Category: Case Studies and Articles

Freeze and Squeeze

Why planning works to preserve family businesses

 

Despite all the press coverage about the death tax, in reality, few people worry about confiscatory estate taxes.  However, those owning family businesses and farms seem to provide a disproportionate share of federal and state revenues at death.  Although there is some temporary federal relief offered if you accept the moving goal post formula for estate taxes, the operative word is “temporary”.  A significant and new problem for many is the increasing percentage of estates subject to higher income taxes and the recently enacted estate and inheritance taxes imposed by revenue-starved states. 

 

The solution?

Consider making charitable gifts of those assets that trigger both income and estate tax at death (income in respect of a decedent or IRD), and keep the estate from ballooning in value.   With a little prior planning, there is no need to pay unnecessary taxes if owners freeze the value of their growing business and transfer it before tax liabilities mount up.  How does that work?  Easily, but few taxpayers take advantage of their right to make tax-free gifts to heirs on a regular basis.  It is a shame, because over time, significant value can be compressed and given via lifetime and annual exclusion gifts, especially if husband and wife join to make full use of gifts to children, in-laws, and grandchildren.  For many families with four married children, and grandchildren, it is common for half a million dollars in estate value to be transferred free of tax.  By making those gifts repeatedly over the years, most estates would see significant tax savings.  Yet few families take advantage of this right. Why?  Most family business owners resist making gifts fearing loss of control, and are unwilling to take a proactive long-range view of the planning process.

 

Plan now, notlater

Sam Walton, founder of the Wal-Mart empire, is a great example of successful transition tax planning.  He passed the bulk of his business interests to his heirs with little tax erosion by preparing the plan early in his career.  Sam and Helen started their retail business after World War II with $5,000 in savings and $20,000 borrowed from Helen’s father; then built that stake into a multi-billion dollar marketing behemoth.  Along the way, they learned lessons in business succession planning and resolved to create a family owned business, Walton Enterprises, in which they transferred 20% of their business interests to each of their four children (Rob, John, Jim, and Alice) and kept their remaining 20% portion as separate shares.  When Sam passed away in 1992, owning only his 10% ownership interest in the $26 billion Walton business, the taxable value of his estate was much smaller because of his prior gifts.  Although specific details are not available for the entire Walton zero estate tax plan, Sam’s 10% ownership of Walton Enterprises passed tax-free through a marital trust for his wife.  As reported by Forbes magazine’s best estimates of family wealth in the annual “Forbes 400” (September 2002), his planning meant that each of the five principal Walton heirs is now worth $18.8 billion.  When Mrs. Walton passes on, her interests divide when the non-voting shares flow to the Walton charities, while the voting shares transfer to their younger heirs who will continue to control the retail, banking and real estate business.  

 

The planning concept is simple.  The best way to reduce or eliminate estate taxes is to freeze the value and give it away before assets appreciate, so worth grows in the heirs’ hands.  This transfers the tax value.  Maintaining control is a different issue; keep the managing interest separate and retain command of the family business.  The advantage of passing non-voting ownership interests to heirs is that discounting and compression may result in a lower tax value when heirs do not have significant management influence.  Typically, the IRS allows independent appraisers to lessen the taxable value of a business if there are minority interests, limited marketability, and lack of control.  That is the “squeeze” in the planning, and it means that it becomes easier to pass a business at a discount.  This is not “do it yourself brain surgery”; proper planning and legal procedures must be used, so seek competent counsel and do it right.

 

Had that unplanned growth and value stayed in Sam and Helen Walton’s hands, and been subject to tax under current rates, the tax bill would exceed $47 billion today.  It would be hard to imagine any family business being unaffected by a need for that kind of liquidity in just nine months after the death of a principal owner.

 

What Sam Walton achieved through effective planning –

• Reduced his gift and estate taxes
• Improved his planning options
• Protected some of his assets from creditors
• Transferred assets to heirs without losing control
• Kept his children tied to the family business by shifting an equity interest to heirs
• Achieved flexibility of structure and design through the partnership
• Avoided probate by using methods that operate by contract
• Ensured privacy for his dealings
• Leveraged use of his tax-free transfers, like the annual exclusion gifts that are now $11,000 and the new $1,000,000 applicable exclusion or $1,100,000 generation skipping exemptions.

