAT and what are the traps found 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.

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Categories
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Uses and Misuses of Life Insurance in a Planned Giving Program

Uses and Misuses of Life Insurance in a Planned Giving Program

 

The old adage, “you should never look a gift horse in the mouth”, may not hold true with gifts of life insurance because so few nonprofit organizations really understand it as a risk management tool and not as an investment.  While nothing should be easier than making a beneficiary designation change to make sure an insurance settlement passes in whole or part to a charity, few donors make those simple choices.  Why not?  Their advisors don’t suggest it as a planning option, donors don’t realize that insurance proceeds can be split up among many beneficiaries and changing a revocable beneficiary designation generates no income tax deduction.

 

I have a client who wanted to name a large university foundation as the beneficiary of his insurance policy and he asked me to get the T.I.N. and proper name of the organization so I could finish off the beneficiary designation form.  Simple, yes?  No, the university’s planned giving officer proceeded to tell me that the university would only accept it if the policy named them as owner and irrevocable beneficiary of the contract.  I tried to explain that the client only wanted to name the foundation as a beneficiary and wasn’t looking for a tax deduction, but she wouldn’t back off her need for all of the paperwork, so when I reported back to the client, he said, “forget it”.  Why shouldn’t a charity gratefully accept a donor’s offer to name it as either a primary or successor beneficiary?  It could be the development office is more concerned with “booking the gift” rather than listening to what the donor wanted to accomplish. On the other hand, charities have been burned by over-aggressive agents touting insurance as a way to build an endowment if the charity will just let the insurance sales team solicit their best donors.  The common result is that dollars the charity needs today are redirected into commissionable products with less immediate value that are often dumped on the charity’s doorstep when the donor loses interest in this new endowment plan.  As a result, many charities don’t want to have anything to do with either insurance products or insurance producers and that’s a shame because insurance and annuity beneficiary designations are perhaps the easiest deferred gifts to solicit since the products are so often found in donor’s hands.

 

The use of life insurance in charitable giving makes perfect sense for a number of donor situations. 

1.  Those supporters whom the charity has come to depend on for support and guidance, much like a key-employee in a commercial enterprise, may use an insurance contract to guarantee ongoing financial support for a specific project of importance to the donor.  By leveraging small amounts of annual premiums, often a larger gift may develop over time.  Is this a cost effective approach?  Maybe, maybe not; what has to be determined is this contract being treated as an “investment” or is it the result of extra money being contributed over and above normal contributions by a donor who fully intends to continue making premium payments.  If it’s treated as an investment then some basic assumptions have to be addressed, as there’s nearly always a point beyond which a tax-exempt charity can more efficiently invest in their endowment fund the same premium dollars and generate a greater impact.  The problem for many insurance agents is they forget that the wealth building tax advantages of an insurance wrapped investment won’t apply to an already tax-exempt 501(c)3 charity.  Does it make sense to buy a new policy solely for the use of a charity?  Maybe, if there’s a risk that the donor’s services and support would be lost to the charity before typical mortality or before a traditional investment account could build up enough value to sustain itself, but there is a “crossover” where the traditional investment account will eventually outperform the insurance contract.

 

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 $5,000 annual premium paid for 20 years into a VUL insurance policy ($150,000 death benefit for a 65 year old nonsmoker, earning 10% in sub-accounts) as compared to the same $5,000 annually invested into a mutual fund (10% returns) for 20 years. The VUL policy collapses before statistical mortality if the policy doesn’t maintain at least a 10% gross return and if the premiums don’t continue past 20 years.  The cash values available to the charity from the policy if surrendered after 20 years in this hypothetical illustration would be $134,482 as compared to the traditional investment account value of $315,012.  The “crossover” for investment efficiency occurs if the donor doesn’t die prior to year 14, so each case must be evaluated on its individual merits.  Obviously many different kinds of policies exist, but in the interests of simplicity the basic policy vs. investment comparison was made.

 

While it’s true that a life insurance death benefit passing to charity is like found money, few policies actually perform as illustration projections prepared years ago predict.  Interest rates, crediting levels and mortality expenses change, and this variability isn’t factored in when policies are transferred to charity.  Where’s the problem?  The guaranteed levels of performance are usually considerably less than wildly optimistic projections that many agents used back when interest rates were 10% to 14%.  To that end, annual reviews of a charity’s insurance portfolio should be conducted by an objective analyst to ensure the policies are performing as designed.  If they deviate significantly, then decisions can be made in a timely manner to preserve the value by reducing death benefit or increasing the premium payments or, if the charity chooses to surrender the policy it should be done before the policy has a chance to implode.

