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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.

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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

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  • 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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How to Give Away Your Taxes

How to Give Away Your Taxes

Capturing Social Capital is more than enlightened self-interest; it is a means of asserting control over assets you have spent a lifetime accumulating. When exploring estate planning techniques, normally you must include powers of attorney, wills, trusts, business agreements and the use of gifts. Planned gifting programs are best utilized within a complete estate plan, and offer the donor a great opportunity to give away tax liabilities. After all, the joy of giving allows you the choice of transferring assets to children, charity or Congress. Of the planning tools used, charitable giving may be more powerful than you have imagined, but it has been avoided by too many professional advisors.

What will sponsoring a charity do for you?

It will make your life more interesting, more exciting, more flexible, more fun and more meaningful.

Changes in lifestyle, economy and government programs have greatly influenced trends in modern charitable giving. Typically, the institutional priority today is a more donor driven philanthropy instead of the traditional needs driven approach. In order to compete for limited donor support, charities have to move from a gift getting mentality to a problem solving manner of thinking. Organizations can best accomplish this shift in mind-set by developing partnerships with their donors. Charities with a proactive outlook in their development efforts will be able to better respond to the changes in the gifting environment. This flexible approach allows institutions the continued opportunity to provide improved services and support to their clients.

In order to understand their future partners, today’s charities must better understand family dynamics and motivations. Prosperous families recognize that they are in jeopardy and must address those risks to protect both their wealth and the individuals in their family. These risks include a lack of feeling competent, no cohesiveness, too little commitment to something more important than self and guilt about having wealth. Unfortunately, there is a lack of information about property and money management, and nobody is trained to inherit wealth. The solution is to work with charitable groups and family foundations. This mentoring activity allows younger family members to learn how to manage assets, plan and budget before they inherit the bulk of their noncharitable bequests. Besides preserving wealth, the elder generation wants to create a significance that survives them, so gifting programs can create a sense of immortality. Whether or not clients have purely charitable interests, most families have community or social issues that influence their outlook. By establishing a trust or foundation to support these activities, death will not interfere with the transfer of an important value system.

Often gifts are made by charitable bequests, but this may be the worst tool to shift assets, as it creates an obligation in the estate that may come before other necessary distributions. As an alternative, the government recognized two components to a charitable gift in 1969 by dividing the income and remainder interest. Four of these split interest planning tools now have the potential to both give something away and still keep the use of it. Of these, Charitable Remainder Trusts, have recently been popularized as powerful tax reduction techniques. In reality, they allow donors the opportunity to give away assets, retain an income stream, take tax deductions and still retain control over the ultimate disposition of the remainder gift. Besides a need for tax deductions, donors must also have charitable intent and a desire to maintain control. Remainder trusts may guarantee a fixed amount for life or a term of years based on either a fixed annuity calculation or a percentage of the trust’s annual value. Of the four types of trusts best known by their acronyms (CRAT, SCRUT, NICRUT, NIMCRUT), the Net Income with Make-Up Charitable Remainder Uni-Trust or “spigot trust” is the most flexible. Each trust has very different applications, depending on needs for future gifts, flexibility, donor tax deductions, income and control. Charitable Lead or Income Trusts are designed to pass the principal of a gift to heirs after a charity has received an income stream for a period of time. If the asset produces more than the required income payout, all of the future appreciation and the asset itself will pass back to the heirs without further estate tax obligations. These techniques are best understood as enlightened self-interest because both good works and family priorities are promoted.

For donors with purely charitable inclinations, the next three tools address some of the security issues which most concern the older client. While these techniques do not preserve any assets for the family, they are more practical as a means of supporting charitable works and giving final control to the philanthropic institution. Charitable Gift Annuities are programs in which the institution must guarantee a lifetime of income for the donor, but any unused funds revert to the charity at the donor’s death. This technique is most useful for the very elderly or those with no family wealth to pass along to heirs. Pooled Income Funds, owned and run by the charity, are similar to mutual funds. The institution is then required to pay the donor each year’s investment proceeds on a proportional basis. Ultimately, the principal amount will pass to the charity and be used at their discretion. Life insurance may also be purchased and gifted to a charity in a direct program that offers a guaranteed benefit for donors with a fixed budget. Charitable gifting is not limited to the ultra-wealthy, as any sized estate plan may benefit from its use. To evaluate the best use of gifts within the estate planning blueprint, experienced legal, tax and financial advisors should be consulted.