Statistical Information on Injuries in the Horse Business – Summary by Emmy R. Miller, PhD, RN

Are You Trapped with Retirement Plan Assets?

 

“Give my stuff to charity!  What kind of crazy estate plan is that?”  That’s a typical response when clients ask about ways to eliminate unnecessary estate taxes and are told to make gifts.  It’s an understandable reaction.  It’s also not intuitively obvious how giving away something the client needs can be a good thing, especially if the potential donor was raised during the Depression.  The epiphany comes when clients look at the choices they have for assets not consumed to support their lifestyle; those remaining assets can only go to children, charity or Congress.  Once the options are explored, many people make an informed decision to pass property to heirs and other assets to charities that either had or will have some impact on their family’s life.  How can they be smarter making that decision?

 

Good assets and bad assets.

Actually, most people don’t see much difference between the two, as any inherited asset ought to be a good asset, right?  Well, some inherited assets come with an accompanying income tax bill, even in estates too small for an estate tax.  Who’s at risk?  Many professionals and retirees have worked a lifetime and have accumulated a significant 401(k), 403(b) or an IRA and don’t realize that their heirs will not receive the full value of that account.

 

Option #1.  As it turns out, giving heirs all the assets that can be legally excluded from tax and leaving the rest of the estate to charity works if (and it’s a big if) tax avoidance and philanthropy are the only goals.  It’s a simple, easy to understand process with no need for expensive tax planning or specialized legal advice.  While this technique might shortchange family heirs, it is an ideal solution for charitably motivated families.  However, even if the family has an altruistic desire to make a charitable gift, there’s no reason it can’t be done in a tax efficient manner.  How so?  Make those charitable bequests with assets that otherwise would be taxed twice.  For example, in 2002 and 2003 anything in excess of $1,000,000 is subject to a federal estate tax.  A simple estate plan would sweep anything above that level to charity.  A better plan would be to give away those assets on which an added income tax is owed.  What qualifies?  Use those “income in respect of a decedent” (IRD) assets.  Start with an IRA, a retirement plan account, a deferred annuity, savings bonds and don’t forget earned, but uncollected professional fees; these are all unattractive and taxable assets for your heirs.  Instead, a bequest made from that donated IRA means a charity receiving $100,000 collects the whole value without paying any tax.  In the traditional estate plan, children might be penalized 75 or 80 percent if they inherited those IRD and tax-deferred dollars.  Better to let family heirs inherit assets that “step up” in basis, so if they’re sold later, there won’t be much of an income tax due.  This proactive approach is more tax efficient, as the charity receives more, the heirs get to keep more and the IRS gets zilch.

 

Option #2.  With the latest rules on required minimum distributions, many financial planners propose “stretch IRA” programs and make a good case for their use.  Unfortunately, for all the planning that goes into them, few heirs leave the plans alone long enough for the stretch to do any good.  For owners of significant retirement plans, naming a charitable remainder trust as beneficiary might make better financial sense.  While there’s usually no charitable income tax deduction, there’s often a significant estate tax deduction and this charitable roll-over still ensures a steady income stream for a surviving spouse that’s not going to be subject to required distributions that erode the value of the asset.  For older heirs, a CRT funded with IRD assets might be an ideal solution to eventually convert an ordinary income pump to an income stream taxed at capital gains rates.

 

The problem is that without changes in beneficiary designations or specific language in the Will, the estate can’t make charitable gifts of income.  Bequests are normally made from principal unless there has been a proactive decision to give away tax liabilities.  Seek guidance from competent professional advisors to make sure these gifts are properly implemented, and do it now.

