“Give my stuff to charity! What kind of crazy estate plan is that?” is a typical client response. When they ask about ways to eliminate unnecessary estate taxes and are told to make gifts during lifetime that’s an understandable reaction. It’s not intuitively obvious how giving away something the client may need can be a good thing, especially if the potential donor was raised during the Depression. The epiphany comes when the client looks 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 a decision to pass some property to heirs and other things to charities that either had or will have some impact on their family’s life. How can they be smarter making that decision?
As it turns out, giving heirs 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 anything in excess of $700,000 is subject to a federal estate tax. A simple estate plan would be to 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? “income in respect of a decedent” (IRD) assets. Start with an IRA, a retirement plan account, a deferred annuity, and savings bonds; and don’t forget earned, but uncollected professional fees. This means a charity receiving $100,000 from that donated IRA collects the whole value without paying any tax. In the traditional estate plan, children might lose 75 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. The second plan is more tax efficient, as the charity receives more, the heirs get to keep more and the IRS gets zilch.
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.
“If you don’t watch out, you can set up a situation where a child never has the pleasure of bringing home a paycheck.”
— T. Boone Pickens, Jr.
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.
FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s more to estate and charitable planning than simply running calculations, but it does give you a chance to see how the calculations affect some of the design considerations. Which tools work best in which planning scenarios? Check with our office for solutions.
Why Allow the Government’s Default System to Work Against Your Family
Regain Control of Family and Business Assets
Preserve Personal Wealth and the Benefits of Community Influence
Pass More to Heirs and Charity/Community by Giving Away the IRS’s Money
A Note to Professional Gift/Estate Planners and Advisors
One of the most helpful tools in cultivating planned gifts is understanding the problems your client/donors face as they work to shelter assets accumulated over a lifetime of work. Until you can show client/donors how planned giving can be incorporated into their estate and financial plans, you will be an outsider looking in. When you can insert your organization into the planning process, you help donors realize how to become more efficient in conserving their social capital. Instead of asking for resources, as planned giving specialists you need to understand that the tools of financial and estate planning can be made to benefit both the donor’s family and your own nonprofit organization. Surveys indicate donors would be more supportive if they only realized how to give without creating hardship on their families or adversely affecting their lifestyle and security. Successful planned gifts can only be made after these issues are fully addressed by the planner. You must show them how their gifts can be made by simply rearranging their assets while addressing the problems of transition.
Would You Expend Your Assets This Way?
In the course of speaking to audiences across the United States, I often refer to farm families I work with in the Midwest. Farm families don’t have a lock on estate and continuity problems, but it’s useful to look at a basic estate planning opportunity for ideas. As a rule in central Illinois, it takes at least 800 acres of ground to support a family farm operation today. With productive farmland selling for $3,000 or more per acre, that quickly translates into $2.4 million just for the value of their “dirt”. But few farmers own just “dirt” today; they also have a tractor, a combine, a residence, a truck, a car, a little savings, maybe a small retirement plan, plus grain in their bins. Add it up, and these family farmers can easily have $3 million in their taxable estate. With estate taxes hitting $1 million on just this farmer’s assets, imagine how the heirs feel about writing that check to the IRS. If the family has done some transition planning, maybe they will have adequate liquidity to pay the taxes, but how many of those tax dollars came back to help their community? How much control does the family exert on how those tax dollars are actually spent? Finding ways to manage and control a family’s “social capital” is one of the responsibilities of an effective estate planning team and it separates real planners from those who try to solve problems in a traditional and one dimensional approach.
These concepts aren’t limited just to farm families. Instead, they apply to anyone who has managed to create personal wealth in a family business or an investment account. When I ask clients how they feel about sending a check off to the IRS and having $150,000 of their $1 million earmarked just to pay interest on the federal debt, a lot of clients say “if it was my money, I wouldn’t spend it that way”. It’s my contention that it is their money, and they should take control of it. Who better to recognize the needs in their local community? Is there a social program, a church or educational mission that should be supported? Would local influence and interest promote more solutions to community problems? If so, why not take the opportunity to redirect tax dollars back to the community and let the family have some influence on the direction those dollars should take?
These are powerful concepts, and in these changing economic times, there is significant value in voting your “social capital” and providing better stewardship of your family’s assets. For more information or a sample “zero estate tax plan”, contact our office for a courtesy evaluation.
Uses and Misuses of Life Insurance in a Planned Giving Program
The old adage, you should never look a gift horse in the mouth, may not hold true with gifts of life insurance because so few nonprofit organizations really understand it as a risk management tool and not as an investment. While nothing should be easier than making a beneficiary designation change to make sure an insurance settlement passes in whole or part to a charity, few donors make those simple choices. Why not? Their advisors dont suggest it as a planning option, donors dont realize that insurance proceeds can be split up among many beneficiaries and changing a revocable beneficiary designation generates no income tax deduction.
