Category: Case Studies and Articles

Partnering a CLAT and a Stretch IRA – Vaughn W. Henry & Associates

Partnering a CLAT and a Stretch IRA

Janet Bari (67), a professor emeritus of the local university’s art department, and her husband, Virgil (68), are typical Midwesterners.  They live modestly on $22,000 of social security income and what Janet makes by selling handmade jewelry and sculptures.   They own their country home, have no debts, pay cash for all of their purchases and avoid any sort of an ostentatious lifestyle.  She and Virgil married twenty years ago and each have children from previous marriages; both have a desire to preserve assets for their children, grandchildren and still provide for a degree of comfort and security in retirement.

Janet jumped onto the mutual fund bandwagon long before it became popular and regularly set aside savings in her IRA and 403(b) retirement plan, and has since accumulated over $1 million in tax deferred savings.  After realizing that she was also creating a potential IRD (income in respect of a decedent) tax trap, she redirected her on-going savings program to non-qualified equity accounts and has been pleased with the 14%+ returns over the last twelve years and her investment account has since grown to $500,000.  Always a big supporter of charitable causes, she and Virgil regularly give $5,000 to $15,000 away annually, even though their accountant has warned them that they can’t make complete use of the annual charitable deductions on their tax return.

When asked about goals and priorities, Janet said she hoped to leave each child with a level of financial support that wouldn’t be a disincentive to work, but would encourage heirs to develop their own business and philanthropical interests.  She wanted her family to receive the proceeds of her investment account, and although already making numerous $10,000 annual exclusion gifts, she was unwilling to make significant lifetime gifts to her heirs now and use up her applicable exclusion amount (unified credit).  Janet also expressed concern about helping a disabled granddaughter and a desire to protect her retirement plan assets from unnecessary taxation at death.

Of the many solutions proposed to her, the following scenario seemed to make the most sense.  It was easy to implement, provided a lot of flexibility and allowed her to make use of her retirement plan assets in a tax efficient fashion.  Since she hadn’t reached her required beginning date of 70½ years of age, Janet was able to take her $1 million in retirement plan assets and break the account up into seven different Individual Retirement Accounts (IRA) naming different family members as beneficiaries to each.  This strategy allowed her to have a longer payout when calculating the minimum required distributions (MRD), thus stretching out the payments over joint life expectancies that included some very young beneficiaries.  By stretching the payments out and by taking all the required distributions from just one $600,000 IRA account, the one she and her spouse shared, this allowed the six remaining accounts of $50,000 to $100,000 to continue compounding in a tax-deferred environment.  Since she was concerned about one granddaughter’s disability and future financial needs, Janet chose to fund that girl’s IRA at a higher level than those naming other grandchildren as beneficiaries.

Her advisor reminded her often that beneficiary designations can be modified, so if Janet has need of funds, she can always accelerate her withdrawals from any or all of her accounts, and this provides for adequate income security.  While Janet has no need of additional retirement income now, she has invested her seven IRA accounts in equity mutual funds and fully expects that they will continue to grow even after she’s forced to commence distributions.  She also named a charity to receive any balance in her primary IRA, limiting the IRD exposure while still providing for her husband, should he survive her.

To continue funding her charitable interests, a 5% non-grantor charitable lead annuity trust (CLAT) was established with the $500,000 investment account.  Since it has historically produced annual income and appreciation in excess of 14%, it was assumed that it could sustain a yearly gifting program of $25,000 and still have the capacity to grow over a twenty-year period of time.  The CLAT, a tax paying trust, can make charitable contributions and offset any earned income as a stand-alone taxable entity and make use of charitable deductions that Janet’s personal tax return cannot claim because of her AGI limitations.  By making distributions to a community foundation, Janet, as CLAT Trustee, can redirect the proceeds through a donor advised fund to charities of interest to the Bari family.  The foundation offers the Bari family the ability to accommodate any changes in their charitable contributions through their donor advised fund as family needs evolve over the years.  If Janet passes away before the twenty-year term expires, her children can step in and continue offering advice as to the direction of philanthropic support the trust will provide in the community.  If the trust pays out $25,000 annually and continues its historic performance for the duration of the trust’s term, there will be between $3 million and $7 million in the account that will pass nearly tax free to the heirs as if it used only $255,750 of Janet’s unified credit.  This is very efficient discounting and will provide the heirs with the resources for security and an opportunity to create their own remainder trusts in the future (see detailed flowchart).

A CLAT can be easily described as a “deferred inheritance trust” and this offers the Bari family a degree of certainty as to when assets will be available to both charity and family members.  For the truly philanthropic, this plan offers donors a very useful means of passing assets to heirs in predetermined amounts, especially when insurance and wealth replacement trusts may not be economically viable options.

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

The FLIP CRUT Charitable Trusts with Flexibility – Vaughn Henry & Associates

The Flip CRUT

The IRS has “flipped out” with an unusual series of holiday decisions that have positive applications for clients with charitable trusts. In light of erratic market performance and declining fixed income investments, many donors with net income charitable remainder trusts have been disappointed with their beneficiary payments. Notably, the NIMCRUT or “spigot” trust (sometimes called a type 3 CRUT) is the most difficult§664trust to manage because of the restriction on paying out only distributable net income (DNI). DNI in most states is defined as interest, rents, royalties and dividends offset by trust expenses. When charities, unsophisticated money managers at best, invest as trustees, most often bond type assets are used to generate income, but this prevents the trust from ever appreciating. The new regulations, TD 8791, released on December 10, 1998 now allow any net income unitrust, either NICRUT or NIMCRUT, to be reformed into a FLIP CRUT without challenge by the IRS. This is much more flexible than most commentators expected, as the proposed rules originally called for a triggering event to be included in the original trust document and a more rigid set of asset restrictions. This largesse by the IRS may result in a flurry of court filings before the June 8, 1999 deadline.

