Author: Gabriel

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.

article

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

Turning off the Ordinary Income Pump

Post author By Gabriel
Post date April 23, 2002

Turning off the Ordinary Income Pump

Employer Stock in Selected 401(k) Plans

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

Despite the clamor for pension reform resulting from the Enron debacle, many of the nations best companies still have plenty of their own stock in their profit-sharing and 401(k) retirement plans. While there are no taxes when assets are sold and reinvested inside these plans, lifetime withdrawals typically produce all ordinary income, taxed at the owners highest marginal tax rate. In addition, such assets can be hit at death with both the income tax and the estate tax, consuming up to 80% of their value as IRD assets (income in respect of a decedent). These IRD assets are more frequently found and many people dont recognize the tax traps associated with a lifetime of tax deferred savings.

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

What Works?

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

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

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

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

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

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

Who is Eligible?

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

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

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

⁽¹⁾DC Plan Investing,InstituteofManagementand Administration,New York

⁽²⁾IRC Sec. 72(m)(7)

⁽³⁾IRC 402(e)(4)(D)

Need Instructions or More Ideas? Call Us

Last Updated: November 11, 2002

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

Case Studies and Articles

Real Estate and the CRT

Post author By Gabriel
Post date April 21, 2002

Real Estate and the CRT

Controlling 100% of Your Family’s Social Capital

Real Estate Income Property Converted for Retirement

Sarah Sullivan, a widow age 72, has a modest estate with some cash savings and an apartment complex that has become increasingly burdensome to manage. As a former high school biology teacher, she is comfortable with her pension, but she would like to travel with her grandchildren while her health remains good. The rental property generates a decent source of income, but the responsibilities of day to day management keep her tied closely to the units. As the property ages, recurring repairs and dealing with renters has taken most of the enjoyment out of the property since her husband passed away some 5 years earlier. She would like to move to Florida to spend more time with her adult daughter and grandchildren. However, she is unwilling to sell the apartments and pay 30% of her proceeds as a capital gains tax. Besides the income tax issue, she was especially incensed to learn that she would also have the remaining balance taxed again at death when she passes that value on to her family. With a tentative offer of $680,000 for her property, she views this as an opportunity to sell and retire more comfortably. Her attorney suggested a charitable remainder uni-trust (CRUT) as a possible planning tool to minimize tax liabilities and retain some control over 100% of the family capital. The attorney requested that our firm to run a sample scenario*, and compare what would happen if (a) she kept the apartment complex and continued to operate it, or (b) sold it and paid the tax, reinvesting the balance, or (c) gifted it to an IRC § 664 Trust. The following presentation was reviewed and accepted by Mrs. Sullivan, her family and advisors. The major attraction was that the CRT would revert to a family type foundation after Mrs. Sullivan passed away. In this way, the family keeps a presence in the community and commits annual funds to the school district’s high school science program.

Income Property CRT Strategy (seehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)	Keep Asset and Pass to Heirs (A)	Sell Asset and Reinvest the Balance (B)	Gift Asset to CRT and Reinvest (C)
Fair Market Value of Apartment Complex	$680,000	$680,000	$680,000
Less: Cost of Sale (legal fees, commissions, appraiser)		27,200	$27,200
Adjusted Sales Price		$652,800	$652,800
Less: Tax Basis		$40,000
Equals: Gain on Sale		$612,800
Less: Capital Gains Tax (federal and state combined)		$183,840
Net Amount at Work	$680,000	$468,960	$652,800
Annual Net Return From Asset Valued at $680,000 @ 5%	$34,000
Annual Return From Asset Reinvested in Balanced Acct @ 9%		$42,206
Avg. Annual Return From Asset in 7% CRUT Reinvested @ 9%			$51,808
After-Tax (31%) Avg. Spendable Income	$23,460	$29,122	$35,748
Statistical Number of Years of Cash Flow for Income Beneficiary	15	15	15
Taxes Saved from $330,664 Deduction at 31% Marginal Rate			$102,506
Tax Savings and Cash Flow over One Life Expectancy	$351,900	$436,836	$638,724
Total Increase in Net Cash Flow Compared to Original Asset		$84,936	$286,824

* Hypothetical evaluations are provided as a professional courtesy to members of the estate planning community. Call for suggestions.