 

2.  Donors who have old policies once acquired for other reasons (e.g., mortgage or debt risks, education for children, survivor income security, veteran’s policies or those provided by employers) may no longer need the coverage and choose to transfer ownership to a nonprofit.  If the donor transfers the ownership of the contract to a nonprofit organization, then besides removing the asset from the donor’s estate, it will often generate an income tax deduction if all of the rights of ownership are completely transferred.  How is the deduction calculated?  Generally, the donor receives a current income tax deduction equal to the lesser of cost basis or fair market value of the policy.

 

An often unrecognized problem for an asset potentially worth more than $5,000 is the valuation of the policy. Some would argue that the insurance carrier can easily assess and report its value on a form 712, but careful examination of an IRS form 8283 (required if the value is more than $500) would seem to prohibit the agent and insurance carrier, as parties to the transaction, from performing the valuation and thus there may be a real need for an outside appraiser to assign value.

 

Gift acceptance policies of the charity should address the following issues:

  • Will the organization make ongoing premium payments if the policy underperforms?  Or will the original donor continue to make gifts of cash or better yet appreciated assets in order to meet ongoing premium liabilities?
  • Does the state recognize that the charity has an “insurable interest” in the life of the insured?
  • Should a cash value policy be surrendered or held, and what types of policies should be accepted.
  • How should the policy be booked for campaign purposes?
  • Is there a minimum quality threshold for the carrier’s financial ratings for size and financial strength?
  • Who evaluates the current and ongoing annual policy statements and projections showing “guaranteed and projected performance values”?
  • Define terms that confuse development officers, e.g., is the policy is truly “paid up” or has the premium simply “vanished” only to reappear later?
  • Understand that there are some tax traps if the policy has outstanding loans,
  • Should the charity viaticate its gifted policies?  Will the donor object to an investor having access to his/her medical profiles and be upset with the occasional ghoulish aspects of selling the policy to an investor looking for a quick return on an investment.
  • How do charities track death claims?

 

3.  Other charitable uses of life insurance offset the gift of assets by replacing the wealth so heirs aren’t unduly affected.  These so called “wealth replacement” policies are very popular when working with large bequests and charitable remainder trusts or gift annuities.  Why shouldn’t the heirs just inherit those assets and skip the insurance policy hassle?  It might be more tax efficient to have heirs receive an asset that always steps up in value at death, unlike receiving annuity payments or retirement plan proceeds which come with an accompanying income tax and artificially inflates the taxable estate of the deceased donor.  If the life insurance is properly structured and held outside of the estate, then the proceeds pass to heirs without income, gift or estate tax liabilities.  With the proposed loss of step-up in basis under EGTRRA 2001 when the estate tax is phased out insurance may be a preferred asset.

 

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A classic use of life insurance would be to fund the needs for wealth replacement in a zero estate tax plan. This client-donor has a $5 million estate composed of an appreciated family business, investments and pension assets.  By passing $2 million to a 7% CRT and concurrently creating an irrevocable life insurance trust (ILIT) to hold a policy designed to replace the contributed assets and place it in a GST exempt trust, the family has the capacity to eliminate gift and estate taxes. The premium payments are often economically funded with the cash flow from the charitable remainder trusts (or occasionally the charitable gift annuity) and the income freed by income tax deductions.  The family is in an improved position by having inherited assets that step up in basis, more liquidity in trusts to provide security and a chance to support family charitable interests through private foundations, donor advised funds and public charities.

 

Caution is Needed

A number of problems can develop because so few financial advisors understand the nonprofit culture, and because few development officers completely understand how life insurance functions or is marketed or sold.  Charities need to be careful; for example charitable reverse and split dollar concepts may jeopardize their organization’s exempt status.  Charitable split dollar ran afoul of self-dealing, fraud and step transaction rules because the charity was often used as a conduit to pass benefits to noncharitable beneficiaries all the while accepting tax deductible assets to pay the premiums.  The problem from the charity’s perspective was one of strings being attached to these “gifts” that required the exempt organization to direct those contributions to pay the premium.  Clearly this was not a gift that allowed the charity the choice to invest prudently. 

 

The IRS hammered this form of abuse with rules found in Notice 99-36.  In Notice 2000-24, it provided compliance guidance on the new reporting requirements imposed by the Ticket to Work and Work Incentives Improvement Act of 1999 as it related to charitable split-dollar insurance arrangements.  Congress used this law as signed on December 17, 1999 in HR 1180 to remove CSD as a planning option for charities and insurance producers.  Ignoring these rules subjects the charity to excise taxes and possible loss of exempt organization status.  Other potential abuses include financed insurance where the charity borrows the premium to insure a number of lives or invests its funds in a “dead pool” of a large number of policies with the expectation that someone will die annually and thus provide a return on its investment.  The charity is pushing the ethical and legal envelope by using commissioned agents to sell a gift annuity.  Recent action* by the SEC claiming jurisdiction over the sale ofa CGA may foretell the end of charities who cozy up to financial services professionals.   Although the Philanthropy Protection Act of 1995 seemed to preclude offering a commission for a gift annuity, these aggressive practices have become more common.