 

 

A good plan deals with concerns beyond tax efficiency; it must also meet the needs of the family.  For instance, will the plan provide for proper management by underage or unprepared heirs?  Has it been decided if there’s an upper limit on what heirs could or should receive?  What does the concept of money mean to the client?  How much is too much?  Could an inheritance provide a disincentive to work and succeed?  Does the plan try to pass assets to all heirs equally, or have past gifts and interactions been considered in an effort to be equitable?  Since there’s more to a legacy than just money, the estate plan should include passing down a family’s value system and influence.  How have the family’s core values been addressed in the master plan?    The problem is that few professional advisors like to deal with such intimate and personal questions.  Most tax and estate planners spend years honing their analytical skills only to find that clients don’t create and implement estate plans for purely logical reasons.  Instead, there’s an overriding emotional motivation that’s often unsolicited in discussions with client.  The problem is that even an elegant estate plan that does everything it’s supposed to accomplish won’t be well received if the family doesn’t understand and agree with its goals.  As a result, there’s paralysis by analysis, and nothing gets accomplished until both the logical and emotional needs for family continuity planning occur.  Rather than try to plan an estate on an asset-by-asset basis, take a big picture view of the family’s goals and values and see how the planning can be made to meet those needs.	Subscribe to Henry & Associate   Gift and Estate Planning Discussions Want to be kept up to date   on CRT planning issues? Join our mailing list!     Check our Trust and Planning Archive Hosted by Henry & Associates	Subscribe to Henry & Associate   Gift and Estate Planning Discussions Want to be kept up to date   on CRT planning issues? Join our mailing list!			Check our Trust and Planning Archive	Hosted by Henry & Associates
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Things You Really Need to Know About Planned Gifts – Henry & Associates

Why financial advisors fail to ask clients about charitable planning:

 

1. it’s not a priority

 

2. they’reafraid of offending their clients and losing the business

 

3. they’renot that charitably inclined themselves and can’t envision clients giving away anything that shortchanges the kids or uses up resources that might be needed later

 

4. planned giving is sort of complex and has a lot of tax code issues to work through, why bother to learn about such an obscure field when so few people do it?

 

5. they assume their clients aren’t charitable

 

6. they say that the clients never asked about planned giving, so they didn’t bring it up

 

7. advisors worry about giving away money under management because it reduces their own revenue stream, or they can’t figure out how a product or service they provide can be worked into the planning process, so there’s no incentive to suggest it

8. most don’t know much about the many technical issues and avoid the topic so as to not appear to be incompetent or unknowledgeable in front of their clients

 

9. they don’t want to do team planning with other experts because they will be giving up control of their client if other advisors horn in on the planning process

 

10. clients are fee sensitive, why should an advisor go spend money to learn something they’ll rarely use and probably can’t bill for?

 

As it turns out, it is mostly an education issue, but many experts feel that the client MUST say in front of all of their advisors, “I want to make a gift; show me how to make it happen”, before the advisor takes it seriously.

 

Until this happens, many advisors assume that the client is using them as a fence or a barrier to keep charities and fundraisers away from them.  You know the lines, “my lawyer doesn’t think this is a good idea” or “my broker says I can’t use the deduction, maybe next year”, or “I’d probably do something later, but you know how it is when your CPA says it’s not a good time”, all excuses that make sense, but may not be entirely accurate.  Getting the client to establish their goals and priorities early in the process makes it easier to plan correctly, and it removes many of the objections that may pop up later on in the planning process.

 

Many individuals are receptive if they see how to give their support away tax efficiently and develop some organized planning to their philanthropy.  What will not work is having a charity believe that it can deputize a tax, financial or legal advisor and make them part of their fundraising or development office by pressuring them to go after charitable gifts from their clients.  That cannot happen because commercial advisors need to be objective and not bring an agenda to the table by promoting a specific charity.  Instead, what can work is a better planning partnership where both the values of the client and his or her financial goals blend into an integrated estate plan.

 

Recent surveys have shown that less than five percent of professional advisors* bring up the idea of charitable planning in their discussions with clients, and many of those only do so after the client introduces the topic.  The lack of charitable bequests in the estate planning process is a concern since over 70 per cent of families already make annual charitable gifts, but less than six per cent do so from their wills or trusts.  Why is there a difference between the two?  It is probably faulty communication between clients and their advisors, since clients make those decisions to support charitable organizations based on their values and interests, but fail to ask about continuing their legacy in discussions with financial and legal advisors.

