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Partnering a CLAT and a Stretch IRA – Vaughn W. Henry & Associates

Partnering a CLAT and a Stretch IRA – Vaughn W. Henry & Associates

Partnering a CLAT and a Stretch IRA

Janet Bari (67), a professor emeritus of the local university’s art department, and her husband, Virgil (68), are typical Midwesterners.  They live modestly on $22,000 of social security income and what Janet makes by selling handmade jewelry and sculptures.   They own their country home, have no debts, pay cash for all of their purchases and avoid any sort of an ostentatious lifestyle.  She and Virgil married twenty years ago and each have children from previous marriages; both have a desire to preserve assets for their children, grandchildren and still provide for a degree of comfort and security in retirement.

Janet jumped onto the mutual fund bandwagon long before it became popular and regularly set aside savings in her IRA and 403(b) retirement plan, and has since accumulated over $1 million in tax deferred savings.  After realizing that she was also creating a potential IRD (income in respect of a decedent) tax trap, she redirected her on-going savings program to non-qualified equity accounts and has been pleased with the 14%+ returns over the last twelve years and her investment account has since grown to $500,000.  Always a big supporter of charitable causes, she and Virgil regularly give $5,000 to $15,000 away annually, even though their accountant has warned them that they can’t make complete use of the annual charitable deductions on their tax return.

When asked about goals and priorities, Janet said she hoped to leave each child with a level of financial support that wouldn’t be a disincentive to work, but would encourage heirs to develop their own business and philanthropical interests.  She wanted her family to receive the proceeds of her investment account, and although already making numerous $10,000 annual exclusion gifts, she was unwilling to make significant lifetime gifts to her heirs now and use up her applicable exclusion amount (unified credit).  Janet also expressed concern about helping a disabled granddaughter and a desire to protect her retirement plan assets from unnecessary taxation at death.

Of the many solutions proposed to her, the following scenario seemed to make the most sense.  It was easy to implement, provided a lot of flexibility and allowed her to make use of her retirement plan assets in a tax efficient fashion.  Since she hadn’t reached her required beginning date of 70½ years of age, Janet was able to take her $1 million in retirement plan assets and break the account up into seven different Individual Retirement Accounts (IRA) naming different family members as beneficiaries to each.  This strategy allowed her to have a longer payout when calculating the minimum required distributions (MRD), thus stretching out the payments over joint life expectancies that included some very young beneficiaries.  By stretching the payments out and by taking all the required distributions from just one $600,000 IRA account, the one she and her spouse shared, this allowed the six remaining accounts of $50,000 to $100,000 to continue compounding in a tax-deferred environment.  Since she was concerned about one granddaughter’s disability and future financial needs, Janet chose to fund that girl’s IRA at a higher level than those naming other grandchildren as beneficiaries.

Her advisor reminded her often that beneficiary designations can be modified, so if Janet has need of funds, she can always accelerate her withdrawals from any or all of her accounts, and this provides for adequate income security.  While Janet has no need of additional retirement income now, she has invested her seven IRA accounts in equity mutual funds and fully expects that they will continue to grow even after she’s forced to commence distributions.  She also named a charity to receive any balance in her primary IRA, limiting the IRD exposure while still providing for her husband, should he survive her.

To continue funding her charitable interests, a 5% non-grantor charitable lead annuity trust (CLAT) was established with the $500,000 investment account.  Since it has historically produced annual income and appreciation in excess of 14%, it was assumed that it could sustain a yearly gifting program of $25,000 and still have the capacity to grow over a twenty-year period of time.  The CLAT, a tax paying trust, can make charitable contributions and offset any earned income as a stand-alone taxable entity and make use of charitable deductions that Janet’s personal tax return cannot claim because of her AGI limitations.  By making distributions to a community foundation, Janet, as CLAT Trustee, can redirect the proceeds through a donor advised fund to charities of interest to the Bari family.  The foundation offers the Bari family the ability to accommodate any changes in their charitable contributions through their donor advised fund as family needs evolve over the years.  If Janet passes away before the twenty-year term expires, her children can step in and continue offering advice as to the direction of philanthropic support the trust will provide in the community.  If the trust pays out $25,000 annually and continues its historic performance for the duration of the trust’s term, there will be between $3 million and $7 million in the account that will pass nearly tax free to the heirs as if it used only $255,750 of Janet’s unified credit.  This is very efficient discounting and will provide the heirs with the resources for security and an opportunity to create their own remainder trusts in the future (see detailed flowchart).

flowchart1A CLAT can be easily described as a “deferred inheritance trust” and this offers the Bari family a degree of certainty as to when assets will be available to both charity and family members.  For the truly philanthropic, this plan offers donors a very useful means of passing assets to heirs in predetermined amounts, especially when insurance and wealth replacement trusts may not be economically viable options.

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The FLIP CRUT Charitable Trusts with Flexibility – Vaughn Henry & Associates

The FLIP CRUT Charitable Trusts with Flexibility – Vaughn Henry & Associates

The Flip CRUT

The IRS has “flipped out” with an unusual series of holiday decisions that have positive applications for clients with charitable trusts. In light of erratic market performance and declining fixed income investments, many donors with net income charitable remainder trusts have been disappointed with their beneficiary payments. Notably, the NIMCRUT or “spigot” trust (sometimes called a type 3 CRUT) is the most difficult§664trust to manage because of the restriction on paying out only distributable net income (DNI). DNI in most states is defined as interest, rents, royalties and dividends offset by trust expenses. When charities, unsophisticated money managers at best, invest as trustees, most often bond type assets are used to generate income, but this prevents the trust from ever appreciating. The new regulations, TD 8791, released on December 10, 1998 now allow any net income unitrust, either NICRUT or NIMCRUT, to be reformed into a FLIP CRUT without challenge by the IRS. This is much more flexible than most commentators expected, as the proposed rules originally called for a triggering event to be included in the original trust document and a more rigid set of asset restrictions. This largesse by the IRS may result in a flurry of court filings before the June 8, 1999 deadline.

Flip Away

What’s a FLIP CRUT? It is a hybrid CRT that starts off as a NIMCRUT or NICRUT because the contributed asset is hard to value (see the new IRS definitions) and illiquid. For example, raw land contributed to a standard unitrust produces little, if any, income. However, when the required payout must be made, there’s no liquidity to make the payment. The only recourse is to distribute a portion of the land back to the income beneficiary since the CRT may neither postpone the payment nor borrow the funds. This tends to make the income beneficiary unhappy since the land was contributed as a way to avoid capital gains liability and reposition the assets into something capable of producing spendable income. The old solution was to use a net income trust that paid out the lesser of earned income or a fixed percentage of annually revalued trust assets. In this way, the trust would payout only what it could earn, but it wouldn’t compel the trustee to imprudently liquidate the assets at a loss just to make an income beneficiary’s distribution. Generally, this meant the beneficiary was in the same position as before the contribution, receiving only what income the land produced. However, after the trust sold the land, the beneficiary found out that the trust payout was still limited to what the trust “earned” in the way of net income. Many clients went along with the NIMCRUT concept expecting to receive a 7% or 8 % income stream once the property was sold, only to find out that they were still limited to receiving the lesser of net income for life. Additionally, in the real world of financial markets, there was little hope of ever invading the “make-up” account to offset lost ground. This called for sophisticated investment advice and many documents do not allow the use of these tools, as trusteesnever researched the use of non-typical trust investment products like specially designed deferred annuities and zero coupon bonds to control timing and income recognition.

The typical alternative of defining capital gains as “income” was a band-aid means of managing this choke point in a NIMCRUT. However, this strategy adversely affectsinvestment choices by requiring the trust to sell the best performing investments and keep the worst performers. This technique wrecks the long-term performance of the trust and isn’t recommended.