 

How to approach the gift of an insurance policy? When interviewing clients or potential donors, find out what policies are in place and don’t forget those group plans provided by an employer.  Review the ownership and beneficiary designations and oftentimes clients discover ex-spouses or deceased beneficiaries are still listed, so it’s a great opportunity to suggest changes and introduce a charity into the equation.  If they’ll consider naming a charity for 5% of the death benefit, maybe 10% is an option.  If they’ll split the death benefit for 10%, maybe 25% or 50% is possible, and if they’ll consider 50%, maybe they’ll just transfer the ownership of the entire policy by absolutely assigning it and be done with the whole process.  But you won’t know unless you ask, and since few donors appreciate that they can actually split the beneficiary designations, they don’t consider it.

 

Summary

Billions of dollars of life insurance are in force in this country, and frequently these policies are no longer needed for their original purpose.  Charities ought to explore the use of insurance along with other gift options when they discuss philanthropy with their donors.

 

* SECURITIES AND EXCHANGE COMMISSION,Washington, D.C. LITIGATION RELEASE NO. 17290 /December 21, 2001

SECURITIES AND EXCHANGE COMMISSION v. ROBERT R. DILLIE and MID-AMERICA FOUNDATION, INC., Defendants, and MID-AMERICA FINANCIAL GROUP, INC., Relief Defendant (U.S.D.C., District of Arizona,PhoenixDivision, Civil Action No. CV-01-2493-PHX-JAT)

 

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Vaughn W. Henry

PhilanthroCalc for the WebCONTACT 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.

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IRS Information, Regulations and Commentary on Charitable Legal Issues

10 Reasons to Review Your Planning

Ten Charitable Planning Mistakes to Avoid

 

by Vaughn Henry and Johni Hays

 

This article highlights specific areas of the charitable planning process where mistakes seem to re-occur based on the authors’ combined experiences as charitable planning consultants.  Newcomers to the field of planned giving aren’t the only ones making mistakes because as you read through the article, you’ll see that all types of planners, from the seasoned professional to the charitable planning novice, show up in the following examples.  By sharing real-life situations, the authors hope to provide practical experience and knowledge from the trenches, not from the painful school of hard knocks, but via the less painful old cliché, “learn from the mistakes of others.”

 

1.         Not Putting the Donor’s Interests Ahead of All Others

 

As planners work together as a team to recommend a charitable plan for clients, it is imperative to always put the client’s interests ahead of the charity, the attorney, the CPA, and the agent.  It seems like a statement of the obvious, but sometimes a plan can seem so good, the planner doesn’t want to throw water on the proposal by bringing up the possible downsides.  Here’s a case where the planners went a step further down the wrong path by intentionally omitting relevant information the donors needed. 

 

In the case of Martin v. Ohio State University Foundation (Ohio App., 10th App. Distr., 2000), the donors of a NIMCRUT sued their life insurance agent, the life insurance company, and the charity that also acted as their NIMCRUT’s trustee.  An attorney and an insurance agent proposed a charitable plan to a couple that included the donation of $1.3 million of undeveloped farmland to a NIMCRUT.  The donors would use income from the NIMCRUT to purchase a $1,000,000 life insurance policy costing $40,000 per year for wealth replacement for the donor’s children.

 

 The donors received several proposals over the course of a few months.  Each and every proposal showed the NIMCRUT paying the donors income immediately after the execution of the NIMCRUT.  Since the donor’s annual income prior to the transaction was only $24,000, the donor was counting on the trust income to pay the insurance premiums.

 

The charity’s representative wrote a comment on the last proposal shown to the donors that a net income trust funded with non-income producing land can’t make any income payments until after the land is sold.  When the insurance agent saw the comment on the proposal, he deleted it before giving it to the donors. Unfortunately, the land was not sold until two and one-half years later and no income was paid to the donors during that time.  In the meantime the agent tried to loan the clients enough money to pay the insurance premiums, but in the end the policy lapsed.  The donors sued for fraud, negligent misrepresentation, breach of contract and breach of fiduciary duty asserting they had never been told the truth about income not being payable from the NIMCRUT until after the land was sold.

 

In the Martin case, the advisors failed to give the donors accurate and complete information as to how the charitable gift would work in their situation.  They intentionally deceived the clients for what appears to be their own financial gain.  At all times and in all aspects of planning with clients, the goal must be to provide advice that is in the clients’ best interests, not the planners. Clients deserve the best and accurate advice from their planners even if it prevents the gift from occurring.