Why Retiring Farmers Might Use a Rawhide Trust

 

“The estate tax is the government’s way of getting even for all of your income tax maneuvering”

 

One of the problems farmers, ranchers and other family business owners have with the built up tax liability that exists when owners sell out and retire is how to control the timing of tax triggers.  Why is that?  Many farm business owners look at their books annually and decide to buy feed, seed, fuel, and fertilizer before year-end to show little taxable profit.  Those years of income deferral come back to haunt farmers the last year of business with a vengeance when they close out the business.  Since everything they sell is depreciated or an ordinary income asset, it is a common trap; there is no offsetting business expense to reduce taxable income, so the last year is a bonanza for the IRS.

 

“Rawhide trusts” that make use of livestock, agricultural products, or farm equipment, may exist not to generate an income tax deduction but to defer recognition of taxable income, which may be an important part of an exit strategy for a farm business owner.

 

Internal Revenue Code §1231 defines “livestock” as including cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals, and other mammals.  However, poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc. are not included.  This distinction is important because “livestock” held by the taxpayer for draft, breeding, dairy, or sporting (e.g., racing) purposes may qualify for long-term capital gain treatment upon sale, exchange, or involuntary conversion.  Specifically, livestock will qualify for IRC §1231 treatment if held:

) for 24 months or more from the date of acquisition in the case of cattle or horses, or

(ii) for 12 months or more from the date of acquisition in the case of such other livestock.

An outright contribution of qualified “livestock” to a public charity that puts them to a related use should qualify for a fair market value deduction.  Donors must distinguish between animals purchased and those raised by the donor; the latter are going to be ordinary income assets.  The term “certain capital gain property” as used above means any capital asset which if sold on the date of contribution at its fair market value would have resulted in long-term capital gain to the donor.  While it is useful to a veterinary school or university animal science program when a donor contributes livestock or race horses that qualify for a full fair market deduction, these gifts may not be quite as suitable for transfer to a CRUT because there is no “related use” for livestock inside a charitable remainder trust.  Although, if the donor contributes tangible property (livestock, equipment, grain, etc.) as a way to avoid recognizing an immediate income tax on sale of an asset, even if it creates a tiny deduction hinged on tax basis and not fair market value, then CRT planning still may be a useful solution.  (PLR 9413020)

 

Crops

The determination of whether crops are tangible personal property or part of real estate depends on whether the crop has been harvested.  Reg. §1231-1(a) provides that “unharvested” crops sold with the land on which the corps are located (and which has been owned by the seller for more than one year) are considered long-term capital gain property.  It is immaterial if the length of time that the crop, as distinguished from the land, is held for more than a year.  Accordingly, for charitable deduction purposes, a contribution of land containing unharvested crops to a public charity is based on the fair market value of the land and crops on the date of contribution and is still subject to the 30% AGI deduction limitation.  The use to which the charitable organization places the crops sold as a part of the donated land is immaterial to the donor’s deduction because those crops are not considered tangible personal property.  However, this income generated from the sale of crops could be considered unrelated business income under IRC §512 by the charitable organization.  Because a CRT currently has severe penalties for unrelated business income, so any land with unharvested crops may be unsuitable for transfer to a charitable remainder trust because the production of UBTI causes the trust to lose its tax-exempt status.  If a donor contributes harvested crops, a tangible personal property item, it is considered ordinary income property.  The deduction for a contribution of ordinary income property to a public charity is limited to the lesser of fair market value or cost basis, and is subject to the 50% deduction limitation even if donated for a related charitable use because unharvested crops are considered a gift of a futures contract.

 

If a farmer harvests or contributes crops, it does not cause realization of income.  However, if a property owner receives crops as apart of a sharecropping agreement, then it is ordinary income when received.  After being recognized as an ordinary income asset, if the sharecropper contributes those crops then a charitable contribution deduction for their fair market value is available.

[1]the tax treatment for a sale that results in a net capital loss, is an ordinary loss.