Triggering the Flip

Now it is possible to convert existing net income trusts into straight percentage unitrusts if the drafting attorney can identify a “triggering event or date” that is “outside the control of the trustee or any other person.” Examples of triggering events, in addition to sale of unmarketable assets include retirement at a specified age (not any arbitrary retirement date), marriage, divorce, death or birth of a child.

The trustee has a fiduciary duty to be even handed to both the income beneficiary and the remainder beneficiary. In a net income unitrust, greater equities favor the charitable remainderman since the portfolio appreciates. However, this investment choice produces little DNI and is often detrimental to the income beneficiary. On the other hand, greater fixed income securities initially favor the income beneficiary but limit future growth, and that damages both of the remaindermen. Equities often play a lesser role in a NICRUT than in a straight unitrust because of the difficulty of earning a 5% net income. Remember, this isn’t total return, since appreciation isn’t usually defined as income, so a diversified portfolio of equities and fixed income instruments wasn’t often used. Once the trust is flipped to a standard CRUT, then total return can be part of the investment philosophy and invasion of principal could occur during downturns in the market, something not allowed in a typical net income unitrust. Does this mean NIMCRUTs are out? No, the retirement planning unitrust still makes terrific use of the strategy, especially in light of a recent IRS Technical Advice Memorandum (TAM 9825001), and may well replace the traditional pension plan for high income earners with an estate tax liability. However, the FLIP-CRUT will likely become more prominent once planners understand the flexibility.

Divorce

On a slightly different note, clients occasionally ask about dividing charitable remainder trusts upon divorce.

The IRS issued two (identical) rulings authorizing such a split: Private Letter Rulings 9851006 and 9851007 (Sep. 11, 1998). Husband and wife had a single 5% net-income-with-makeup charitable remainder unitrust (NIMCRUT) that was to last for both of their lives. After the divorce, the IRS approved dividing the NIMCRUT into two separate 5% NIMCRUTs, with one NIMCRUT for each spouse. The assets were split 50-50.

For more information on charitable and estate planning strategies, check our home page at http://members.aol.com/crtrust/CRT.html

Henry & Associates

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Tune Up Your School Foundation – Vaughn Henry & Associates

Tune Up Your School Foundation – Vaughn Henry & Associates

Time to Tune-up the School Foundation

Vaughn W. Henry © 1999

Most school superintendents admit to a love – hate relationship with their foundations. They recognize the need to have one, but don’t have the time or energy to battle with one more group of civilians to support projects the superintendent sees as mission critical. The time to re-energize the foundation approach has come, brought to the forefront by demographic and economic changes over the last 15 years. Why? Schools that create a viable means of support outside of tax generated revenues will find themselves in a position to respond more quickly to changing community needs. Without a viable foundation and endowment, the school system may find itself without the necessary financial strength to continue operating as it should. For small towns, the loss of the local school is often a symptom of a dying community. Too few young people stay, too few jobs or services remain and a once thriving town becomes a wide spot in the road. Healthy schools mean that small towns have a chance to survive in today’s technologically driven economy.

While the Illinois Association of School Boards (IASB) reports that 50% of the school districts have a foundation designed to support the district’s financial and development needs, the majority are inactive or ineffective. At the last three IASB/IASA annual conferences and at a recent INSPRA meeting, a quick poll showed that existing foundations did not use planned giving or gift development programs consistently, if at all. Instead, these home grown and operated nonprofit organizations generally relied on special events like pancake breakfasts, chili suppers, car washes, sales of athletic wear and concessions at sporting events to meet their growing needs. That understandable, but limited approach results in too few dollars raised; of course people start programs based on what they’ve been exposed to, and events have been around for a long time. Unfortunately, the funds raised through special events often have a fairly high cost in terms of employee and member time commitments, with little net gain. One foundation reported raising $70,000 at a local golf outing, but admitted to spending almost $62,000 to raise it. Those are dismal results at best, given the huge effort required by volunteers and frustration generated by spending so much of the revenue in what could be only described as a public relations exercise. Contrast that with a recent bequest to the Lincoln, Illinois High School Foundation of nearly $500,000. Of particular importance is the fact that fewer than 10.8% of donors (Seven Faces of Philanthropy, Prince et al, 1994) are motivated to aid an organization via special events, so a different strategy is needed if new significant support is going to occur.

The American Association of Fund Raising Counsel reports that of the $174.52 billion raised for U.S. charities in 1998, only 13.5% went to education with almost all of it destined for higher education. Yet the typical student spends 12 years in the primary and secondary school system gaining a basic foundation for a four-year college degree. While 75% of the educational effort is made at the local level, why don’t graduates support their basic school system in the same way as their collegiate institutions? Generally, it’s because they’re not asked. A fundraising precept (almost carved in stone) is, if you don’t ask, you don’t get. Superintendents often say they’re uncomfortable asking for financial support for what’s commonly perceived as a tax supported institution, but the state and land grant universities have developed healthy endowments and development programs, why should the tax assisted school districts be any different? While administrators need to be sensitive to communities that have recently rejected unpopular bond issues, the school foundation is an entirely different entity and it needs to be presented that way. The reality is that foundations and corporate grants, popular resources for bureaucrats, only provide about 15% of the charitable support for nonprofit organizations. The bulk of the financial support comes from bequests and individual gifts that are largely ignored by local school foundations.

Estate Tax Influences

The ongoing inter-generational transfer of wealth presents a significant opportunity, as assets destined for unnecessary taxes can be redirected back to local tax-exempt purposes. Unfortunately, few people realize that they have choices about where those dollars wind up. While large group social special events are relatively simple to design and promote by amateur supporters, the major dollars are more efficiently generated elsewhere. Major funding could result from proactive estate and wealth conservation planning, but most foundation members and school administrators lack experience with sophisticated financial and estate planning tools and avoid using these tools because of perceived complexity.

What to do?

  1. Understand that planned giving in particular is a complicated field, subject to changes almost daily. While general practice attorneys, financial planners, accountants and trust officers may have rudimentary background; they aren’t experts. Seek specialists to coach your professional advisors so the committee has better focus and understands when charitable planning opportunities exist.
  2. School administrators, often ex-officio members of the foundation’s board, don’t have the tax and legal background needed to competently discuss the financial and estate planning tools. Since most board members don’t possess the skills either, find professional advisors willing to serve as resources and develop a network capable of addressing donor needs. Properly done, that integrated approach will also provide ongoing support for your district’s needs.
  3. Focus on the priorities of the school district and the students’ needs outside of day to day educational requirements. The foundation should be seen in the same light as a savings account, while the school district’s annual budget commitments operate from the checking account. They have different purposes, different needs
  4. Implement a business plan; create a planned giving committee separate from the foundation board. Be careful about conflicts of interest, and be up front with professional advisors that there’s not an exclusive right to solicit donors for products and services when discussing foundation needs. A good policy manual, available from several commercial providers, should be very clear about what acceptable gifts and solicitation tools the foundation will utilize. This approach offers several advantages:
  • Setting board policy isn’t a factor with this committee but creating strategy and planning partnerships are, so there should be no compliance problems with the new §4958 regulations already adding to administrative burdens for public charities.
  • Learn how to showcase the facility and present the school district in a way that makes it seem more like the heart of the community instead of a money pit soaking up tax dollars. Provide continuing educational programs that help remind donors and advisors that the foundation is a willing partner in implementing community gifts.
  • Get away from the “poor me” mindset. Donors want to give to successful programs and there needs to be suitable motivation to support the cause.
  • Learn how to appeal to the donor’s sense of heroism and immortality and if you can do it in a tax efficient manner, donors will be more likely to refer peers and repeat gifts.
  • Although there are risks, create funds that give donors a sense of control. Don’t pursue the too common mindset, “we’re the charity and we know best” found in many nonprofit organizations; that nearly arrogant sense of moral superiority doesn’t create the motivation needed to encourage business owners and people who have accumulated wealth. These donors tend to be very control oriented, and the trick is to provide them with the sense of ownership without giving up the charity’s integrity and compromising its tax-exempt purpose.
  • Identify the mission of the foundation in such a way that it creates a vision of future accomplishments and becomes easier to ask for and receive ongoing support.

