Category: Case Studies and Articles

Take Charge – Avoid Planning Pitfalls – Vaughn Henry & Associates

Take Charge – Avoid Planning Pitfalls

Vaughn W. Henry © 1999

“Over and over again, the courts have said there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich and poor, and all do right for nobody owes any duty to pay more tax than the law demands. Taxes are enforced exactions, not voluntary contributions.” — Judge Learned Hand, 1934

f you adopt this philosophy-and most reasonable people do, consider this. With income tax, you get a chance every year to make sure you’re arranging your affairs the way you want them. But you only get one chance with estate taxes-and that chance is your estate plan.

veryone should have a plan that conserves and distributes assets, provides income for survivors, and prevents unnecessary payment of excessive tax or transfer costs. A carefully crafted estate plan even offers you an opportunity to pass down something along with your property; that is, your system of values.

ot only should you have this kind of plan-you can. This isn’t just an abstract, unachievable goal; it’s a real possibility. But it doesn’t always happen that way. When we examine why, we find the reasons fall into two general categories. Both professional advisors and their clients bear some of the responsibility when estate plans fail to achieve their ideal objectives.

What? Me? A Client?

he alarming fact is many clients don’t even realize they need estate-planning help. They fail to recognize that their assets have appreciated to the point where estate taxes are a concern. They don’t realize that the combined value of appreciated real estate, a retirement plan, insurance proceeds, ownership interest in a family business, and other assets pushes their net worth beyond the limits of the current $650,000 estate tax exemption-if they even realize such an exemption exists. So they never become clients-or become clients too late in the game to take advantage of all available options.

“Estate taxes are the government’s way of making up for all the cheating you did on income taxes.”— Will Rogers

onsider the classic example of the midwestern farmer. Over the years he has heeded his advisors’ advice. He has deferred income-and consequently, income tax–by not selling product, prepaying for supplies, trading in equipment and upgrading without selling. He has lived poor-but he’s going to die rich. And as his assets balloon in value, so does the potential for estate tax liabilities. Still other clients recognize they have estate tax liabilities-but allow a “paralysis by analysis” mentality to set in, which prevents them from making the decisions they need to make to set a plan in motion. Even the best plan is bound to fail without if no one follows it through.

Advice for Advisors

rofessional advisors have an obligation to educate clients-to offer them estate-planning options they may not know are available to them. But too often, these advisors make invalid assumptions. Some-like an attorney I met recently who advises farmers in an area where farm land routinely sells for $3,000 to $4,000 an acre–assume their clients aren’t wealthy enough to have estate tax liabilities. Guess again.

ome advisors even assume their clients don’t mind paying estate taxes so long as heirs receive significant assets and all taxes and fees are paid.

ome take a reactive rather than a proactive position with their clients. Adopting the attitude that “the customer is always right,” they give their clients precisely what they ask for. The result is that clients are limited in their options by their own knowledge.

nd some are simply ill equipped to advise their clients effectively. As general practitioners, they haven’t the time or inclination to keep up with subtle changes in estate tax law. They lack the technical expertise to craft anything but a “cookie cutter” plan.

Now for the good news.

here are several tools available to minimize or even eliminate estate and gift taxes entirely. You won’t learn about them in any government pamphlet. But qualified advisors can show you how to legally and ethically disinherit the IRS, while addressing common concerns like providing for disabled dependents, managing assets for minor children, and charitable giving.

ncreasingly popular are plans that decide in advance, what percentage of the estate will pass to children, charity, and the government. Anyone with appreciated assets might be well advised to look into a §664 Charitable Remainder Trust (CRT) plan. The Charitable Remainder Trust offers many advantages, including life-time income security, reduced income and estate taxes, plus the opportunity to direct family wealth according to their own values.

haritable Remainder Trust planning is a highly specialized field that encompasses both estate and wealth preservation planning. These trusts are complex in design-certainly not a do-it-yourself project. And they’re not the best strategy for everyone.

n fact, there’s no such thing as a one-size-fits-all estate plan. The most successful plans are drafted by a team of qualified advisors-a team that takes the “big picture” into consideration and offers you a range of flexible strategies. With forethought and early planning, your estate plan can help you achieve your financial, familial and philanthropic objectives.