[2]Thompkins v.U.S.(S.D.Ill.1977)

 

© 2002 — Vaughn W. Henry

 

Trail of Tiers – Why Investment Choices Affect CRT Management – Henry & Associates

Trail of Tiers – Why Investment Choices Affect CRT Management

Too many trustees forget that managing a charitable remainder trust (CRT) isn’t quite like managing a personal or business entity when it comes to recognizing income for tax purposes.  The differences are evident when examining their investment philosophies.  For a charity, even those with highly experienced investment managers and sophisticated board members, almost all of their endowment funds produce income not subject to tax in their nonprofit organization.  As a result, it makes little difference to an exempt organization whether that 10% annual return comes in the form of bond interest, stock dividends or from the sale of appreciating securities.  Income is income, and it’s all generally exempt from income tax.  The same thing can be said about money managers of pension and retirement accounts.  Neither has to think about tax efficiency.  However, for the trustee of a §664 CRT, the accounting rules are somewhat different because of the “4 tier” treatment of income distributions from the trust.  Many advisors are familiar with LIFO and FIFO (last in – first out or first in – first out) treatment when selling assets and reporting tax, but a CRT uses WIFO (worst in – first out).  Because the assets retain the character of the donor’s basis and holding period, even when sold inside the tax-exempt trust the income distributions generate tax liabilities with all income passing out as first tier (ordinary) before more favorable tax treatment can occur.

Consider Susan Barry’s CRAT as an example.  She contributed $1 million of appreciated stock in a publicly traded consumer products manufacturer to her 5% CRAT.  As a result, she will receive $50,000 annually from the trust for the balance of her life.  While she will receive some tax deduction for the gift of a future interest to charity, of more concern to her is the tax treatment of the income she receives from her trust.  If the trustee reinvests her $1 million of stock into bonds to preserve principal, all of the income that passes to Susan will be tier #1, ordinary income, taxed to her at nearly 40%.  This means she will get to keep $30,000 of the $50,000 distribution.  That’s a $10,000 annual penalty for an asset that would have otherwise been taxed at just 20%.

Considering the Prudent Investor Rule, suppose the trustee chose to use a portfolio of stocks and bonds, believing this to be the most beneficial for both the income and remainder beneficiary.  Generating a respectable performance with 10% returns annually, the blended portfolio produces bond income, preferred or common stock dividends and some appreciation.  Unfortunately, all of the tier #1 interest and dividend income has to be paid and taxed before any tier #2 capital gains can be used.  This investment strategy produces some growth benefiting the charitable remainderman, but it still has a negative effect on Susan’s spendable income, since it’s still all taxed at ordinary rates.  If the portfolio were more aggressively invested in individual growth stocks or tax efficiently managed mutual funds, more of the income distributions would come from tier #2, realized capital gains, leaving Susan with a distribution taxed at just 20% and handing her $40,000 of spendable income.

Trustees need to remember they have a duty to manage the trust’s assets for the benefit of both the remainder and income beneficiary.  If it can be done without exposing the trust to excessive risk or volatility, I think it can be argued that both sets of beneficiaries benefit from the growth associated with a more equity oriented portfolio inside a CRT.

© 2000 — Vaughn W. Henry

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Stock transfers to a CRAT

A Dirt, Dirty Shame

Malpractice Coverage – VIII

Don’t Leave Home Without It

eighth in a series on design and implementation issues)

 

One of most popular assets contributed to a charitable remainder trust is dirt, better known as real estate. Why?  Commonly owned, occasionally wildly appreciated; it often underperforms as an income-producing asset; and under the right circumstances it can be converted to a retirement income stream while minimizing capital gains liabilities. 

 

Unfortunately, very few planners understand the traps and dead ends associated with the use of real property inside a CRT. 

 

Ed Thomas was encouraged to use a §664 trust as financial planning tool in order to avoid capital gains liabilities.  Persuaded by his stockbroker that contributing his appreciated farmland to a charitable remainder trust would be the perfect tool to avoid (although it was improperly suggested he could evade tax with a CRT) capital gains tax.  Ed jumped on this technique as a solution to his problems.  Since the highest and best use of the land hinged on its significant development potential, selling it through the CRT made sense.  Inheriting this land years ago, Ed had a tenant farmer managing it, only rarely saw the property since it was located out of state, and had no interest in farming.  None of Ed’s children had any interest in the farm and there was no emotional attachment, so it sounded like a perfect solution for a client who had some charitable interests and a desire to minimize tax.  Where it went wrong was in depending on bad advice from people who had little real world experience with charitable trusts funded with hard to value assets.