With a coordinated strategy, not only will annual giving prosper, but future planned gifts will more easily fall into place. In order to make this occur, delegate someone to implement the planning processes now. Spend some time training the board and supporting committees on tools available, not with the goal of making them experts, but focus on recognizing when tools may be beneficial and call in technical support to implement the gift. If possible, find advisors willing to be coached and supported in this new field long enough that they can become competent. Although it’s time consuming, this approach will allow the foundation and community to prosper.

Vaughn W. Henry is a planned giving specialist based in Springfield, Illinois. His web site, http://gift-estate.com, has numerous articles, case studies and professional resources suitable for foundations and administrators seeking more background to improve their development activities.

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO

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Creative Estate Planning When the Stock Market Declines – Vaughn Henry & Associates

Creative Estate Planning When the Stock Market Declines – Vaughn Henry & Associates

Making the Most of Market Declines

Vaughn W. Henry

Not all stock market gyrations are bad things. Recent declines in equity portfolio values actually may present some excellent opportunities for estate and gift planning. The IRS and Congress have been trying to tighten restrictions on “estate compression tools” (legal structures that deflate an asset’s fair market value), especially Family Limited Partnerships (FLP) with exclusive holdings in publicly traded stock. The feds’ argument is that publicly traded stocks have an established value, are easily partitioned, and that significant discounting taken for minority interests, lack of control and lack of marketability in those limited partnership units is abusive. On the other hand, the FLP with land and closely held businesses probably will not have difficulty using those same legitimate discounts. However, partnerships with cash and liquid assets may need more care in handling those assets. What other options exist to pass family wealth? Consider a lead trust. Why? The long awaited bull market correction presents an ideal opportunity to gift assets that have intrinsic worth, but are temporarily at a lower value without a lot of legal mumbo-jumbo. A stock portfolio of $1 million that suffers a 25% – 35% decline due to erratic and unjustified market behavior has presented the owner with a legal and timely way to trim the family’s estate and gift tax bill. The old adage about striking while the iron is hot is sure true in today’s financial environment.

Other than traditional outright gifts to heirs, the combination of the government’s low Applicable Federal Mid-Term Rate (§7520 120% Annual AFR) and the stock market decline means that a Charitable Lead Annuity Trust (CLAT) presents some very exciting ways to pass wealth to family. The added benefit is that of meeting philanthropic interests at the same time. The lead trust is a reciprocal version of the more popular Charitable Remainder Trust (CRT) in that a charity receives a stream of income from the lead trust and after a period of time, the remaining assets pass back to family or heirs at a significant discount. Create these trusts far enough ahead of time and inheritances pass with no tax cost at all. And since the assets placed into trust were in a temporary decline because of market fluctuations, the family inherits a solid portfolio with the capacity to grow significantly. If the charity receiving the trust payments is a donor advised fund inside a community foundation, charitable distributions can enhance family influence and support. The goal of preserving family wealth is not to protect just the hard assets, but to provide opportunities for the family to wield clout in a community and to continue a positive family legacy.

How would it work? George Smith (55 years old, married with 3 children) had a well-balanced and diversified portfolio worth $1 million in July, and in September, after his average values had declined 35%, his portfolio was worth $650,000. George felt his portfolio held some outstanding stocks and viewed this as a buying opportunity, but he wanted to solve estate tax problems too. Advised to think strategically and solve several problems at one time, George created a nongrantor charitable lead annuity trust with his temporarily depressed portfolio. The CLAT stipulated that 8.9% of the initial fair market value be paid out in a monthly annuity to his donor advised fund at a national community foundation. In this way, he funded his charitable interests through his family’s donor advised fund and after 20 years, the portfolio and all of its growth will pass to his family at zero cost in estate taxes. The family’s only cost was to wait for assets they were in line to inherit anyway. By passing assets without any tax cost, the appreciated portfolio is expected to be worth $1.84 million if the underlying funds just experience average market performance, and this will save the family over $1 million in unnecessary estate taxes. Additionally, his 8.9% his charitable gift fund payment of $57,850 for 20 years will provide for his discretionary philanthropic interests in a very tax efficient manner.

 

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Incentive Stock Options and the CRT

Incentive Stock Options and the CRT

Incentive Stock Options and the CRT

image

George Rivera (47) is an industrial engineer with a midwest manufacturing company; his wife, Nancy Rivera (45), is a nurse with a local physicians’ group. George is well compensated and has been provided with incentive stock options as an executive benefit, and he has been exercising them annually with money from his year-end bonus. The qualified options allow George to purchase his employer’s stock at far below market price and his net worth has steadily appreciated over the last few years with continued company growth. Although any stock acquired through an option and held for at least one year qualifies for capital gains treatment, which is usually more advantageous than paying tax at his marginal rate, it still means he turns 30% of his retirement dollars into tax dollars in a normal sale. This is wasteful and unnecessary, see why below.

George’s employer provides access to financial planning services as a company perk. Counseling increased diversification to reduce his exposure to any downturns in the market, his planner is concerned how a decline would affect George’s one stock portfolio. His advisors suggested the use of an IRC §664 Charitable Remainder Trust to bypass the income tax liabilities when he repositions his growth portfolio into one more suitable for wealth preservation and prudent retirement planning. Besides the financial advantages of a CRT, there were also the issues of what money and wealth meant to his family. As a part of the Rivera’s financial plan, George and Nancy completed a profile that detailed their family financial philosophy. While tax avoidance was important, it wasn’t their only motivating influence. Although, the Riveras have no children, they have been active in local community affairs and feel that they have a vested interest in the town where both of their families have been living for many years. With no particular desire to leave distant family with a large inheritance, the Riveras chose retirement security, inflation protection, asset preservation and community projects as more important features of their plan, and the CRT meets those goals very effectively. Even if tax avoidance is the only priority, this performs exceptionally well; but when factoring in the “social capital” issues, the CRT formed the core strategy of their estate and financial plan. As trustees of their own CRT, the Riveras control the assets and investment management decisions and still retain the right to modify the charitable institutions scheduled to receive assets when the trust terminates. As there will be an estimated $8.9 million in social capital inside their charitable trust, it has great potential to impact the local community.

Henry & Associates designed the Rivera scenario* and compared the two options of (a) selling stock and paying the income tax, reinvesting the balance at 10% or (b) gifting the stock to an IRC §664 Trust and reinvesting all of the sale proceeds in a similar 10% equity based portfolio. At the maturation of the CRT, when the surviving spouse (most likely Nancy) passes away, the assets inside the trust will pass to a community hospital and nonprofit nursing home. These organizations provided the Rivera family with health care over the years and deserve their support, although if the Riveras decide to expand the list of charitable remainder recipients, that’s an option.