I have a client who wanted to name a large university foundation as the beneficiary of his insurance policy and he asked me to get the T.I.N. and proper name of the organization so I could finish off the beneficiary designation form. Simple, yes? No, the universitys planned giving officer proceeded to tell me that the university would only accept it if the policy named them as owner and irrevocable beneficiary of the contract. I tried to explain that the client only wanted to name the foundation as a beneficiary and wasn’t looking for a tax deduction, but she wouldn’t back off her need for all of the paperwork, so when I reported back to the client, he said, “forget it”. Why shouldnt a charity gratefully accept a donors offer to name it as either a primary or successor beneficiary? It could be the development office is more concerned with booking the gift rather than listening to what the donor wanted to accomplish. On the other hand, charities have been burned by over-aggressive agents touting insurance as a way to build an endowment if the charity will just let the insurance sales team solicit their best donors. The common result is that dollars the charity needs today are redirected into commissionable products with less immediate value that are often dumped on the charitys doorstep when the donor loses interest in this new endowment plan. As a result, many charities dont want to have anything to do with either insurance products or insurance producers and thats a shame because insurance and annuity beneficiary designations are perhaps the easiest deferred gifts to solicit since the products are so often found in donors hands.
The use of life insurance in charitable giving makes perfect sense for a number of donor situations.
1. Those supporters whom the charity has come to depend on for support and guidance, much like a key-employee in a commercial enterprise, may use an insurance contract to guarantee ongoing financial support for a specific project of importance to the donor. By leveraging small amounts of annual premiums, often a larger gift may develop over time. Is this a cost effective approach? Maybe, maybe not; what has to be determined is this contract being treated as an investment or is it the result of extra money being contributed over and above normal contributions by a donor who fully intends to continue making premium payments. If its treated as an investment then some basic assumptions have to be addressed, as theres nearly always a point beyond which a tax-exempt charity can more efficiently invest in their endowment fund the same premium dollars and generate a greater impact. The problem for many insurance agents is they forget that the wealth building tax advantages of an insurance wrapped investment wont apply to an already tax-exempt 501(c)3 charity. Does it make sense to buy a new policy solely for the use of a charity? Maybe, if theres a risk that the donors services and support would be lost to the charity before typical mortality or before a traditional investment account could build up enough value to sustain itself, but there is a crossover where the traditional investment account will eventually outperform the insurance contract.
$5,000 annual premium paid for 20 years into a VUL insurance policy ($150,000 death benefit for a 65 year old nonsmoker, earning 10% in sub-accounts) as compared to the same $5,000 annually invested into a mutual fund (10% returns) for 20 years. The VUL policy collapses before statistical mortality if the policy doesnt maintain at least a 10% gross return and if the premiums dont continue past 20 years. The cash values available to the charity from the policy if surrendered after 20 years in this hypothetical illustration would be $134,482 as compared to the traditional investment account value of $315,012. The crossover for investment efficiency occurs if the donor doesnt die prior to year 14, so each case must be evaluated on its individual merits. Obviously many different kinds of policies exist, but in the interests of simplicity the basic policy vs. investment comparison was made.
While its true that a life insurance death benefit passing to charity is like found money, few policies actually perform as illustration projections prepared years ago predict. Interest rates, crediting levels and mortality expenses change, and this variability isnt factored in when policies are transferred to charity. Wheres the problem? The guaranteed levels of performance are usually considerably less than wildly optimistic projections that many agents used back when interest rates were 10% to 14%. To that end, annual reviews of a charitys insurance portfolio should be conducted by an objective analyst to ensure the policies are performing as designed. If they deviate significantly, then decisions can be made in a timely manner to preserve the value by reducing death benefit or increasing the premium payments or, if the charity chooses to surrender the policy it should be done before the policy has a chance to implode.
2. Donors who have old policies once acquired for other reasons (e.g., mortgage or debt risks, education for children, survivor income security, veterans policies or those provided by employers) may no longer need the coverage and choose to transfer ownership to a nonprofit. If the donor transfers the ownership of the contract to a nonprofit organization, then besides removing the asset from the donors estate, it will often generate an income tax deduction if all of the rights of ownership are completely transferred. How is the deduction calculated? Generally, the donor receives a current income tax deduction equal to the lesser of cost basis or fair market value of the policy.
An often unrecognized problem for an asset potentially worth more than $5,000 is the valuation of the policy. Some would argue that the insurance carrier can easily assess and report its value on a form 712, but careful examination of an IRS form 8283 (required if the value is more than $500) would seem to prohibit the agent and insurance carrier, as parties to the transaction, from performing the valuation and thus there may be a real need for an outside appraiser to assign value.
Gift acceptance policies of the charity should address the following issues:
Will the organization make ongoing premium payments if the policy underperforms? Or will the original donor continue to make gifts of cash or better yet appreciated assets in order to meet ongoing premium liabilities?
Does the state recognize that the charity has an insurable interest in the life of the insured?
Should a cash value policy be surrendered or held, and what types of policies should be accepted.
How should the policy be booked for campaign purposes?
Is there a minimum quality threshold for the carriers financial ratings for size and financial strength?
Who evaluates the current and ongoing annual policy statements and projections showing guaranteed and projected performance values?
Define terms that confuse development officers, e.g., is the policy is truly paid up or has the premium simply vanished only to reappear later?
Understand that there are some tax traps if the policy has outstanding loans,
Should the charity viaticate its gifted policies? Will the donor object to an investor having access to his/her medical profiles and be upset with the occasional ghoulish aspects of selling the policy to an investor looking for a quick return on an investment.
How do charities track death claims?
