Month: October 2002

Are there good assets and bad assets in your estate? – Henry & Associates

Post author By Gabriel
Post date October 24, 2002

Are You Trapped with Retirement Plan Assets?

Give my stuff to charity! What kind of crazy estate plan is that? Thats a typical response when clients ask about ways to eliminate unnecessary estate taxes and are told to make gifts. It’s an understandable reaction. Its also not intuitively obvious how giving away something the client needs can be a good thing, especially if the potential donor was raised during the Depression. The epiphany comes when clients look 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 an informed decision to pass property to heirs and other assets to charities that either had or will have some impact on their familys life. How can they be smarter making that decision?

Good assets and bad assets.

Actually, most people dont see much difference between the two, as any inherited asset ought to be a good asset, right? Well, some inherited assets come with an accompanying income tax bill, even in estates too small for an estate tax. Whos at risk? Many professionals and retirees have worked a lifetime and have accumulated a significant 401(k), 403(b) or an IRA and dont realize that their heirs will not receive the full value of that account.

Option #1. As it turns out, giving heirs all the 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 and 2003 anything in excess of $1,000,000 is subject to a federal estate tax. A simple estate plan would 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? Use those income in respect of a decedent (IRD) assets. Start with an IRA, a retirement plan account, a deferred annuity, savings bonds and don’t forget earned, but uncollected professional fees; these are all unattractive and taxable assets for your heirs. Instead, a bequest made from that donated IRA means a charity receiving $100,000 collects the whole value without paying any tax. In the traditional estate plan, children might be penalized 75 or 80 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. This proactive approach is more tax efficient, as the charity receives more, the heirs get to keep more and the IRS gets zilch.

Option #2. With the latest rules on required minimum distributions, many financial planners propose stretch IRA programs and make a good case for their use. Unfortunately, for all the planning that goes into them, few heirs leave the plans alone long enough for the stretch to do any good. For owners of significant retirement plans, naming a charitable remainder trust as beneficiary might make better financial sense. While theres usually no charitable income tax deduction, theres often a significant estate tax deduction and this charitable roll-over still ensures a steady income stream for a surviving spouse thats not going to be subject to required distributions that erode the value of the asset. For older heirs, a CRT funded with IRD assets might be an ideal solution to eventually convert an ordinary income pump to an income stream taxed at capital gains rates.

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.

Case Studies and Articles

Things You Really Need to Know About Planned Gifts – Henry & Associates

Post author By Gabriel
Post date October 24, 2002

Things You Really Need to Know About Planned Gifts – Henry & Associates

Things You Need to Know

Creating a planned gift is a great and noble act. However, as more charities, commercial advisors, and prospective donors jump onto the planned giving wagon,there are going to be dissatisfied clients and unhappy charities. Why is that? Simply said, too few advisors and planned giving officers do a good job disclosing all of the restrictions and the potential downside of these irrevocable gifts. Then add in all of the client-donors who do their research on the web and think they can go down to the local super-store and get a ready to use trust off the shelf, there is bound to be disappointment. One of the biggest problems with charitable remainder trusts is that invalid assumptions abound.