 

2.         Recommending a Charitable Gift Without a Full Understanding of the Donor’s Financial Needs and Goals

 

A few planners tend to sell a charitable gift like a financial product.  A charitable gift is not a product; it’s part of an integrated estate and charitable planning process. To illustrate, one planner wanted to set up a CRAT for an older client funded with farm-land. The planner had a fixed annuity he wanted to sell to the trustee using the proceeds from the land.  The planner was under the impression the trust was required to purchase an annuity since it was a charitable remainder “annuity” trust. The planner was then counseled on how a well-balanced mutual fund might be a more suitable vehicle for the proceeds.  Unfortunately, the planner responded he wasn’t licensed to sell mutual funds. 

 

Upon further learning that the annuity would produce tier one ordinary income at the client’s marginal income tax bracket of 42%, the planner replied that since his client would be obtaining a large income tax deduction he could afford to pay more in income taxes.  

 

Sadly, this situation represents a product-selling planner who isn’t mindful of the downside of recommending the CRT. The planner did not ascertain his client’s charitable interests, instead he recommended the concept as a means to avoid or even evade capital gains taxes when in fact, it would potentially increase his client’s tax liabilities.  The recommendations made for this plan weren’t in the client’s best interests and could be considered malpractice on the part of the planner.

 

3.         Serving As Trustee

 

Another misstep can occur during the charitable planning process when the advisor serves as the trustee for either the client’s life insurance or charitable trust.  Financial planners, brokers and insurance agents need to be careful when asked by their clients to serve as the trustee.  The best answer to give a client is “No, thank you.” Serving as trustee can create a serious conflict of interest if the trustee benefits by the transaction, not to mention SEC problems if the agent or broker has a securities license.

 

 If the life insurance agent is selling the policy to the trustee when he also serves as trustee, he is selling a product to himself for which he earns a commission using someone’s else’s money.  It’s a conflict of interest and it is best to leave the trustee’s duties to a trust professional.

 

Generally, non-legal advisors are not well trained in the duties imposed on the trustee as a fiduciary.  Moreover, non-legal advisors are generally not trained to understand the language used in trust documents and what each paragraph means in layman’s terms.  Moreover, most insurance companies will not allow their agents to act as trustees for trusts funded with their own insurance policies.  Additionally, most E&O coverage does not cover acts by an insurance agent acting as a trustee.

 

For many reasons even attorneys are reluctant to serve as trustees because attorneys know all too well the complex duties involved when acting as a fiduciary and following the prudent investor rules.  One trust officer, who found out too late what the trustee’s duties are, served as the trustee of a testamentary CRAT.  He asked how long he could wait to begin making payments to the income beneficiaries as the land inside the CRAT hadn’t sold and there were no other assets inside the trust.  Three years later, the income beneficiaries still hadn’t received their first income payment from a trust that has no legal recourse but to distribute income or assets annually, whether it’s liquid or not.

 

4.         Donating Inappropriate Assets

 

A charitable planner can find himself in an uncomfortable position when he is unfamiliar with the consequences making gifts using various assets.  The tax rules covering charitable deductions for different kinds of assets can be complex, so the best way to prevent these types of mistakes from happening is to know the rules for each type of asset. 

 

To illustrate, one planner suggested a client donate $3,000,000 of art to a CRUT using a 10% income payment.  Even though the client properly executed the CRUT, the client continued to display the artwork in his home.  The planner mistakenly thought the charity would advance the 10% income payment to the trust each year, and he did not know the artwork couldn’t be kept indefinitely on display at the client’s home.  To make matters worse, the charitable deduction was not based on the artwork’s fair market value like the planner told the donor, but instead the deduction for tangible personal property that has no “related use” to the trust was based on the donor’s lower cost basis.

 

Another planner was working with a client whose only other asset beyond $75,000 of mutual funds was a $350,000 IRA.  The planner didn’t realize the entire IRA would be subject to income taxes if the client donated it to charity in exchange for a charitable gift annuity.  Adding to the misunderstanding was the offending charity’s IRA Donation “proposal” which failed to adequately disclose the disadvantages of using an IRA for a charitable gift under current tax laws.  (Note:  proposed legislation, if enacted into law, may allow IRAs to be given to charities during the donor’s lifetime without incurring a taxable event.  See Senate Bill S-1924.)

 

A financial planner, who also wasn’t aware of the consequences of donating the specific asset he recommended, knew his client was coming into a large sum of money soon from the sale of his business.  The planner recommended that his client quickly donate the business to a CRT to help his client avoid taxes.  Upon discovery, however, the client had actually sold his entire business five years ago and this large sum of money was the final payment in a series of installment payments for the buyout.