3. Other charitable uses of life insurance offset the gift of assets by replacing the wealth so heirs arent unduly affected. These so called wealth replacement policies are very popular when working with large bequests and charitable remainder trusts or gift annuities. Why shouldnt the heirs just inherit those assets and skip the insurance policy hassle? It might be more tax efficient to have heirs receive an asset that always steps up in value at death, unlike receiving annuity payments or retirement plan proceeds which come with an accompanying income tax and artificially inflates the taxable estate of the deceased donor. If the life insurance is properly structured and held outside of the estate, then the proceeds pass to heirs without income, gift or estate tax liabilities. With the proposed loss of step-up in basis under EGTRRA 2001 when the estate tax is phased out insurance may be a preferred asset.
A classic use of life insurance would be to fund the needs for wealth replacement in a zero estate tax plan. This client-donor has a $5 million estate composed of an appreciated family business, investments and pension assets. By passing $2 million to a 7% CRT and concurrently creating an irrevocable life insurance trust (ILIT) to hold a policy designed to replace the contributed assets and place it in a GST exempt trust, the family has the capacity to eliminate gift and estate taxes. The premium payments are often economically funded with the cash flow from the charitable remainder trusts (or occasionally the charitable gift annuity) and the income freed by income tax deductions. The family is in an improved position by having inherited assets that step up in basis, more liquidity in trusts to provide security and a chance to support family charitable interests through private foundations, donor advised funds and public charities.
Caution is Needed
A number of problems can develop because so few financial advisors understand the nonprofit culture, and because few development officers completely understand how life insurance functions or is marketed or sold. Charities need to be careful; for example charitable reverse and split dollar concepts may jeopardize their organizations exempt status. Charitable split dollar ran afoul of self-dealing, fraud and step transaction rules because the charity was often used as a conduit to pass benefits to noncharitable beneficiaries all the while accepting tax deductible assets to pay the premiums. The problem from the charitys perspective was one of strings being attached to these gifts that required the exempt organization to direct those contributions to pay the premium. Clearly this was not a gift that allowed the charity the choice to invest prudently.
The IRS hammered this form of abuse with rules found in Notice 99-36. In Notice 2000-24, it provided compliance guidance on the new reporting requirements imposed by the Ticket to Work and Work Incentives Improvement Act of 1999 as it related to charitable split-dollar insurance arrangements. Congress used this law as signed on December 17, 1999 in HR 1180 to remove CSD as a planning option for charities and insurance producers. Ignoring these rules subjects the charity to excise taxes and possible loss of exempt organization status. Other potential abuses include financed insurance where the charity borrows the premium to insure a number of lives or invests its funds in a dead pool of a large number of policies with the expectation that someone will die annually and thus provide a return on its investment. The charity is pushing the ethical and legal envelope by using commissioned agents to sell a gift annuity. Recent action* by the SEC claiming jurisdiction over the sale ofa CGA may foretell the end of charities who cozy up to financial services professionals. Although the Philanthropy Protection Act of 1995 seemed to preclude offering a commission for a gift annuity, these aggressive practices have become more common.
How to approach the gift of an insurance policy? When interviewing clients or potential donors, find out what policies are in place and dont forget those group plans provided by an employer. Review the ownership and beneficiary designations and oftentimes clients discover ex-spouses or deceased beneficiaries are still listed, so its a great opportunity to suggest changes and introduce a charity into the equation. If theyll consider naming a charity for 5% of the death benefit, maybe 10% is an option. If theyll split the death benefit for 10%, maybe 25% or 50% is possible, and if theyll consider 50%, maybe theyll just transfer the ownership of the entire policy by absolutely assigning it and be done with the whole process. But you wont know unless you ask, and since few donors appreciate that they can actually split the beneficiary designations, they dont consider it.
Billions of dollars of life insurance are in force in this country, and frequently these policies are no longer needed for their original purpose. Charities ought to explore the use of insurance along with other gift options when they discuss philanthropy with their donors.
SECURITIES AND EXCHANGE COMMISSION v. ROBERT R. DILLIE and MID-AMERICA FOUNDATION, INC., Defendants, and MID-AMERICA FINANCIAL GROUP, INC., Relief Defendant (U.S.D.C., District of Arizona,PhoenixDivision, Civil Action No. CV-01-2493-PHX-JAT)
Vaughn W. Henry
CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not “do it yourself brain surgery”. When is a CRUT superior to a CRAT? Which type of CRT is best used with which assets? Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When to use a CLUT vs. CLAT and the traps in each lead trust. Which tools work best in which planning scenarios? Check with our office for solutions to this alphabet soup of planned giving tools.
Despite the clamor for pension reform resulting from the Enron debacle, many of the nations best companies still have plenty of their own stock in their profit-sharing and 401(k) retirement plans. While there are no taxes when assets are sold and reinvested inside these plans, lifetime withdrawals typically produce all ordinary income, taxed at the owners highest marginal tax rate. In addition, such assets can be hit at death with both the income tax and the estate tax, consuming up to 80% of their value as IRD assets (income in respect of a decedent). These IRD assets are more frequently found and many people dont recognize the tax traps associated with a lifetime of tax deferred savings.