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

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.

Contact us about seminar programs for non-profit organizations seeking deferred or planned gifting programs.

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‘To give away money is an easy matter, and in anyone’s power. But deciding to who to give, how much, when, for what purpose, and how much is neither in everyone’s power nor an easy matter. Thus, it is that such giving is rare and noble and praiseworthy.’

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Case Studies and Articles

Asset Protection and Multi-Generational Estate Planning Tools

Asset Protection and Multi-Generational Estate Planning Tools

Asset Protection and Multi-Generational Estate Planning Tools

Allen (72) and Elizabeth (64) Becker have a successful chain of franchise fast food restaurants. Starting with just one restaurant 40 years ago, they both worked the grill and cash register, even mopping floors at night to save payroll expenses to get their fledgling business off the ground. Now, after years of hard work, the businesses are valued at $6.25 million and Allen is reluctantly selling the stock in his corporation after experiencing some health problems. With no chance to continue operating the business, there was only a choice between selling the stock and paying the capital gains tax, or using a §664 Charitable Remainder Trust to control 100% of the principal. After Allen’s accountant attended a seminar on using a CRT to more efficiently sell closely-held businesses he met with the Becker family and suggested bypassing the capital gains tax “hit”. However, Allen was initially unwilling to give up all the stock and principal to charity, so a strategy was developed to only transfer 80% of his company stock to the charitable remainder unitrust, and sell the remaining 20% in a routine taxable sale. The new buyer acquired 100% of the stock from two separate sellers (i.e., The Becker CRT and Allen Becker individually). This technique allowed Allen and Elizabeth to use the tax deduction of $1,583,350 created by the transfer of $5 million in corporate stock to their CRT and offset most of the tax liability on the $1.25 million taxable sale. The Beckers then took $1.2 million from the taxable sale proceeds and created an Irrevocable Life Insurance Trust (ILIT) to hold a survivor life insurance policy funded with one payment.

To further protect family assets from the heirs’ mismanagement, their attorney drafted the ILIT to make use of the Becker’s Unified Credit and Generation Skipping Tax Exemptions. This protects all of the proceeds from estate taxes for the duration of the trust, probably 100+ years or so. The advantage of designing this “dynasty trust” is that it controls and protects family assets from taxation, litigation, divorce and spendthrifts while still providing the heirs with an opportunity to distribute and spend family wealth. By using the ILIT to purchase an insurance asset, this special trust now holds capital that creates no current income tax liabilities. At the surviving spouse’s death, the family trust will receive $5 million in insurance proceeds, free of both income and estate taxation. With no other assets in the Becker’s ownership, the family escapes all estate taxation and has $5 million in personal financial capital to use inside the family trust. Besides this tax leveraged asset, there will be an additional $8.8 million in social capital inside their charitable trust. Henry & Associates designed the Becker scenario* and compared the two options of (a) selling stock and paying the income tax, reinvesting the balance at 9% or (b) gifting the stock to an IRC §664 Trust and reinvesting all of the sale proceeds in a similar 9% balanced portfolio. At the termination of the CRT, when the surviving spouse (most likely Elizabeth) passes away, the capital inside the trust will pass to a community foundation with Becker heirs sitting on an advisory board to make recommendations about funding charitable programs of interest to their family. Since diabetes and cancer have affected the Becker family over the years, much of the annual support of about $500,000/year, will be used to fund research and education on these two diseases. This family has regained control of their social capital and now has an effective asset protection strategy that will serve the Becker family for many years.

Partial Corporate Stock Sale CRT Strategy

(see our web-sitehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)

 Sell Asset and Reinvest the Balance (A) Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of 80% of Corporate Stock

$5,000,000

$5,000,000
Less: Cost of Sale (legal fees, commissions, appraiser)

83,000

$83,000
Adjusted Sales Price

$4,917,000

$4,917,000
Less: Tax Basis

$25,000
Equals: Gain on Sale

$4,892,000
Less: Capital Gains Tax (federal and state combined)