 

Donating Various Types of Assets

 

These assets need extra special handling:

·       Encumbered real estate

·       Closely held “C” corporation stock

·       Restricted (Rule 144) stock

·       Stock with a tender offer in place

·       Sole proprietorships, partnerships and on-going businesses

·       “S” corporation stock

 

These assets should generally be avoided in charitable gift planning:

·       Property with an existing sales agreement

·       Installment notes

·       Stock options (both qualified Incentive Stock Options and nonqualified stock options)

·       Lifetime transfers of IRAs and Qualified plan dollars

·       Lifetime transfers of commercial deferred annuities

·       Lifetime transfers of savings bonds

 

5.         Reinvesting CRT Assets Improperly

 

Often times a charitable trust is put together by a financial advisor or insurance agent with the hopes that the donor, who generally serves as trustee, will look to the advisor or agent to reinvest the proceeds of the gifted asset once it’s sold.  While there is nothing wrong with this plan, advisors need to be educated on the complexities associated with prudent investor rules, charitable trust accounting, tax deductions, etc., before they can fully understand the consequences of their recommendations.

 

An example of improperly invested CRT assets occurred when a planner recommended his middle-aged donor establish a CRAT.  Inside the CRAT the donor-trustee bought a “life-only” single premium immediate annuity to “guarantee” the annuity income payable to the income beneficiary.  The flaw underlining this transaction is that the charity’s remainder interest would be left without any assets when the trust terminates, as a single premium immediate annuity for “life only” will end upon the death of the client with no principal balance leftover. This recommendation could make the trust subject to oversight by the state’s Attorney General for imprudent investment and all its advisors are potentially liable to the charity  Remember, a CRT is a split interest gift, and there are two beneficiary groups with a legal interest in these tools, so the trustee often must wear two hats, one as an income beneficiary and one looking out for the charity’s well being.

 

To compound an already unpleasant situation, when the planner was counseled regarding the flaw in his proposal, he and the lawyer argued that the trustee’s purchase was valid because the trust “passed the 10% test.”  The planner and lawyer were then counseled on the difference between the 10% test in terms of the charitable deduction and subsequently investing CRT assets improperly.

 

Another planner, who also recommended a similar plan, suggested his trustee purchase a life insurance policy to pay the charity its portion when the immediate annuity payments end.  However, this plan was similarly destined for failure as the CRAT cannot accept ongoing contributions to pay a lifetime of insurance premiums 

 

Improper investing occurred with a stockbroker who chose to invest his client’s CRT funds with several partnerships (creating UBTI) in the first year of the CRT’s existence.  This choice created a taxable CRT that does not avoid the capital gains liability when the appreciated asset that funded the CRT was sold.  In addition, there was no income tax deduction to offset the reinvestment error, compounding the broker’s poor advice.  Other mishaps have occurred when the trustees were given access to a charge card on a money market account held inside a CRT.  Trustees with charge cards on CRT assets open up self-dealing and debt financed problems similar to trading on margin accounts and charging the CRT interest on the loan when the trades do not materialize as expected.

 

If a planner “sells a CRT”as a way to take assets under management or sell wealth replacement, it isn’t unethical but it sure can be short sighted.  It’s also likely to result in unhappy clients who find themselves stuck with an irrevocable plan that doesn’t meet their needs.  Agents and planners who recommend charitable gifts must be knowledgeable of charitable gift laws and be prepared to pull in a team of experts to implement a plan in the donor’s best interests.

 

Learn from the mistake of an insurance company that allowed a commercial deferred annuity to be removed from inside a CRT.  The CRT’s trustee was the owner and beneficiary of the annuity and the husband was the annuitant.  At the husband’s death, the death claim papers were sent to the surviving spouse who checked the box on the claim form allowing the surviving spouse to change the ownership of the annuity to her own name as an individual.  She then withdrew all the interest earnings in the annuity.  The error wasn’t caught until the spouse complained of the large IRS Form 1099 she received the following January for the interest income she received. This is often a problem in a NIMCRUT using a deferred annuity when the insurance company incorrectly sends out a 1099 to the annuitant, instead of to the tax-exempt CRT, while the CRT is properly issuing a K-1 for the same income distributions, thus doubling the income tax exposure.

 

Understanding the four-tiered system of accounting in a CRT can seem complex.  Often planners may not fully comprehend all the issues involved and this leads to mistakes.  For instance, one attorney counseled his client to fund a CRT with farmland.  He had the trustee purchase tax free municipal bonds after the land sold to obtain tax-free income from the CRT.  However, what the professional didn’t realize, is how the capital gain income from the sale of the real estate is higher on the 4 tier accounting system than any new tax free income generated by the municipal bonds.  Understandably, the client was quite unhappy when the income wasn’t “tax-free.”

 

6.         Not Monitoring the Wealth Replacement Sale

 

A charitable planning case can be effectively implemented with the appropriate professionals including the client’s attorney, CPA, planned giving officer, and the life insurance agent.  However, in charitable plans where life insurance is a part of the overall plan, the purchase of life insurance inside an irrevocable life insurance trust (ILIT) should be monitored by the donor’s estate planning attorney.  Attorneys should direct the process and clearly indicate to the donor, the trustee, and the life insurance agent how the process should work and in what order each step should occur.  Otherwise, what can happen is the insurance sale can be implemented in a way that undermines the donor’s estate plan. The following are life insurance missteps that can cost clients hundreds of thousands of dollars in estate or gifts taxes. 