Incentive Stock Options and a CRT Strategy

(seehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)

Sell Taxable ISO Stock Reinvest the Balance (A)Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of Stock

$1,000,000

$1,000,000

Less: Tax Basis

$300,000

 
Equals: Gain on Sale

$700,000

 
Less: Capital Gains Tax (federal and state combined)

$210,000

 
Net Amount at Work

$790,000

$1,000,000

Annual Return From Asset Reinvested in Balanced Acct @ 10%

$79,000

 
Avg. Annual Return From Asset in 5% CRUT Reinvested @ 10% 

$171,753

After-Tax (40%) Avg. Spendable Income

$47,400

$103,052

Statistical Number of Years of Cash Flow for Income Beneficiaries

44

44

Taxes Saved from $179,900 Deduction at 40% Marginal Rate 

$71,960

Tax Savings and Cash Flow over Joint Life Expectancies

$2,085,600

$4,606,250

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

©Vaughn W. Henry, 1997

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Learning Experiences in CRT Design – Henry & Associates

Learning Experiences in CRT Design – Henry & Associates

Learning Experiences in CRT Design with Families

What to do when a couple isn’t insurable and a wealth replacement trust using life insurance isn’t economically affordable?  A typical solution is to name children as successor income beneficiaries to the CRT.  Factor in the §1089 TRA-97 10% charitable remainder requirement and naming younger income beneficiaries becomes much more difficult.  Many advisors have also forgotten another area in the Code that might cause them further difficulty in beneficiary planning.   Although there’s a natural desire of a client to include children in a CRT, advisors must explain that when a non-spouse is included as an income beneficiary, there’s a taxable gift involved.  If the trust names the spouse and children, then not only are the children receiving taxable gifts, so is the spouse, as the unlimited marital deduction* is lost.  There are solutions in a family situation when using a multi-generational CRT that might be worth considering:

1. To avoid making a taxable gift to a child when creating an inter-vivos CRT, retain the right to revoke the income interest by Will.  Since the gift is incomplete, the value of the CRT’s income interest becomes an estate tax liability if the right to receive income hasn’t been revoked.  In the meantime, the income beneficiary ages and the charitable remainder increases, and that may reduce the transfer cost.  Unless the trust value appreciates significantly, the estate tax value to the heir will be less than the original gift tax value.

* Because of ERTA (1981), a person can gift during lifetime or leave a surviving spouse his/her entire estate free of the federal estate tax, no matter the amount, except for certain terminable interests in property.  Now, only non-terminable or “qualified” terminable interests are eligible as unlimited marital deductions under I.R.C. §2056(b).  What’s terminable?  A terminable interest means the interest will end at the spouse’s death; for example, a life income interest in a trust.  The purpose of the terminable interest rule has been to deny any marital deduction at the first spouse’s death if the property will escape taxation at the second spouse’s death.  There are two “qualified” terminable interests under Code §2056(b) that qualify for gift and estate tax marital deductions.  One is for a “qualifying income interest for life” that passes to the surviving (donee) spouse from the deceased (donor) spouse with the following three conditions:

(1) a surviving spouse must be entitled to all the income from the property, payable annually or at more frequent intervals;

(2) no person can have a power to appoint any part of the property to any person other than the surviving spouse;

(3) the executor must elect to deduct the property on the federal estate tax return. This election is irrevocable. Note that a trust that paid the spouse an income for a term of years (rather than life) could not qualify, nor could a trust that terminated on the occurrence of a contingency (such as the spouse’s remarriage) PLR 8347090 (8-26-83).

The other qualifying terminable interest happens when the surviving spouse is the only income beneficiary of a charitable remainder trust.  The surviving spouse need not have a life income interest, as an income interest limited to just a period of years could still qualify I.R.C. §2056(b)(8).  The IRS, in Technical Advice Memorandum 8730004, noted that a CRT with two successive non-charitable beneficiaries lost the use of the marital deduction. The ruling related to a testamentary charitable remainder trust in which the decedent had named a surviving spouse followed by another non-charitable beneficiary. The Service ruled that since the Code specifies a surviving spouse to be the only non-charitable beneficiary, the interest, therefore, did not qualify for the marital deduction §2056(b)(8).  — ACCESS AUS 1997

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO

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Charitable Family Limited Partnerships by Stephan Leimberg – Vaughn Henry & Associates

Charitable Family Limited Partnerships by Stephan Leimberg – Vaughn Henry & Associates

Charitable Family Limited Partnerships

Prudent Planning or Evil Twin?

by Stephan R. Leimberg

“We all seek the Holy Grail-like chalice from which all who drink will be given large and lasting income tax deductions at little or no cost. But that chalice will be hard to find within the Charitable Family Limited Partnership concept!”

Charitable Family Limited Partnerships: The Promises

Imagine a concept that enables you to obtain a large income tax deduction, generate a largely tax-sheltered capital gain on the sale of business and investment assets, create and retain a strong and steady stream of income, and pass on substantial wealth to your family members at little, if any, gift or estate tax cost.

Its promoters tout that it does all these things and is even better than a CRT since the deduction is higher, the stream of income is potentially greater, the gift you make, unlike an outright gift which once made is gone forever, comes back to your family (and is worth more than when you gave it) forever, and within a few short years (unlike the case where a CRT is used) the charity is out of the picture, and it’s the client’s family who receives the wealth rather than the charity, and all that family wealth is shifted, at little if any gift or estate tax cost.

The Mechanics

Step 1: You create a FLP comprised of a general partner’s interest and one or more levels of limited partnership interest(s).

Step 2: You put business and other appreciated assets and cash into the FLP.

Step 3: You, as general partner, retain a management fee for operating the partnership. The fee ranges from 3 to 10% of asset value. This enables you to keep all or most of the firm’s cash flow, or trickle out a token amount to limited partners at your whim.

You also retain, as General Partner, the right to borrow partnership assets for personal needs at competitive interest rates.

Step 4: You make a gift of (say) 97% of the limited partnership interests to one or more qualified charities. This generates a large current income tax deduction (however, the charitable income tax deduction valuation process considers the fact that even at 97% of all the limited interests in the FLP, the interests conveyed carry limited control and almost no marketability, and must therefore be discounted considerably).

The charitable gifts carry a “put” enabling the charity to force a buy-back of the limited partnership interest, but at a very significant discount from its value when it was received by the charity. For instance, the charity may be given an option to “put” its interest back to the partnership or to the other partners in five to eight years, but at a small fraction of its value.

Step 5: You make a simultaneous gift of the remaining 3% of the FLP’s limited partnership interest to your children and/or grandchildren. The gift tax valuation of these interests also takes into account the lack of control and marketability and so a relatively large gift tax valuation discount may be taken.

Step 5A: To fund the deferred buy-out, life insurance on the donor’s life is purchased. The partnership itself splits the premium dollars with an irrevocable trust that represents the interests of its beneficiaries, the 3% limited partners. Indirectly, since the charity holds 97% of the partnership’s limited interests, the charity is helping to pay insurance premiums. In other words the charity is funding the bulk of the premiums that will be used to buy itself out.

In one variation on the theme, the charity’s “put” enables it to sell its interest to the irrevocable life insurance trust (yes, the same ILIT its dollars have been helping to fund the life insurance that will be used to buy out its interest at a discount). The trust would then receive the partnership interest with a stepped-up basis.

Step 5B: If there is a sale of partnership assets during the donor’s life and before the charity exercises its right to demand a purchase of its interest, approximately 97% of the gain is attributable to the charitable partner, so the client’s family pays tax on only a small fraction of any gain.

Step 6: At the specified “put” date, the charity exercises its option to force a purchase (at pennies on the dollar) of the limited interests the charity was holding. It receives cash in return for the interest, which has been sold back, either (a) to the partnership itself or (b) to the 3% owners. This brings the family business and other holdings of the FLP (together with any appreciation on relatively untaxed capital gains sheltered by the charity’s tax free status) back into the control of the family.

What’s Wrong With This Picture?

Here we go – again! All the parties to this scheme know from inception that this is not a charitable gift, an action of detached disinterested generosity.

Everyone knows, and intends, that this is yet another re-run of the “Let’s Make a Deal” show. Charity, you’ll get a “play-along” fee in return for allowing Mr. and Mrs. “Angry Affluent” to receive a large charitable deduction for their “gift” (even though they have relatively little charitable intent here). We all know this arrangement is designed to disproportionately benefit Mr. and Mrs. A and their family and facilitate their personal estate planning objectives.