$1,467,600
Net Amount at Work

$3,449,400

$4,917,000
Annual Return From Asset Reinvested in Balanced Acct @ 9%

$310,446
Avg. Annual Return From Asset in 6.5% CRUT Reinvested @ 9%

$414,370
After-Tax (42%) Avg. Spendable Income

$180,059

$240,335
Statistical Number of Years of Cash Flow for Income Beneficiaries

23

23
Taxes Saved from $1,583,350 Deduction at 42% Marginal Rate

$665,007
Tax Savings and Cash Flow over Joint Life Expectancies

$4,141,350

$6,192,709

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

©Vaughn W. Henry, 1997

Henry & Associates

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Integrating the Estate Plan – Vaughn W. Henry & Associates

 

Vaughn W. Henry

 

One of the most common problems associated with estate and gift planning is the tendency to use a patchwork quilt approach to the process.  The resulting jumble of uncoordinated documents, conflicting directions, confused advisors and angry heirs makes it nearly impossible to meet client expectations.  Instead, think about ways the estate plan more closely resembles an architectural blueprint.  The design of the estate’s “house” should be based on its needs and use, just like a well thought out residence.  Will the legal structure stand up to family turmoil and weather legal storms, can it be expanded to accommodate new needs and a changing economic climate, is it large enough and well built enough to protect the estate?  You wouldn’t build a house one room at a time.  Nor would you withhold a complicated blueprint from the contractor and all of the plumbers, electricians and roofers or the house wouldn’t be livable.  The architect explains the master plan and design philosophy to all who contribute to the project and makes sure plumbers don’t cut electric lines and roofers don’t shingle over the fireplace chimney.  Why not build an estate plan the same way?  Coordinate the plan and make sure all of the pieces fit together without creating new problems.  Advisors believe well designed estate plans should meet certain goals, namely:

·         Protect the client from financial insecurity in the event of disability, keep options open and improve the management of the estate in the event of the client’s absence.

·         Establish priorities, e.g., should heirs be protected from making inexperienced mistakes, where does a charitable bequest fit into the master plan, how important is control vs. a legitimate tax saving strategy?

·         Gather legal, personal, tax and financial documents in an organized fashion and make them easily available when needed.  Make sure that the tax, legal and financial advisors all work in a cooperative, goal oriented process. imageToo often, professional advisors compete for client control and may not acknowledge limitations in their own areas of expertise.  It’s unreasonable to expect just one advisor to have all the specialized skills needed to complete an estate plan that zeroes out all tax liabilities, so the use of a professional team has become more accepted.

·         Avoid family conflict and future ill will.  When heirs don’t understand the plan and feel they’ve been mistreated, many opt for legal challenges that tie the estate up in court for years, wasting assets and frustrating family members.

·         Minimize expense, delay and publicity of the estate distribution process.  While ease of use and logic are important, the default plan of letting the heirs and IRS fight over the assets doesn’t preserve much of a legacy. 

·         Stipulate who will operate any business and handle family affairs during a disability or after death.  If the estate controls stock in a family business, who votes and controls the stock before it is distributed?  Will the family business succession plan work if outsiders take over the business?  Will the family business have the liquidity to redeem the stock from the estate?

·         Eliminate unnecessary income and estate taxes and provide adequate liquidity to pay final expenses and taxes.

·         Consider making charitable bequests from assets that produce income in respect of a decedent (IRD), incorporate that language in the Will and make sure beneficiary designations are current and accurate.

·         Pass assets to heirs as planned, under conditions that best that meet family needs and their abilities to effectively manage an inheritance.

 

Complaints about the costs of creating an estate plan are often overblown.  Like contractors dealing with change orders and moving misplaced walls when a builder wants to add a closet or move a bathroom, the costs for planning can be controlled by having a master plan and doing the job in a systematic and orderly way.  Each piece builds on another and the plan integrates seamlessly; otherwise keep delaying, starting and stopping and redoing it and the costs invariably go way up.

 

Besides having an estate plan that’s not integrated, too many clients postpone decision-making.  The causes for inaction are numerous, but dealing with complex matters, issues of death or disability, frustration and family harmony are cited by many as reasons.   Making the problems worse are conflicting suggestions from friends, family and well-intentioned, but poorly trained advisors.  So it’s not hard to understand why most people hope that by doing nothing the problem will solve itself.  Benign neglect isn’t a successful planning process; it takes a proactive decision to take control of the process.  Don’t assume any plan will be perfect and never again need adjustment.  Laws change, family needs change and priorities shift, so work towards solving the big problems now and then focus on the little ones later.  As Karin Ireland noted — “Waiting until everything is perfect before making a move is like waiting to start a trip until all the traffic lights are green.” 