Flip Away

What’s a FLIP CRUT? It is a hybrid CRT that starts off as a NIMCRUT or NICRUT because the contributed asset is hard to value (see the new IRS definitions) and illiquid. For example, raw land contributed to a standard unitrust produces little, if any, income. However, when the required payout must be made, there’s no liquidity to make the payment. The only recourse is to distribute a portion of the land back to the income beneficiary since the CRT may neither postpone the payment nor borrow the funds. This tends to make the income beneficiary unhappy since the land was contributed as a way to avoid capital gains liability and reposition the assets into something capable of producing spendable income. The old solution was to use a net income trust that paid out the lesser of earned income or a fixed percentage of annually revalued trust assets. In this way, the trust would payout only what it could earn, but it wouldn’t compel the trustee to imprudently liquidate the assets at a loss just to make an income beneficiary’s distribution. Generally, this meant the beneficiary was in the same position as before the contribution, receiving only what income the land produced. However, after the trust sold the land, the beneficiary found out that the trust payout was still limited to what the trust “earned” in the way of net income. Many clients went along with the NIMCRUT concept expecting to receive a 7% or 8 % income stream once the property was sold, only to find out that they were still limited to receiving the lesser of net income for life. Additionally, in the real world of financial markets, there was little hope of ever invading the “make-up” account to offset lost ground. This called for sophisticated investment advice and many documents do not allow the use of these tools, as trusteesnever researched the use of non-typical trust investment products like specially designed deferred annuities and zero coupon bonds to control timing and income recognition.

The typical alternative of defining capital gains as “income” was a band-aid means of managing this choke point in a NIMCRUT. However, this strategy adversely affectsinvestment choices by requiring the trust to sell the best performing investments and keep the worst performers. This technique wrecks the long-term performance of the trust and isn’t recommended.

Triggering the Flip

Now it is possible to convert existing net income trusts into straight percentage unitrusts if the drafting attorney can identify a “triggering event or date” that is “outside the control of the trustee or any other person.” Examples of triggering events, in addition to sale of unmarketable assets include retirement at a specified age (not any arbitrary retirement date), marriage, divorce, death or birth of a child.

The trustee has a fiduciary duty to be even handed to both the income beneficiary and the remainder beneficiary. In a net income unitrust, greater equities favor the charitable remainderman since the portfolio appreciates. However, this investment choice produces little DNI and is often detrimental to the income beneficiary. On the other hand, greater fixed income securities initially favor the income beneficiary but limit future growth, and that damages both of the remaindermen. Equities often play a lesser role in a NICRUT than in a straight unitrust because of the difficulty of earning a 5% net income. Remember, this isn’t total return, since appreciation isn’t usually defined as income, so a diversified portfolio of equities and fixed income instruments wasn’t often used. Once the trust is flipped to a standard CRUT, then total return can be part of the investment philosophy and invasion of principal could occur during downturns in the market, something not allowed in a typical net income unitrust. Does this mean NIMCRUTs are out? No, the retirement planning unitrust still makes terrific use of the strategy, especially in light of a recent IRS Technical Advice Memorandum (TAM 9825001), and may well replace the traditional pension plan for high income earners with an estate tax liability. However, the FLIP-CRUT will likely become more prominent once planners understand the flexibility.

Divorce

On a slightly different note, clients occasionally ask about dividing charitable remainder trusts upon divorce.

The IRS issued two (identical) rulings authorizing such a split: Private Letter Rulings 9851006 and 9851007 (Sep. 11, 1998). Husband and wife had a single 5% net-income-with-makeup charitable remainder unitrust (NIMCRUT) that was to last for both of their lives. After the divorce, the IRS approved dividing the NIMCRUT into two separate 5% NIMCRUTs, with one NIMCRUT for each spouse. The assets were split 50-50.

For more information on charitable and estate planning strategies, check our home page at http://members.aol.com/crtrust/CRT.html

Henry & Associates

Tune Up Your School Foundation – Vaughn Henry & Associates

Time to Tune-up the School Foundation

Vaughn W. Henry © 1999

Most school superintendents admit to a love – hate relationship with their foundations. They recognize the need to have one, but don’t have the time or energy to battle with one more group of civilians to support projects the superintendent sees as mission critical. The time to re-energize the foundation approach has come, brought to the forefront by demographic and economic changes over the last 15 years. Why? Schools that create a viable means of support outside of tax generated revenues will find themselves in a position to respond more quickly to changing community needs. Without a viable foundation and endowment, the school system may find itself without the necessary financial strength to continue operating as it should. For small towns, the loss of the local school is often a symptom of a dying community. Too few young people stay, too few jobs or services remain and a once thriving town becomes a wide spot in the road. Healthy schools mean that small towns have a chance to survive in today’s technologically driven economy.