For more articles and case studies, go to http://gift-estate.com

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A Wash CRT

A “Wash CRT”

Some donors want to maximize their donations so there can be a nearly equal charitable tax deduction to offset the capital gains in a taxable sale. The following is an example of the math needed to create such a Charitable Remainder Trust(CRT).

For math wizards who will check the algebra and need some confirmation, a $617,491.40 contribution to a two life 5% CRUT generates a 36.532% deduction of $225,581.96. At the donor’s 39% tax bracket, that saves the donor $87,976.96 in tax payments. With a 23% capital gains tax rate, a $382,508.60 taxable sale requires $87,976.98 to offset that tax liability. The difference between the two numbers is due to rounding errors, but it provides a framework in the design process.

Successful Transitions in Family Corporations

Keith Roth (74) has a closely-held corporation which has been involved in processing snack foods and distributing soft drinks for the last 42 years. Now he’s trying to figure out how to retire and leave his two sons, Jerry (41) and Robert (46) in positions of ownership. Like most family owned businesses, Keith has reinvested most of the income his growing business has generated in capital improvements and development. Unfortunately, he didn’t start any sort of a retirement plan until just a few years ago and counted on the business to continue producing income. Now that he has two heirs in line to take over the business, he wants to travel and enjoy the fruits of his labors with his wife of 45 years while they’re both healthy. Like many start-up corporations, he deferred taking salary until the corporation became profitable. Once the business got off the ground, Keith took significant salary and bonuses, but the IRS soon came along and threatened penalties for excessive compensation. Naturally, the IRS wanted those dollars distributed out as taxable dividends instead of compensation, so Keith deferred additional salary and reinvested back in his business. A few years later, the IRS came back and wanted to know about retained earnings and tried to assess penalties for not distributing the doubly taxed dividends again. Because of planned plant expansion, Keith was able to avoid the 50% penalty, but the family corporation is cash heavy now that major building plans are completed. With two of his sons in the business, Keith already transferred additional shares to them to reward the boys for their “sweat equity” in building the profitable business. But, how to pass majority ownership to the boys without incurring tax? In the process of meeting with the family’s financial advisors, it was suggested that an IRC §664 Trust might offer the family a tool to accomplish their estate planning and business continuity goals. The advantages of using this technique were:

• Jerry and Robert were able to gain control of the family corporation as their minority ownership changed to a majority interest, while the nonparticipating heirs were assured of equitable treatment and value by their parents
• excess accumulations inside the corporation were swept out by the redemption of Keith’s stock from his CRT, thus avoiding tax and penalties
• Keith and his wife were able to fund their retirement in ways that eliminated the capital gains liability on his stock and reinvest 100% of their capital to produce more income
• “social capital” dollars that otherwise would have gone to the IRS to pay unnecessary taxes were re-directed back to nonprofit causes of special interest to the Roth family, but only after Keith and his wife passed away

Corporate Stock Redemption	Without CRT (A)	With 7% CRT (B)
Sale Proceeds	$6,000,000	$6,000,000
Basis in Stock	$10,000	—
Taxable Amount	$5,990,000	—
Capital Gains Taxes @ 25%	$1,497,500	—
Tax Deduction Available	—	$2,335,458
Amount Reinvested	$4,492,500	$6,000,000
Income with 7% Yield	$314,475	$420,000
After-Tax Income (42% rate)	$182,395	$243,600

Henry & Associates designed the Roth scenario* and compared the options. Option (A) sell stock and pay the capital gains tax on the appreciation and reinvest the balance at 7% or Option (B) gifting the property to an IRC §664 Trust and reinvesting all of the sale proceeds in a 7% diversified income portfolio.