This is yet another classic example of using a charity to serve a private rather than public purpose. If personal economic goals were not a substantial element, why not merely give the charity an outright gift of the FLP limited partnership interest?

An IRS Blueprint

There are at least three specific roadblocks the IRS will place in the way of a current deduction:

  1. The intent of the parties from inception is based on the unwritten, but very real, understanding between the parties that after a relatively short period of time, the charity will sell its interest back to the partnership or the other partners, and receive nothing more than pennies on the dollar.
  2. Here’s a (simplified) “best case” (from the taxpayer’s viewpoint) IRS position:
  1. The IRS could easily argue that what the charity received at the time of the contribution was the sum of —

No matter what reasonable discount rate is assumed, when you crunch the numbers, the sum of the two real rights the charity is being given fall far below the $700,000 deduction actually taken. Clearly, at best, the difference would be disallowed and appropriate interest and penalties would be imposed.

A more likely IRS approach is that there is no allowable income or gift tax deduction. The IRS will argue that what the “donor” gave here is in reality a possible, but certainly uncertain, stream of dollars over a period of years followed by a “balloon” (remainder) payment.

Since this “partial interest” gift is not in the form allowed by the Code (e.g. not a CRT or remainder interest in a home or farm), there is no Code-based sanction for a deduction. The result of a disallowance of the income tax deduction is obvious. But consider the implications of the disallowance of the gift tax deduction; the entire value of the transfer to the charity, less any allowable annual exclusion, would be taxable!

Although promoters may argue that the “put” is merely an option and that there was never a legal obligation for the charity to sell (and therefore the contribution of the 97% interest in the FLP must be respected), consider the probability that parties, particularly the donor, would never have entered into the transaction had it not been contemplated from inception that the charity would have no practical choice but to exercise its put.

This is just like the CSD concept in that promoters are hoping to obscure the substance of the overall plan with a focus on each step of the form. Yet the IRS and the courts will put the pieces of the puzzle together and view it as a whole, since the taxpayer here would not enter into any portion of the transaction unless it was contemplated that the whole would work. (Again, if the transaction was intended merely to benefit charity, why not a Palmer-like outright “no strings attached gift?”)

If the transaction is viewed in its entirety, the intent of the promoters and the client becomes obvious. The combination of the —

  • generous management fee reserved by the “donor,” when added to
  • the overvalued deduction valuation, on top of
  • the underpayment for the partnership interest that was, just five years previous to its intended resale to the “donor’s” partnership, valued much higher (and the fact that the “put” in no way is grounded on an objective or reality-based formula) must lead a court (as well as any other intelligent and honest observer) to the conclusion that the transaction was something very different than a contribution solely for the benefit of a public charity.

Certainly, the spirit, if not the letter, of the private inurement and private benefit rules have been violated. This is clearly not a gift for the exclusive benefit of the charity or its intended beneficiaries.

Certainly, under “intermediate sanctions” regulations, if the donor has been a substantial contributor to the charity or he/she or their family is/are for some other reason considered “disqualified persons,” that is, persons who by their relationship with the charity, have a direct or indirect power over the decisions of the charity or a position of trust vis a vis its actions, they will be severely penalized for any “excess benefit” transaction. Here, both an unjustifiable management fee and the underpayment to the charity at the time of the put could easily result in harsh excise taxes, in addition to the normal interest and penalties.

The Bottom Line

When promoters use form to obfuscate substance and when the exemptions of a charity are exploited to achieve private objectives, expect problems. I have never known a client who was happy to have his name on a well-known case.

The “I’m Different” Defense

You’ll hear, of course, many promoters claiming, just as they did in Charitable Split Dollar, “I’m different.” “My variation will work even if other “more greedy” versions will not.”

You’ll hear about an “I’m different” version where —

  • the management fee is lower,
  • the FLP’s payout to the charity is higher,
  • the charity gets a better deal on the sell-back, or
  • the charity’s money isn’t used to finance the buyout of its own interest.

One Last Time

The central issues to focus on are:

  • Is the arrangement you are examining a transfer representing “detached disinterested generosity” or an incredibly great deal for the charity and a relatively negligible benefit for the donor (deductible), or is it a take-it-or-leave-it deal in which the major beneficiary is the “donor” (nondeductible)?
  • Is the gift of the right to uncertain income for a period of years followed by a balloon payment (the “put”) a partial interest gift (nondeductible)?
  • Are both the original transfer to charity and the buy-back from the charity REALLY valued at arms’ length (O.K.) or are (or can) valuation games being (be) played? The deduction, if any, will be limited to the real and measurable value of what the charity gets at the date of the original transfer.

The less in it for the donor and the more for the charity, the better the odds.

At the very least, —

  • it has to be a true charitable gift,
  • it must be a gift of the donor’s entire interest, and
  • there must be the total absence of the ability to play games with valuation.

If any one of these elements is missing, you have an invitation to litigation.

And giving the charity “something,” a “go along with the deal” fee, is not good enough. It’s not enough that the charity ends up with something other than an empty bag. Throwing the charity a bone, in return for a lopsided benefit, was not what Congress had in mind when it created the income tax deduction for gifts to charity.

Categories
IRS Information, Regulations and Commentary on Charitable Legal Issues

Charitable Split Dollar Plans – Vaughn Henry & Associates

Charitable Split Dollar Plans – Vaughn Henry & Associates

An open letter on Charitable REVERSE SPLIT DOLLAR – AND ITS PROGENY

by Stephan R. Leimberg, JD CLU

KEY CLAIMS

  • There have been five key claims for Charitable Reverse Split Dollar arrangements and their progeny:
  • First, funding of life insurance will be – in essence – income tax deductible.
  • Second, no party will be subject to income or gift tax liability (and it may also be possible to beat the estate tax).
  • Third, the donor will be able to use tax deductible dollars to provide for his or her own retirement income.
  • Fourth, this is a “no cost”, “nothing to lose”, “sure thing” with substantial benefits for charity, and
  • And fifth, this is a very, very good financial opportunity for the agent who is able to convince the client-donor and the charity to implement the plan and split the insurance.

Let me make my viewpoint very clear:

First, either all – or a significant portion of the check the donor-insured – or his or her corporation – writes – will not be deductible.

Second, the donor will incur significant income or gift tax liability – or both. And the person who prepares and signs the donor’s tax return will also likely face legal as well as ethical challenges.

Third, this is not a good deal for the charity. In fact, it may potentially be a New Era level public relations, economic, and legal disaster. The overpayment of premiums and the loss of interest on the “unearned premium account” may be deemed an imprudent course of action, probably a violation of the charity’s state charter, and a risk of its tax exempt status. In fact the charity may be sued by the donor on the grounds that he or she relied on the charity’s counsel checking out the viability of the plan.

Fourth, although the agent who sells this concept may realize a very short term gain, in the long-run, my prediction is that selling this concept will prove very expensive to both the wallet and the reputation of that agent.

Let me explain why I feel that donors, charities, tax preparers, insurance agents, as well as plan promoters will all loose from the marketing of charitable reverse split dollar and the “I’m different” schemes that make the same promises:

In examining CRSD – just as in any tax transaction, the IRS and the courts will look at both the formal written documents – and the substance – the totality and reality – of the transaction as a whole. The IRS and the courts can ignore your words can be ignored if they don’t comport to your actions.

Seemingly unrelated pieces of a puzzle can be re-assembled by the IRS when it’s clear that the parties intended from the start that each piece was intended to be part of a whole and no part of the puzzle works without the other parts.

In my opinion, both the “substance-over-form” doctrine and the “step transaction” doctrine – will be applied here – vigorously!