Many people nearing retirement or after leaving an employer irrevocably roll these assets into an IRA, wait until the mandatory withdrawal age (April 1 after the year the owner turns 70 ½), and then begin withdrawals under the required minimum distribution rules. From an IRA, withdrawals are 100% taxable ordinary income. There is another, more tax-efficient way.
Under retirement plan distribution rules (3), if you meet certain requirements, you can convert the appreciation from ordinary income to long-term capital gain by taking an in-kind distribution of the employer securities inside your 40l(k) or profit-sharing plan There is no capital gain tax until you sell, but you report as ordinary income only the cost basis of the stock. This forces most people to sell stock to raise cash in order to pay the tax, but this sale would also trigger the 20% capital gain tax on the appreciation. What to do?
You can structure a win-win situation for you and for your favorite charity. The ordinary income tax to which you are subject when you receive an in-kind distribution can be offset by the charitable deduction generated by funding a CRT.
Example: $2.5 million market value with $300,000 cost basis. Income tax is due on $300,000 cost basis. Owner sells the stock triggering 20% capital gain tax on the appreciation. Total income tax and capital gain tax is $555,800.
Solution:Part Sale/Part Gift. Sell $500,000 worth of shares. Contribute $2 million worth of shares to a CRT.
SalePortion Ordinary income tax on $300,000 basis; 20% capital gain tax on gain from the sale of $500,000.
CRT Portion Charitable income tax deduction on remainder value of CRT. No immediate capital gain tax when CRT sells the shares. Lifetime income to owner/spouse; preferential tax treatment under the 4-tier system On death, CRT assets go to donors charity. (For age M65/F65, 5% CRT, 5.4% discount rate, deduction is $705,540 to be claimed up to IRS contribution ceilings)
Who is Eligible?
Employee must have been a participant for five years, and attained age 59 1/2; or have terminated service with the employer; or be significantly disabled (2)
Summary of Advantages of an In-kind (3) Distribution via CRT Planning
Ordinary income from pension distributions can be converted to long-term capital gains.
Avoids double taxation as IRD asset at death.
Avoids the confusing minimum distribution requirements.
Property can be transferred without triggering income tax on amount exceeding cost basis.
Lifetime income to donor and spouse.
Charitable deduction for CRT offsets income tax from in-kind distribution.
Donors favorite charity receives substantial gift on death of CRT beneficiaries.
(1)DC Plan Investing,InstituteofManagementand Administration,New York
CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct Please note — there’s much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not “do it yourself brain surgery”. When is a CRUT superior to a CRAT? Which type of CRT is best used with which assets? Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When to use a CLUT vs. CLAT and the traps in each lead trust. Which tools work best in which planning scenarios? Check with our office for solutions to this alphabet soup of planned giving tools.
Real Estate Income Property Converted for Retirement
Sarah Sullivan, a widow age 72, has a modest estate with some cash savings and an apartment complex that has become increasingly burdensome to manage. As a former high school biology teacher, she is comfortable with her pension, but she would like to travel with her grandchildren while her health remains good. The rental property generates a decent source of income, but the responsibilities of day to day management keep her tied closely to the units. As the property ages, recurring repairs and dealing with renters has taken most of the enjoyment out of the property since her husband passed away some 5 years earlier. She would like to move to Florida to spend more time with her adult daughter and grandchildren. However, she is unwilling to sell the apartments and pay 30% of her proceeds as a capital gains tax. Besides the income tax issue, she was especially incensed to learn that she would also have the remaining balance taxed again at death when she passes that value on to her family. With a tentative offer of $680,000 for her property, she views this as an opportunity to sell and retire more comfortably. Her attorney suggested a charitable remainder uni-trust (CRUT) as a possible planning tool to minimize tax liabilities and retain some control over 100% of the family capital. The attorney requested that our firm to run a sample scenario*, and compare what would happen if (a) she kept the apartment complex and continued to operate it, or (b) sold it and paid the tax, reinvesting the balance, or (c) gifted it to an IRC § 664 Trust. The following presentation was reviewed and accepted by Mrs. Sullivan, her family and advisors. The major attraction was that the CRT would revert to a family type foundation after Mrs. Sullivan passed away. In this way, the family keeps a presence in the community and commits annual funds to the school district’s high school science program.
Less: Cost of Sale (legal fees, commissions, appraiser)
Adjusted Sales Price
Less: Tax Basis
Equals: Gain on Sale
Less: Capital Gains Tax (federal and state combined)
Net Amount at Work
Annual Net Return From Asset Valued at $680,000 @ 5%
Annual Return From Asset Reinvested in Balanced Acct @ 9%
Avg. Annual Return From Asset in 7% CRUT Reinvested @ 9%
After-Tax (31%) Avg. Spendable Income
Statistical Number of Years of Cash Flow for Income Beneficiary
Taxes Saved from $330,664 Deduction at 31% Marginal Rate
Tax Savings and Cash Flow over One Life Expectancy
Total Increase in Net Cash Flow Compared to Original Asset
* Hypothetical evaluations are provided as a professional courtesy to members of the estate planning community. Call for suggestions.
Normally, a wealth replacement trust would be established to offset the loss of value in the charitable gift. As once the asset is irrevocably transferred to the CRT it is unavailable to the heirs, and many families opt for insurance protection to replace the value of the gift. However, she and her husband had already purchased a $500,000 “second to die” insurance policy to provide liquidity for estate taxes, so this policy was simply converted to a different use and shifted out of her estate via gifts to her family while the early policy value was low. Now, since there won’t be estate taxes to pay; the existing policy will be used instead to offset much of the value lost in the gift.