While the Illinois Association of School Boards (IASB) reports that 50% of the school districts have a foundation designed to support the district’s financial and development needs, the majority are inactive or ineffective. At the last three IASB/IASA annual conferences and at a recent INSPRA meeting, a quick poll showed that existing foundations did not use planned giving or gift development programs consistently, if at all. Instead, these home grown and operated nonprofit organizations generally relied on special events like pancake breakfasts, chili suppers, car washes, sales of athletic wear and concessions at sporting events to meet their growing needs. That understandable, but limited approach results in too few dollars raised; of course people start programs based on what they’ve been exposed to, and events have been around for a long time. Unfortunately, the funds raised through special events often have a fairly high cost in terms of employee and member time commitments, with little net gain. One foundation reported raising $70,000 at a local golf outing, but admitted to spending almost $62,000 to raise it. Those are dismal results at best, given the huge effort required by volunteers and frustration generated by spending so much of the revenue in what could be only described as a public relations exercise. Contrast that with a recent bequest to the Lincoln, Illinois High School Foundation of nearly $500,000. Of particular importance is the fact that fewer than 10.8% of donors (Seven Faces of Philanthropy, Prince et al, 1994) are motivated to aid an organization via special events, so a different strategy is needed if new significant support is going to occur.

The American Association of Fund Raising Counsel reports that of the $174.52 billion raised for U.S. charities in 1998, only 13.5% went to education with almost all of it destined for higher education. Yet the typical student spends 12 years in the primary and secondary school system gaining a basic foundation for a four-year college degree. While 75% of the educational effort is made at the local level, why don’t graduates support their basic school system in the same way as their collegiate institutions? Generally, it’s because they’re not asked. A fundraising precept (almost carved in stone) is, if you don’t ask, you don’t get. Superintendents often say they’re uncomfortable asking for financial support for what’s commonly perceived as a tax supported institution, but the state and land grant universities have developed healthy endowments and development programs, why should the tax assisted school districts be any different? While administrators need to be sensitive to communities that have recently rejected unpopular bond issues, the school foundation is an entirely different entity and it needs to be presented that way. The reality is that foundations and corporate grants, popular resources for bureaucrats, only provide about 15% of the charitable support for nonprofit organizations. The bulk of the financial support comes from bequests and individual gifts that are largely ignored by local school foundations.

Estate Tax Influences

The ongoing inter-generational transfer of wealth presents a significant opportunity, as assets destined for unnecessary taxes can be redirected back to local tax-exempt purposes. Unfortunately, few people realize that they have choices about where those dollars wind up. While large group social special events are relatively simple to design and promote by amateur supporters, the major dollars are more efficiently generated elsewhere. Major funding could result from proactive estate and wealth conservation planning, but most foundation members and school administrators lack experience with sophisticated financial and estate planning tools and avoid using these tools because of perceived complexity.

What to do?

1. Understand that planned giving in particular is a complicated field, subject to changes almost daily. While general practice attorneys, financial planners, accountants and trust officers may have rudimentary background; they aren’t experts. Seek specialists to coach your professional advisors so the committee has better focus and understands when charitable planning opportunities exist.
2. School administrators, often ex-officio members of the foundation’s board, don’t have the tax and legal background needed to competently discuss the financial and estate planning tools. Since most board members don’t possess the skills either, find professional advisors willing to serve as resources and develop a network capable of addressing donor needs. Properly done, that integrated approach will also provide ongoing support for your district’s needs.
3. Focus on the priorities of the school district and the students’ needs outside of day to day educational requirements. The foundation should be seen in the same light as a savings account, while the school district’s annual budget commitments operate from the checking account. They have different purposes, different needs
4. Implement a business plan; create a planned giving committee separate from the foundation board. Be careful about conflicts of interest, and be up front with professional advisors that there’s not an exclusive right to solicit donors for products and services when discussing foundation needs. A good policy manual, available from several commercial providers, should be very clear about what acceptable gifts and solicitation tools the foundation will utilize. This approach offers several advantages:

• Setting board policy isn’t a factor with this committee but creating strategy and planning partnerships are, so there should be no compliance problems with the new §4958 regulations already adding to administrative burdens for public charities.
• Learn how to showcase the facility and present the school district in a way that makes it seem more like the heart of the community instead of a money pit soaking up tax dollars. Provide continuing educational programs that help remind donors and advisors that the foundation is a willing partner in implementing community gifts.
• Get away from the “poor me” mindset. Donors want to give to successful programs and there needs to be suitable motivation to support the cause.
• Learn how to appeal to the donor’s sense of heroism and immortality and if you can do it in a tax efficient manner, donors will be more likely to refer peers and repeat gifts.
• Although there are risks, create funds that give donors a sense of control. Don’t pursue the too common mindset, “we’re the charity and we know best” found in many nonprofit organizations; that nearly arrogant sense of moral superiority doesn’t create the motivation needed to encourage business owners and people who have accumulated wealth. These donors tend to be very control oriented, and the trick is to provide them with the sense of ownership without giving up the charity’s integrity and compromising its tax-exempt purpose.
• Identify the mission of the foundation in such a way that it creates a vision of future accomplishments and becomes easier to ask for and receive ongoing support.

With a coordinated strategy, not only will annual giving prosper, but future planned gifts will more easily fall into place. In order to make this occur, delegate someone to implement the planning processes now. Spend some time training the board and supporting committees on tools available, not with the goal of making them experts, but focus on recognizing when tools may be beneficial and call in technical support to implement the gift. If possible, find advisors willing to be coached and supported in this new field long enough that they can become competent. Although it’s time consuming, this approach will allow the foundation and community to prosper.

Vaughn W. Henry is a planned giving specialist based in Springfield, Illinois. His web site, http://gift-estate.com, has numerous articles, case studies and professional resources suitable for foundations and administrators seeking more background to improve their development activities.