 

 

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IRS Information, Regulations and Commentary on Charitable Legal Issues

MAYBE IT’S (NOT JUST) ME – % Vaughn Henry & Associates

MAYBE IT’S (NOT JUST) ME – % Vaughn Henry & Associates

I’m not alone – at least about the dangers of CRSD (Charitable Reverse Split Dollar) and its progeny, what some people are calling charitable split dollar. Here are some recent comments:

Eric Dryburgh: In the highly respected Charitable Gift Planing News, August 1998, Pg. 5 ( 972-386- 8975) the author states,

“There are many variations on the theme, involving insurance trusts, partnerships, and other legal entities. Nevertheless, the basic legal concepts and legal risks are the same.”

“The charity must issue a receipt which accurately reflects what it receives. If the funds are not used to pay the policy premium, the receipt can appropriately reflect an unrestricted gift of cash. If the charity pays the policy premium, however, the receipt should reflect a nondeductible gift.”

NCPG: The Executive Committee of the National Committee on Planned Giving (NCPG) has reviewed a number of these plans and has concluded,

“Life Insurance “Quid Pro Quo” Poses Risks to Donors, Charities” and stated, “Notwithstanding the promoters’ claims to the contrary, NCPG strongly suggests that donors and charities not proceed with the kind of gift arrangement described above without first obtaining a private letter ruling from the IRS on the “quid pro quo” and partial interest issues

Its position paper states “CRSD is a high-risk venture that may expose donors to adverse income tax and transfer tax consequences and may endanger the tax-exempt status of charities that participate.” “Failure to note on receipts a charity’s intention to participate in the CRSD plan could violate both federal tax law and the Model Standards of Practice for the Charitable Gift Planner, adopted by NCPG May 7, 1991. Furthermore, participation by the charity in a CRSD program could put the charity at risk of loss of tax exempt status under the private inurement rules, which the IRS has interpreted broadly, in other contexts, to include contributors to organizations.”

Horowitz Scope Goldis: In “The Myths of Charitable Split Dollar and Charitable Pension”, Journal of the American Society of CLU & ChFC, September 1995, Pg. 98 the authors state on the subject of CRSD:

This is not merely aggressive tax planning, it is egregious and borders on tax fraud…”

Douglas Freeman: Planners should also carefully read the objective, balanced, and scholarly “CHARITABLE REVERSE SPLIT-DOLLAR: BONANZA OR BOOBY TRAP?” by well known and highly respected Los Angeles attorney Douglas K. Freeman in the Journal of Gift Planing, 2nd quarter, 1998 (317 -269 – 6274). Freeman states in a recent ALI-ABA Course of Study on Charitable Giving Techniques given May 7th and 8th in San Francisco,

The reverse split-dollar technique is aggressive planning without substantial reliable authority”, “charitable reverse split-dollar is an attempt to stretch an aggressive program further”. “Charities should never use their influence and reputation to promote a risky program that could influence donors to engage in an arrangement that could result in adverse economic or tax consequences to such donors.”

Scrogin and Flemming: Attorneys John J. Scrogin and Kara Flemming of Roswell, Georgia wrote two excellent and well reasoned discussion articles in the May 1998, Pg. 2 and June issues of Financial Planning Magazine entitled, “A Gift With Strings Attached?” and “One Gift, Many Unhappy Returns” in which the authors state that charitable reverse split dollar plans may suffer the same fate that befell tax shelters in the 1980’s and that donors, charities, tax preparers, and plan promoters are all vulnerable if the IRS cracks down on charitable reverse split dollar plans.

Frank Minton: Frank Minton, the Ethics Chairman of the National Committee on Planed Giving, has stated that,

“Overcharging charities for premiums by using actuarial tables that exaggerate the true cost of life insurance benefit the donor by reducing the amount the donors must pay.”

Michael Huft:In the November 1998 issue of Trusts & Estates, Michael Huft states,

“The problems faced by the charity are potentially more serious than those faced by the donor, for in addition to the possibility that the charity will fail to realize the expected benefits of CRSD, the charity may lose its tax exempt status and its trustees or directors may face liability for breach of fiduciary duty.”