Highly appreciated real estate transferred to a CRT is a classic use of a §664 Trust, and one of the nation’s largest trust administrators reports that 28% of CRTs were created with real estate as the contributed asset. However, there are potential land mines that need to be discovered and neutralized before plunging into the transaction. For what problems should the planner watch?
1. In the design of the trust, generally, stay away from standard CRUT or CRAT instruments because they lack the flexibility to deal with liquidity shortfall problems if the land doesn’t sell immediately. As a rule, it’s usually better to use the NIMCRUT or FLIP-CRUT. These specialized charitable remainder trusts offer more options to avoid distributing parcels of land back to the income beneficiary when income is not adequate to meet required payouts.
2. Is the property debt free? If not, there may be a problem contributing the mortgage holder’s assigned interest to an irrevocable trust. The trust can’t be placed in a position of paying off the note, so any property contributed to a CRT should either have the debt paid off or the mortgage transferred to another parcel that is not contributed to the CRT. Specifically, a debt-encumbered asset may generate four distinct sets of problems that need to be addressed.
Unrelated Business Income – if a CRT earns unrelated business income for the year in which it’s made, the CRT is non-qualified and subject to tax. This is a disaster if the original contribution year generated UBTI, as not only is the charitable deduction lost, the capital gains liability is accelerated. This potential malpractice error effectively negates the advantage of creating the CRT in the first place. So how does mortgaged property create UBTI? Through Unrelated Debt Financed Income (UDFI) or “acquisition indebtedness” which may occur if the mortgage has materially changed in the previous five years or if the donor has owned the property for less than five years.
Self-dealing – the contribution of mortgaged property by a disqualified person raises some troubling issues, especially if partial interests are involved.
Bargain Sales – require the recognition of a pro-rata capital gains tax liability.
Grantor Trust – any trust that is non-qualified, and if there is any other owner of the asset, the CRT would be non-qualified and a tax paying entity. A number of attorneys have tried to address this concern by stipulating debt payment be made from principal or from assets outside the trust, but these suggestions create management problems for most donors and raise the issue of self-dealing.
The basic solutions include:
the retirement of existing debts
transferring debt to other non-contributed parcels as collateral
sell enough land in a taxable sale to finance the debt payment and offset those added tax liabilities with deductions from the donation of debt-free real estate assets
contribute a fractional interest in the indebted property to the charitable remainderman, if the property is eventually going to pass to the charity anyway. Some planners have advocated the contribution of an option to circumvent the debt-financed rules, but the IRS effectively shut this strategy down by ruling that no contribution exists when options are used.
3. Are there environmental problems, title defects or liens, on-going lease agreements (especially with prohibited persons)? Find out how the property is legally owned and whether or not it may be contributed to a CRT. Make sure there’s no prior commitment to sell, or you run afoul of the step-transaction rules.
4. Does the IRS consider the donor a “dealer”? If so, the appreciation is not treated as a preferred capital gain, but as ordinary income on inventory; the deduction is then based on basis, not fair market value. To protect the donor’s beneficial tax treatment, there are four tests under §1237 that may be worth pursuing:
this parcel wasn’t held by the taxpayer as inventory for sale to customers in the ordinary course of business
the taxpayer held no other property for sale in the ordinary course of business
no substantial improvements to enhance the parcel’s value were made
the parcel was inherited or held for five or more years. If all four tests are met, dealer status may be avoided.
5. If the CRT’s trustee then chooses to develop and sell lots in the property, will the CRT then generate unrelated business income and be treated as a dealer and exposed to UBTI? Maybe. Seldom appreciated by most planners, a charity can have unrelated business income and just pay tax on that portion of the resulting income that is not substantially related to the charitable purpose of the charity. On the other hand, if a CRT has unrelated business income, it loses its tax-exempt status for an entire year and becomes a tax-paying trust, and that creates severe, even catastrophic, burdens.
Other articles on poorly designed trusts using land and the well designed planned gifts are available at Zero Estate Tax Planning, as well as the case studies for Berger, Moore, Williams and Sullivan. Ongoing CRT and Planned Giving Workshops available for nonprofit organizations, boards, planned giving and estate planning councils and for-profit financial services firms. Need an evaluation of potential assets going into a CRT? We provide courtesy preliminary analyses for the professional estate and gift planning community. Call for a hypothetical fact finder
Socially Responsible Planning – A Compensation Bonus and the CRT
Dan (30) and Pamela (26) Newberg work for a hi-technology software developer on the West Coast. As a part of their compensation, they have been provided low-basis stock as a bonus for their extraordinary development skills. After an initial public offering, the $80,000 basis stock is now worth $1,000,000. The stock produces no income, but has historically appreciated annually at 10%. This young couple has expressed an interest in using an IRC§664 net income with make-up charitable remainder unitrust (NIMCRUT) as a retirement planning tool to diversify their investment portfolio and reduce volatility. As IPOs tend to be erratic, they want to capitalize on the current high market value. The Newbergs have other assets and want to consider two scenarios to provide a supplemental pension plan designed to pay them $800,000 of after-tax annual income starting at age 65. For ease of investment comparisons and consistency, a well-structured tax deferred variable annuity earning a moderate 9% was selected to fund the CRT and a comparably invested after-tax mutual fund the other scenario. The unique ability to control the distributable net income (DNI) inside the NIMCRUT is a major advantage. The Newbergs are active in conservation and wilderness preservation groups and want to support environmental and educational programs. By controlling their social capital, they create a sense of economic citizenship benefiting causes they feel are inadequately supported by the federal government. Under the recently enacted 1997 Taxpayer Relief Act (July 28, 1997), this scenario will no longer work as originally planned. Consult your tax advisors and see the chart of Unitrust Remainder Calculations to review the opportunities.