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

Incentive Stock Options and the CRT

Incentive Stock Options and the CRT

George Rivera (47) is an industrial engineer with a midwest manufacturing company; his wife, Nancy Rivera (45), is a nurse with a local physicians’ group. George is well compensated and has been provided with incentive stock options as an executive benefit, and he has been exercising them annually with money from his year-end bonus. The qualified options allow George to purchase his employer’s stock at far below market price and his net worth has steadily appreciated over the last few years with continued company growth. Although any stock acquired through an option and held for at least one year qualifies for capital gains treatment, which is usually more advantageous than paying tax at his marginal rate, it still means he turns 30% of his retirement dollars into tax dollars in a normal sale. This is wasteful and unnecessary, see why below.

George’s employer provides access to financial planning services as a company perk. Counseling increased diversification to reduce his exposure to any downturns in the market, his planner is concerned how a decline would affect George’s one stock portfolio. His advisors suggested the use of an IRC §664 Charitable Remainder Trust to bypass the income tax liabilities when he repositions his growth portfolio into one more suitable for wealth preservation and prudent retirement planning. Besides the financial advantages of a CRT, there were also the issues of what money and wealth meant to his family. As a part of the Rivera’s financial plan, George and Nancy completed a profile that detailed their family financial philosophy. While tax avoidance was important, it wasn’t their only motivating influence. Although, the Riveras have no children, they have been active in local community affairs and feel that they have a vested interest in the town where both of their families have been living for many years. With no particular desire to leave distant family with a large inheritance, the Riveras chose retirement security, inflation protection, asset preservation and community projects as more important features of their plan, and the CRT meets those goals very effectively. Even if tax avoidance is the only priority, this performs exceptionally well; but when factoring in the “social capital” issues, the CRT formed the core strategy of their estate and financial plan. As trustees of their own CRT, the Riveras control the assets and investment management decisions and still retain the right to modify the charitable institutions scheduled to receive assets when the trust terminates. As there will be an estimated $8.9 million in social capital inside their charitable trust, it has great potential to impact the local community.

Henry & Associates designed the Rivera scenario* and compared the two options of (a) selling stock and paying the income tax, reinvesting the balance at 10% or (b) gifting the stock to an IRC §664 Trust and reinvesting all of the sale proceeds in a similar 10% equity based portfolio. At the maturation of the CRT, when the surviving spouse (most likely Nancy) passes away, the assets inside the trust will pass to a community hospital and nonprofit nursing home. These organizations provided the Rivera family with health care over the years and deserve their support, although if the Riveras decide to expand the list of charitable remainder recipients, that’s an option.

Incentive Stock Options and a CRT Strategy (seehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)	Sell Taxable ISO Stock Reinvest the Balance (A)	Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of Stock	$1,000,000	$1,000,000
Less: Tax Basis	$300,000
Equals: Gain on Sale	$700,000
Less: Capital Gains Tax (federal and state combined)	$210,000
Net Amount at Work	$790,000	$1,000,000
Annual Return From Asset Reinvested in Balanced Acct @ 10%	$79,000
Avg. Annual Return From Asset in 5% CRUT Reinvested @ 10%		$171,753
After-Tax (40%) Avg. Spendable Income	$47,400	$103,052
Statistical Number of Years of Cash Flow for Income Beneficiaries	44	44
Taxes Saved from $179,900 Deduction at 40% Marginal Rate		$71,960
Tax Savings and Cash Flow over Joint Life Expectancies	$2,085,600	$4,606,250

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

©Vaughn W. Henry, 1997

Creative Estate Planning When the Stock Market Declines – Vaughn Henry & Associates

Making the Most of Market Declines

Vaughn W. Henry

Not all stock market gyrations are bad things. Recent declines in equity portfolio values actually may present some excellent opportunities for estate and gift planning. The IRS and Congress have been trying to tighten restrictions on “estate compression tools” (legal structures that deflate an asset’s fair market value), especially Family Limited Partnerships (FLP) with exclusive holdings in publicly traded stock. The feds’ argument is that publicly traded stocks have an established value, are easily partitioned, and that significant discounting taken for minority interests, lack of control and lack of marketability in those limited partnership units is abusive. On the other hand, the FLP with land and closely held businesses probably will not have difficulty using those same legitimate discounts. However, partnerships with cash and liquid assets may need more care in handling those assets. What other options exist to pass family wealth? Consider a lead trust. Why? The long awaited bull market correction presents an ideal opportunity to gift assets that have intrinsic worth, but are temporarily at a lower value without a lot of legal mumbo-jumbo. A stock portfolio of $1 million that suffers a 25% – 35% decline due to erratic and unjustified market behavior has presented the owner with a legal and timely way to trim the family’s estate and gift tax bill. The old adage about striking while the iron is hot is sure true in today’s financial environment.

Other than traditional outright gifts to heirs, the combination of the government’s low Applicable Federal Mid-Term Rate (§7520 120% Annual AFR) and the stock market decline means that a Charitable Lead Annuity Trust (CLAT) presents some very exciting ways to pass wealth to family. The added benefit is that of meeting philanthropic interests at the same time. The lead trust is a reciprocal version of the more popular Charitable Remainder Trust (CRT) in that a charity receives a stream of income from the lead trust and after a period of time, the remaining assets pass back to family or heirs at a significant discount. Create these trusts far enough ahead of time and inheritances pass with no tax cost at all. And since the assets placed into trust were in a temporary decline because of market fluctuations, the family inherits a solid portfolio with the capacity to grow significantly. If the charity receiving the trust payments is a donor advised fund inside a community foundation, charitable distributions can enhance family influence and support. The goal of preserving family wealth is not to protect just the hard assets, but to provide opportunities for the family to wield clout in a community and to continue a positive family legacy.