Hypothetical evaluations are provided as a professional courtesy to members of the estate planning community. Call for suggestions or schedules on upcoming workshops for professional advisors, nonprofit development officers and charitable boards..

Henry & Associates

Gift & Estate Planning Services © 1998

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

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Planned Gifts Don’t Have to be Deferred – Vaughn W. Henry & Associates

Planned Doesn’t Always Mean Deferred

One of the biggest stumbling blocks planned giving officers have with their supervisors and other development staff is the long-term nature of a “planned gift”.  By definition, a planned gift is often tied to a donor’s estate or financial plan and implies a long wait.  As a result, many nonprofit organizations don’t solicit for charitable trusts and bequests because of design complexity and the length of time needed before the deferred gift “matures”.  For fundraisers used to working one on one with a donor’s annual gifts in support of charitable programs, most remain wary about jumping into a complex and hard to understand planned giving effort.  Besides needing to understand business succession, income and estate tax concepts, a more sophisticated gift forces planned giving officers to deal with the donor and all of the for-profit advisors who have to sign off on their client’s convoluted plan.

Not All Planned Gifts are Deferred,

Some Provide Current Support to Charities

Johnson Plan 72/72 – 8% AFR	All Deferred Traditional CRAT	Partial Immediate Gift – Deferred Gift CRAT w/Balance
Establish CRT With …	$500,000	$400,000
Percent Initial Annual Payout	5%	6.25%
Annual Distribution (fixed payment)	$25,000	$25,000
CRT Income Tax Deduction	$288,360	$188,360
Outright Tax Deductible Gift Now	–	$100,000

To counter the impression that a planned gift only helps a charity at the end of a long wait, look at the case study of George and Ruby Johnson.  It is illustrative of the flexibility in a well-designed gift, as it helps both the donor and the nonprofit organization.  George has accumulated some stock and real estate in his portfolio and uses the dividends from $500,000 worth of stock in his electronics company to pay the $25,000 annual fees for his vacation home.  However, since his son has taken over the reins of the business, the dividends from his stock have been reduced as revenue has been reinvested in upgrading the company’s technology.  Seeking a reliable source of funding for his golfing excursions, George approached the planned giving officer at his alma mater about “one of those CRT things” they had previously discussed.  George proposed a simple 5% CRAT funded with his stock that would generate the cash flow needed, but the planned giving officer offered a different plan.  While the traditional 5% CRAT was prized, it wasn’t as appealing to the college’s foundation, already in the middle of a large capital campaign, as a current gift.  The experienced development officer knew that George just needed something that generated $25,000 a year, so he suggested the plan be modified to pay 6.25% from a $400,000 CRAT.  That produced a $25,000 annual distribution and the remaining $100,000 could then be used to fund an immediate capital campaign gift.  The $288,360 charitable income tax deductions generated by both approaches are equal; the difference is that the foundation receives a portion of the planned gift now, rather than waiting for the CRAT to mature when George and Ruby pass away.

A new development officer needs to recognize planning opportunities, e.g., when the donor sells appreciated assets, has a need to diversify; or receives an inheritance, significant retirement assets or stock options.  Knowing when a tool is useful makes it more likely it be used when really needed, and the proper tool that solves a donor’s problem is less likely to be derailed by the donor’s financial and tax advisors.  Cultivate this ability to help the donors, and more tax efficient gifts will follow.

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

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Tools for Tax Relief

Taxed to Death?

Powerful Tools and New Tax Laws

 Taxes, taxes, taxes — on what you make, what you save, what you buy, what you own and what you leave your kids. Are there solutions? You bet. Some of the country’s most progressive families have learned that many taxes are voluntary and only poor planning forces the unwary into paying more taxes than necessary. What’s the catch? You need to learn about and use the tools legally available to all, including those rarely discussed or understood.