Normally, a wealth replacement trust would be established to offset the loss of value in the charitable gift. As once the asset is irrevocably transferred to the CRT it is unavailable to the heirs, and many families opt for insurance protection to replace the value of the gift. However, she and her husband had already purchased a $500,000 “second to die” insurance policy to provide liquidity for estate taxes, so this policy was simply converted to a different use and shifted out of her estate via gifts to her family while the early policy value was low. Now, since there won’t be estate taxes to pay; the existing policy will be used instead to offset much of the value lost in the gift.

Case Studies and Articles

Real Property and the CRT – Henry & Associates

Post author By Gabriel
Post date April 21, 2002

Real Property and the CRT – Henry & Associates

The CRT and Real Estate Contributions

Vaughn W. Henry

Highly appreciated real estate transferred to a CRT is a classic use of a §664 Trust, and one of the nation’s largest trust administrators reports that 28% of CRTs were created with real estate as the contributed asset. However, there are potential land mines that need to be discovered and neutralized before plunging into the transaction. For what problems should the planner watch?

1. In the design of the trust, generally, stay away from standard CRUT or CRAT instruments because they lack the flexibility to deal with liquidity shortfall problems if the land doesn’t sell immediately. As a rule, it’s usually better to use the NIMCRUT or FLIP-CRUT. These specialized charitable remainder trusts offer more options to avoid distributing parcels of land back to the income beneficiary when income is not adequate to meet required payouts.

2. Is the property debt free? If not, there may be a problem contributing the mortgage holder’s assigned interest to an irrevocable trust. The trust can’t be placed in a position of paying off the note, so any property contributed to a CRT should either have the debt paid off or the mortgage transferred to another parcel that is not contributed to the CRT. Specifically, a debt-encumbered asset may generate four distinct sets of problems that need to be addressed.

Unrelated Business Income – if a CRT earns unrelated business income for the year in which it’s made, the CRT is non-qualified and subject to tax. This is a disaster if the original contribution year generated UBTI, as not only is the charitable deduction lost, the capital gains liability is accelerated. This potential malpractice error effectively negates the advantage of creating the CRT in the first place. So how does mortgaged property create UBTI? Through Unrelated Debt Financed Income (UDFI) or “acquisition indebtedness” which may occur if the mortgage has materially changed in the previous five years or if the donor has owned the property for less than five years.
Self-dealing – the contribution of mortgaged property by a disqualified person raises some troubling issues, especially if partial interests are involved.
Bargain Sales – require the recognition of a pro-rata capital gains tax liability.
Grantor Trust – any trust that is non-qualified, and if there is any other owner of the asset, the CRT would be non-qualified and a tax paying entity. A number of attorneys have tried to address this concern by stipulating debt payment be made from principal or from assets outside the trust, but these suggestions create management problems for most donors and raise the issue of self-dealing.

The basic solutions include:

the retirement of existing debts
transferring debt to other non-contributed parcels as collateral
sell enough land in a taxable sale to finance the debt payment and offset those added tax liabilities with deductions from the donation of debt-free real estate assets
contribute a fractional interest in the indebted property to the charitable remainderman, if the property is eventually going to pass to the charity anyway. Some planners have advocated the contribution of an option to circumvent the debt-financed rules, but the IRS effectively shut this strategy down by ruling that no contribution exists when options are used.

3. Are there environmental problems, title defects or liens, on-going lease agreements (especially with prohibited persons)? Find out how the property is legally owned and whether or not it may be contributed to a CRT. Make sure there’s no prior commitment to sell, or you run afoul of the step-transaction rules.