 

Problem 1 – Ed had an old appraisal from a realtor who listed the property last year and believed after consulting his broker that the sale price would set the value of the income tax deduction, and that he needed no new appraisal.

The IRS requires a qualified appraisal (dated no earlier than 60 days prior to the transfer) for any contributed real property valued at greater than $5,000 [Treas. Reg. §1.170A-13(c)(2)].  There will also be an IRS 8283 form completed to back up the claim for an income tax deduction, and when the property is sold by the trustee an IRS 8282 reports the sale proceeds.

 

Problem 2 – Ed sold the land and contributed the sale proceeds believing he had avoided a capital gains liability.

Gain on the sale of an appreciated asset is not attributable to the donor if the sale occurs after the asset transfers to the CRT.  If the donor retains either direct or indirect control over the asset, or if there is an express or implied prearranged obligation on the part of the CRT to sell the property, then the subsequent sale is taxable.  In this case, Ed has a real problem since he never bothered to transfer title to the CRT and he sold it as an individual.  Since the CRT never legally owned the real estate, capital gains liabilities were triggered [Reg. §664-1(a)(3);Rev. Rul. 60-370, 1960-2 C.B. 203

 

If he had a “buyer in the wings”, with either an escrow agreement or an obligation to sell, even if he had contributed the real estate to the CRT before the sale, he would still have recognized the taxable gain.  Avoiding assignment of income, prearranged sales, and step transactions is a valid concern with real property, caution and competent counsel is necessary to avoid unnecessary tax problems.  [Palmer v. Commissioner, 62 T.C. 684 (1974), affirmed, 523 F.2d 1308 (8th Cir. 975).]  As for the capital gains avoidance, a CRT is primarily a capital gains deferral tool – the tax is not completely avoided, since income distributions to Ed will retain the character (basis and holding period) of the contributed asset.

 

Problem 3 – Ed wanted the charitable remainder to be a soon to be created private foundation.

Normally, a charitable remainder trust funded with cash or appreciated, publicly traded securities would create an income tax deduction equal to the fair market value of the donated asset.  However, if a CRT funded with real property and, upon termination, transfers its interest to a private foundation, then the income tax deduction is just limited to basis, not fair market value.  In Ed’s unfortunate case, because he already made several errors, he wound up funding the CRT with cash (net proceeds from the improper sale) and not his appreciated land.  The only bright spot in this disaster is that cash to a CRT with a private foundation remainder interest generates a fair market value deduction available for use against 30% of Ed’s adjusted gross income (AGI).  If the CRT does not have a permissible charitable remainder beneficiary or an eligible successor charity, the CRT will not qualify as a §664 remainder trust.

 

Problem 4 – Ed wanted his children to draw a salary from the foundation and use the foundation accounts to subsidize his children’s expenses for college.

Reasonable and necessary compensation for legitimate service to a private foundation is allowed, but paying for their educational expenses is out.  The IRS has a number of regulations that create obstacles (quid pro quo, self-dealing, private inurement) for a taxpayer trying to use an exempt organization for personal purposes.  Because few donors have the interest or background to manage a private foundation, most commentators recommend a $5 million to $10 million funding threshold before considering the use of a private foundation over the more structured donor advised funds operated by a public charity.

 

Problem 5 – Ed’s advisor suggested that a CRAT (annuity trust) was the best tool.

A CRAT may have only one contribution, so liquidity is a serious problem inside an annuity trust.  If the land does not sell quickly, then expenses for maintenance, taxes, insurance, and the required income payouts are made with in-kind distributions.  Generally, a FLIP-CRUT, NIMCRUT/NICRUT, or an SCRUT with additional cash contributions would be a better choice for any hard to value asset like real estate.

 

So many traps, so little time – take extra care to avoid the common problems associated with accepting real estate and funding a CRT, and seek experienced planners for guidance.