Billitteri and Stehle: In “Brilliant Deduction?”, The Chronicle of Philanthropy, August 13, 1998 the authors quote Marc Owens, director of the I.R.S. Exempt Organizations Division:

“The service is examining whether donors improperly violate federal tax laws by participating in these deals, which currently are being offered by a small number of estate planning companies and their representatives….Charities are supposed to be doing charitable things, not acting as a clearing house for one’s life insurance premiums.”

The service is “actively looking at charitable split-dollar plans in pending cases that include both audits of existing charities and applications by new groups seeking tax-exempt status.”

The article quotes Attorney Douglas K. Freeman as saying

“This thing has some fatal flaws, and the worst part of this is, it puts the charitable institutions at risk.”

Conrad Teitell: Teitell noted in the Oct. -98 edition of his TaxWise Giving that charities and their representatives that give inaccurate information to donors about a gift’s fair market value or incorrectly tell donors that a quid pro quo gift is fully deductible are subject to the abusive tax shelter penalties of IRC Sec. 6700 and 6701. This is the civil penalty imposed on promoters, salespeople, and their assistants who organize or sell a “plan or arrangement” constituting an “abusive” tax shelter.

Abusive is defined as a statement concerning a tax benefit that the person knew – or had reason to know – were false and “gross” valuation overstatements of the property’s value. Both the false or fraudulent statement and the gross valuation overstatement must relate to a material matter. Teitell points out that “a person furnishing a gross valuation overstatement need not have knowledge of the overvaluation to be penalized.” He notes that “an aiding and abetting provision imposes a penalty on persons (such as the president or treasurer of a charity) who help prepare false or fraudulent tax documents that could result in a tax underpayment provided the person knew or had “reason to believe” that the document is material to the tax law. Under the reason-to-believe standard, a person has knowledge if he or she deliberately remains ignorant of what otherwise would have been obvious.” No plan or arrangement is required.” See Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program for FY 1999. Teitell notes that “It may be a kinder and gentler IRS, but it wasn’t born yesterday.” Will these rules apply to those who make the five key claims listed below? (Is it worth making your client famous to find out?).

The Bottom Line(s) Up Front:

Promoters make five key claims for Charitable Reverse Split Dollar arrangements and their progeny:

(1)Funding of life insurance will be – in essence – income tax deductible.

(2)No party will be subject to income or gift tax liability (and it may also be possible to beat the estate tax).

(3)The donor will be able to use tax deductible dollars to provide for his or her own retirement income.

(4)From the charity’s perspective, this is a “no cost”, “nothing to lose”, “sure thing” with substantial benefits, and

(5)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 on any plan that makes all these promises – no matter what it’s called:

First, in my opinion, in every one of these CRSD or CSD plans I’ve examined, either all – or a significant portion of the check the donor-insured – or his or her corporation – writes – will not be deductible. Deductions already taken in open tax years are likely to be disallowed.

Second, the donor will incur significant income or gift tax liability – or both. There may, therefore, be an understatement of gift as well as income tax with accompanying additional tax, interest, and if the understatement is large enough and substantial authority for the taxpayer’s position can’t be shown, penalty provisions may apply. The person who prepares and signs the donor’s tax return may 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. If there has been overpayment of premiums and a loss of interest on the “unearned premium account,” the arrangement may be deemed an imprudent course of action by the board of directors and officers of the charity, probably a violation of the charity’s corporate charter, and a risk of its tax exempt status. It is even possible that 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.

Fifth, I realize that attorneys I personally like and respect from prestigeous law firms (e.g. Michael Goldstein of Husch & Eppenberger) have issued favorable opinion letters or spoken on behalf of these arrangements and have voiced their view that these plans are “a planning technique suitable for consideration by informed taxpayers who are not risk adverse.” If they and their law firms are comfortable with these arrangements, fine. As long as the client and the charity are both FULLY appraised of the risks and the discussion is protected by the attorney-client privilege, there is no limit to what tools or techniques may be considered. I’m saying both that the CRSD and CSD plans I’ve examined will not work as commonly described – and potential IRS and/or Congressional over-reaction may result in harming – not only the players – but others (and other planning tools and techniques) as well.

