Category: Case Studies and Articles

Vaughn W. Henry

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

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

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

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

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

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

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

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

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

 

First things first

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

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

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

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

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

Converting Appreciated Stock Efficiently

Converting Appreciated Stock Efficiently

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

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

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

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

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

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

Partial Stock Sale CRT Strategy (see our web-site http://members.aol.com/CRTrust/CRT.html for other tools)	Keep Asset and Do Nothing	Sell Asset and Reinvest the Balance (A)	Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of Publicly Traded Appreciated Stock	$750,000	$750,000	$750,000
Less: Tax Basis		$110,294
Equals: Gain on Sale		$639,706
Less: Capital Gains Tax (federal and state combined @ 23%)		$147,192
Net Amount of Capital at Work	$750,000	$602,868	$750,000
Current Net Return at 1.4% Dividend Rate	$10,500
Annual Return From Asset Reinvested in Balanced Acct @ 9%		$54,258
Avg. Annual Return From Asset in 6.5% CRUT Reinvested @ 9%			$68,084
After-Tax (31%) Avg. Spendable Income For Each Scenario	$7,245	$37,438	$46,978
Years of Projected Cash Flow for Income Beneficiaries		29	29
Taxes Saved from $186,923 Deduction at 31% Marginal Rate			$57,946
Added Tax Savings and Cash Flow over Joint Life Expectancies		$875,599	$1,210,199
Transfer to Family Charitable Interests	$0	$0	$1,151,505

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

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

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Design a CRT to Irritate Your Client-Donors

The Error of Our Ways

Why Some Charitable Trusts Make Donors Irrevocably Unhappy

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

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

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

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

Henry & Associates

Gift & Estate Planning Services© 1998

22 Hyde Park Place – Springfield, Illinois 62703-5314

217.529.1958 – fax 217.529.1959 toll-free 800.879.2098

email[email protected]

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One of the things I’ve learned about helping new development officers is that the quicker they can find partners amongst for-profit advisors, the faster they can get their programs off the ground.  Why is that?  A Prince survey of wealthy donors published in 1997 stated that for-profit advisors motivated 78.3% of planned gifts.  Since many development officers come up through the ranks as educators or social workers, few have a lot of real world financial experience with significant wealth, so some donors may not feel comfortable divulging information of a confidential nature to employees of charities.  On the other hand, the gatekeepers to private wealth are the professional advisors, so it makes sense to create planning partnerships to further your program’s success. 

Once settled into the job, a new development officer should gather other professional advisors around and create a synergistic relationship.  Where to start?  Find a mentor, even a virtual one, and bounce ideas around.  You’ll never learn if you don’t ask questions because this is a complicated business.  Unfortunately, most development people are thrown into the deep end of the pool without any training and they are soon overwhelmed.  With all of the technical material to learn, information on the charity’s mission and history to absorb, and donor cultivation to keep current, there’s more than enough to stay busy, so delegate the learning to a support group.  Start a planned giving committee and make use of community resources, encourage a bank or financial services firm to co-sponsor an event, find area speakers who are respected and knowledgeable to reinforce frequent presentations.  Offer workshops and ongoing training for advisors, establish relationships and you’ll encourage more cooperation but accept the fact that donors are inclined to support more than one charity.  The problem with some advisors (I’m being blunt here) is that they usually have to see why it’s helpful to them and their clients, and not just an altruistic, tax deductible strategy that many development officers use to motivate gifts from donors.  By presenting objective solutions to donors’ financial and estate planning problems, you can educate advisors how planned giving fits into the process.  Client donors seek advice from many sources, often listening to the last person who talked to them.  If every advisor they refer to validates the planning process and gift planning tools, they will be more comfortable doing something unnatural, i.e., giving their stuff away while they’re still using it. 

Other tools to use?  Make use of the Internet discussion groups, which are especially important in small development shops with no one to bounce ideas around.  Join your local planned giving council and get involved.  Attend workshops and seminars, get as many of your pre-approved committee members as you can to come to your organization and do programs for both the staff and donors, learn wherever you can.