4. Does the IRS consider the donor a “dealer”? If so, the appreciation is not treated as a preferred capital gain, but as ordinary income on inventory; the deduction is then based on basis, not fair market value. To protect the donor’s beneficial tax treatment, there are four tests under §1237 that may be worth pursuing:

this parcel wasn’t held by the taxpayer as inventory for sale to customers in the ordinary course of business
the taxpayer held no other property for sale in the ordinary course of business
no substantial improvements to enhance the parcel’s value were made
the parcel was inherited or held for five or more years. If all four tests are met, dealer status may be avoided.

5. If the CRT’s trustee then chooses to develop and sell lots in the property, will the CRT then generate unrelated business income and be treated as a dealer and exposed to UBTI? Maybe. Seldom appreciated by most planners, a charity can have unrelated business income and just pay tax on that portion of the resulting income that is not substantially related to the charitable purpose of the charity. On the other hand, if a CRT has unrelated business income, it loses its tax-exempt status for an entire year and becomes a tax-paying trust, and that creates severe, even catastrophic, burdens.

Other articles on poorly designed trusts using land and the well designed planned gifts are available at Zero Estate Tax Planning, as well as the case studies for Berger, Moore, Williams and Sullivan. Ongoing CRT and Planned Giving Workshops available for nonprofit organizations, boards, planned giving and estate planning councils and for-profit financial services firms. Need an evaluation of potential assets going into a CRT? We provide courtesy preliminary analyses for the professional estate and gift planning community. Call for a hypothetical fact finder

Henry & Associates

Case Studies and Articles

Socially Responsible Retirement Planning

Post author By Gabriel
Post date April 19, 2002

Socially Responsible Retirement Planning

Socially Responsible Planning – A Compensation Bonus and the CRT

Dan (30) and Pamela (26) Newberg work for a hi-technology software developer on the West Coast. As a part of their compensation, they have been provided low-basis stock as a bonus for their extraordinary development skills. After an initial public offering, the $80,000 basis stock is now worth $1,000,000. The stock produces no income, but has historically appreciated annually at 10%. This young couple has expressed an interest in using an IRC§664 net income with make-up charitable remainder unitrust (NIMCRUT) as a retirement planning tool to diversify their investment portfolio and reduce volatility. As IPOs tend to be erratic, they want to capitalize on the current high market value. The Newbergs have other assets and want to consider two scenarios to provide a supplemental pension plan designed to pay them $800,000 of after-tax annual income starting at age 65. For ease of investment comparisons and consistency, a well-structured tax deferred variable annuity earning a moderate 9% was selected to fund the CRT and a comparably invested after-tax mutual fund the other scenario. The unique ability to control the distributable net income (DNI) inside the NIMCRUT is a major advantage. The Newbergs are active in conservation and wilderness preservation groups and want to support environmental and educational programs. By controlling their social capital, they create a sense of economic citizenship benefiting causes they feel are inadequately supported by the federal government. Under the recently enacted 1997 Taxpayer Relief Act (July 28, 1997), this scenario will no longer work as originally planned. Consult your tax advisors and see the chart of Unitrust Remainder Calculations to review the opportunities.

The Facts

Annual adjusted gross income	$125,000, which meets their current lifestyle needs
Income tax bracket	36%
Capital gains bracket	28%
Investment options	9% D.A. inside CRT and 9% mutual fund for non-charitable options

Summary

The charitable scenario provides for comparable net income of $18.4 million for retirement over the Newberg’s joint life expectancies, and simultaneously produces $61.2 million to support the charities that mean so much to this childless couple.

