Tax Free Assets?

Tax Free Assets?

Unconventional Control of Family Assets

Vaughn W. Henry

 Unconventional maybe, but for sure this is an effective and powerful means to re-exert control over assets that would otherwise be lost to unnecessary taxation.

For those client/donors who already make significant donations and who may not be able to make full use of the charitable deductions, consider how the Lead Annuity Trust (CLAT) might be a useful alternative. If the purely philanthropical tools don’t motivate the client, consider this as an advanced estate and financial planning strategy designed to effectively pass assets down to heirs. An added benefit is that it maintains control of the social capital generated by the family when a family foundation is built into the final plan.

A reciprocal trust arrangement to the more popular Charitable Remainder Trust(§ 664 CRT), the Lead Trust is created under IRC §170 (f)(3). The major difference is the lead trust is a taxable trust providing periodic payments to a charity with the remainder either passing back to the donor or on to the donor’s heirs.

Why does this work well for some families intent on passing assets down more efficiently? Discounting and control. For example, a $3.03 million piece of farmland that generates 5.09% annual income but is expected to appreciate significantly because of location is already an estate tax liability just waiting to happen for many families. One possible scenario that employs efficient tools for conserving and passing value incorporates a Family Limited Partnership (FLP) and a non-grantor CLAT. The farmland is transferred into the FLP and the 99 limited partnership units are passed into the lead trust. The net effect, with a 30% discount typically attributable to unmarketable minority assets in a FLP, is the CLT receives income generating assets valued at $2.1 million. By passing out 7.25% of the initial value of the trust annually to the family’s charitable foundation or donor-advised fund in the local community foundation, the heirs will receive the discounted farmland valued in the trust at just $605,766 by deferring possession for 16 years. This value is less that the donor’s unified credit, and so the transfer avoids estate tax through a double discount strategy. At the same time, remember that the land is also appreciating at 6% inside the CLT and so it passes to the heirs without additional taxation at a value of $7.62 million. (There are some wrinkles if A FLP is used, generally a CLAT has to be rid of any ongoing business entity within 5 years or Excess Business Holdings may trigger unfavorable tax treatment. In this example a 2 trust CLAT, one holding FLP units and another holding land and securities, would be more likely to succeed.) What’s the cost? A deductible contribution to charity. In this case, $38,062.50 paid quarterly to the family’s foundation can be distributed to further advance the family’s values and charitable legacy while still passing assets to heirs efficiently. If the appreciating farm could be passed without paying any estate taxes, would a family give up the right to the income earnings on their farmland? Follow the math below. Questions? Check with our office for design options and suggestions.

© Henry & Associates 1998, 2000

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The 10 Per Cent Solution — CRT Planning Traps

The 10 Per Cent Solution — CRT Planning Traps

Vaughn W. Henry

As a result of changes to tax law, be aware that there are a few wrinkles that crept into the creation of a charitable remainder trust (CRT). In an effort to force charitable intent and minimize abuses, the §1089 section of the Taxpayer’s Relief Act of 1997 now mandates a 10% remainder value for the charity’s portion of the split interest gift. What factors affect the charity’s remainder? Number and age of beneficiaries or length of trust term, per cent payout to the income beneficiary, type of CRT and contributed asset, the §7520 120% applicable federal rate (AFR) and initial contribution all affect the tax deduction. However, the remainder is also significantly affected by the investment returns inside the trust and the IRS has little control over that influence. For this reason, the trustee needs to be very aware of the long-term results of a diversified and well-structured portfolio.

TRAPS

When discussing a CRT as a planning option, pay close attention to the charitable remainder calculations. From a practical perspective, it just means taking more care to make sure the trust qualifies. Concerns about having a CRT eligible as a tax-exempt trust under §664 are made more difficult if there are either high payouts or young income beneficiaries. During the planning process, the problem often occurs if there is a large disparity between ages of the income beneficiaries, e.g., parent – child or with spouses of much different ages. It may also occur if several income beneficiaries are included, for example, if a grandparent attempted to set up a trust for his 4 grandchildren. The choice between per cent payout and per cent deductibility also needs to be examined over the time frame of the trust. Unfortunately, too many planners view income tax deductions as the primary motivation to establishing a CRT. In reality, the power of the trust is in conserving the capital gains and investing the entire sale proceeds of an appreciated asset inside a trust that compounds the investment performance tax-free. An added benefit is the control or influence over the trust’s social capital disposition that becomes an important component of the plan for many families.