As an example of the collegiality found on the Internet, I asked for some suggestions for new development officers and was offered several excellent ideas, some of which follow:

·      “No one makes a gift until asked to do so.” — Sam Highsmith, JD

·      “Do your giving while you’re living so you’re knowing where it’s going.” — Hal Moorman

·      “Give appreciated capital assets while you’re alive.  Leave IRD assets at death.” — Douglas Wise

·      “if you are benefiting another person who is not your spouse with your charitable gift, it will cost you either unified credit or gift tax” — Stuart Sullivan

·      “if you are wealthy enough, your are going to be a philanthropist when you die, you can choose the charities or the government will choose them for you”  — Stuart Sullivan

·      “Many individuals do not know what the term “charitably inclined” or “nonprofit” means.  However, they are apt to respond positively when asked, “have any organizations meant a lot to you or your family, such as your church or university or Girl Scouts?”  — Kate Busch

·      “Remember, new development person, it costs money to give money away.  Treat a prospect with respect because a gift is an expense from her/his perspective.” — Dick Zinzer

·       “Using a private foundation as the donee charity can permit a family to control the manner in which the family’s wealth is dispensed for social causes, be a focal point for future family interaction, give children, grandchildren, and descendants a clear sense of social and moral duty and purpose, not to mention providing substantial tax deductions.” — Wes Yang, Esq.

·      If you have to make a choice, develop your people skills first and the technical knowledge second.  You meet the people, you can hire the technicians. — Mike Howell

·      “Generally, you should make a charitable bequest out of an IRA or other retirement plan rather than from your will or revocable trust.” — Scott Blakesley, Esq.

Copyright 1999 – Vaughn W. Henry

Flexibility in a CRT

Flexibility and Options

The Power of the NIMCRUT

Vaughn W. Henry

 For those considering an IRC § 664 – Charitable Remainder Trust as an estate or retirement planning tool, take a look at the Net Income with Make-up provisions of a CRT (NIMCRUT). While the standard Charitable Remainder Uni-Trust (CRUT) requires 5% as a minimum annual distribution, based on annually revalued assets, it is rigid in its distribution rules. Add a net income feature and you receive the lesser of all the trust income or the original pay-out percentage, whichever is less. If you make income, you have to take it, with no ability to defer it until later. However, if the trust makes no income, the beneficiary receives nothing. Thus, income potential is forever lost in poor performing years. The problem with trusts that may effectively last for several lifetimes is that IRS prototype (pre-approved and standardized) trust documents do not allow for much flexibility in managing complicated distributions. Instead, use a customized NIMCRUT, and it becomes a “spigot trust”. Called spigot, like a water valve, the special trustee directs the trust administrator to turn the income streams on and off as needed by the beneficiary. The traditional NIMCRUT funding approach uses growth mutual funds to prevent unwanted income from spilling out of the trust. When income is needed, the assets inside the trust are generally repositioned into income funds capable of generating the required pay-out. Unfortunately, this does not effectively control ordinary income that forces unwanted distributions out of the trust. This happens when net income is produced from the occasional capital gains or dividends generated by any investment in the CRT. While funds producing 2% ordinary income and 8% growth are not shabby, it becomes more efficient when all 10% of the gain can be deferred and retained inside the trust to compound tax-deferred for future use. The down side occurs when the equity market has a bad year and there is no “distributable net income” (DNI) produced, so the beneficiary cannot access any funds during that year. During the accumulation phase, this is not a problem; but, during the distribution phase it creates a serious management problem when using mutual funds. Briefly, a solution may lie in a proper trust drafting and a series of deferred annuity contracts that have “earned income”, but as long as an independent trustee refuses to accept it, the money can remain undistributed. Unfortunately, few annuity providers offer the administrative support to work within these specially constructed NIMCRUTs. Those that do, have learned how to flex according to the needs of their clients. When the trustee holds several annuity contracts and specifies that one be completely invested in a fixed portfolio, the income beneficiary can be assured that at least some income will always be available for distribution. This is much different from the mutual fund approach, over which the trustee has no discretionary control in distribution. Properly structured, a NIMCRUT can provide a vehicle for managing tax-deferred growth. Regarded as the eighth wonder of the world, tax-deferred compounding investments can fund both college educations and retirement needs from the same CRT account. Best of all, this can be done without the usual age restrictions and penalties on pre 591/2 distributions from tax sheltered savings. For example, the trustee may direct the “spigot” be opened to pay for children’s tuition and then closed until income is needed for retirement, when it is again reopened. By aggregating the undistributed income in a make-up account, the accumulated deficiencies may be made up by paying out excess funds in years that produced extra income. Generally, NIMCRUTs work best for younger trust beneficiaries with hard to value assets that may be difficult to immediately market (e.g. farm land, development property, etc.) and reposition within the trust. Given the capacity to accumulate a little cushion when income is not needed, the NIMCRUT is ideal as a retirement supplement. This ability to store income and grow it efficiently provides for future substantial distributions from the make-up account.