A Charitable Remainder Trust (§664 CRUT or CRAT) is a charitable giving vehicle, not a tax avoidance scam While there are tax advantages, it still requires that the trustmaker have some charitable intent.
Generally, a CRT is transactionally driven. Donors create them to minimize an immediate capital gains tax liability and keep more value at work. Since some assets are unsuitable inside a CRT, double-check early in the research process with advisors on how to best fund the CRT.
Treat the income tax deduction like icing on the cake. Because it is a deduction, and not a credit, it offsets the adjusted gross income (AGI) on the taxpayers annual return. The problem is that the deduction is only a present value of the future gift and if the remainder charity is a public 501(c)3, it is limited to 50% of the donors AGI for cash contributions and 30% for contributions of selected appreciated assets. Other contributions either will not generate a tax deduction or may be limited to tax basis, so knowing what works and what does not is an important skill competent advisors bring to the planning table.
The income tax deduction may be wasted unless the donor makes significant income, even over the six tax years it is available, as it may not be completely used up. For example, a 75 year-old donor of appreciated farmland valued at $600,000, lives poor but may die rich. Although rich, this donor has never made more than $45,000 in a year and is going to be hard- pressed to use the $360,000 deduction a 5% CRUT produces.
Trustmakerswho act as trustees have to wear two hats. They must prudently manage the trust assets for the benefit of the charitable remainder as well as to produce tax efficient income. This is one reason charities acting as trustee may leave themselves open to hard feelings, dissatisfied donors and possible liability issues that show up years in the future if the trust does not perform as predicted.
An annuity trust can run out of money and implode. A CRT stands on its own merits, so investment performance can make or break a charitable trust. If it falls apart, the charity is not going to make up the shortfall.
A CRT created to pay lifetime income for one or two beneficiaries bases its projections on IRS actuarial tables. Life expectancies are a median number, so 50% of people will live longer than expected and planners need to factor in the possibility that the trust will last long enough for a beneficiary who reaches age 100 to continue receiving an income stream.
Donors who try to create a CRT with less than $150,000 of assets may have the equivalent of a jet engine on a jeep. They have selected a vehicle that usually requires document drafting, appraisals, and ongoing administration expense; there is a minimum threshold for a CRT to stand on its own.
A CRT can be set up to benefit more than one charity. Properly drafted trusts will allow for changes or additions to the list of charitable beneficiaries. A CRT can even allow for current distributions directly to a charity if the donor builds in that flexibility.
If a CRT trustmaker has more than one income beneficiary (other than himself/herself), there may be an estate or gift tax liability for that gift of an income interest. If there are more than two income beneficiaries or if there is a large spread in ages, there is a likelihood that the CRT will not pass the 10% remainder test
Managing investments inside a CRT, or a CLT for that matter, is not the same as managing a 401(k) or IRA. Retirement accounts always produce ordinary income; a well-managed CRT should do better than that.

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Malpractice Issues #7 in CRT Planning – Vaughn W. Henry

Post author By Gabriel
Post date October 19, 2002

Sometimes its interesting to sit in the back of the room during a seminar on advanced estate planning and listen to concepts. Its a great way to learn and observe presentation skills in order to make my own workshops easier to understand. Unfortunately, some folks doing these seminars have only a loose grasp on the nuances of how charitable trusts really function; as a result, often learn what not to do.

In one memorable session, a stockbroker was pitching the CRT as a capital gains by-pass trust and told his audience that when clients contribute appreciated assets to a CRT they can completely avoid tax. Then he suggested that the best replacement asset would be a bundle of tax-free municipal bonds. His thinking was that by using a tax-free bond it would generate only tax-free income for the income beneficiary.

The broker believed income from the CRT was tax-free because, after all, it bypasses capital gains. In reality, the CRT only defers capital gains since annual payments are still taxed to the income beneficiary under the 4-tier fiduciary accounting system. Using the brokers proposed scenario of swapping $1 million of appreciated assets for tax-free income, the eventual payout on a 5% CRAT funded with appreciated stock or land with $100,000 of basis would result in eighteen years of payments taxed at 20%. Why? The unrealized capital gains have to be distributed and taxed before any tax-free income can be distributed. The problem with investing in a tax-free bond portfolio is that the potential for growth is severely compromised in order to obtain the illusory goal of tax-free income. In other words, its just plain dumb. Plus, the IRS disqualifies any CRT where the trustee is obligated to use a tax-free bond or where any restrictive investment policies exist[Reg.1.664-1(a)(3)]

How do these misconceptions get a foothold? Many professional advisors, despite all their talk about vast CRT experience, have never actually worked around a §664 CRT. While most advisors have experience with the thousands of pension plans and millions of clients setting aside money in retirement plans, few have seen, much less understand, a split-interest CRT.

As it turns out, the most reliable measure of client satisfaction with charitable planning is related to their advisors experience and level of sophistication.*

The latest IRS data* on charitable remainder trusts lists only 85,000 active trusts filing required paperwork, most under $500,000 in value. Thats not many trusts created since 1969, the first year that charitable remainder trusts were recognized. With so few CRT’s in existence, it is difficult to obtain experience. Nonetheless, after attending a short course, too many advisors profess expertise. In reality, their new love of CRT’s has more to do with selling life insurance, annuities, or reinvesting assets in the market. Whenever product is pushing process, the client is the one harmed. And, any advisor who does not put the client’s needs ahead of commissions, billable hours, or fees, should make sure his or her malpractice coverage is paid up.