Planning Articles and Links

Donors and Their Planned Gifts – Henry & Associates

Post author By Gabriel
Post date April 19, 2002

Donors and Their Planned Gifts – Henry & Associates

Donor Motivations – Don’t Make Assumptions

What Motivates Donors?
NCPG 2000 Survey of Donors Charitable Bequest Donors vs. CRT Donors	Bequest	CRT
Percent of donors citing “a desire to support the charity” as an important factor in their decision to make a gift	97%	91%
Percent of donors citing “the ultimate use of the gift by the charity” as an important factor in their decision to make a gift	82%	79%
Percent of donors citing “desire to reduce taxes (income or estate)” as an important factor in their decision to make a gift	35%	77%
Percent of donors citing “long-range estate and financial planning issues” as important factors in their decision to make a gift	35%	76%
Percent of gift donors who report no affiliation with the charity that will benefit from their planned gift.	21%	24%
Percent of gift donors who have not notified the charitable beneficiary of their gift.	68%	50%
Donors citing a financial or legal advisor as the first source of the idea for their gift	28%	68%
Donors citing a charity’s published material as the first source of the idea for their gift	34%	26%
Planned Giving in the United States 2000: A Survey of Donors (NCPG

Planned giving is generally situational. That is to say, the eventual gift to a charity may be a secondary consideration if it solves a current problem for the donor client. As situations change, the opportunity to introduce a planned giving solution must adjust as well. This is one reason that advisors need to promote and constantly reintroduce the use of planned gifts, since donor needs change. What might not have been appropriate once may now be an ideal situation to make a gift. Remember, planned gifts usually are made with assets, but annual gifts tend to come from income. Planners need a different mindset to use both properly, as each type of asset triggers a different set of planning tools or concerns. While donative intent is important, after all, it is a charitable planning tool; there may also be split-interest gifts generating legitimate donor benefits as well.

Gifts of Securities – these are excellent sources of charitable support. Rather than sell $130 of stock and pay tax on the gain in order to make $100 gift, it’s much better to make the gift of appreciated stock directly to charity. The nonprofit organization doesn’t pay tax on the paper profit and receives 100% of the fair market proceeds, while the donor gets a tax deduction for the entire value. There are cautions about using stock as gifts, e.g., is the stock publicly traded or restricted in any way? Rule 144 stock owned by insiders, or acquired with stock options, may create problems. For mutual funds, the fair market value that fixes the gift for IRS tax deductions is the value at the close of trading, while individual stocks are valued as an average of the high and low for the day’s trading. Closely-held stock in family businesses is more difficult to value and market when given to a nonprofit organization, and if the gift is intended for a private foundation, the deduction isn’t fair market value; instead, it’s the donor’s taxable basis. S corporation stock must be carefully handled. While recent changes in tax law allow its ownership by charitable organizations, the tax treatment often makes it an unattractive asset to receive by a tax-exempt entity.

Real Estate – great gifts, but there are more issues than with gifts of cash or stock. Will there be environmental or legal restrictions on land use that affect its salability? Was land held for development? If so, it may be treated as an ordinary income asset or inventory, thus the deduction is limited to basis. If it’s not inventory property, then is it mortgaged or encumbered? Is it readily marketable? If so, is there a buyer in the wings? One of the problems with real estate contributions to a charitable trust is having the IRS label the sale as a step transaction, so any pre-arranged sales or disqualified persons acting as buyers may trigger future problems when a CRT is used, but the same concerns may not be a problem for a charitable gift annuity.

Life Income Plans – charitable gift annuities, charitable remainder trusts, pooled income funds and life estates all offer donors a chance to use an income tax deduction now for a gift that won’t pass to the charity until some time in the future. Each type of tool provides the donor with varying degrees of control over the final disposition of the gift, the need for experienced private sector advisors and changing levels of income benefits.

Life Insurance, Retirement Accounts & Savings Bonds – are terrific gifts, many times directed by beneficiary designation, and with savings bonds and retirement savings the donor avoids IRD treatment by passing 100% of the value directly to charity.