Charitable Reverse Split Dollar and the “progeny” I’ve examined – let’s be honest – is an integrated inter-dependent series of steps attempting to obtain a very good result for the donor and his family with relatively little of the client’s dollars for the charity.

Let’s address the law: We’ll start with the obvious. To get an income tax deduction for a gift to charity, you must both intend to make a gift – and – in fact – make one. If there’s no donative intent, in other words if you really don’t intend to make a gift, the entire deduction may be disallowed.

And for gift tax purposes, a transfer is not a gift – where the transferor’s primary impetus is the anticipation of personal economic benefits in return for that transfer.

Yet, that’s exactly what we have here – a donor anticipating hugh amounts of cash values flowing to his or her children’s trust. No Gift – no deduction. Strike one!

Even if you can show you intended to make a gift, to the extent you get something of value back from the charity, a “this for that”, the deductible amount of your gift must be reduced. This is called the quid pro quo rule.

So to the extent your contribution to charity is offset by a material economic benefit from charity, your deduction is only the excess of what you give over what you get back.

It is the reasonable expectation of a benefit in return for your gift – and not the legal right to get it – that’s important here.

The IRS takes this quid pro quo rule seriously: In fact, a representative of the charity – probably the president or director – will have to sign a legal document attesting – under penalty of purgery — how much – if anything – you’ve received in return for your gift.

Ask yourself how you would testify – in court and under oath – to the following questions:

Mr. Donor, what did you expect to get from this arrangement?

Did you know that the charity is laying out amounts substantially greater than it should for the term insurance coverage it actually receives – maybe five or six times as much as it should be paying?

Did you know that – because the charity is overpaying its share of the premium – a substantial benefit is flowing – through the split dollar arrangement – to your family’s trust?

Do you think the promissed amount of cash values would be in your children’s trust – if it didn’t get substantial economic help – in the form of overpayments of premiums – from the charity’s participation?

Did you know that the charity is also laying out even more money if the plan calls for a “unearned premium” account? Did you know that interest or growth on that money doesn’t go to the charity – it’s diverted to your family’s trust?

Did you know this unearned premium account is the equivalent of a long term interest free loan from the charity to your children’s trust? Can you give us any reason why Section 7872 shouldn’t be imposed – to impute several hundred thousand dollars of taxable interest to the trust over the plan’s span?

By the way, would you ask your counsel to provide the court with the legal authority for levelizing P.S. 58 costs – what’s the citation?

Were you aware that your cash contributions each year were part of an integrated plan designed mainly to put money in the hands of the charity – only so that it could turn around and use all or the bulk of those dollars to make all these great things possible – for you and your children?

You said you knew all these things – and in fact all these things reflected the plan and the promises that were explained to you by the agent who set this arrangement up.

Yet you took a tax deduction for the entire $100,000 check you wrote. Care to justify that? Would you care to explain why you didn’t reduce that $100,000 deduction on your income tax return by the value of the benefit your family received?

Quid Pro Quo – That’s strike two.

If all else fails, the IRS could allow the deduction – and then argue that, to the extent the children’s trust was enriched through the charity’s participation, the taxpayer has recovered the benefit for which he was allowed a deduction.

That recovery of his tax benefit is taxable income under Code Section 111. And then it’s a constructive taxable gift from the donor to his children.

What about the argument that there is no taxable economic benefit from the reverse split dollar arrangement? After all, isn’t there a revenue ruling that allows the taxpayer to choose to use – or not use – the insurer’s published rates rather than P.S. 58 rates?

The answer is, No, there is no ruling – with respect to reverse split dollar. In fact, this is what PLR 9604001 is all about – wealth generated by one party and shifted to and received by another may be taxable income to the recipient. The IRS could treat the increases in cash value in the children’s trust as currently taxable income – not under Section 83 – but under Code Section 61 – which subjects to tax “all income from whatever source derived”.

Let’s move to the partial interest rule:

The partial interest rule has a very simple purpose. Congress intended that a charitable gift be used exclusively for charitable purposes.

Let me repeat. The Code (Sec. 170(f)(3)(A) makes it very clear that you get an income tax deduction – only if the transfer isn’t going to be diverted back to – or for the benefit of – the donor. That’s why the Code denies a deduction for anything less than an unrestricted gift of the donor’s entire interest in the cash or asset contributed. A real honest to goodness – no strings attached, nothing up my sleeve – contribution.

If you give anything less than your entire interest, you don’t get a deduction.

And to make sure no games are played, the Regulations state, “if you divide the the property up in order to beat this partial interest rule, we’re still not going to allow a deduction. Don’t try to do by indirection what we have told you you can’t do directly.

In reality, the charity really ever owns the whole $100,000 check it receives each year from the donor. In fact, it knows – even before it receives each year’s check – that it will never receive next year’s check – if it doesn’t do what the donor intends it to do – use all or the bulk of the money for the split dollar premium payment.

So the pretense that the contribution is total and unrestricted and that the charity has full, absolute, and unrestricted use of the money flies in the face of the uncontraverted intentions of the parties – and the facts. That clearly violates the spirit – as well as the letter – of the Congressional intent in the Code that a charitable gift be used exclusively for charitable purposes.

Clearly, the parties intend that the charity will never get to use the entire check. They agree to that the first day they shake hands. The best the charity gets is a tenuous and temporary and in some cases diminishing piece of a small part of what the charity could buy on its own.

So, there’s no way the IRS or a court will believe an argument – no matter how couched – that the donor has given his entire interest, an unrestricted gift of cash – when both the facts and the promotional literature of the proponents of CRSD say otherwise.

Think About It: The end and intended result of CRSD is no different than if your client gives the cash value of an existing life insurance policy to a trust for his children and then assigns a portion of the death benefit to the Boy Scouts. There, it’s just a little more obvious – but no less certain that a gift of only a partial interest has been made to charity.

True, it was designed to make it look like the corporation or the donor gave – and gave all – with no strings attached – and with nothing expected in return.

But everyone knows the purpose of the client’s corporation writing the check was to create the appearance of separate and independent events and therefore the appearance of a gift of the check writer’s entire interest.

But the separate parties are a magician’s trick. The end result is circular. Dollars flow from the donor (or an entity controlled by the donor) through the charity and back – if not to the donor – to a party related to or controlled by the donor. Clearly, a violation of the partial interest rule. Simplistic subterfuge:

So again we put the donor back on the stand and the IRS attorney asks,

You never expected the charity to take the entire $100,000 each year and purchase crutches or wheelchairs, did you? You had an understanding with the charity – a pre-arrangement – that the charity would use the money – all or almost all – each year – to help your children’s trust pay for the life insurance?

In essence the charity’s role in this plan was to serve as your conduit – your funnel – your agent – to move the bulk of the money you give it each year to your children – and not to the crippled children it is chartered to serve. Is that correct?

There is clearly a pattern of timing, conduct, and expectations by all of the parties to CRSD that effectively assure the donor and his or her family of substantial economic benefits – and none of these benefits would be possible if the charity had – in reality – been given a total and complete – rather than a partial interest.

Nor will the argument that the charity has no legal obligation to pay premiums win the day. The law doesn’t require a legal contract to apply either the quid pro quo or the partial interest rule. If there’s a reasonable expectation of a quid pro quo, the law does not require that the charity be legally obligated to pay the economic benefit. It’s enough that the parties expect that result.

Partial interest rule – Strike three!

Now let’s look at the terms, private inurement and private benefit.

Both of these Code provisions are highly technical. But both echo the same purpose as the partial interest rule: When you make a gift to charity, that money belongs to the charity. It is to be used by the charity – EXCLUSIVELY – for charitable purposes. There should be no diverting of the charity’s dollars to any person or entity that’s not a legitimate recipient of the charity’s tax-exempt objectives.