OPTIONS

If the CRT does not qualify, then a term of years trust (not to exceed 20) or a CRT with a lower income payout might. In the example above, the 5% payout is already the least allowable, so it may make sense to try to include fewer income beneficiaries instead. How could this work? In the case of a married couple, consider offering the younger, healthier and probably female partner the income beneficiary designation. If she’s the last to die (a statistical probability), then the income stream would pass to the family unit as it would have if both spouses were each receiving 50% of the CRT. There is no difference. However, if she predeceased her spouse, then he loses all the future income benefits and there is an increased risk to consider. To reduce the risk of income loss to the non-income beneficiary, an insurance policy could be acquired for a term long enough to recover the value of the contribution.

RESULTS

A successful unitrust produces a steady stream of increasing revenue; if properly invested, it also delivers tax efficient income. Besides benefiting the income beneficiary, high quality investment returns also produce a larger corpus for the charity. In the example above, the IRS assumes that the trust won’t generate more than the AFR of 6.6% and that seems to be an unrealistically poor return for a trustee’s performance over the young income beneficiaries’ 50 year life expectancy. Moving the trust investments from an 8% return eventually producing $1.1 million to 10% means that $2.8 million goes to charity instead, and a 12% return generates $7.3 million to charity. The fiduciary obligation to manage for both current income and the deferred beneficiary should encourage the trustees to look long term and seek sophisticated investment counsel for best results.

Vaughn W. Henry

Susan Barry, a 66-year-old widow, has 320 acres of productive farmland on the edge of town.  She and her late husband resided there for most of their 35-year marriage, but when he passed away two years ago, she turned the management duties over to her tenant farmer who now rents her ground.  The past two years have been dismal for farm income, and real estate developers frequently solicit her.  Her children aren’t interested in farming and the land is the principal asset in her estate, since Mr. Barry never got around to starting a retirement plan and didn’t believe in using life insurance.  Mrs. Barry has been active in the local hospital’s auxiliary and was advised by one of the development staff to consider a §664 charitable remainder annuity trust (CRAT).  The gift planner, Sally Singleton, had a persuasive set of reasons for her recommendations that included:

a)     A CRAT avoids capital gains on the appreciated property.

b)    A CRAT produces a steady, secure income stream to finance her retirement.  Gift planners know that older donors like safety and security, hallmarks of the CRAT.

c)     The land was appraised at $1.5 million, so the CRAT income stream of $75,000 would be greater than the farm’s current rental income of $125 per acre.

d)    The use of a 1 life 5% CRAT paid annually would provide Mrs. Barry with an income tax deduction of $853,837.

e)     The use of an IRS prototype CRAT document would reduce legal costs.

f)      The hospital could act as trustee and manage the investment account along with its other endowment funds.

g)    Mrs. Barry might continue to reside in the farm home until the land was sold at the end of the farming season to the developer.

From the hospital’s perspective, this is a classic CRT plan and fits the guidelines nearly perfectly.  When Mrs. Barry called the development officer, Ms. Singleton, and declined her CRT solution, Sally was surprised.  After all, it was a pretty good plan, what was the problem with the scenario?  Where did it go wrong?

First things first

Who’s the client?  Who benefits?  In this case, the hospital probably would benefit to the detriment of the income beneficiary.  While Mrs. Barry is charitably inclined, her modest estate doesn’t require that 100% of her farmland be contributed to a CRT to avoid an estate tax.  Remember, she has some “step-up in basis” on half the jointly owned property, so the capital gains liability, while significant, isn’t the only reason to act.  In this case, it makes more sense to contribute only half of the land to a CRT, and use the tax deductions to offset some of the gain from a taxable sale of the portion she retains.  This equity will provide her with the capital needed to relocate and still have a comfortable cushion.  Additionally, even though her children weren’t interested in the farm, Mrs. Barry didn’t want to completely disinherit them.  By splitting the land into two parcels, she’ll be able to use her exclusions to pass her heirs some assets and value free of tax.  The strategy of skimming the top off of her taxable estate and dropping it into a CRT and aggressively gifting to heirs works well to solve current estate tax liabilities.