Don’t Make Assumptions

31% of all planned gift donors have never made even a cash contribution to the charity that benefits from their planned gift. Don’t make assumptions about your client/donor base. While many donors are motivated by the most altruistic of intentions, there are other reasons for their charitable impulses (control, guilt, social interactions, religious, tax relief, community building, repayment, etc.) and commercial advisors may suggest a private foundation as a part of an estate plan. Foundations have been used for years by the well to do. Although with an increasing accumulation of wealth in the hands of the middle class, many of these families are now in the enviable position to create a family foundation as well. From a “social capita” perspective, most people understand they have assets over which they will exert no control at death. Therefore, they need to decide whether they want those dollars used to pay tax (an involuntary philanthropic payment to the IRS) or to self-directed charitable entities.

How best to regain control over those assets? Consider using a private foundation for larger estates and a community foundation with a donor advised fund for smaller estates. Where’s the break point? Generally, $5 million or less going into a private foundation with family control is of marginal effectiveness from a management point of view. The costs for creating the entity (either as a corporation or a trust), maintaining the records, filing the tax returns and paying the 2% excise tax that private foundations are required to submit are likely to erode the income and principal available to meet the required 5% payout for its charitable purpose. An alternative tool is the increasingly popular “donor advised fund” in a community foundation. The DAF provides the family with a voice in decisions to support charitable organizations of interest to them within the framework of a tax-exempt public charity. Besides offering guidance, staffing and infrastructure, a community foundation provides a more attractive way to make use of the charitable income tax deduction for many assets like closely held stock and tangible property. Additionally, using a community foundation avoids many of the tax traps associated with private foundations with regard to disqualified persons, prohibited transactions, self dealing and private inurement that gives the IRS ways to crack open a foundation and penalize its board for inadvertent mistakes or improper activities. Properly done, this strategy offers advisors great opportunities to help their clients achieve a sense of fulfillment otherwise unavailable in traditional estate planning — offer it as an option and see where it takes the conversation.

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

Case Studies and Articles

Family Wealth and Responsibility – New Tools for Old Problems

Post author By Gabriel
Post date April 15, 2002

Family Wealth and Responsibility – New Tools for Old Problems

Family Wealth and Responsibility – New Tools for Old Problems

Dr. Gerald (64) and Suzanne (62) Berger have a diversified estate with the basic estate planning provisions already in place. Like most professionals, Dr. Berger has the bulk of his estate tied up in a qualified retirement plan (QRP) which is valued in excess of $5 million. Besides owning some commercial real estate, farm ground and an appreciating stock portfolio, the Bergers also own vacation homes in two other states. With three children, the Bergers have had a lifetime commitment to their church and many charitable organizations and wanted to review their estate planning options. Their credit shelter trusts in place, and the remaining assets held in joint tenancy, it appeared that the Berger estate and income tax liabilities at death would take almost 70% of their accumulated wealth. Dissatisfied with that scenario, they asked their professional advisors to present a plan that would eliminate unnecessary taxes, assure them of retirement income security, pass their children an inheritance of $1million each and the remainder to the many charities they have supported.