Charitable trusts have the capacity to prevent death from interfering with passing down a value system. Besides obvious philanthropic interests, why use a charitable trust? The CRT allows for:

• Estate planning options
• Increased cash flow from more diversified assets
• Improved asset management and retirement planning
• Tax-free conversion of individual and corporate appreciated assets
• Redirected “social capital” (those assets targeted for tax liquidation) by having the family control the ultimate use, not the government
• Income tax deductions for split-interest gifts

Who else would benefit from such a vehicle? Anyone with or apt to have a fully funded qualified plan with excessive accumulations. With no IRC §415 limitations, the tax deferred accumulations within a “spigot trust” offer the trust beneficiary the similar performance of another retirement plan without the burden of meeting anti-discrimination regulations for employees. After evaluating the numbers on many pensions where years of savings are ultimately lost to estate tax, income tax and excise tax, look at the CRT for viable planning alternatives.

ãVaughn W. Henry,Henry & Associates. 1996, 1998

E-mail [email protected]

Springfield, Illinois 62703-5314

(217)529-1958 or toll-free 1(800)879-2098

home

 

Statistical lifetime trust income for both donors = $4,478,161

Calculated charitable gift of remainder interest = $5,070,433

Current income tax deduction = $250,920 for the $1 million transfer

Example of one scenario in a 5% NIMCRUT earning 10% and deferring payout until year 6, withdrawing assets from the make-up account and then drawing an increasing stream of income for life. The donors (age 56/54)) contribute $1 million in highly appreciated stocks (although cash works too), avoiding the capital gains tax on the appreciation. They receive current tax deductions of $250,920 available over six years and then an income stream for their joint lives, statistically for 35 years. The donors designed the deferred income to be available to buy a vacation home as they enter retirement. By creating a wealth replacement trust for their heirs, they effectively remove a $1 million asset from their taxable estate, while transferring that value to their children tax-free. This trust is primarily designed for younger donors who want to maintain control of their income stream. Hard to value assets like real estate can also work well inside of this trust. There is a new TAM from the IRS on this procedure that addresses the self-dealing concerns by some legal commentators. Properly done, the NIMCRUT works as designed.

Statistical lifetime trust income for both donors = $1,750,000

Calculated charitable gift of remainder interest = $13,740,680

Current income tax deduction = $408,986 for the $1 million transfer

The second scenario is a 5% Charitable Remainder Annuity Trusts (CRAT) earning 10% and paying out a 5% annuity, or $50,000/year for the donors’ joint life expectancies (35 years). The donors (age 56/54)) contribute $1 million in highly appreciated stocks (although cash works too), avoiding the capital gains tax on the appreciation. They receive current tax deductions of $408,986 that reflects the probability of a higher remainder interest being left to the charity. By creating a wealth replacement trust for their heirs, they effectively remove a $1 million asset from their taxable estate, while transferring that value to their children tax-free. This tool is best used for much older donors unconcerned about inflation who want to leave a larger gift to charity. Funded with stocks, cash or other liquid assets, it provides for a straightforward and uncomplicated income stream.