How would it work? George Smith (55 years old, married with 3 children) had a well-balanced and diversified portfolio worth $1 million in July, and in September, after his average values had declined 35%, his portfolio was worth $650,000. George felt his portfolio held some outstanding stocks and viewed this as a buying opportunity, but he wanted to solve estate tax problems too. Advised to think strategically and solve several problems at one time, George created a nongrantor charitable lead annuity trust with his temporarily depressed portfolio. The CLAT stipulated that 8.9% of the initial fair market value be paid out in a monthly annuity to his donor advised fund at a national community foundation. In this way, he funded his charitable interests through his family’s donor advised fund and after 20 years, the portfolio and all of its growth will pass to his family at zero cost in estate taxes. The family’s only cost was to wait for assets they were in line to inherit anyway. By passing assets without any tax cost, the appreciated portfolio is expected to be worth $1.84 million if the underlying funds just experience average market performance, and this will save the family over $1 million in unnecessary estate taxes. Additionally, his 8.9% his charitable gift fund payment of $57,850 for 20 years will provide for his discretionary philanthropic interests in a very tax efficient manner.

 

Converting Taxable Assets to Tax Free Corporate Income

Converting Taxable Assets to Tax Free Corporate Income

• Reposition corporate assets without tax liabilities
• Create tax-free income
• Generate more income and control more capital
• Fund corporate foundations and community philanthropy
• Learn how to give away the IRS’ money

The wealth of the U.S is primarily tied up in closely-held and illiquid business operations, and any strategy that frees up assets efficiently is worth a second look. As the ABCD Corporation streamlined its revamped business operations, Rebecca Watson (corporate CFO) decided to unload a parcel of land no longer needed for plant expansion. The good news was that the land had development potential and its fair market value was considerably higher than its tax basis. The bad news was that to sell and reposition assets in a conventional sale, Ms. Watson would create federal and state taxes on the realized gains equal to 35% of the profit in the transaction, a totally unacceptable loss of value.

Seeking tools to minimize the tax, Rebecca solicited suggestions from an estate planner who was familiar with IRC §664 Trusts*. By developing an integrated strategy and transferring the parcel of land to the trust, the corporation was able to create an immediate income tax deduction, sell the asset without tax liabilities, reposition the tax-free proceeds to a dividend paying preferred stock that generates tax-free income from 80% of the ensuing dividends. After a term of 20 years, the trust will mature and the remainder passes to fund the corporation’s foundation. By controlling more of the corporation’s “social capital”, the business will effectively shelter an extra $1.8 million from the IRS and leave their corporate foundation almost $1.5 million more value than through traditional planning.

Alternatively, a conventional taxable sale resulted in only $2.085 million to reinvest in business investments funding future expansion. The corporation lost the use of $825,000 in unnecessary tax, a hefty penalty, to get rid of an unneeded parcel of land. Instead of paying tax, the §664 Trust served to control more capital, produce more income and fund a corporate foundation that serves public affairs and community development functions for the business. As a marketing strategy, any activity that improves community relations and enhances corporate image eventually impacts on the bottom line, so when a corporate philanthropic approach evolves that also makes good economic sense, this business chose to utilize its options for enlightened self-interest.

*Contact our office for suggestions or courtesy illustrations for professional planners.

Corporate Tax Saving CRT –http://members.aol.com/CRTrust/CRT.html	Sell Asset and Pay Tax	§664 Trust
Fair Market Value of Development Real Estate	$3,000,000	$3,000,000
Less Cost of Sale	$90,000	$90,000
Adjusted Sales Price	$2,910,000	$2,910,000
Less Adjusted Cost Basis	$160,000
Gain on Sale	$2,750,000
Tax at 35% (federal and state)	$962,500
Capital Controlled – Amount Available to be Reinvested	$1,787,500	$2,910,000
Annual Return from 8% Taxable (@ 34% Tax) Bond	$143,000
Avg. Annual Return 7% §664 Trust Earns 8% in Pref. Stock Dividends		** $219,809
Avg. After-tax Cash Flow From Repositioned Assets	$86,908	$190,794
Taxes Saved From Deduction of $755,085 @ 34% Tax Rate		$256,729
Total After-tax Cash Flow and Tax Savings After 20 Years	$1,738,160	$4,072,609
Increased Cash Flow to Corporation		$2,334,449
Asset Value Owned by Corporation After 20 Year Term	$2,085,000
Asset Value Transferred to Corporate Foundation After 20 Year Term		$3,550,753

** The dividend deduction for corporate dividends is another reason why taxpaying corporations should consider using mutual funds and preferred stocks. Tax law permits a corporation to deduct from income the first 80% of dividends received on stock it owns in another corporation [I.R.C., §243(a)(1)]. Thus, 80% of a stock or mutual fund distribution that is attributable to dividends is deductible from the corporation’s income. It includes in its income only the 20% balance of the dividend, so in the 34% corporate tax bracket, only 13.2% of the corporation’s dividend income is lost to income tax.

© 1997, Vaughn W. Henry

Henry & Associates

A Partnership From Hell

Failing to stabilize and protect estate values is one of the classic errors in most estate plans. Avoid this situation by consulting your tax, financial and legal advisors.

A partnership from hell — that’s what it must feel like to suddenly be in business with your best friend’s spouse. Worse yet, finding yourself forced to work through his/her attorney, and it could be catastrophic to own a business with the ex-wife’s new husband and his attorney. How does this happen? If your succession plans do not include the possibility of death, disability or retirement for the owners of a closely held business, then you are faced with just this scenario. (If you think this situation is bad, imagine a partnership with the IRS, a consequence of a poorly designed estate plan.) While the Chrysler Corporation can have Lee Iacocca step down and not disrupt the company’s profitable outlook, not many closely held or family businesses have the same degree of continuity.