Annual adjusted gross income
$125,000, which meets their current lifestyle needs
Income tax bracket
Capital gains bracket
9% D.A. inside CRT and 9% mutual fund for non-charitable options
The charitable scenario provides for comparable net income of $18.4 million for retirement over the Newberg’s joint life expectancies, and simultaneously produces $61.2 million to support the charities that mean so much to this childless couple.
Family Wealth and Responsibility – New Tools for Old Problems
Family Wealth and Responsibility – New Tools for Old Problems
Dr. Gerald (64) and Suzanne (62) Berger have a diversified estate with the basic estate planning provisions already in place. Like most professionals, Dr. Berger has the bulk of his estate tied up in a qualified retirement plan (QRP) which is valued in excess of $5 million. Besides owning some commercial real estate, farm ground and an appreciating stock portfolio, the Bergers also own vacation homes in two other states. With three children, the Bergers have had a lifetime commitment to their church and many charitable organizations and wanted to review their estate planning options. Their credit shelter trusts in place, and the remaining assets held in joint tenancy, it appeared that the Berger estate and income tax liabilities at death would take almost 70% of their accumulated wealth. Dissatisfied with that scenario, they asked their professional advisors to present a plan that would eliminate unnecessary taxes, assure them of retirement income security, pass their children an inheritance of $1million each and the remainder to the many charities they have supported.
The Berger’s estate assets were evaluated and those suitable for compression and distribution to family members were placed into a Family Limited Partnership (FLP). This allowed the heirs to receive “paper value” and ownership of some of the business interests and future appreciation was removed from the Berger estate. The FLP still allows Dr. Berger, through his revocable living trust, to maintain control and management as long as he retains ownership of the general partnership units, and the children and grandchildren will eventually own 99% of the limited partnership units. The farm and commercial real estate properties were examined and the advisors found that after management fees, expenses and maintenance, those properties were generating a net return of less than 2%. While the property managers noted that the real estate assets might appreciate in value, they admitted that for clients seeking less complexity in their retirement, those real properties were no longer suitable. Since the Bergers had depreciated much of the property and had low basis in their farmland, any outright sale would generate a capital gains tax at the 20% federal and 3% state rates. A more viable option was to use the §664 Charitable Remainder Trust (CRT) to control 100% of the principal. After Berger’s estate planning team suggested bypassing the capital gains tax “hit” with the CRT, a serious effort was made to see how else this split-interest trust could be made to work inside the estate plan. One of the most powerful solutions was to make use of the qualified retirement account to provide wealth replacement, retirement security and further charitable support to family philanthropies. At the Berger’s ages, it was easy to acquire an economical survivor life insurance contract and with some pension plan modification have their profit sharing plan pay for the insurance with pre-tax dollars. Later, the plan would distribute the policy to the Family Limited Partnership as a “paid-up” contract and distribute additional partnership units to children and grandchildren via annual exclusion gifts. The advisors also changed the beneficiary designations on Dr. Berger’s pension plan to name his wife as primary beneficiary and his CRT as contingent beneficiary. This strategy allows Mrs. Berger to disclaim her interest in the pension so the qualified funds would instead flow to the CRT, of which she is still an income beneficiary. In this way, Mrs. Berger will still have a option of keeping the taxable qualified funds or, if she has other adequate assets, she can allow the CRT to control those funds. The end result is that her retirement income is secure and the non-taxed CRT would pass qualified funds at her death to the newly created family foundation. The family would pay no income tax, no estate tax, the family foundation would be funded with pre-tax dollars and the CRT’s remainder interest.
To make sure each child receives their $1 million inheritance and further protect family assets from any of the heirs’ mismanagement, the Berger’s attorney drafted a new Irrevocable Life Insurance Trust (ILIT) to make use of the Berger’s remaining Unified Credit and Generation Skipping Tax Exemptions. Properly structured, the ILIT protects all of the insurance policy proceeds from estate taxes for the duration of the trust. In addition to creating a “dynasty trust” and basing it in South Dakota, the perpetual nature of the trust will control and protect family assets from taxation, litigation, divorce and spendthrifts while still providing the heirs with an opportunity to distribute and spend family wealth for many generations. Besides controlling this tax leveraged asset, there will be an additional $12 million in “social capital” controlled inside the Berger family’s charitable trust. The alternative was to pass $7 million to the IRS and leave the heirs with less, a clearly unacceptable result for a family so interested in maintaining control of their family wealth.