Statistical lifetime trust income for both donors = $4,309,931

Calculated charitable gift of remainder interest = $4,920,774

Current income tax deduction = $250,920 for the $1 million transfer

Example of a third scenario in a 5% Standard Charitable Remainder Uni-Trust (CRUT) earning 10% and paying out 5% annually producing an increasing stream of income for life. The donors (age 56/54)) contribute $1 million in highly appreciated stocks (although cash works too), avoiding the capital gains tax on the appreciation. They receive current tax deductions of $250,920 available over six years and then an income stream for their joint lives. By creating a wealth replacement trust for their heirs, they effectively remove a $1 million asset from their taxable estate, while transferring that value to their children tax-free. This trust is designed for donors concerned about inflation who still wish to leave a significant gift to charity. The standard CRUT does not offer any choice in deferring income generated from the trust, but may offer more tax efficient distributions now that the Taxpayer Relief Act of 1997 has changed capital gains treatment.

Designing charitable trusts to meet the different needs of donor and charity offers great flexibility. Besides manipulating the payout from the CRT, and choosing the type of trust and character of assets held by the trust, the trustee often has the ability to change the remainderman to reflect concerns about use of the family’s social capital.

Approximate Unitrust Deduction Factors

Approximate Unitrust Deduction Factors

 “FAIL” based on Disqualification if deduction (remainder) is less than 10%

(based on 8% AFR, quarterly distributions at the following CRT payout levels)

CRT	5%	5%	6%	6%	7%	7%	8%	8%	9%	9%	10%	10%
AGE	1 life	2 life	1 life	2 life	1 life	2 life	1 life	2 life	1 life	2 life	1 life	2 life
20	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail
25	.10	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail
30	.13	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail
35	.16	.10	.12	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail	Fail
40	.20	.12	.15	Fail	.12	Fail	Fail	Fail	Fail	Fail	Fail	Fail
45	.25	.16	.19	.11	.15	Fail	.12	Fail	.10	Fail	Fail	Fail
50	.30	.20	.24	.15	.20	.11	.17	Fail	.14	Fail	.12	Fail
55	.35	.25	.30	..19	.25	.15	.21	.11	.18	Fail	.16	Fail
60	.42	.30	.36	.24	.31	.19	.27	.16	.24	.13	.21	.10
65	.48	.37	.43	.30	.38	.25	.34	.21	.30	.18	.27	.15

Example below of aCRT §664Trust that would be disallowed under the new law:

Average age of husband and wife	34
Value of property transferred to a CRT	$250,000
Payout rate for a standard unitrust	5%
AFR discount rate and earnings assumption	8%
Income tax charitable deduction (remainder)	$24,610
Approximate joint life expectancy	50 years
Projected future charitable remainder	$1,019,669

Under the new tax law, the couple above would be prevented from using a CRT because the income tax charitable deduction is just less than 10% of the fair market value of the property they transferred to their CRT. The charitable organization they would have named as beneficiary would also be denied the benefit of a future gift of over $1 million. While some argue that the 10% limit on present value of the charitable gift limit any future value to the charity, the real effects are going to be based on what the trust actually earns in the intervening years. It is unrealistic to assume that a young couple creating a CRT for 40 years or more would invest in financial products that would return only the applicable federal rate (AFR) of return instead of investing prudently for growth and income in a well-diversified investment portfolio. In this case, an 8% AFR is typically a bond rate and the S&P stock market returns would be in the 12% to 14% range; under these conditions, the charity would receive far more than the projected future value. For another example of this law’s effect, see the following case study.

This law was signed into legislation with the Taxpayer Relief Act of 1997 and is effective as of July 28, 1997. Existing testamentary trusts may also need to be modified to meet these requirements and additional contributions to existing trusts now must also meet the 10% remainder rules.