 

1)     The insurance policy is issued prior to the life insurance trust’s implementation.  This occurs when the insurance agent issues the policy before the irrevocable trust is executed and funded.  If the policy is applied for before the trust is executed, it is commonly applied with the insured as the policy owner.  If the ownership is thereafter transferred to the irrevocable trust, the threeyear in contemplation of death rule occurs causing the policy to be pulled back into insured’s estate if he dies within three years of the transfer.

It’s a preferred practice to have the donor’s insurability determined using “trial” applications, but once insurability is approved, the policy should not be issued until the ILIT is executed, funded, and withdrawal power letter have been sent to trust beneficiaries and the Crummey powers lapse.  At that point the agent submits completely new applications with the trustee as the owner and beneficiary. The trustee then pays the premium to the agent and the policy is then officially issued.

 

2)     The insurance agent accepts the premiums directly from the insured and applies those premiums to the policy owned by the ILIT  The proper procedure requires that the agent obtain the premium check from the trustee’s funds, not from the insured’s personal funds, when the trust beneficiaries have withdrawal powers.  The goal is to have the trust funded and the withdrawal beneficiaries notified and their right to those annual exclusion gifts lapse prior to the trustee paying the premium. 

 

If, on the other hand, the agent obtains a premium check directly from the donor’s personal funds, the premium amount is not considered a gift of present interest since the trustee never had the funds, nor have the beneficiaries been notified of their withdrawal rights and therefore, their gifts cannot fall within the annual exclusion gift amount.  The insured must file a gift tax return for these gifts and use part of his estate tax exemption equivalent of the unified credit (currently $1,000,000) to cover the premiums.

 

7.         Selling the Numbers on a Charitable Illustration.

 

The various illustrations from charitable planning software vendors are generally provided to prospective donors to give them diagrams or flowcharts to describe the type of charitable gift being presented.  The mistakes made when presenting these illustrations arise from a misunderstanding of the variables behind the illustration. For example, a common mistake is to create a CRT with a non-spouse as an income beneficiary, e.g., mom, dad and child, and the illustrations are cranked out without any cautionary words about the loss of the unlimited marital deduction and the effect of taxable gifts with a CRT being included in the trustmaker’s estate.  The software produces the correct “income tax deduction,” but does not address the more complex gift or estate tax issues.

 

The charitable planner must know the variables that produced these calculations and numbers.  The planner must know and understand the footnotes and assumption behind every proposal.  With a charitable remainder trust, for example, the planner needs to know what interest rate is being used to assume the future growth of the CRT assets.  In addition, the interest rate must be a reasonable number. In turn, the planner must inform the client of the variables used in the illustration.  The client must know what numbers he can rely on and those he cannot.  It’s simply an education process, and the more the client knows and understands, the better and happier the client will be.

 

8.         Selling Charitable Gift Annuities

 

Planners new to the field of charitable giving frequently have a misconception surrounding a charitable gift annuity.  Since planners may sell commercial annuities to clients for commissions, they sometimes assume that a charitable gift annuity is an annuity offered for sale to the public from their insurance company. 

 

However, a charitable gift annuity is not a commercial annuity offered by a life insurance company.  It can only be offered by a charity and is an agreement between a donor and a charity in which the donor gifts an asset to a charity in exchange for lifetime income for the donor.  The income provided to the donor from the charitable gift annuity is always paid by the charity.

 

The young planner who was asked to work with a particular charity’s donors to conduct seminars and help establish charitable gift annuities best illustrates this misconception. The planner thought the insurance company had an annuity for him to sell at the seminar and that he would be earning a commission on each charitable gift annuity “sold.” The agent asked if these donors would be bringing their checkbooks to the seminar and if these gift annuities are mostly “one-interview sales.”

 

To make the confusion even worse, a few charities are under IRS scrutiny for their practice of paying advisors a “finder’s fee” for bringing clients to establish a charitable gift annuity with them. Not only are these practices considered highly unethical by some professional advisors, but also it may be a violation of the Philanthropy Protection Act of 1995. An advisor cannot help fulfill the donor’s charitable mission and values by giving donations to causes in which the client feels strongly if the advisor steers all potential donors to only one charity – the one that will pay him a finder’s fee.

 

9.         Unknowingly Practicing Law Without A License

 

The unauthorized practice law is generally thought to be committed by a non-lawyer when that person provides legal advice to another either verbally or through the drafting of legal documents.  The unauthorized practice of law can occur in charitable and estate planning through the misuse of computerized legal documents also known as “specimen” documents.

 

The reason for providing specimen documents is so the planner can bring something to the planning process as a “value added service” for the client’s attorney. These sample documents are intended for use by the client’s attorney when that attorney may not be an expert in the field and could use a “starting point” in drafting.  It’s a way for the agent to be professional and helpful in the planning process.