Henry & Associates designed the Berger scenario* and compared the options. Option (A) sell marginally productive income properties and pay the capital gains tax on the appreciation and reinvest the balance at 10% or Option (B) gifting the property to an IRC §664 Trust and reinvesting all of the sale proceeds in a 10% balanced portfolio. At the maturation of the CRT, when the surviving spouse (most likely Mrs. Berger) passes away, the capital inside the trust will pass to a family foundation with Berger heirs sitting on the board funding charitable programs of interest to their family.
“Planned giving is not an option for young accumulators.” Have you heard that? Don’t believe that all young people are mostly concerned with acquiring the newest and latest gadgets to the exclusion of something they strongly believe in and are willing to financially support. Case in point, Jennifer (30) and Jason (30) Williams are a proactive couple with a new child. Married less than 5 years, both are professionally employed with well-paying jobs providing competitive benefits packages. Besides their home and vehicles, they have already topped out in their retirement plan contributions and own a small parcel of investment property for which they paid just $7,500 a few years ago. Now they find that their suburban community is encroaching on their undeveloped land, and the fair market value has risen accordingly. Even with the reduction in federal capital gains rates, they are unwilling to sell the land and lose control of a significant part of the sale proceeds. These losses include federal, state and city income taxes, and so they researched the use of an IRC §664 Trust to shelter the capital gains inherent in the sale of their property. Already supporting their local church, Jennifer feels like they are charitably inclined, although they both profess to be averse to unnecessary taxes and are concerned about future income security.
Jennifer was initially supportive of assets eventually going to their church, but was reluctant to contribute 100% of their real estate to an irrevocable trust, citing college funding concerns for their daughter, Jamie. Jason, on the other hand, argued that the tax savings would offset costs, and they could afford additional savings for future college expenses. Their financial advisor suggested a CRUT be set up as a “spigot trust” or NIMCRUT allowing them some latitude in distributing income when they need it for college and retirement expenses down the road. It was also suggested to compromise and only contribute 6 of the 71/2 acres to the CRT, retaining a portion outside the trust to be sold in a recombined unit to the new buyer. In this way, the Williams get their “seed money” back to reinvest in other property, and the tax deduction generated by the contribution of the remaining acreage to their CRT would offset this taxable sale.
Partial Sale – Partial CRT Gift of Real Estate
Sell 100% of Land Outright
Sell Land 20% Taxably and CRT 80%
$25,000 outside CRT, $100,000 inside
Net sale after taxes and expenses
Spendable income stream from 10% fund (earning 3% OI/7% CG – paid out at 5% annually) in after-tax investments over Jennifer’s life expectancy
Tax savings from $14,407 deduction in a one-life $100,000 NIMCRUT in 31% marginal bracket
Spendable income from $100k CRT deferred until 60 years of age at 10% earnings over Jennifer’s life
Amount left to family charity from CRT
Estate left to heirs after taxes from just this asset
The only stumbling block to this scenario was the recently enacted TRA 1997 – Section 1089 which now mandates a 10% remainder interest inside a CRT. Prior to July 28, 1997, a 5% CRUT for Jennifer and Jason’s joint lives would have been easily done. Now, they are prevented from using such planning tools because of their age and the inability to take a low enough income payout to qualify their charitable trust under the new law. Although they could have opted for a qualifying term of years trust, the maximum allowed is only 20 years and that did not meet their needs for an income stream as they approached retirement. What eventually worked was a one-life NIMCRUT based on just Jennifer’s life expectancy. The rationale was that as the slightly younger and female spouse, she would probably outlive Jason and the income stream would be effectively available for both their lives. To protect Jason’s future income interest in his wife’s trust, which would terminate with her premature death, he chose to insure her life to at least make sure that he wouldn’t give up all potential income from the jointly contributed property. Since they needed insurance on Jennifer’s life anyway to address survivor income for their child, they felt like this compromise solved the problems as well as could be expected under the new law and still provided for their security In the final analysis, they were able to increase spendable income, reduce unnecessary taxes and pass more total assets to heirs in ways that met their financial planning needs for both security and control. Have a similar case? Call us.
End of the Year Estate Planning – Vaughn Henry & Associates
End of Year Planning Options
Vaughn W. Henry
Even with the stock market’s hiccups, many people have seen their investment portfolios, land values and business interests steadily increase in value. Why is this a problem? More and more of the middle class are coming under the scrutiny of the IRS estate tax auditors, and families may be forced to pay taxes at rates in excess of 80% because of poor planning.
Inflation is a subtle process. Don’t think so? Well, remember your first house? Did it cost less than your last car? For most of you, it did, and this is one cause of the problem. So what are some of the available solutions? Besides sophisticated tax planning, there are some simple tools to squeeze, freeze and pass an estate to heirs, if you move forward now. Why now? The problems generally get worse by waiting and options more limited, so almost everyone with an estate, and for sure those in excess of $900,000 should look at potential tools and be familiar enough with them to react if the estate gets near the $1 million federal threshhold. Also, there is a planning window that may close if a fickle Congress feels that too much revenue is slipping through the cracks. So complete your plan while the rules are favorable.