The Berger’s estate assets were evaluated and those suitable for compression and distribution to family members were placed into a Family Limited Partnership (FLP). This allowed the heirs to receive “paper value” and ownership of some of the business interests and future appreciation was removed from the Berger estate. The FLP still allows Dr. Berger, through his revocable living trust, to maintain control and management as long as he retains ownership of the general partnership units, and the children and grandchildren will eventually own 99% of the limited partnership units. The farm and commercial real estate properties were examined and the advisors found that after management fees, expenses and maintenance, those properties were generating a net return of less than 2%. While the property managers noted that the real estate assets might appreciate in value, they admitted that for clients seeking less complexity in their retirement, those real properties were no longer suitable. Since the Bergers had depreciated much of the property and had low basis in their farmland, any outright sale would generate a capital gains tax at the 20% federal and 3% state rates. A more viable option was to use the §664 Charitable Remainder Trust (CRT) to control 100% of the principal. After Berger’s estate planning team suggested bypassing the capital gains tax “hit” with the CRT, a serious effort was made to see how else this split-interest trust could be made to work inside the estate plan. One of the most powerful solutions was to make use of the qualified retirement account to provide wealth replacement, retirement security and further charitable support to family philanthropies. At the Berger’s ages, it was easy to acquire an economical survivor life insurance contract and with some pension plan modification have their profit sharing plan pay for the insurance with pre-tax dollars. Later, the plan would distribute the policy to the Family Limited Partnership as a “paid-up” contract and distribute additional partnership units to children and grandchildren via annual exclusion gifts. The advisors also changed the beneficiary designations on Dr. Berger’s pension plan to name his wife as primary beneficiary and his CRT as contingent beneficiary. This strategy allows Mrs. Berger to disclaim her interest in the pension so the qualified funds would instead flow to the CRT, of which she is still an income beneficiary. In this way, Mrs. Berger will still have a option of keeping the taxable qualified funds or, if she has other adequate assets, she can allow the CRT to control those funds. The end result is that her retirement income is secure and the non-taxed CRT would pass qualified funds at her death to the newly created family foundation. The family would pay no income tax, no estate tax, the family foundation would be funded with pre-tax dollars and the CRT’s remainder interest.

To make sure each child receives their $1 million inheritance and further protect family assets from any of the heirs’ mismanagement, the Berger’s attorney drafted a new Irrevocable Life Insurance Trust (ILIT) to make use of the Berger’s remaining Unified Credit and Generation Skipping Tax Exemptions. Properly structured, the ILIT protects all of the insurance policy proceeds from estate taxes for the duration of the trust. In addition to creating a “dynasty trust” and basing it in South Dakota, the perpetual nature of the trust will control and protect family assets from taxation, litigation, divorce and spendthrifts while still providing the heirs with an opportunity to distribute and spend family wealth for many generations. Besides controlling this tax leveraged asset, there will be an additional $12 million in “social capital” controlled inside the Berger family’s charitable trust. The alternative was to pass $7 million to the IRS and leave the heirs with less, a clearly unacceptable result for a family so interested in maintaining control of their family wealth.

Henry & Associates designed the Berger scenario* and compared the options. Option (A) sell marginally productive income properties and pay the capital gains tax on the appreciation and reinvest the balance at 10% or Option (B) gifting the property to an IRC §664 Trust and reinvesting all of the sale proceeds in a 10% balanced portfolio. At the maturation of the CRT, when the surviving spouse (most likely Mrs. Berger) passes away, the capital inside the trust will pass to a family foundation with Berger heirs sitting on the board funding charitable programs of interest to their family.

Real Estate Asset Sale CRT Strategy (seehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)	Keep Asset and Do Nothing	Sell Asset and Reinvest the Balance (A)	Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of Farm and Business Property Holdings	$5,000,000	$5,000,000	$5,000,000
Less: Cost of Sale (legal fees, commissions, appraiser)		$150,000	$150,000
Adjusted Sales Price		$4,850,000	$4,850,000
Less: Tax Basis		$75,000
Equals: Gain on Sale		$4,775,000
Less: Capital Gains Tax (federal and state combined)		$1,098,250
Net Amount at Work		$3,751,750	$4,850,000
Current Net Return at 2%	$100,000
Annual Return From Asset Reinvested in Balanced Acct @ 10%		$375,175
Avg. Annual Return From Asset in 5% CRUT Reinvested @ 10%			$477,582
After-Tax (42%) Avg. Spendable Income	$58,000	$217,602	$276,997
Statistical Number of Years of Cash Flow for Income Beneficiaries		27	27
Taxes Saved from $1,723,850 Deduction at 42% Marginal Rate			$724,017
Added Tax Savings and Cash Flow over Joint Life Expectancies		$4,309,241	$6,636,947

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