 

Unfortunately, the planner or the client can misuse these specimen documents.  Some non-lawyers have asked if they can “just fill in these blanks” because their client doesn’t want to pay an attorney. Whether it is a specimen life insurance trust or a charitable remainder trust, many costly errors have been made when a non-lawyer or donor takes the position that one document fits all and fills in the blanks of a specimen document. Further, many of these specimen trust agreements are ineffective as they are based on IRS prototype documents that are too rigid and don’t provide donors with the flexibility to create a legitimate planning tool that meets their unique needs. 

 

 Form books can also get a professional in trouble.  One attorney who hurriedly drafted a trust for his client found this out the hard way after inserting boilerplate language from a forms book.  The language gave the trustee of the CRT the power to pledge trust assets and to borrow funds;those powers put the exempt status of the CRT at risk.

 

Charitable gifts are complex and the laws with respect to charitable giving as well as property law can and will vary by the donor’s particular state law.  Specimen documents do not take into account any state law nuances.  In fact, for this very reason, the practice of providing specimen documents to planners has caused enough litigation to stop some insurance companies from supplying these documents

 

10.       Recommending Aggressive Charitable Techniques

 

Planners could scuff their professional reputations when they are involved in aggressive planning techniques and later the IRS or the courts condemn the plan they once recommended.  One of the most recently promoted aggressive charitable planning arrangements was charitable split or reverse split dollar.  This was an idea whereby the donor purchased a policy and had the death benefit split between the charity and the donor’s family.  However, the donor took a charitable deduction for the entire premium knowing that the donor’s family would personally benefit from this transaction. Sure enough, in 1999 charitable reverse split dollar arrangements were shot down by Congress [H.R. 1180, the Tax Relief Extension Act of 1999] and the IRS handed down some severe penalties in IRS Notice 99-36, 1999-26 I.R.B. 1.

 

Some life insurance companies refused to accept or underwrite business from their agents if this concept was behind the life insurance sale.  Other companies accepted the life insurance premiums without passing judgment on how that business came to the insurance company or how the agent advised their clients on tax deductibility.

 

Even though Congress has passed legislation stopping this charitable tax technique, its promoters are still using this concept.  The latest version of the technique uses a charitable remainder trust that owns life insurance under the disguise that the donor-income beneficiary is an “employee” of the charitable remainder trust.  The trust is employing the donor-income beneficiary and hence the charitable plan now falls within the “employment” context of split dollar funded life insurance and thus, outside of the prohibiting legislation However, this plan may raise self-dealing issues that will be sure to capture the attention of the IRS.

 

Conclusion

 

        The above article demonstrates the pitfalls that planners want to stay clear of as they work to help clients in the area of charitable planning.  Take this as a great opportunity to learn from the mistakes made by others and avoid the pitfalls in your practice.

 

Clients need complete disclosure of the advantages and disadvantages of the plan being proposed.  Wellinformed clients tend to be appreciative of the extra effort and it is an important factor in client satisfaction surveys.  Take the extra time and make sure the clients’ charitable plan is proposed with the client’s best interests first.

 

Vaughn Henry’s consultancy, Henry & Associates, specializes in gift and estate planning services, wealth conservation and multi-generational family entities. Vaughn also owns http://www.gift-estate.com/, a frequently updated wealth planning resource Web site, and resides in Springfield, IL.

 

Johni Hays is the Director of Advanced Markets for AmerUs Life Insurance Company in Des Moines, Iowa.  She is also the co-author of the book The Tools and Techniques of Charitable Giving, published by The National Underwriter Company. She can be reached at [email protected]

 



 

 

Vaughn W. Henry

 

Vaughn Henry provides training and consulting services on the charitable estate planning process.   As an independent advisor to charitable organizations on planned giving, Vaughn’s clients include some of the Forbes 400 and large U.S. corporations. His consultancy, Henry & Associates, specializes in gift and estate planning services, wealth conservation, and domestic and international financial services.

 

Since 1977, Vaughn has been a widely recognized and popular presenter to charitable groups, business owners, accountants, attorneys and financial services providers. He specializes in deferred gifting and the Economic Citizenship concept, and creative gifting for the Reluctant Donor. He helps charities learn how to develop larger gifts from difficult prospects and to work more cooperatively with donor advisors.

Vaughn received his BS in Agricultural Science and MS in Animal Science from the University of Illinois and is completing work toward a Ph.D. in management. Prior to consulting, he taught at the college level where he generated entrepreneurial funding for college programs. He continues to consult farm, ranch and closely held family businesses in operational and management techniques, specializing in small business communication technology, human resources training, operations, management and multi-generational estate planning. He is a licensed insurance and securities practitioner. Vaughn owns www.gift-estate.com, a frequently updated wealth planning resource Web site, and resides in Springfield, IL.