Many people allow the “tax tail to wag the dog”, postponing decisions that would benefit their security and solve financial problems. For example, interested in selling your appreciated assets? If you have land, stocks, a farm, business or vacation property that has gone up in value and you dislike paying out tax on your paper profits, then there are alternatives to paying that hidden penalty. This tax on capital gain is kind of a sneaky way to generate revenue, since people object to the penalty of selling property, they wind up sitting on it until death. Then the estate tax, at rates up to 55%, has a chance to further nibble away at family assets.

After the Taxpayer Relief Act of 1997 was signed into law, there was a lot of talk about how helpful it was going to be. The early feeling was that the reduction in capital gains taxes would allow the sale of property without losing so much of the value to the IRS. Congress loudly touted this as a major development in their “tax relief” package. Now that the dust has settled; what a surprise, it seems people still object to paying the 20% tax to the IRS and the income tax at the state level (in Illinois, it’s 3%, other states are as high as 10%). What to do? Financial and estate planning specialists suggest using a special tax-exempt trust that benefits both family and community. These trusts bypass the payment of capital gains taxes on the sale of appreciated property and redirect dollars that otherwise would go to the IRS back to community or family charities.

What’s the advantage? If you want to:

• Increase your income
• Decrease your taxes
• Pass more assets to heirs
• Control the destination of your dollars
• Reinvest 100% of sale proceeds
• Favor family over the IRS
• Benefit charity instead of government

then one technique to consider is the Charitable Remainder Trust (CRT). This special financial planning tool has been available in its current format since 1969 as a §664 Trust. While often mentioned in passing as a powerful planning tool, it is rarely implemented. Why? It’s complicated and requires trained advisors to give the family the full benefit of all the available advantages. There are many nonprofit organizations that promote its use, but too often professional advisors and development officers lack the background to fully counsel their client-donors on the best way to make use of the CRT. Family business operations can also make use of these trusts as a device to ease the second and third generation’s transition into ownership and control while saving taxes. If a family expects heirs to eventually sell the business, then there are many more advantages to this technique.

If you want additional information on ways to avoid unnecessary tax and expense, call or write. If your professional advisors need to learn more about these techniques, have them check into the website at http://members.aol.com/CRTrust/CRT.html or contact one of our planning offices for a customized evaluation.

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Generations of Income With a CRT – Vaughn Henry & Associates

Generations of Income

Vaughn W. Henry

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

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

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

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

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

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

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

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

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

For additional information and case studies, check our website.

Farm Property and the CRT

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

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

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

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

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

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

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

---

© 1997, Henry & Associates, Springfield, Illinois

Henry & Associates

Gift & Estate Planning Services

Charitable Education Trusts for Grandkids – Henry & Associates

Charitable Education Trusts for Grandkids

Vaughn W. Henry © 1999

“There are two systems of taxation in our country:

one for the informed and one for the uninformed.”

Honorable Learned Hand (1872-1961)

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

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

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

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

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

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

Tax Free Assets?

Tax Free Assets?

Unconventional Control of Family Assets

Vaughn W. Henry

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

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

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

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

	Typical Plan	FLP/CLAT
Initial Value	$3.03 million	$3 million
Family Value	$3.03 million	LP of $2.1 million
Yearly Transfer to Charity	$0	$152,250
Total Paid to Family Charity	$0	$2,436,000
Annual Income Earned & Taxed	$154,227 less 31% tax	LP earns $152,700 offsets deduction = $0 Tax
Land Value in 16 Years @ 6%	$7,697,266	$7,621,055
Estate Tax Due @55% on Land	$4,233,496	$0
Net Heirs’ Value	$3,463,770	$7,621,055
Social Capital Controlled	$0	$2,436,000

© Henry & Associates 1998, 2000

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The 10 Per Cent Solution — CRT Planning Traps

The 10 Per Cent Solution — CRT Planning Traps

Vaughn W. Henry

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

TRAPS

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

OPTIONS

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

RESULTS

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

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