When a small business owner-employee steps out of the picture, the surviving partners and surviving spouse usually have differing goals. The business owner usually wants to continue operations and put any profits back into growing the business, while the surviving spouse wants income and minimal risk. The logical solution is for the surviving partner or the business to buy out the deceased owner’s interest, but that entails coming up with cash. Where does an owner look for funding to maintain control? There are only four sources of funding to provide value to heirs, and they are cash in the business, sale of assets, borrowed funds and insurance products.

Each of these sources of capital has advantages and disadvantages, so decisions are based on personal needs and economic evaluations.

1. Use cash in the business or personal funds to buy out the surviving spouse. By accumulating after-tax funds on a steady basis, it’s possible to set aside adequate capital to purchase those business interests. These sinking funds work well enough if there is adequate time, but the risk is absorbed by the partners if something happens too early and derails the plan. In a 33% tax bracket, one needs to earn $1.50 to have $1 available for this purchase. Also remember that funds set aside in a corporation may be subject to excess accumulation penalties. Even businesses with significant cash flow may not be able to sustain required payments with a principal player who contributed to the profitable operation out of the picture. Uncertainty and unfavorable tax leveraging are the major disadvantage of this method.

2. Assets sold under pressure rarely bring more than discounted garage sale prices. As long as they are not the major income producing assets of the business, maybe you can do without them. However, most nonessential assets will not bring their full market value, so the best assets must be offered for sale instead. Business liquidators report that a 40% loss in value is typical, so that option would appear to be undesirable.

3. If borrowing credit is still intact after the loss of a major “rainmaker” in the business, maybe a lending institution will loan the survivor the funds. Of course, the money needs to be repaid with interest using after-tax dollars. Even if the heirs finance an installment sale, the business will eventually have to purchase itself more than once. In this case, the surviving heirs must assume the risk that the business will continue to be profitable enough to provide a steady source of income with a restructured management team.

4. Properly structured insurance products within a buy-sell agreement have the potential to provide necessary tax-free cash when the event (death, disability or retirement) that triggers the need for funding exists. There are a number of strategies available to purchase these special insurance contracts with tax advantaged premium payments. Some of today’s most popular discretionary perks now include using life insurance products in creative ways to pay for personal needs with corporate dollars. Recent changes in tax laws now make these discretionary programs more appealing, making them one of the few tools available that favor the small business owner.

Buy-sell agreements form much of the basis for continuity in business operations, whether it be for sole proprietors, partners or corporations. A well-drafted agreement ensures the family that the business will be either retained or disposed of fairly. The contract also establishes an upper limit for the IRS as a market value for estate tax purposes. If there is a closely held business interest in your estate, it would be a good idea to sit down with your estate planning team and explore the various options to preserve value and control. Good planning can reduce uncertainty, expenses, tax liabilities and improve both the clients’ and heirs’ income potential.

For creative ways to preserve corporate value, protect heirs active in the business, resolve excess accumulation issues and generate retirement income for the founding business owner, look at an IRC Section 664 trust as a powerful transition tool. For more information, e-mail us.

Vaughn Henry deals with planned giving and estate conservation work and is a member of the Central Illinois Chapter of the International Association for Financial Planning.

• Business Continuity Planning
• Closely-held Businesses Passed Down With Tax Leveraged Options
• Family Farm Operations Preserved
• Multi-generational Estate Planning

Contact us for suggestions on planning options to preserve your family business.

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How to Give Away Your Taxes

Capturing Social Capital is more than enlightened self-interest; it is a means of asserting control over assets you have spent a lifetime accumulating. When exploring estate planning techniques, normally you must include powers of attorney, wills, trusts, business agreements and the use of gifts. Planned gifting programs are best utilized within a complete estate plan, and offer the donor a great opportunity to give away tax liabilities. After all, the joy of giving allows you the choice of transferring assets to children, charity or Congress. Of the planning tools used, charitable giving may be more powerful than you have imagined, but it has been avoided by too many professional advisors.

What will sponsoring a charity do for you?

It will make your life more interesting, more exciting, more flexible, more fun and more meaningful.

Changes in lifestyle, economy and government programs have greatly influenced trends in modern charitable giving. Typically, the institutional priority today is a more donor driven philanthropy instead of the traditional needs driven approach. In order to compete for limited donor support, charities have to move from a gift getting mentality to a problem solving manner of thinking. Organizations can best accomplish this shift in mind-set by developing partnerships with their donors. Charities with a proactive outlook in their development efforts will be able to better respond to the changes in the gifting environment. This flexible approach allows institutions the continued opportunity to provide improved services and support to their clients.

In order to understand their future partners, today’s charities must better understand family dynamics and motivations. Prosperous families recognize that they are in jeopardy and must address those risks to protect both their wealth and the individuals in their family. These risks include a lack of feeling competent, no cohesiveness, too little commitment to something more important than self and guilt about having wealth. Unfortunately, there is a lack of information about property and money management, and nobody is trained to inherit wealth. The solution is to work with charitable groups and family foundations. This mentoring activity allows younger family members to learn how to manage assets, plan and budget before they inherit the bulk of their noncharitable bequests. Besides preserving wealth, the elder generation wants to create a significance that survives them, so gifting programs can create a sense of immortality. Whether or not clients have purely charitable interests, most families have community or social issues that influence their outlook. By establishing a trust or foundation to support these activities, death will not interfere with the transfer of an important value system.