I am conservative – as charged by at least one promoter. As an author and advisor, the last thing I want to do is to make my client – or yours – famous. And it’s also true that I still believe the IRS will not back down on its position in TAM 9604001. I said it when the TAM was first issued in my Miami (Heckerling) Tax Institute address cited below – and I still believe the IRS will win if the underlying principles are tested in the courts. It’s 1999, three years have passed, and there has been no sign the IRS has seen the error of its ways – or will. If anything, the IRS might push Congress to eliminate all its aggrevation over the issue by mandating interest-free loan treatment.

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 essentially make the same promises to the donor:

In examining CRSD and its progeny – just as in any tax transaction – the IRS andthe courts will look beyond the formal written documents – to the substance – the totality and reality – of the transaction as a whole. The IRS and the courts can ignore your words if they don’t comport to your actions and clear intent. Transactions will be characterized for tax purposes according to their overall economic substance rather than the terms used to describe them.

Seemingly unrelated pieces of a puzzle can be re-assembled by the IRS and the courts 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 to this point) – 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 annual “charitable donation” ending up in the hands of the charity.

Advisors should ask themselves how a promoter – with a straight face – can – both verbally and in writing – tout any arrangement that provides “tax sheltered accumulation, creditor protection for family wealth, an option for tax free retirement income, substantial death benefits for the client’s family, the potential for estate tax free life insurance proceeds at no gift or GSTT cost, and plan values that can be owned individually, or by an irrevocable or revocable trust (or an FLP or LLC) and help those who want to make deductible deposits in excess of qualified plan contribution limits – and at the same time say to the IRS (and then possibly under oath in court) that the neither the client nor the client’s family received anything (directly or indirectly) of value

At best, promoters can honestly claim only that the charity has a present expectation of future reward and has not received “an empty bag.”

And (even if true) those claims merely beg the question since the charity was supposed to have ALL of the money the client claimed as a deduction, not merely the dregs of a tattered rag.That the charity may not seriously overpay or that it may eventually really will get some thing out of the deal of some value is irrelevant

The ultimate test – no matter what the plan is called – is simple: One must merely ascertain the answer to these questions:

  • Is this really a case of detached disinterested generosity – or is it a deal the insured is making with the charity? Do the parties intend that the donor (or the donor’s family or family trust) will receive – directly or indirectly – anything of meaningful economic value from the charity in return for the check the donor wrote? If so, the plan is an invitation to litigation. At best, the deduction must be reduced by the value received.
  • Is life insurance really needed by the charity, can this need be documented, and if so, is the insurance under the arrangement appropriate in amount and type? If not,the charity faces fame but not fortune. Remember Leimberg’s Third Law of Tax Planning: “The Last Thing You Want to Do Is Make Your Client Famous.
  • Was the transaction as a totality good for charity? Did the charity pay more than a reasonable amount for what it received? If yes, the president and board of the charity will soon become familiar – on a first name basis – with the state’s Attorney General who is charged with making sure charitable dollars are charitably used (and not abused, misused, or diverted to private noncharitable hands).
  • What benefits would the donor – insured’s trust have received had the charity not participated? In other words, is there even a small amount in the donor-insured’s trust attributable to the charity’s money? Any wealth in the donor-insured’s trust at any time or manner generated by dollars that were claimed to be the charity’s money is too much.

A rose’s thorn by any other name is still a rose’s thorn. You can’t expect to disguise a pig as a peacock and expect to beat the butcher!

REFERENCES:http://members.aol.com/CRTrust/CSD.html (Vaughn Henry’s CRT Information Web Site

http://members.aol.com/CRTrust/CSD2.html (Vaughn Henry’s CRT Information Web Site

http://www.ncpg.org/charitablepaper.html (NCPG, “Position Paper)

http://home.ease.lsoft.com/archives/aba-ptl.html (ABA searchable discussion archive)

Tax Planning With Life Insurance: 2nd Edition (800 -950-1210)

http://www.deathandtaxes.com/csd.htm(JJMacNab)

http://www.leimberg.com(Leimberg Associates, Inc. Web Site)

Split Dollar Life Insurance: Rip, Split, or Tear? 31st Annual Philip E. Heckerling (Miami) Institute on Estate Planning, Chapter 11.

Audio Tape Discussion between Michael Goldstein and Stephan R. Leimberg, Manulife Financial (Available from any Manulife Agent or by calling Advanced Markets at 617 854 4323.)