Year	Total Estate Assets* ($)	Pension Assets in Estate ($)	Total Tax Attributed To Pension**	Total Transfer Taxes *** ($)
2002	4,298,873	2,116,030	1,478,666	2,003,259
2003	4,618,258	2,235,631	1,532,920	2,155,407
2004	4,959,333	2,358,408	1,582,281	2,095,725
2005	5,323,313	2,483,855	1,628,167	2,247,712
2006	5,711,647	2,611,877	1,695,109	2,201,003
2007	6,125,467	2,741,273	1,761,268	2,384,155
2008	6,566,085	2,871,123	1,844,696	2,607,429
2009	7,035,126	3,001,109	1,928,213	2,168,521
2010	7,533,713	3,129,281	1,095,248	1,095,248
2011	8,063,583	3,255,132	2,447,101	4,386,750

 

* Net of cash flow and pension withdrawals based on minimum required distributions.

** Total tax = Federal Estate Tax attributable to pension and income tax on inherited pension and state death tax attributable to pension

*** Tax schedule based on EGTRRA 2001 and combined income tax rates (state and federal) of 35%, the hypothetical case assumes both deaths occur in 2003 with a $1 million applicable exclusion amount for illustration purposes

Dr. and Mrs. George Olsen (both 70) have lived below their means for most of their lives and have accumulated a tidy nest egg.  As a dentist, most of George’s wealth is tied up in his $2 million IRA while his wife Angela has set aside the money she inherited in her own $2 million stock portfolio. 

 

George plans to continue part time in his dental practice and slowly phase out to make more use of his time in retirement.  When he sold his practice to a junior partner, he opted for a salary continuation plan and that will provide a steady, but finite source of retirement income.  With his salary, social security, the few stock dividends, and required distributions from his IRA, the Olsens will live comfortably.  George and Angela both have their IRA and stock portfolio assets invested with allocations that have averaged 10% over the last 25 years, and they expect their investments to continue to grow steadily.

 

While they have split their estates to take advantage of each spouse’s applicable exclusion amount, their estate planning has been haphazard at best.  Unfortunately, they have also incorrectly willed everything back to each other, effectively recombining their divided estates.  Based on their goals, they want to provide for financial security, but they do not want to enrich their children or provide any disincentive to work or succeed.  As such, they intend to leave each of their two children $1 million as their financial legacy, but the balance of their estate is destined for charitable causes important to the Olsen family. 

 

Their stockbroker has suggested a stretch IRA as a way to minimize taxes, but their accountant has recommended a different course of action if they really want to benefit philanthropic causes.  The accountant’s plan is to change their IRA beneficiary designations from their children instead to the charities.  By doing do, they will avoid the double taxation inherent in receiving “income in respect of a decedent” (IRD) and pass their income tax liability on to a tax-exempt charity.  By doing so, not only can the Olsens be tax efficient, but their children actually wind up with more tax-free assets too.

Q. – “I’ve just been given 10 minutes with the attorneys attending a “fundamentals of estate planning” state bar institute teleconference.  If you were me and had just two days to prepare, what would you want them to know about how I can help them meet their clients’ needs.”  – Planned Giving Officer

 

A. – Here’s my quick advice to the Planned Giving Officer

 

“1. Give away IRD Assets.

 

 2. Help clients ascertain their charitable interests through values-based questions (i.e., just because the client didn’t ask about a charitable gift in their estate plan doesn’t mean they’re not charitably inclined, they probably didn’t ask about a defective unfunded ILIT using Crummey gifts either, but you drafted them one).

 

 3. New legislation will continue to move the goal posts, especially with retirement assets, so you’re always willing to run sample illustrations or refer them to your stable of planning experts to help them solve client problems.”

The Olsen family plan evolved from a traditional plan (option 1) where children inherit assets after paying income and estate taxes.  Option 2 is the broker’s charitable plan.  He uses a stretch IRA, with named beneficiaries, passing the heirs the IRD assets but the charity receives its bequest by liquidating Angela’s stock portfolio.  The accountant’s more tax-efficient plan (option 3) calls for passing the heirs their same $2 million legacy.  Angela’s portfolio steps up in basis, and the charitable bequests come first from the IRD assets; as a result, no tax is due.

 

Navigating the Estate Planning Maze