Planning Articles and Links

IRD and IDIT Planning in the Estate – Henry & Associates

Post author By Gabriel
Post date October 19, 2002

Making a Plan to Deal with EGTRRA

John and Dee Owens, both 65, have a family business that they expect to pass down to their son, John Jr., but they have other children to whom they plan to leave their stock portfolio and retirement accounts. Through a series of corporate transactions, John Jr. will receive the stock owned by his father at no gift or estate cost and in return, his parents will have income through a deferred compensation and salary continuation agreement. With their lifestyle and retirement security addressed, John and Dee turned their attention to their remaining assets to see how they could best pass them to their other three children who arent involved in the family businesses. In 2002, the Owens jointly held stock portfolio had a value of $5 million and Johns IRA was worth $1.5 million. Theyve decided to take only the minimum distributions, as required by law, to stretch out their retirement account. This lets them leave the stock portfolio untapped to let it continue to appreciate as it has for the last 16 years.

When the Owens sat down to discuss their planning needs with their tax, legal and planning advisors, they were stunned to see how the estate tax relief they believed would protect their estate really affected their planning. With Congress constantly tinkering with the estate tax by trying to raise the exempt amount, abolish the tax, or reintroduce the tax it has become increasingly difficult to plan when the goalposts keep moving. After EGTRRA 2001, everyone agreed to plan for what they knew today, keep their planning flexible and their options open. The result was an integration of several tactics and strategies designed to achieve a zero estate tax plan. With only two principal assets left to plan for, and a desire to control their social capital, the Owens proceeded as follows.

Their Stock Portfolio

Given the uncertainty about the long-term nature of tax reform and estate tax relief, John and Dee decided to act now, rather than hope for an unlikely repeal of the death tax. When the Owens saw how quickly their equity values would grow away from their ability to exempt those assets from tax, they created a family limited partnership to hold their stocks and some other investment assets. After the partnership started, the Owens made lifetime exemption gifts of limited partnership assets to the kids, and then agreed to sell the remaining partnership units to an intentionally defective irrevocable dynasty trust (IDIT) for the benefit of their three kids and grandchildren. By doing this installment sale, the Owens freeze the value, eliminate another appreciating asset from their estate and transfer the growth to their heirs. This leaves only the need to deal with the income in respect of a decedent (IRD) assets found in their IRA and note to clean up the loose ends. When their planning is finished, there should be no estate tax on their assets at death

Their IRA

By the time John and Dee factored in the required distributions commencing at age 70 and viewed how their remaining estate would appreciate to, and beyond, life expectancy, they concluded that the IRS was likely to harvest significant taxes from their estate. Even in 2010, when the federal estate tax disappears for one year, there was still an income tax liability projected with their IRA.

IRA planning has been in the news lately because of relaxed new distribution rules and, some say, easier choices about beneficiary designations. As a result, the common advice for many is to make use of a stretch IRA as a way to delay recognition of the deferred income for as long as possible. That may make sense for many families, but they must understand some quirky issues if the stretch option is used. Firstly, only a surviving spouse has the ability to roll over and start an IRA with new beneficiaries under his/her own life expectancy. Secondly, while the stretched IRA may protect heirs from immediate income tax liabilities, it is not sheltered from estate tax. This double dip by the tax collector may ultimately reduce the value of the inherited IRA by 70%. Thirdly, after going through all of the gyrations needed to stretch an IRA and protect it from tax, many younger beneficiaries disrupt the planning by simply cashing in the IRA and paying the tax. In their mind, it was free money and there wasnt any reason to wait to enjoy their inheritance. Fourthly, an IRA only produces ordinary income, taxed at higher rates than capital gains due from stock sales and lastly, the IRA cant step up in basis like the inherited stock portfolio.

After the Owens reach age 70, their qualified retirement account typically wont appreciate as quickly as the stock portfolio. Why? Even though invested just like their equity account, the required distributions nibble away at the IRAs growth. However, even with an account slowly eroded by mandatory payments, the IRA has the potential to be a significant asset and clients should know their options that include:

1. Preserve the IRA via minimum distributions for as long as possible and split it into multiple accounts. Then name each beneficiary to receive the proceeds over their life expectancies. Seek competent counsel in this area, as the rules change based on the IRA owners payout status.

2. Spend the IRA (qualified retirement plan asset) and dont pass anything to heirs. While this solves the estate and inherited income tax problem, there is a timing issue (running out of money before running out of time) involved unless the account is annuitized.