Henry & Associates

Improving Success Rates for the Nonprofit Organization

Improving Success Rates for Nonprofit Organizations

The key to success for a nonprofit organization’s development officer is to go back to the fund-raiser’s core role. That is to say, improve relationships with donor-clients and develop an extensive knowledge of the charity’s role in the community. Learn enough about current and planned gifting strategies to know when to insert the charity into a client-donor’s financial and estate plan, but do not feel that you must know all the tax and financial tools used. Instead, turn to those professionals who provide the technical expertise on integrating gifts into financial plans and encourage client-donors to seek out those advisors who view the big picture. Become more efficient in conserving the social capital of your donors by learning that every transaction, whether it be a sale of a business or farm, shifting from growth stocks to income mutual funds, or transitioning a family business to heirs is an opportunity to help the donor meet financial goals and still provide needed support for your organization. Only after personal security and family succession issues are resolved will the donor feel that they can address questions about charitable gifts. If the fund-raiser places the family at risk, there is increased opportunity that gifts will not be forthcoming and the ever increasing potential for adverse litigation starts to be a major concern. Disinherited heirs are an unforgiving lot and when they are not made aware of the scope and intent of entire estate plan they can create huge obstacles causing nothing but grief and ill will. To that end, I like to encourage client-donors to create a written family financial philosophy and convey those concepts to their heirs.

If you would like to do joint seminars or workshops on planned giving or estate planning for your board, professional advisers or donors, we have technical resources and materials available to nonprofit organizations to make those strategic alliances more effective. We can help you prepare software presentations with PowerPoint™ and can help you acquire the hardware to present your own seminars to clients and donors. If you do not have the software to evaluate either a CRT or planned giving options, we provide a preliminary analysis for CRAT, SCRUT, NICRUT, NIMCRUT, CLAT, CLUT, CGA and PIF scenarios as a professional courtesy, give us a call.

©Vaughn W. Henry, 1997, 2001

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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.

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Investment Choices Affect CRT Management – Part II – Henry & Associates

Trail of Tiers II – More on Why Investment Choices Affect CRT Management

For the trustee of a §664 CRT, the accounting for the “4 tier” treatment of distributions can be best described as WIFO (worst in – first out).   Consider the choices made for Susan Barry’s CRAT as an example.  She contributed $1 million of appreciated stock in a publicly traded consumer products manufacturer to her 5% CRAT and will receive $50,000 annually from the trust for the balance of her life.  Unfortunately, her financial advisor was more interested in selling product than solving problems and suggested that the trust reinvest her stock portfolio inside the CRT with tax-free municipal bonds.  His rationale was that the trust would be able to pay out her $50,000 distribution in tax-free income.  This is typical for some promoters who have a basic understanding of charitable trusts, but lack a lot of depth.

What actually happens if tax exempts are used as investments in a CRT funded with appreciated property is that all of the unrealized capital gains have to be paid before any tier 3 tax exempt income can pass to Susan.  Since she had only $100,000 basis in her $1 million of stock, this means $900,000 of realized capital gains must be paid out (and taxed at 20%) before any of the tax free income can be recognized.  Since the tax free municipal bonds only earn 5.25% the trust corpus can’t grow to benefit the charitable remainderman.  This becomes even more important in a unitrust (CRUT), as the income beneficiary would be shortchanged as well, since the CRT distributions couldn’t keep up with inflation.  In Susan’s CRAT, it would take 18 years of sub-par performance before she could benefit from the tax free income.  That’s poor trust management in the opinion of many trust administrators and a few state attorneys general who often oversee CRT performance to protect the charities’ interests.

Hypothetical Performance Over Ten Years	5% CRAT	5% CRAT	5% CRAT	5% CRUT
$1 million transfer ($100,000 basis) to CRT	5% Income Portfolio	5% Income 5% Growth	10% Tax Efficient	10% Tax Efficient
1st Year Income Payout	$50,000	$50,000	$50,000	$50,000
Tier #1 Income Distribution Taxed @ 40%	$50,000	$50,000	$0	$0
Tier #2 Income Distribution Taxed @ 20%	$0	$0	$50,000	$50,000
10th Year Income Payout	$50,000	$50,000	$50,000	$74,305
Remainder to Charity in 10th Year	$1,000,000	$1,796,871	$1,796,871	$1,552,970

Trustees have a duty to manage the trust’s assets for the benefit of both the remainder and income beneficiary.  It can be done without exposing the trust to excessive risk or volatility and with appropriate custom document provisions, tax efficient investing should be an integral part of any CRT trust management.