In addition to serving on the board of the National Association of Philanthropic Planners, Vaughn’s affiliations include the Sangamon Valley Estate Planning Council, Central Illinois Planned Giving Council (NCPG) and numerous trade and professional financial services organizations. He has been featured in many professional publications, including The Wall Street Journal, Worth, Forbes, Investors Business Daily, Journal of Practical Estate Planning, Planned Giving Design Center, Leimberg Services Newsletters, Planned Gifts Counselor, and Planned Giving Today.

 



Johni Hays, JD, CLU

 

Johni Hays is Director of Advanced Markets for a Midwest life insurance company.

Johni has extensive experience in estate and business planning, life insurance planning, charitable giving, retirement planning, annuities, and federal taxation.  She has lectured extensively on estate, business and retirement planning in addition to publishing articles nationally on charitable giving.  Johni is a co-author of the book The Tools and Techniques of Charitable Giving, published by The National Underwriter Company and is the charitable giving commentator for Steve Leimberg’s electronic newsletter service, Leimberg Information Services, Inc., (LISI). 

 

Johni was previously Advanced Markets Counsel for ManuLife Financial in their U.S. headquarters in Boston.  In addition, Johni served as an estate planning attorney with Myers Krause & Stevens, Chartered law firm in Naples, Florida, where she specialized in life insurance as a part of the overall estate plan.  She also was with Principal Mutual Life Insurance Company for nine years as a marketing consultant in the Mature Market Center in Des Moines.

 

Johni graduated cum laude with a Juris Doctor degree from Drake University in Des Moines, Iowa in 1993.  She also holds a Bachelor of Science degree in Business Administration from Drake University where she majored in insurance, and graduated magna cum laude in 1988.

 

            Johni is a member of the National Council on Planned Giving, the Mid-Iowa Planned Giving Council, the Mid-Iowa Estate & Financial Planners Council, and the State Education Council for “Leave a Legacy – Iowa.”  Johni is a Chartered Life Underwriter (CLU) and a Fellow of the Life Management Institute (FLMI), and she has been a member of both the Iowa Bar and the Florida Bar since 1993. She can be reached at [email protected]

 

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PhilanthroCalc for the WebCONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s more to estate and charitable planning than simply running calculations, but it does give you a chance to see how the calculations affect some of the design considerations. Which tools work best in which planning scenarios? Check with our office for solutions.

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As an independent advisor to charitable organizations on planned giving, Vaughn’s clients include some of the Forbes 400 and large U.S. corporations. His consultancy, Henry & Associates, specializes in gifting, estate planning and wealth conservation resources to professional advisors.

Since 1977, Vaughn has been a widely recognized and popular presenter to charitable groups, business owners, accountants, attorneys and financial services providers. He specializes in deferred gifting and the Economic Citizenship concept, and creative gifting for the Reluctant Donor. He helps charities learn how to develop larger gifts from difficult prospects and to work more cooperatively with donor advisors.

Vaughn received his BS in Agricultural Science and MS in Animal Science from the University of Illinois and is completing work toward a Ph.D. in management. Prior to consulting, he taught at the college level where he generated entrepreneurial funding for college programs. He continues to consult farm, ranch and closely held family businesses in operational and management techniques, specializing in small business communication technology, human resources training, operations, management and multigenerational estate planning.

In addition to NAPP, Vaughn’s affiliations include the Sangamon Valley Estate Planning Council, Central Illinois Planned Giving Council (NCPG) and numerous trade and professional financial services organizations. He has been featured in many professional publications, including The Wall Street Journal, Worth, Forbes, Investors Business Daily, Journal of Practical Estate Planning, Planned Giving Design Center, Leimberg Services Newsletters, Planned Gifts Counselor, Planned Giving Today, Tax Analysts, RIA’s Estate Planning Tax Notes and Exempt Organization Tax Review, CNBC and The Chronicle of Philanthropy

Vaughn owns www.gift-estate.com, a frequently updated wealth planning resource Web site, and resides in Springfield, IL.

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VWH www.gift-estate.comVaughn W. Henry
Henry & Associates
Gift and Estate Planning Services

Client Privacy

Need Instructions or More Ideas? Call Us

PhilanthroCalc for the WebCONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s more to estate and charitable planning than simply running calculations, but it does give you a chance to see how the calculations affect some of the design considerations. Which tools work best in which planning scenarios? Check with our office for solutions.

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Gift & Estate Planning Services © 1996, 1997, 1998, 1999, 2000, 2001, 2002
If you like the content of this page, please link to it, don’t copy and paste it to your page, this site is copyrighted (lists are copyrightable under Title 17, USC, Chapter 1, Section 103(a)).

www.megalaw.com “This site contains links to other Internet sites. These links are not endorsements of any products or services in such sites, and no information in such site has been endorsed or approved by this site.”