Often gifts are made by charitable bequests, but this may be the worst tool to shift assets, as it creates an obligation in the estate that may come before other necessary distributions. As an alternative, the government recognized two components to a charitable gift in 1969 by dividing the income and remainder interest. Four of these split interest planning tools now have the potential to both give something away and still keep the use of it. Of these, Charitable Remainder Trusts, have recently been popularized as powerful tax reduction techniques. In reality, they allow donors the opportunity to give away assets, retain an income stream, take tax deductions and still retain control over the ultimate disposition of the remainder gift. Besides a need for tax deductions, donors must also have charitable intent and a desire to maintain control. Remainder trusts may guarantee a fixed amount for life or a term of years based on either a fixed annuity calculation or a percentage of the trust’s annual value. Of the four types of trusts best known by their acronyms (CRAT, SCRUT, NICRUT, NIMCRUT), the Net Income with Make-Up Charitable Remainder Uni-Trust or “spigot trust” is the most flexible. Each trust has very different applications, depending on needs for future gifts, flexibility, donor tax deductions, income and control. Charitable Lead or Income Trusts are designed to pass the principal of a gift to heirs after a charity has received an income stream for a period of time. If the asset produces more than the required income payout, all of the future appreciation and the asset itself will pass back to the heirs without further estate tax obligations. These techniques are best understood as enlightened self-interest because both good works and family priorities are promoted.

For donors with purely charitable inclinations, the next three tools address some of the security issues which most concern the older client. While these techniques do not preserve any assets for the family, they are more practical as a means of supporting charitable works and giving final control to the philanthropic institution. Charitable Gift Annuities are programs in which the institution must guarantee a lifetime of income for the donor, but any unused funds revert to the charity at the donor’s death. This technique is most useful for the very elderly or those with no family wealth to pass along to heirs. Pooled Income Funds, owned and run by the charity, are similar to mutual funds. The institution is then required to pay the donor each year’s investment proceeds on a proportional basis. Ultimately, the principal amount will pass to the charity and be used at their discretion. Life insurance may also be purchased and gifted to a charity in a direct program that offers a guaranteed benefit for donors with a fixed budget. Charitable gifting is not limited to the ultra-wealthy, as any sized estate plan may benefit from its use. To evaluate the best use of gifts within the estate planning blueprint, experienced legal, tax and financial advisors should be consulted.

Vaughn W. Henry deals primarily with planned giving programs and estate conservation work and is a member of the Central Illinois Chapter of the International Association for Financial Planning.

Failing to stabilize and protect estate values is one of the classic errors in most estate plans. Avoid this situation by consulting your tax, financial and legal advisors.

Contact us about seminar programs for non-profit organizations seeking deferred or planned gifting programs.

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‘To give away money is an easy matter, and in anyone’s power. But deciding to who to give, how much, when, for what purpose, and how much is neither in everyone’s power nor an easy matter. Thus, it is that such giving is rare and noble and praiseworthy.’

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Vaughn W. Henry

 

One of the most common problems associated with estate and gift planning is the tendency to use a patchwork quilt approach to the process.  The resulting jumble of uncoordinated documents, conflicting directions, confused advisors and angry heirs makes it nearly impossible to meet client expectations.  Instead, think about ways the estate plan more closely resembles an architectural blueprint.  The design of the estate’s “house” should be based on its needs and use, just like a well thought out residence.  Will the legal structure stand up to family turmoil and weather legal storms, can it be expanded to accommodate new needs and a changing economic climate, is it large enough and well built enough to protect the estate?  You wouldn’t build a house one room at a time.  Nor would you withhold a complicated blueprint from the contractor and all of the plumbers, electricians and roofers or the house wouldn’t be livable.  The architect explains the master plan and design philosophy to all who contribute to the project and makes sure plumbers don’t cut electric lines and roofers don’t shingle over the fireplace chimney.  Why not build an estate plan the same way?  Coordinate the plan and make sure all of the pieces fit together without creating new problems.  Advisors believe well designed estate plans should meet certain goals, namely:

·         Protect the client from financial insecurity in the event of disability, keep options open and improve the management of the estate in the event of the client’s absence.

·         Establish priorities, e.g., should heirs be protected from making inexperienced mistakes, where does a charitable bequest fit into the master plan, how important is control vs. a legitimate tax saving strategy?

·         Gather legal, personal, tax and financial documents in an organized fashion and make them easily available when needed.  Make sure that the tax, legal and financial advisors all work in a cooperative, goal oriented process. Too often, professional advisors compete for client control and may not acknowledge limitations in their own areas of expertise.  It’s unreasonable to expect just one advisor to have all the specialized skills needed to complete an estate plan that zeroes out all tax liabilities, so the use of a professional team has become more accepted.

·         Avoid family conflict and future ill will.  When heirs don’t understand the plan and feel they’ve been mistreated, many opt for legal challenges that tie the estate up in court for years, wasting assets and frustrating family members.

·         Minimize expense, delay and publicity of the estate distribution process.  While ease of use and logic are important, the default plan of letting the heirs and IRS fight over the assets doesn’t preserve much of a legacy. 

·         Stipulate who will operate any business and handle family affairs during a disability or after death.  If the estate controls stock in a family business, who votes and controls the stock before it is distributed?  Will the family business succession plan work if outsiders take over the business?  Will the family business have the liquidity to redeem the stock from the estate?

·         Eliminate unnecessary income and estate taxes and provide adequate liquidity to pay final expenses and taxes.

·         Consider making charitable bequests from assets that produce income in respect of a decedent (IRD), incorporate that language in the Will and make sure beneficiary designations are current and accurate.

·         Pass assets to heirs as planned, under conditions that best that meet family needs and their abilities to effectively manage an inheritance.