That’s why Section 501(c)(3) of the code states that to remain qualified, no part of the charity’s earnings – broadly defined – can go to a private shareholder or individual. That’s the private inurement rule. The same code section further prohibits charitable money passing to private interests. The private benefit rule encompasses transfers of benefits from charities to almost anyone – other than the appropriate objects of the charity’s bounty.

Let’s go back on the stand:

When the charity entered into this CRSD – it essentially agreed to pay the highly inflated P.S. 58 rate – rather than the actual cost of insurance. And it may also agree to levelize its payments for the term insurance it’s getting – meaning that it pays – up front – in the early policy years – even more – than the admittedly inflated P.S. 58 rates. And your family’s trust will not pay the charity interest on the use of its money or reimburse the charity for any overpayments.

So in all these ways, the charity was helping you meet your personal insurance needs with death benefits and increasing cash values in your children’s trust’s policy, wasn’t it?

Certainly, this is a private benefit. And providing a private benefit violates the intent of the rule requiring exclusive use of a charity’s money and resources for charitable purposes. This violation is exactly what the code was intended to prohibit.

By the way, one of the claims made by promoters was that this arrangement would provide substantial benefits for the charity. But if – for any reason – the CRSD plan ends before the insured dies – just what does the charity get?

Can it be argued that – even if there is some benefit to the donor or his family – it’s incidental? Yes, you could argue that – but it appears the promotional literature promises just the opposite – big deductions for the client and big cash values plus a substantial death benefit for the client’s family. Compare those two with what the charity gets.

Private Benefit – Strike Four!

Now let’s turn to the Uniform Management of Institutional Funds Act. Again, back on the stand – only this time the president of the charity is now in front of the court:

Mr. President, USA today – – reported on Friday – June 5th that the Dow Jones Industrial Average was up 13% from 6 months ago. Why didn’t you invest the $100,000 a year you received from Mr. Donor in the market?

Wouldn’t it have made more sense for you to have used the entire check you received from Mr. Donor over each of the last three years – as a premium on a policy your charity owns and is the beneficiary of – than to enter into this split dollar plan where your charity only gets a small fraction of what the donor’s contribution could have purchased?

Why didn’t you use the entire check you received this year to buy term insurance on the donor’s life?

Mr. President: How do you justify the use of your charity’s money to enrich a private individual and/or his family? What defense do you have against a charge that you knowingly overpaid – significantly – for insurance – no less a crime than if you deliberately overpaid a truck dealer for a truck the charity bought?

Mismanagement of the charity’s funds – Strike five!

Let’s talk about the COMPLICITY ISSUE:

Mr. President: did you send Mr. Donor a letter each year for the last three years stating that he received nothing of economic value in return for his $100,000 checks? But you were aware that Mr. Donor’s family trust would be getting thousands of dollars of cash values and death benefits – because of your charity’s participation in the plan?

The President of the charity is either guilty of gross investment negligence – or of complicity to fraud. I’m talking about the patently untrue statement he signed under penalty of purgery that the charity provides the donor nothing of economic value in return for his or her contribution. Where are all these great benefits coming from – if not from the charity?

Complicity to fraud. Strike six!

Finally, compliance exposure:

I can see the lawsuits now by clients claiming they were never fully informed about the tax exposure. Some of them may sue the charity – as well as you.

No gift, quid pro quo, partial interest rule, private benefit, mismanagment of charitable funds, signing official documents the parties know contain incomplete and untruthful information.

If you still think charitable reverse split dollar works – call me. I’ll defend you – down to your last dollar.

Steve Leimberg

Leimberg Associates, Inc.

610 527 4712

E-mail: Leimberg

CONCLUDING REMARKS:

How will the IRS catch me? I’ve got a cancelled check for – say $100,000 – that shows the date the charity cashed it. How will they ever find out?

Every tax attorney I know has heard this question a thousand times.

The answer here is simple. The IRS finds the promoters – the marketers. And I don’t think that finding the promoters will be hard.

The IRS then requires them to submit a list of the names of all the people who have set up a CRSD plan. Bingo. You’re it.

What will it cost if they catch me? Well, for openers, aside from the tax and interest, there’s a 20% accuracy-related penalty.

Guess who has the burden of proving that the underpayment of tax was not negligent? Then there are possible civil fraud penalties – 75% of the tax.

What about the opinion letters?

They are worthless – unless there’s substantial reliable authority for the position. And there isn’t.

Certainly, you can’t use the existing private rulings on reverse split dollar. Even if you could, the taxation of reverse split dollar itself is without substantial reliable authority.

And you certainly can’t claim reliance on marketing promises as a defense.

Here’s the bottom line:

We don’t need to place our clients, our community’s charities, and ourselves in harms-way. We don’t need to use an idea so risky and so uncertain that a legal defense fund is required to promote it.

Read the book, Tax Planning With Life Insurance or read the Tools and Techniques of Life Insurance Planning and you’ll find dozens of alternative ways life insurance can be used creatively – to legitimately – and without risk – accomplish charitable as well as personal goals.

As an author and lecturer, it’s my job to encourage creativity and stimulate fresh thinking. But it’s also my responsibility to let you know when I think you – my reader or listener – can get into trouble – even if – as in the case of equity split dollar – you may not really want to hear it.

If this thing winds up on the front page of the Wall Street Journal, it will hurt all the agents in the U.S. who are selling any form of split dollar arrangements – since the press and the public really can’t or will not distinguish between one form of split dollar and the other. The result could very well be the impetus for adverse rulings, regulations, or even legislation that would harm both legitimate split dollar sales and the legitimate uses of life insurance in charitable planning.

The Maybe It’s Me article tells it like it is – in lay terms. I urge you to read it – and share it – with those contemplating a charitable reverse split dollar arrangement and their counsel.

I also urge you to read the scholarly and incisive article by Doug Freeman, who I consider one of the leading experts in Charitable Planning in the U.S. I also suggest you read the excellent May and June two-part Financial Planing Magazine commentary by John Scroggin and Kara Fleming that are also cited in my article. The later two attorneys state, “Effectively, the program is a sham and will collapse of its own weight in a thorough audit.”

Determining the edge of the split dollar envelope is much like the study of geometry. They both start with theorems of pristine simplicity and gradually progress into the dark caverns of complexity.

The trick in analyzing any complex tax transaction, however, is to reduce it to its basic components and then attempt to reconcile the results with fundamental principles.

If dollars seem to move in circles or if benefits appear to shift without tax consequence, one had better illuminate the transaction with traditional tax tenets and common sense because, if for no better reason, this is the crucible that the Service and the courts will apply.”

In an article in the Spring, 1996 Benefits Law Journal article entitled, The Evolving Edge of the Split Dollar Envelope, the authors said:

“G. Quintiere & G. Needles, The Evolving Edge of the Split-Dollar Envelope, Benefits Law Journal, Vol. 9, No. 1, Spring 1996.

In the movie, the Devil’s Own, Brad Pitt plays an Irish terrorist against the good guy cop played by Harrison Ford.

Pitt sets the stage for the ending when he explains to Ford the difference between an American fairy tale and an Irish fairy tale. In an American fairy tale, the ending is always “happily ever after”. CRSD is not an American fairy tale – and it will end badly.

Let your brain – and your conscience – be your guide.

For another look at the same topic, see: Maybe It’s Me

Categories
Case Studies and Articles

Converting Taxable Assets to Tax Free Corporate Income

Converting Taxable Assets to Tax Free Corporate Income

Converting Taxable Assets to Tax Free Corporate Income

image
  • Reposition corporate assets without tax liabilities
  • Create tax-free income
  • Generate more income and control more capital
  • Fund corporate foundations and community philanthropy
  • Learn how to give away the IRS’ money

The wealth of the U.S is primarily tied up in closely-held and illiquid business operations, and any strategy that frees up assets efficiently is worth a second look. As the ABCD Corporation streamlined its revamped business operations, Rebecca Watson (corporate CFO) decided to unload a parcel of land no longer needed for plant expansion. The good news was that the land had development potential and its fair market value was considerably higher than its tax basis. The bad news was that to sell and reposition assets in a conventional sale, Ms. Watson would create federal and state taxes on the realized gains equal to 35% of the profit in the transaction, a totally unacceptable loss of value.