While it’s often true that older client/donors don’t like risk, and a CRAT is often a tool to avoid unnecessary risk, in this case, the CRAT is the wrong tool.  If the development deal falls through, and the rental income is inadequate, a CRAT must distribute either cash or land back to Mrs. Barry.  A delayed sale means the CRAT might not have the liquidity to meet trust obligations, and since she can’t contribute extra cash to meet the required payout, a CRAT presents big hurdles.

The CRAT’s income tax deduction, while available over a total of six years, is limited to 30% of Mrs. Barry’s AGI.  Since she’s not likely to make the nearly $500,000/year it would take to use the deductions, most of the income tax savings are a fiction.  It would be better to increase the income payout to 7% or 8%, and change to a quarterly payout unitrust (CRUT) that allows additional contributions of cash just in case the sale doesn’t go through. Better yet, Mrs. Barry should make use of a FLIP CRUT to avoid the problems of contributing an illiquid asset.   Also, a 66 year old has a 50% chance of living longer than 16 years.  This longer time frame might make the unitrust more suitable as a way to offset modest inflation that would nearly halve the buying power of a CRAT payment over time.  For a 7% unitrust to function well, the trust investments need growth/income potential of 8 – 12%, so a well-diversified equity portfolio is required.

The use of a prototype legal document without outside counsel is a poor idea, as is providing complicated advice without getting the donor’s accountant, attorney and financial advisor into the loop.  If Ms. Singleton had briefed all of the donor’s advisors and asked for input, she might have been able to present a plan that everyone could support and understand.  IRS prototype documents aren’t designed for one size fits all cases, especially if there’s a hard to value asset involved.  Also, the charity takes on a potentially adversarial role by acting as trustee, and lately more legal liability and increased scrutiny is added to the mix.  While the charitable remainderman wants to preserve corpus, often by investing in bonds and preferred stocks, the income beneficiary of a CRT (especially a CRUT) would like growth.  Better yet, assets should produce capital gains instead of the higher taxed ordinary income generated from interest and dividends.  Additionally, the trustee must be very careful about commingling funds with other endowment accounts, as the CRT must track income earned and paid out under the trust’s four tier accounting system.

As for Mrs. Barry residing in her home after contributing it to the CRT, she’s a disqualified person and such actions might be considered self-dealing under §4941.  This provides more reason to split the real estate into two parcels, contributing one portion to the CRT and retaining the other portion with the home, and then jointly listing them for sale to the developer.

Converting Appreciated Stock Efficiently

Converting Appreciated Stock Efficiently

David (63) and Jean (62) Grant opted for early retirement and possess an estate comprised primarily of publicly traded stock. Faced with a declining income stream, the Grants are concerned that almost all of their estate is tied up in just one company stock, valued in excess of $1 million. Like others who benefited from stock options and familybusiness interests, this high risk lack of diversity was a motivation to seek other alternatives. However, in order to have a diversified portfolio the Grants must typically sell and pay tax on their paper profits. While appreciation is a great way to accumulate wealth, now that they need to spend it in retirement, the 1.4 % dividend rate is just not adequate. So, a §664 CRT was suggested as a tool to assist them in meeting their goals to cut capital gains taxes.

Although the Grants are charitably inclined, there was some mention that the eventual transfer to charity probably would exceed $1.1 million, and that seemed a little more than the family initially desired. So they asked about increasing the payout to generate more income while they could enjoy their retirement. There were three comments made by their planning staff that answered those objections:

1. The future value of the capital gains liability of $147,192 at 9% over 29 years would be $1.79 million and so the charity is actually receiving less than the present value of just the capital gains tax. In a CRT, the Grants will have the right to control and generate income from capital that otherwise would have gone to the IRS. In a typical transaction, a seller of appreciated assets pays the tax and doesn’t think about conserving it. This is a great example of recognizing opportunities to do good works with the IRS’ money.

2. A lower payout CRUT generates a higher income tax deduction; over time, if the investment portfolio performs well, it will also produce more net income for the Grants. This is contrary to logic for many prospective donor-clients, but they need to remember how assets compound in a tax-exempt trust during their lifetime.