© 2000 — Vaughn W. Henry

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Too Much Stock – Too Little Diversification – Vaughn Henry & Associates

Too Much Stock – Too Little Diversification

Vaughn W. Henry © 2000

John Li (50) is a systems engineer for one of the biggest suppliers of sophisticated computer equipment for the Internet.  He and his wife, Katherine, have two girls, both finishing professional programs in graduate school.  As a result of prudent investing, good luck and a wildly successful public offering of his employer’s stock, John is considering early retirement so he can travel and enjoy his hobbies of flying and sailing.  Besides his significant retirement plan account, John has $3 million in zero basis stock in his employer’s company and is in line with qualified stock options to acquire an additional $5 million over the next three years.  Faced with planning for the disposition of an estate of $10 million (almost all of it in an undiversified portfolio), John and Katherine decided that they’d like to build a “Zero Estate Tax Plan” into their estate planning.  In short, they’re willing to give to charity those assets that would otherwise default to the IRS in the form of estate and capital gains taxes.  As a part of this strategy, they will also make aggressive gifts of stock to their two daughters and other family heirs over the next few years.  By freezing estate growth and squeezing the value of the assets, the Li’s estate planning team will be able to eliminate the unnecessary taxes.  Additionally, it will provide an excellent retirement income stream and leave their heirs in control of a family influenced charity funded with unused retirement plan assets and stock proceeds from their charitable remainder trust (CRT).

	Sell	CRT
Net fair market value (FMV)	$3,000,000	$3,000,000
Taxable gain on sale	$3,000,000
Capital gains tax (20%) at federal level	$600,000
Net amount invested	$2,400,000	$3,000,000
Annual return of reinvested portfolio	10%	10%
Reinvested for 10% annual income produces	$240,000
Trust payout of 5% (averaged with 10% returns over trust term of 40 yr.)		$433,190
Annual average after-tax cash flow @ 39% tax	$146,400	$264,246
Years – projected joint life expectancy	40	40
Taxes saved with $579,600 deduction @ 39%		$226,044
Tax savings and cash flow over 40 yr.	$5,856,000	$10,795,878
Total increase in cash flow	$5,856,000	$10,795,878
Total value of asset in estate in 40 yr.	$2,400,000	$0
Estate taxes on this asset at 55%	$1,320,000
Net value to family	$1,080,000
Total insurance expense for wealth replacement	$0	– $530,000
Insurance benefit in wealth replacement trust	$0	$3,000,000
CRT remainder value to family charity	$0	$21,119,966
Total value to Li family from this asset only	$1,080,000	$23,589,966

How does this work?  The stock that John owns is publicly traded, so its value is readily ascertained and is easily transferred to the Li Family Charitable Trust.  This §664 CRT will take the highly appreciated stock and sell it without current tax liabilities and reposition it into a more balanced portfolio of equities designed for both growth and security.  The CRT, with John as trustee, will buy and hold stocks and mutual fund shares so that most of the portfolio will continue to appreciate while John and Katherine, as income beneficiaries, receive quarterly payments of 5% of the trust’s value every year.  They’ve made the decision that leaving each daughter with a $5 million inheritance is part of their family’s financial goals, so with some stock and life insurance held in trust, the two girls will be well protected for the future.  Everything else in their estate will be either spent during retirement or left to their charitable trust when they pass away.   After examining the numbers, the Li family felt that it made great sense to re-exert control over their social capital and follow through with their plan. Since John felt a need to sell in order to diversify his unbalanced portfolio, the only comparison to be made was between selling – paying tax – reinvesting the net proceeds and contributing the stock – reinvesting inside the CRT.   By combining a charitable remainder trust with a wealth replacement trust for their heirs, John leaves his family in control of the estate and produces a “Zero Estate Tax Plan” that suits their planning goals with a family financial philosophy of wealth preservation and charity.

