Author: Gabriel

Generations of Income With a CRT – Vaughn Henry & Associates

Generations of Income

Vaughn W. Henry

Conventional estate planning wisdom holds that a planner should neither tie up most of a family’s wealth in a CRT nor use the tax exempt trust for clients without much of an estate tax liability. Generally, those principles are sound. However, in the following case, there are reasons to consider the §664 trust as a viable option that solves unique problems.

Annabelle Leighton, a 72-year-old widow, has been living on her social security payments and some modest cash rental income from her father’s farm, inherited 23 years ago. Out of a somewhat misguided sense of obligation, she has allowed her tenant to continue renting her ground at a rate far below the fair market value because he used to farm it for her father. This hesitancy to replace him as her manager and tenant meant that the rental revenue from highly appreciated farmland was not enough to properly assure an adequate income for her and her daughter. While other farmers were interested in renting her ground, her loyalty to her tenant precluded her from negotiating a more generous payment, so she concluded that retirement and a sale would be the easiest way to get out of a bad business arrangement. Recently, she’s had several realtors solicit her to sell the ground for the expansion of a nearby residential and commercial development, but there’s a significant capital gains liability. To further complicate matters, Mrs. Leighton’s only child, Laurie (53), is mildly retarded and living in a group home.

One of the options available for the charitably inclined Leightons is to create a 2 life charitable remainder trust (CRT) with Mrs. Leighton as trustee and income beneficiary, and Laurie as a successor income beneficiary. Normally, multi-generational or non-spousal income beneficiaries create gift and estate tax problems, so the following features were drafted into her custom CRT document.

Firstly, Mrs. Leighton is the income beneficiary and her daughter’s income interest is revocable by will, only to commence after Mrs. Leighton passes away. This ensures Annabelle’s retirement security and prevents the naming of Laurie, a nonspousal income beneficiary, from creating a current gift tax liability, since the gift of the income interest is still incomplete.

Secondly, by allowing Laurie to receive an income stream from the CRT, the likelihood of her being cut off from future resources is reduced and the danger of her losing the land or cash by fraud or mismanagement is eliminated.

Thirdly, the trust includes options for changes in charitable beneficiaries and the power to invade principal for current distributions to charity.

Mrs. Leighton appointed a corporate fiduciary to act as her successor trustee with three primary responsibilities:

1. The trustee will reduce the corpus in the trust to the maximum level covered by Mrs. Leighton’s applicable exclusion amount so there is no estate tax liability when the income interest transfers to Laurie. By distributing just enough principal to the charitable beneficiaries, the trustee will effect a zero transfer tax. This action is very important because a CRT can not pay the tax obligations of the estate. Preplanning is important since the old unified credit of $600,000 in 1997 slowly increases to $1 million by 2006, and it would be difficult to forecast how much could be in the trust before the successor income interest transferred to Laurie creates an unnecessary tax. Because the estate tax-free income interest needs to be recalculated annually, the trust corpus might exceed $2 million before any reduction would be needed when Laurie’s income stream commences.
2. The trustee will retain the right to change the charitable remainder interests. Initially, the group home, a 501(c)3 organization, was named as the primary beneficiary, with a few other nonprofit organizations receiving minor benefits. If the trustee feels that Laurie’s well being has suffered and the general quality of care has declined, the trustee will be authorized to move Laurie from the home and name a series of other charities to receive the trust’s largesse. Mrs. Leighton felt that this clause might encourage the group home to maintain a high quality operation and take a little extra interest in supervising her daughter’s care.
3. The trustee was also charged with overseeing Laurie’s income stream to ensure that her needs were properly met.

Normally, it’s not a good idea to put most of the donor’s resources in a charitable trust with the idea of protecting assets. However, in this case, with no other family members on the horizon and Laurie’s special needs, the CRT can be made to provide both adequate income protection and some powerful planning options. Structuring the transfer properly means there is no tax and the family’s strategic charitable interests are enhanced.

For additional information and case studies, check our website.

Farm Property and the CRT

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

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

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

Moore Farm CRT Strategy (see our sitehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)	Keep Asset at Work and Pass to Heirs (A)	Sell Asset and Reinvest the Balance (B)	Gift Asset to CRT and Reinvest (C)
Fair Market Value of 80 Acres of Development Land	$800,000	$800,000	$800,000
Less: Cost of Sale		$32,000	$32,000
Adjusted Sales Price		$768,000	$768,000
Less: Tax Basis		$40,000
Equals: Gain on Sale		$728,000
Less: Capital Gains Tax (federal and state)		$218,400
Net Amount at Work	$800,000	$549,600	$768,000
Annual Return From Asset Valued at $800,000 @ 3.5% (land continues appreciating at 6%)	$28,000
Annual Return From Asset Reinvested in Balanced Acct @ 10%		$54,960
Avg. Annual Return From Asset in 6% CRUT Reinvested @ 10%			$88,189
After-Tax (31%) Spendable Income	$19,320	$37,922	$60,850
Statistical Number of Years for Cash Flow for Joint Lives	31	31	31
Taxes Saved from $210,016 Deduction at 31% Marginal Rate			$65,105
Tax Savings and Cash Flow over Joint Life Expectancies	$598,920	$1,175,594	$1,951,461
Total Increase in Net Cash Flow Compared to Original Asset		$576,674	$1,352,541
Value of Assets After Estate Tax (at 55%) Paid	$2,678,764	$302,280	$0
Value of Charitable Remainder to Family Sponsored Charity			$2,590,566
Optional Use of Wealth Replacement Trust (WRT) to Offset Gift**			$3,968,815
Total Value to Family (Income and Heirs’ Inheritance)***	$3,327,684	$1,477,874	$5,144,409

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

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

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

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© 1997, Henry & Associates, Springfield, Illinois

Henry & Associates

Gift & Estate Planning Services

Charitable Education Trusts for Grandkids – Henry & Associates

Charitable Education Trusts for Grandkids

Vaughn W. Henry © 1999

“There are two systems of taxation in our country:

one for the informed and one for the uninformed.”

Honorable Learned Hand (1872-1961)

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

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

Yr.	Watson’s Tax Deduction	Yearly Value of NIMCRUT	Pre-Tax Income to College Aged Granddaughter
	$27,858	$50,000	$0
		$56,000	$0
		$62,720	$0
		$78,676	$0
		$88,117	$0
		$98,691	$0
		$100,534	$10,000
		$102,098	$10,500
		$103,350	$11,000
10		$104,761	$10,991

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

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

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

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).

A 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.

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

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

Incentive Stock Options and the CRT

Incentive Stock Options and the CRT

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

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.

 

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, https://gift-estate.com, has numerous articles, case studies and professional resources suitable for foundations and administrators seeking more background to improve their development activities.

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