3. Since the portfolio of stock is liquid, by contributing only 75% of their stock holdings to the CRUT, the Grants have the remaining 25% that may be sold outside of the CRT and offset any taxable sale with some of the tax deductions generated by the deferred gift to charity. This provides back-up income.

While the Grants are concerned about their children, they intend to spend their retirement taking care of their own income and security needs, and if there is a little something extra left for heirs, that will be fine. However, they have no intention of impoverishing themselves to leave a windfall for their children. As a result, they purchased only a small life insurance contract and gifted it directly to their children to replace some of the wealth they were transferring into their §664 Trust. The remainder of their trust will go to three favorite charities and a local college as a way to shift something back to their community and keep control of their “social capital”.

Henry & Associates designed the Grant scenario* and compared the options. Option (A) sell stock and pay the capital gains tax on the appreciation and reinvest the balance at 9% or Option (B) gifting the property to an IRC §664 Trust and reinvesting all of the sale proceeds in a 9% balanced portfolio. A SCRUT was used instead of a NIMCRUT to assure the income beneficiaries of a more reliable income stream. For younger donors with a desire to control the timing and amount of income, the NIMCRUT may be a better tool.

* Hypothetical evaluations are provided as a professional courtesy to members of the estate planning community. Call for suggestions or schedule a workshop for your professional advis60213084102/http://members.aol.ors, development officers or charitable board members.

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Design a CRT to Irritate Your Client-Donors

The Error of Our Ways

Why Some Charitable Trusts Make Donors Irrevocably Unhappy

Sometimes it’s important to learn when a charitable trust won’t work as planned. A CRT is not always a “magic bullet”. What should be a win-win-win estate planning scenario sometimes turns into a lose-lose-lose disaster. Don’t make the mistake of promoting or using them as solutions for all estate and financial planning problems. A prime example of this is a case study for Georgia Miller, a semi-retired business owner who wanted to set up a charitable remainder trust. Ms. Miller, a 61 year old widow with no heirs, was persuaded by a foundation officer at the local university to transfer appreciated business development property to her §664 trust. The original purpose of the CRT was to help her avoid paying capital gains tax and provide a better source of funding for her retirement. Already charitably inclined, it made good sense to Georgia who had a long history of supporting this university to create this trust. After all, this was a classic example of taking an under-performing appreciated asset, repositioning it for retirement income and providing some charitable support for the nonprofit institution.

The first of many problems started with the development officer and an inexperienced university attorney who were not quite as sophisticated as they should have been. As gift planners, they suggested a 5% charitable remainder annuity trust (CRAT) as the deferred giving vehicle of choice. They also used an IRS prototype document and named the school as both the trustee and irrevocable charitable remainder recipient. The donor, Ms. Miller, was named as the CRT’s sole income beneficiary. The errors compounded when her business property was deeded to the CRAT and the rental income dropped due to a “temporary” glut on the market. This over-supply of office space also negatively affected the marketability of the building. Faced with a lack of income, the trustee should have been thinking about solving problems, but failed to act appropriately. As trustee, the university was unwilling to sell the property below appraised value and take a loss. Why? If the trustees sold the property in a depressed market, it meant that the school would eventually receive less funding at the maturation of the trust and this was a concern. The trustee took the position that there was no income and convinced the donor to not expect any income distributions until the building could either be sold or start generating additional rental income. Ms. Miller became disillusioned with the performance of her charitable trust, originally marketed as a tax advantaged retirement supplement, and she sought guidance from another planning firm to review her options. A few of the many comments follow:

1. While a CRAT is generally the easiest CRT to explain and administer, it may not be the best tool for a woman who is expected to live 20 or more years. A CRUT or uni-trust, which pays out a percentage of annually revalued trust assets, might be more suitable for someone concerned about inflation’s effect on a fixed annuity payment. Since a CRUT pays out a percentage annually, it depends on good investment results. So if the portfolio of CRT investments performs well, the income stream should increase every year.
2. Georgia’s 5% CRAT generates a significant income tax deduction of 51.6% of the gift’s fair market value. Since a donation of appreciated property allows her to use her charitable deduction against 30% of her adjusted gross income (AGI), it will reduce her income taxes somewhat. Although she can carry forward the deduction for five additional years, her modest income tax liabilities will not allow her to make full use of the nearly $500,000 in tax deductions available from her gift. A higher payout CRUT would have provided both more initial income and the opportunity for a rising level of payments. This recommended change from a 5% CRAT to an 8% CRUT would also produce a lower and more useable charitable income tax deduction and address the concerns about inflation’s effect on her retirement income stream. The school, however, would not be expected to receive quite as large a remainder interest at her death, thus the school’s preference for a CRAT.
3. Putting any “hard to value” real property into a CRAT is often an invitation to disaster. If the property can neither generate adequate income, nor be sold to provide the required payout, there is no option for the trustee except to distribute “in kind” assets back to the income beneficiary. The trustee has no ability to defer required payments, so the trustee was creating the potential for debt financed problems in the CRAT by not distributing income to Ms. Miller. On the other hand, in a CRUT, it’s possible for the donor to make additional contributions, which may then be paid back out as income distributions, to satisfy the required payments to the income beneficiary. In a more restrictive CRAT, additional contributions aren’t allowed and this means that pieces of the donated property must be deeded back to the income beneficiary. This creates an administrative nightmare. Not only is there an issue of new deeds and multiple interests in the property after an in-kind distribution, there may be adverse tax issues that crop up after this action. If hard to value real property must be used, then a better choice would have been a net income only (NICRUT) or net income with make-up charitable remainder unitrust NIMCRUT) or a recently approved FLIP trust. All of these uni-trust variations provide much more flexibility in dealing with unmarketable assets in a CRT.
4. By acting as trustee, the school has positioned itself in a fiduciary role that exposes it to serious liability. It appears that the trust was established more for the benefit of the charity, and the donor did not have adequate counsel to explain and better plan the trust to meet her individual needs. It might have been more prudent to allow a third party act as trustee, or even have the donor to continue to act as her own trustee, as long as there was an independent party to handle the transaction and valuation issues of the real estate in trust.
5. Some business assets inside a CRT generate unrelated business taxable income (UBTI), and this is a serious problem. While a nonprofit organization can accommodate the UBTI by paying tax on the pro-rata taxable earnings without affecting its nonprofit status, a CRT can not. UBTI means that the trust is entirely taxed in the year it earns this type of income, and so any unrealized capital gains would be recognized when sold inside the trust. Besides losing the charitable deduction and recognizing taxable gain, the asset is locked in an irrevocable trust and the donor is likely to be experiencing a world of frustration.
6. IRS approved prototype documents are very restrictive and generally do not address all the concerns about removal of trustees, modifying the charitable remainder interests and managing trust assets for tax efficiency. A custom document will deal with the donor’s needs and provide more flexibility and control, this option might be a more useful approach in Ms. Miller’s case. Many charities do properly act as trustee and administer charitable trusts quite well, but non-profits doing so are taking another look at the liability issues and often back out of the responsibility. By naming the university as both trustee and irrevocable remainderman, the school’s foundation expected to maintain control of the trust and report the proceeds as available in their capital campaign. However, the development officer was concerned that if the donor fully understood that the charitable remainder could be both modified and the trust proceeds split among her favorite organizations, the university might not be the beneficiary of the entire trust corpus, and this was unacceptable to the university. Most donors prefer to retain some ability to modify their CRT beneficiary and reflect their changing lifestyles and interests, so that power should be reserved in the trust. These issues are a concern in any CRT, and anything affecting the independence of all parties in the transaction should be addressed before the CRT is implemented.
7. There were other concerns, but the purpose of this article was more to discuss problems and how they might have been prevented. The CRT would have been an excellent tool in Ms. Miller’s financial and estate plan, if it had been properly designed and executed. Quality technical support and competent advisors are critical for success of a complex plan using a charitable remainder or lead trust, and planning partnerships among tax and legal specialists is a must.

For more ideas, case studies, workshops or a courtesy CRT evaluation, see our planning and resource web-site at http:// members.aol.com/CRTrust/CRT.html

Henry & Associates

Gift & Estate Planning Services© 1998

22 Hyde Park Place – Springfield, Illinois 62703-5314

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