Categories
Case Studies and Articles

Estate planning malpractice issues – Vaughn W. Henry & Associates

Estate planning malpractice issues – Vaughn W. Henry & Associates

Once again estate tax relief is being discussed in Congress, one of the unforeseen consequences is that for many people, already reluctant to solve estate planning problems, this gives them just another excuse to procrastinate.  While 95 % of families aren’t faced with a federal estate tax problem, there are still many reasons to design a business succession strategy or complete an estate plan to preserve the security, control and value of their estate.  For any family that pays unwanted estate taxes, either their advisors were unskilled or the parents were negligently oblivious to the information provided by numerous print articles, books, news reports, seminars and advice from their professional counselors.  What brings this comment to the forefront?  Lately I’ve been receiving inquiries from litigation firms seeking referrals to heirs of families that have paid estate taxes and lost businesses or farms.  The obvious conclusion is there are disgruntled heirs out there who feel that their cut of the estate was diminished in some way because dad’s advisors somehow “fumbled the ball”.   After the dust from the great tobacco lawsuit war settles, the next target may be providers of estate planning solutions that didn’t work as the heirs expected.  Who’s on the hook?  Attorneys, trust officers, accountants, financial and gift planners and life insurance agents all provide estate-planning advice; a lot has backfired.  I expect some are now concerned about heirs looking to correct errors of omission and commission when the tax bill comes due.

  • Clients create tax neutral living trusts believing they’ve solved tax problems and/or never bother to re-title their assets and properly fund the trust.
  • Clients maintain joint ownership of significant assets when provisions should be made to preserve the clients’ exemptions (the applicable exclusion is $675,000 per person this year- 2000) or the will passes significant property back to the surviving spouse after ownership was previously split for tax purposes.
  • Advisors fail to use ways to make gifts to heirs of assets by using tax-free annual exclusions.
  • Advisors fail to test their client’s tolerance for charity.
  • Advisors don’t “freeze, squeeze, stuff and spread” assets.
  • Failure to make use of special tax elections like special use valuations or alternate valuation dates.
  • Improper beneficiary designations for retirement plans and insurance have come back to haunt blended families when benefits are incorrectly paid to ex-spouses or unforeseen heirs.
  • Owning insurance that improperly winds up being counted in the taxable estate can expose heirs to unnecessary tax.  Incorrect use of irrevocable life insurance trusts.
  • The estate plan didn’t provide for adequate liquidity and didn’t preserve or stabilize the value of the family business.

perceptionsfailures
The amazing thing about estate taxes is that so few semi-affluent families take a proactive role to effectively and legally avoid them.  Too many wealthy families don’t know that estate taxes are voluntary and, with a suitable plan, may be eliminated.  In a study of affluent business owners, the financial survey firm of Russ Prince & Associates, found that only 15.3% of heirs felt that estate taxes were going to be a significant problem in their own family’s business succession plans.  After those businesses failed, a follow up study of the same heirs who mistakenly thought taxes weren’t going to be an issue, 97.1% felt the founders’ own negligence in their estate and business planning contributed to the failure.  Now there’s an attitude that can be tweaked enough to shift blame to a target more accessible and financially better off than dad.  The damages are easy to assess; after all, the tax bill is an obvious place to start.  Since tax planners tend not to want to drag out litigation for fear of disrupting an ongoing business that depends on advisors keeping a low profile, they may be real targets of opportunity for unhappy family heirs.

The percentage of families with investable assets in excess of $1 million continues to rise and clusters of wealth exist in places where advisors still fail to provide appropriate advice.  What does this mean for planners and their clients?  More consideration should be given to creating teams of specialists who can craft a plan that meets the family’s need for liquidity, tax reduction, control and security.   Unfortunately, there are professional advisors who don’t feel a responsibility to save taxes or preserve an estate.  It’s not uncommon to hear “the kids inherited more than they deserved” or “it’s not my job to cut a tax bill” or “the client never asked me about taxes, they only wanted a simple will”.  Many commentators feel that an advisor has an ethical duty to present a range of options to a client that includes tax reduction and a discussion of family values an estate plan propagates.  One might contrast this situation with a patient going to a physician about a head cold, and the examining doctor observes a large irregular and discolored mole.  The patient didn’t ask the physician about skin cancer, but the doctor has a duty to pursue the diagnosis and treatment, not wave it off and later claim in a malpractice trial that the deceased patient never asked him to do anything about an obvious problem.  There should be no more excuses about clients not asking about whether or not tax saving techniques were available, clients generally don’t have enough background to judge what’s appropriate for their situation.  After all, they chose an experienced professional advisor instead of a cookie cutter approach that assumes one size fits all; clients should have a family friendly plan crafted to meet their unique needs for flexibility.  Professional tax and legal advisors should make a greater effort to educate their clients and help them understand the problem and provide solutions that meet all of their clients’ concerns.