3. Take withdrawals from the IRA and buy life insurance to replace the value of assets transferred to charity. Whether this option is economical depends on the clients age, health, tax status, and timing of death. Success also depends on the insurance ownership being outside the estate to avoid unnecessary taxes on the proceeds.

4. Take taxable withdrawals from the IRA and set up a concurrent charitable remainder trust with the appreciated equity portfolio. Use the tax deduction to offset the IRA tax liabilities and the extra cash flow to buy life insurance inside an irrevocable trust. Insurance proceeds structured in this fashion are generally income and estate tax free, and more net wealth may accrue to the heirs without concerns about a loss of step up in basis.

5. Name a charitable remainder trust (probably a CRUT rather than a CRAT) as the IRA beneficiary for the surviving spouse, or name children as income beneficiaries if all of the estate planning tax considerations have been addressed. Besides minimizing the immediate recognition of ordinary income, it provides a structured way to ensure the heirs wont fritter away the proceeds. Additionally, it may eventually allow capital gains income distributions from the trust instead of being an ordinary income pump for life.

6. Name a charity to be the IRA beneficiary in order to establish a gift annuity for a surviving spouse. Its also possible to name children as annuitants, but this has to be handled properly because of the nature of the contracts and the potential for gift or estate tax liabilities.

7. Name a charity as the IRA beneficiary to pass to a nonprofit organization those assets subject to tax. That lets heirs receive capital assets that will step up in basis at death. This choice is especially useful for clients with a desire to support charity and do so tax efficiently.

Case Studies and Articles

Why financial advisors fail to ask clients about charitable planning – Henry & Associates

Post author By Henry
Post date October 3, 2002

Why financial advisors fail to ask clients about charitable planning:

1. it’s not a priority

2. they’reafraid of offending their clients and losing the business

3. they’renot that charitably inclined themselves and can’t envision clients giving away anything that shortchanges the kids or uses up resources that might be needed later

4. planned giving is sort of complex and has a lot of tax code issues to work through, why bother to learn about such an obscure field when so few people do it?

5. they assume their clients aren’t charitable

6. they say that the clients never asked about planned giving, so they didn’t bring it up

7. advisors worry about giving away money under management because it reduces their own revenue stream, or they cant figure out how a product or service they provide can be worked into the planning process, so theres no incentive to suggest it

8. most don’t know much about the many technical issues and avoid the topic so as to not appear to be incompetent or unknowledgeable in front of their clients

9. they don’t want to do team planning with other experts because they will be giving up control of their client if other advisors horn in on the planning process

10. clients are fee sensitive, why should an advisor go spend money to learn something they’ll rarely use and probably can’t bill for?

As it turns out, it is mostly an education issue, but many experts feel that the client MUST say in front of all of their advisors, I want to make a gift; show me how to make it happen, before the advisor takes it seriously.

Until this happens, many advisors assume that the client is using them as a fence or a barrier to keep charities and fundraisers away from them. You know the lines, my lawyer doesn’t think this is a good idea or my broker says I can’t use the deduction, maybe next year, or I’d probably do something later, but you know how it is when your CPA says it’s not a good time, all excuses that make sense, but may not be entirely accurate. Getting the client to establish their goals and priorities early in the process makes it easier to plan correctly, and it removes many of the objections that may pop up later on in the planning process.

Many individuals are receptive if they see how to give their support away tax efficiently and develop some organized planning to their philanthropy. What will not work is having a charity believe that it can deputize a tax, financial or legal advisor and make them part of their fundraising or development office by pressuring them to go after charitable gifts from their clients. That cannot happen because commercial advisors need to be objective and not bring an agenda to the table by promoting a specific charity. Instead, what can work is a better planning partnership where both the values of the client and his or her financial goals blend into an integrated estate plan.

Recent surveys have shown that less than five percent of professional advisors* bring up the idea of charitable planning in their discussions with clients, and many of those only do so after the client introduces the topic. The lack of charitable bequests in the estate planning process is a concern since over 70 per cent of families already make annual charitable gifts, but less than six per cent do so from their wills or trusts. Why is there a difference between the two? It is probably faulty communication between clients and their advisors, since clients make those decisions to support charitable organizations based on their values and interests, but fail to ask about continuing their legacy in discussions with financial and legal advisors.

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