Henry & Associates

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Can Capital Campaigns be based on Planned Gifts? – Vaughn W. Henry & Associates

Can Capital Campaigns be based on Planned Gifts?

While lead trusts generally aren’t promoted like remainder trusts, there are ways to combine the two tools to provide significant gifts to charity today.  Learning about basics is doubly important for advisors to better help donors improve their options and social capital control.  The following case isn’t one suitable for many donors, but the concept has merit for the right circumstances.  For those organizations able to present the idea to a major supporter, it might be the way to get that capital project off the ground without going through a long fundraising campaign or another unpopular bond issue and still help the donor solve financial planning problems at the same time.

Jack Wise, a 66 year old business owner, was approached by a local charity group he’d supported for many years about ways to finance a school district’s youth center.  The community previously rejected an increase in property taxes and school officials wanted a fresh perspective on ways to build the needed facility.  Jack’s financial advisor offered an idea that gave the district new options.  By taking $2 million of Jack’s stock portfolio with modest income earnings of 3% per year, the advisor placed $1 million of the stock into a 6% CRAT to replace Jack’s existing earnings of $60,000 per year.  The remaining $1 million in growth stock was combined with some idle development property worth $2.73 million into a family limited partnership (FLP).  Then 40% of the limited partnership units were contributed to a 6% CLAT designed to produce $60,000 in annual distributions to charity.  The minority interests were discounted by 33% for lack of marketability and control; meaning that the fair market value of assets held by the charitable lead trust were also valued at $1 million.

Once the $1 million in appreciated stock was placed into Jack’s charitable remainder trust, the trustee loaned the school district the $1 million to finance the youth center and commence construction.  The note owned by the CRT requires a payment of 6% interest annually, but where does the school get the funds to pay the note since the youth center isn’t a revenue-producing asset?  It comes from the CLAT payment of $60,000 that passes through their foundation’s hands and back to Jack’s CRAT in order to provide him with the same level of life style he previously enjoyed from the stock and land contributed to his two estate planning trusts.  Besides receiving income from the CRT, an income tax deduction of $522,340 is created and usable for six years.  Additionally, the assets in the CLAT, eventually passing to his heirs, do so for a discounted value of $522,340.  Combined with aggressive annual gifting and other lifetime gifts of FLP units to family members, Jack can pass the $3.43 million plus all the projected growth to heirs for no gift or estate tax while building the Jack Wise Community Center now.

How does this compare to doing nothing?  Jack’s $3.43 million, plus all the associated growth would normally be reduced 50% at death by estate taxes.  By making these three planning tools work within his estate plan, Jack can help a charity fulfill its mission, support a familyphilanthropy, pass more assets to his family and generate an income tax deduction when he can actually make use of it, all without reducing his current income stream.

While this case is a little complex for a quick study article, it made good sense to Jack’s advisors and played a major role in his “zero estate tax master plan”.  Learn more about charitable remainder (CRT) and charitable lead (CLT) trusts and find creative ways to introduce them as solutions to client and donor planning problems.

This example of a $1 million youth center was paid for by one donor as a result of creative estate planning.  Tired of sending kids out door to door selling candy, pizzas and magazines?  How about those car washes and bake sales?  Nickel and dime fundraising efforts may build community spirit, but they often irritate donors and there’s plenty of risk in today’s world when peddling stuff on the street to strangers.

It’s become increasingly important to incorporate planned giving into any development program that plans to be around for any length of time.  Long term gifts require an outlook that ecompasses more that putting money on the table today, both new and experienced planners need to make use of the tax planning strategies to help donors be tax efficient in their support of philanthropy.

As an additional note, the July 24, 2000 issue of USA Today had an article, Fundraisers pay for schools’ needs, that contained some interesting statistics concerning the increased use of fundraising activities in schools.