Categories
Case Studies and Articles

Using an ESOP and a CRT to Preserve Family Wealth

Using an ESOP and a CRT to Preserve Family Wealth

 

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 Using an ESOP with a CRT to Preserve Family Wealth

One of the most difficult tasks an entrepreneurial business founder must face is getting out of a family run enterprise, especially when there are no heirs involved in management. To create liquidity, one of the most creative tools available is the “chesop”. Actually, this technique is an employee stock ownership plan (ESOP) with an IRC §664 Trust (CRUT) designed to minimize tax liabilities on the transaction. Whether the non-income producing employer’s stock or, more commonly, the reinvested proceeds under the §1042 roll-over provisions are transferred directly to the CRUT, the effect is the same.

  • More income
  • Lower taxes
  • More assets to heirs
  • Family Control of “social capital” for community resource

Ken Wiggins (63 widower) owns an automobile dealership and wants to create liquidity and slow down. He has been active as a volunteer at the local hospital since his wife of 38 years passed away, and prefers to continue community service during his retirement. His two daughters are already well provided for through his wife’s trust and he is faced with a business that requires more time and patience than he is willing to provide. His advisors suggested that his management staff and long term employees might be better able to continue operating the dealership profitably, and an ESOP would be an effective tool to transfer the business ownership. In order to qualify for tax deferral, Mr. Wiggins must put at least 30% of his corporate stock into the ESOP, but then he has up to 15 months to reinvest the proceeds into other qualified replacement property and postpone any recognition of his capital gain. While the original basis and tax liability remain, he would have a more diversified portfolio with which he could make cost-effective retirement planning decisions. Knowing full well, on exchanged stock, there will be some stocks that perform poorly, but when sold would trigger the deferred capital gains tax, he needs further alternatives to better manage his $4 million estate. By selecting those under performing assets to be sold, and contributing this stock to a §664 Charitable Remainder Uni-Trust, the repositioned asset is now capable of producing a stream of retirement income. One advantage of this technique is that instead of creating a taxable liability, there is an income tax deduction that may be used to offset the redemption of his other qualified §1042 stocks*. Besides producing more income, the remainder interest serves to create a family philanthropic fund that his daughters and grandchildren will oversee. For further information on this or other case studies, contact our office

ESOP CRT –http://members.aol.com/CRTrust/CRT.html

Sell Business – Pay Tax

ESOP – §664 Trust

Fair Market Value of Stock Contributed to ESOP

$2,500,000

$3,000,000

Less Adjusted Cost Basis

$65,000

 
Gain on Sale

$2,435,000

 
Capital Gains Tax at 30% (federal and state)

$730,500

 
Capital Controlled – Available to be Reinvested @ 8%

$1,769,500

$2,910,000

Annual Return from 8% Income Fund

$141,560

 
Avg. Annual Return 6% Payout §664 Trust with 8% Portfolio 

$186,129

Avg. After-tax Cash Flow From Repositioned Assets

$81,255

$106,838

Taxes Saved – Deduction of $1,031,425 @ 42.6% Tax Rate 

$439,387

Total After-tax Cash Flow and Tax Savings After 22 Years

$1,787,620

$2,789,830

After Estate Taxes, Asset Value Owned by Mr. Wiggins’ Heirs

$887,750

$0

Transferred to Wiggins’ Family Fund / Community Foundation

$0

$3,864,949

* The IRS has released a private letter ruling permitting §1042 “ESOP replacement stock” to be transferred to a §664 CRT and avoid immediate capital gains recognition. See PLR 9715040 (January 15, 1997). The seller may reinvest ESOP proceeds in “qualified replacement property” sec. 1042(c)(4) and that includes most publicly traded stock.

Henry & Associates