Gifts to Charities
A simple planning process is to just sweep everything in excess of the estate tax exclusions to charity. If done properly, you can even give charities your income tax problems at death by naming them to receive retirement plan proceeds, since your heirs would have a significant income tax if they received them instead. Highly appreciated assets are often given to charities as a way to be more tax efficient since the capital gains are never realized and the charities can convert the gift to cash without paying tax. If a donor sells the asset and gives the cash, then there is an unnecessary tax paid to be charitable. Transfer old insurance policies directly to charity if there’s no estate liquidity needs. Charitable remainder and lead trusts, gift annuities and life estates are legal and ethical tools to meet financial security needs and benefit charity while still providing estate tax relief. With tax efficient wealth replacement vehicles, the family will not be short-changed if giving away wealth is a concern. Some of these tools require expert guidance, and few advisors understand them well, so it makes sense to use a team approach to solve planning problems.
Gifts to Heirs
Your estate can limit growth by making gifts to heirs now. Gifts to heirs are still limited to $11,000 per donor per recipient, and married couples can agree to join to make a tax-free gift of $22,000 of value. Where a lot of family members go off the approved IRS track is that they believe there is an exception to this rule when providing gifts at Christmas, Hanukkah, weddings, graduations and birthdays. There isn’t. Also, if you write a check to your child for college tuition and expenses, you may have given your child a taxable gift. For most families, expensive gifts are not likely to produce estate and gift tax problems because they are counted against what used to be called the “Unified Credit”, now called the Applicable Exclusion Amount. From 1987 – 1997 the value was limited to $600,000 and the amount free of tax crept up to a heady $1,000,000 in 2002. So it is unlikely that many American families will be exposed to the estate tax since they won’t transfer more than that total amount of exempt wealth either while alive as outright gifts or at death as an inheritance. However, middle class families with increasing portfolio values in family businesses, farms, expected inheritances and large insurance or retirement plans will more frequently slide into a tax trap once reserved for the ultra wealthy. If they only know what most families of wealth knew, namely that estate taxes are paid only if you fail to plan. The estate and gift tax is a straight-forward tax that is easy to avoid if you start early and make good choices about your planning options.
As the end of the year rolls closer, take a look and see if this introductory checklist of estate planning actions makes sense, and set up a time to review them with your professional advisors:
Review your current will and trusts. With recent tax law changes, almost all tax planning wills and trusts are now out of date. If estate tax planning isn’t a factor, make sure your trustee and successor trustee designations are accurate.
Is your Durable Power of Attorney current? Is there an updated living will on file with family members and health care providers? Have funeral arrangements and decisions on anatomical gifts been discussed with family?
Inventory and make a written record of contents of any safe deposit box with a trusted family member, remove will and codicils, trust instruments, insurance policies on your life, burial instructions, cemetery plot deeds and any property which does not belong to you. File them elsewhere.
Review and update your life insurance policy and retirement plan beneficiary and contingent (back-up) designations and settlement provisions. If you have a taxable estate, have you considered shifting ownership of your life insurance to a trust or to your heirs?
Have you gone down to your bank and named designated heirs to receive account proceeds at your death? Generally, naming them as “joint owners” is too risky and it doesn’t solve tax problems; instead, consider using a “Payable on Death” (POD) designation to redirect the account without unnecessary probate problems. This still doesn’t solve tax problems, but at least it’s uncomplicated and a functional way to see that the account isn’t tied up needlessly.
Review, and if necessary, revise existing business buy-sell agreements; prepare agreements if there are none; re-value purchase price under those agreements that require periodic review. Buy-sell agreements are critical to preserve the value of a family business and provide liquidity at a time when family members are often too distracted to make sound business judgments. Do you have the necessary liquidity, and if not, are you insurable?
Should annual exclusion gifts be made to your heirs? Remember, gifts of appreciated assets pass at your tax basis, so there may be an income tax due if the asset is eventually sold by your heirs. However, the $11,000 annual exclusion gifts are one of the few meaningful tools to reduce the value of an appreciating estate and it’s a shame so few families use it correctly. If you write checks to heirs, make sure they’re issued far enough ahead of time so they will be cashed before the end of the year.
If there are family medical or educational expenses to be paid, make any checks payable directly to the institution, not to the individual. This action allows you to also make their $11,000 gifts without creating an unnecessary tax.
Not all year end tax planning is estate oriented, sometimes there are good reasons to act and save on income taxes too.
Maximize your IRA, or if you have a pension then defer additional salary as many employers make a matching contribution to their plans; those extra deferrals may also increase your employer’s contribution.
Make charitable contributions before December 31. Remember, the deduction is usually recognized on the date the charity receives the gift, not the date on the check.
Defer income, if you have the option of recognizing it next year.
Prepay deductible expenses, make an added mortgage payment or prepay your property tax. Bunch up your medical expenses (maybe it makes sense to get elective procedures, eyeglasses or dental work done now) to itemize every other year. Consider taking the standard exemption one year and then push two year’s charitable and any medical deductions into the alternate year.
Offset your capital gains with losses, as volatile as the market is many portfolios will have both. You may be able to offset other passive income up to $3,000 and those gains will be tax-free when you match up losses as the portfolio is rebalanced.
Tax planning is a complex process, and you should seek qualified advice to make the best choices about the control of your estate. Craft a plan, review it annually and exercise your own options. For more information, check our Internet web-sites for free articles and software, starting at –gift-estate.com