Seeking tools to minimize the tax, Rebecca solicited suggestions from an estate planner who was familiar with IRC §664 Trusts*. By developing an integrated strategy and transferring the parcel of land to the trust, the corporation was able to create an immediate income tax deduction, sell the asset without tax liabilities, reposition the tax-free proceeds to a dividend paying preferred stock that generates tax-free income from 80% of the ensuing dividends. After a term of 20 years, the trust will mature and the remainder passes to fund the corporation’s foundation. By controlling more of the corporation’s “social capital”, the business will effectively shelter an extra $1.8 million from the IRS and leave their corporate foundation almost $1.5 million more value than through traditional planning.

Alternatively, a conventional taxable sale resulted in only $2.085 million to reinvest in business investments funding future expansion. The corporation lost the use of $825,000 in unnecessary tax, a hefty penalty, to get rid of an unneeded parcel of land. Instead of paying tax, the §664 Trust served to control more capital, produce more income and fund a corporate foundation that serves public affairs and community development functions for the business. As a marketing strategy, any activity that improves community relations and enhances corporate image eventually impacts on the bottom line, so when a corporate philanthropic approach evolves that also makes good economic sense, this business chose to utilize its options for enlightened self-interest.

*Contact our office for suggestions or courtesy illustrations for professional planners.

Corporate Tax Saving CRT –http://members.aol.com/CRTrust/CRT.html

Sell Asset and Pay Tax

§664 Trust

Fair Market Value of Development Real Estate

$3,000,000

$3,000,000

Less Cost of Sale

$90,000

$90,000

Adjusted Sales Price

$2,910,000

$2,910,000

Less Adjusted Cost Basis

$160,000

 
Gain on Sale

$2,750,000

 
Tax at 35% (federal and state)

$962,500

 
Capital Controlled – Amount Available to be Reinvested

$1,787,500

$2,910,000

Annual Return from 8% Taxable (@ 34% Tax) Bond

$143,000

 
Avg. Annual Return 7% §664 Trust Earns 8% in Pref. Stock Dividends 

** $219,809

Avg. After-tax Cash Flow From Repositioned Assets

$86,908

$190,794

Taxes Saved From Deduction of $755,085 @ 34% Tax Rate 

$256,729

Total After-tax Cash Flow and Tax Savings After 20 Years

$1,738,160

$4,072,609

Increased Cash Flow to Corporation 

$2,334,449

Asset Value Owned by Corporation After 20 Year Term

$2,085,000

 
Asset Value Transferred to Corporate Foundation After 20 Year Term 

$3,550,753

** The dividend deduction for corporate dividends is another reason why taxpaying corporations should consider using mutual funds and preferred stocks. Tax law permits a corporation to deduct from income the first 80% of dividends received on stock it owns in another corporation [I.R.C., §243(a)(1)]. Thus, 80% of a stock or mutual fund distribution that is attributable to dividends is deductible from the corporation’s income. It includes in its income only the 20% balance of the dividend, so in the 34% corporate tax bracket, only 13.2% of the corporation’s dividend income is lost to income tax.

© 1997, Vaughn W. Henry

Henry & Associates

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Case Studies and Articles

A Partnership From Hell

A Partnership From Hell

Failing to stabilize and protect estate values is one of the classic errors in most estate plans. Avoid this situation by consulting your tax, financial and legal advisors.

A partnership from hell — that’s what it must feel like to suddenly be in business with your best friend’s spouse. Worse yet, finding yourself forced to work through his/her attorney, and it could be catastrophic to own a business with the ex-wife’s new husband and his attorney. How does this happen? If your succession plans do not include the possibility of death, disability or retirement for the owners of a closely held business, then you are faced with just this scenario. (If you think this situation is bad, imagine a partnership with the IRS, a consequence of a poorly designed estate plan.) While the Chrysler Corporation can have Lee Iacocca step down and not disrupt the company’s profitable outlook, not many closely held or family businesses have the same degree of continuity.

When a small business owner-employee steps out of the picture, the surviving partners and surviving spouse usually have differing goals. The business owner usually wants to continue operations and put any profits back into growing the business, while the surviving spouse wants income and minimal risk. The logical solution is for the surviving partner or the business to buy out the deceased owner’s interest, but that entails coming up with cash. Where does an owner look for funding to maintain control? There are only four sources of funding to provide value to heirs, and they are cash in the business, sale of assets, borrowed funds and insurance products.

Each of these sources of capital has advantages and disadvantages, so decisions are based on personal needs and economic evaluations.

1. Use cash in the business or personal funds to buy out the surviving spouse. By accumulating after-tax funds on a steady basis, it’s possible to set aside adequate capital to purchase those business interests. These sinking funds work well enough if there is adequate time, but the risk is absorbed by the partners if something happens too early and derails the plan. In a 33% tax bracket, one needs to earn $1.50 to have $1 available for this purchase. Also remember that funds set aside in a corporation may be subject to excess accumulation penalties. Even businesses with significant cash flow may not be able to sustain required payments with a principal player who contributed to the profitable operation out of the picture. Uncertainty and unfavorable tax leveraging are the major disadvantage of this method.

2. Assets sold under pressure rarely bring more than discounted garage sale prices. As long as they are not the major income producing assets of the business, maybe you can do without them. However, most nonessential assets will not bring their full market value, so the best assets must be offered for sale instead. Business liquidators report that a 40% loss in value is typical, so that option would appear to be undesirable.

3. If borrowing credit is still intact after the loss of a major “rainmaker” in the business, maybe a lending institution will loan the survivor the funds. Of course, the money needs to be repaid with interest using after-tax dollars. Even if the heirs finance an installment sale, the business will eventually have to purchase itself more than once. In this case, the surviving heirs must assume the risk that the business will continue to be profitable enough to provide a steady source of income with a restructured management team.

4. Properly structured insurance products within a buy-sell agreement have the potential to provide necessary tax-free cash when the event (death, disability or retirement) that triggers the need for funding exists. There are a number of strategies available to purchase these special insurance contracts with tax advantaged premium payments. Some of today’s most popular discretionary perks now include using life insurance products in creative ways to pay for personal needs with corporate dollars. Recent changes in tax laws now make these discretionary programs more appealing, making them one of the few tools available that favor the small business owner.

Buy-sell agreements form much of the basis for continuity in business operations, whether it be for sole proprietors, partners or corporations. A well-drafted agreement ensures the family that the business will be either retained or disposed of fairly. The contract also establishes an upper limit for the IRS as a market value for estate tax purposes. If there is a closely held business interest in your estate, it would be a good idea to sit down with your estate planning team and explore the various options to preserve value and control. Good planning can reduce uncertainty, expenses, tax liabilities and improve both the clients’ and heirs’ income potential.

For creative ways to preserve corporate value, protect heirs active in the business, resolve excess accumulation issues and generate retirement income for the founding business owner, look at an IRC Section 664 trust as a powerful transition tool. For more information, e-mail us.

Vaughn Henry deals with planned giving and estate conservation work and is a member of the Central Illinois Chapter of the International Association for Financial Planning.

  • Business Continuity Planning
  • Closely-held Businesses Passed Down With Tax Leveraged Options
  • Family Farm Operations Preserved
  • Multi-generational Estate Planning

Contact us for suggestions on planning options to preserve your family business.

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