 

Complaints about the costs of creating an estate plan are often overblown.  Like contractors dealing with change orders and moving misplaced walls when a builder wants to add a closet or move a bathroom, the costs for planning can be controlled by having a master plan and doing the job in a systematic and orderly way.  Each piece builds on another and the plan integrates seamlessly; otherwise keep delaying, starting and stopping and redoing it and the costs invariably go way up.

 

Besides having an estate plan that’s not integrated, too many clients postpone decision-making.  The causes for inaction are numerous, but dealing with complex matters, issues of death or disability, frustration and family harmony are cited by many as reasons.   Making the problems worse are conflicting suggestions from friends, family and well-intentioned, but poorly trained advisors.  So it’s not hard to understand why most people hope that by doing nothing the problem will solve itself.  Benign neglect isn’t a successful planning process; it takes a proactive decision to take control of the process.  Don’t assume any plan will be perfect and never again need adjustment.  Laws change, family needs change and priorities shift, so work towards solving the big problems now and then focus on the little ones later.  As Karin Ireland noted — “Waiting until everything is perfect before making a move is like waiting to start a trip until all the traffic lights are green.” 

 

 

Asset Protection and Multi-Generational Estate Planning Tools

Asset Protection and Multi-Generational Estate Planning Tools

Allen (72) and Elizabeth (64) Becker have a successful chain of franchise fast food restaurants. Starting with just one restaurant 40 years ago, they both worked the grill and cash register, even mopping floors at night to save payroll expenses to get their fledgling business off the ground. Now, after years of hard work, the businesses are valued at $6.25 million and Allen is reluctantly selling the stock in his corporation after experiencing some health problems. With no chance to continue operating the business, there was only a choice between selling the stock and paying the capital gains tax, or using a §664 Charitable Remainder Trust to control 100% of the principal. After Allen’s accountant attended a seminar on using a CRT to more efficiently sell closely-held businesses he met with the Becker family and suggested bypassing the capital gains tax “hit”. However, Allen was initially unwilling to give up all the stock and principal to charity, so a strategy was developed to only transfer 80% of his company stock to the charitable remainder unitrust, and sell the remaining 20% in a routine taxable sale. The new buyer acquired 100% of the stock from two separate sellers (i.e., The Becker CRT and Allen Becker individually). This technique allowed Allen and Elizabeth to use the tax deduction of $1,583,350 created by the transfer of $5 million in corporate stock to their CRT and offset most of the tax liability on the $1.25 million taxable sale. The Beckers then took $1.2 million from the taxable sale proceeds and created an Irrevocable Life Insurance Trust (ILIT) to hold a survivor life insurance policy funded with one payment.

To further protect family assets from the heirs’ mismanagement, their attorney drafted the ILIT to make use of the Becker’s Unified Credit and Generation Skipping Tax Exemptions. This protects all of the proceeds from estate taxes for the duration of the trust, probably 100+ years or so. The advantage of designing this “dynasty trust” is that it controls and protects family assets from taxation, litigation, divorce and spendthrifts while still providing the heirs with an opportunity to distribute and spend family wealth. By using the ILIT to purchase an insurance asset, this special trust now holds capital that creates no current income tax liabilities. At the surviving spouse’s death, the family trust will receive $5 million in insurance proceeds, free of both income and estate taxation. With no other assets in the Becker’s ownership, the family escapes all estate taxation and has $5 million in personal financial capital to use inside the family trust. Besides this tax leveraged asset, there will be an additional $8.8 million in social capital inside their charitable trust. Henry & Associates designed the Becker scenario* and compared the two options of (a) selling stock and paying the income tax, reinvesting the balance at 9% or (b) gifting the stock to an IRC §664 Trust and reinvesting all of the sale proceeds in a similar 9% balanced portfolio. At the termination of the CRT, when the surviving spouse (most likely Elizabeth) passes away, the capital inside the trust will pass to a community foundation with Becker heirs sitting on an advisory board to make recommendations about funding charitable programs of interest to their family. Since diabetes and cancer have affected the Becker family over the years, much of the annual support of about $500,000/year, will be used to fund research and education on these two diseases. This family has regained control of their social capital and now has an effective asset protection strategy that will serve the Becker family for many years.

Partial Corporate Stock Sale CRT Strategy (see our web-sitehttp://members.aol.com/CRTrust/CRT.htmlfor other tools)	Sell Asset and Reinvest the Balance (A)	Gift Asset to §664 CRT and Reinvest (B)
Fair Market Value of 80% of Corporate Stock	$5,000,000	$5,000,000
Less: Cost of Sale (legal fees, commissions, appraiser)	83,000	$83,000
Adjusted Sales Price	$4,917,000	$4,917,000
Less: Tax Basis	$25,000
Equals: Gain on Sale	$4,892,000
Less: Capital Gains Tax (federal and state combined)	$1,467,600
Net Amount at Work	$3,449,400	$4,917,000
Annual Return From Asset Reinvested in Balanced Acct @ 9%	$310,446
Avg. Annual Return From Asset in 6.5% CRUT Reinvested @ 9%		$414,370
After-Tax (42%) Avg. Spendable Income	$180,059	$240,335
Statistical Number of Years of Cash Flow for Income Beneficiaries	23	23
Taxes Saved from $1,583,350 Deduction at 42% Marginal Rate		$665,007
Tax Savings and Cash Flow over Joint Life Expectancies	$4,141,350	$6,192,709

Hypothetical evaluationsare provided as a professional courtesy to members of the estate planning community. Call for suggestions.

©Vaughn W. Henry, 1997

Henry & Associates

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