“Nothing happens around here until someone sells something

“Nothing happens around here until someone sells something

Seminar selling is a great marketing tool; it’s something designed to answer questions, present the speaker as a problem solver, motivate prospects, and generate referrals.  In this particular case, an elderly couple attended a seminar at the local senior center.  The seminar, co-hosted by a charity and three insurance agents, pushed charitable remainder trusts (CRT) by stressing how real estate makes for a problematic inheritance (e.g., estate and/or capital gains tax, liquidity, management concerns, etc.)  In rapidly growing states like California, every senior attending that seminar had a substantial percentage of their net worth in real estate.

Speaker #1 met with elderly clients later and told them a CRT was the perfect tool for them.  Although their estate was valued at $1,200,000 and taxes shouldn’t have been an issue, he scared them with tales of high estate taxes and lack of liquidity.  They agreed to do a CRT benefiting the co-sponsoring charity and the charity’s development officer met with them.  Speaker #1 sold life insurance to fund a “Wealth Replacement Trust” or Irrevocable Life Insurance Trust (ILIT).  Speakers #2 and #3 handled the reinvestment of the real estate sales proceeds.  Speaker #3 is married to the charity’s representative, but this isn’t disclosed.

Speaker #1 brought in his attorney, arranged for insurance coverage, and while insurance is often useful, these clients are high-risk and uninsurable, resulting in a $40,000 premium instead of the projected $10,000.  Further complicating the planning, the rental properties used to fund the CRT had mortgages, and debt encumbered charitable trusts are tax bombs waiting to explode.  To save the sale, Speaker #2 (also a mortgage broker) arranges to transfer the rental property mortgages to the family home.  The charity’s representative also tries to save the sale by telling clients that they can increase the CRT payout rate by replacing the relevant page of the already signed and irrevocable document.  Speaker #1 continues to try to save the sale by implying that premiums will be much lower in years after the second year (he misrepresented that fact).  Speaker #3 also tried to save the sale by telling the clients that their CRT will simply repay the new mortgage on their home in full, once the trust was finalized

The attorney didn’t draft the ILIT until the insurance policy has been in force for over a month.  No one bothered to tell the clients that they needed a qualified appraisal on the transferred properties, so no income tax deduction was available, but that was not a major issue since the clients had almost no income, so the deduction wouldn’t have helped much anyway.  The speakers told clients repeatedly that the income from the CRT would cover the insurance premiums, so clients were writing checks from the charitable trust accounts directly to the insurance company.  Over the next two years, no one did any trust accounting or advised the clients that trust accounting would be required.  Speakers #2 and #3 invested the CRT assets into a deferred annuity earning 6%, even though the CRT payout rate was set at 10%, producing a declining  income stream.  When all the dust settled, the clients had only $200,000 left outside of the CRT, an unaffordable and collapsing insurance policy, a decreasing annual income, and a staggering bill for the accounting work needed to re-file past years’ tax returns and pay penalties and interest.

What were the motivations for all of these shenanigans?  Speaker #1 earned a $30,000 commission.  Speaker #2 earned $4,500 in mortgage broker fees, speakers #2 & #3 earned $12,000 in annuity commissions, and the charity’s representative (married to Speaker #2) earned a percentage-based bonus for bringing in the gift.  Too bad, there should have been some consideration for the client/donor and there wouldn’t have been litigation generated.  If you aim for immediate gratification, you’re likely to do great harm with your toxic planning to all involved.

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Check our Trust and Planning Archive	Hosted by Henry & Associates at Charitable Trust Planning

Vaughn W. Henry

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct Please note — there’s much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not “do it yourself brain surgery”. When is a CRUT superior to a CRAT? Which type of CRT is best used with which assets? Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When to use a CLUT vs. CLAT and the traps in each lead trust. Which tools work best in which planning scenarios? Check with our office for solutions to this alphabet soup of planned giving tools.

Why It Makes Sense to Let a Charity “Use” Your Money

 

Investment Hypo within a CRT – Part II – Henry & Associates

But for Rotten Luck Some People Would Have No Luck at All – Henry & Associates

Investment Hypotheticals Within a CRT – Henry & Associates

CRAT or CRUT?

Selecting the RightTrust for Your Needs

 

One would think a simple “either – or” decision would be the easiest to make, but as it turns out it is not always so straightforward.  Take the choice of charitable remainder trust.  Which works better for the client – the annuity or one of the unitrust variations?  Well, many prospective trust makers throw the choice back to their advisors, assuming that because there is a legal, financial planning, or accounting professional designation or degree that their advisors know what is best.  As it turns out, that’s not necessarily so since so many professionals now specialize and can’t be expected to know all the problems associated with every tax planning situation, and few know anything about §664 split interest trusts.  It is not reasonable to expect litigators and general practitioners to know about obscure tax rules any more than a psychiatrist would be competent to perform a kidney transplant.  The possession of an MD, CFP, CPA, or JD designation only provides a framework for future knowledge and experience.  What is most important is the practical application of that knowledge, and with charitable remainder trusts, there are precious few professionals who have ever seen one, much less understand them.  As an example of the compartmentalization found among professionals, examine the planning that went into former President and Mrs. Clinton’s 1997 tax returns.  Arguably, while theClintonshave access to lots of qualified counsel and even possess law degrees themselves, they still made serious blunders in their charitable and estate planning.  If the first family cannot get it right, it should come as no shock that the majority of clients will not get it right either.

 

TheClintonspaid $291,755 in federal income taxes over the two years.  But they could have paid $167,532 less by having royalties from “It Takes a Village,” Mrs. Clinton’s book about child rearing, sent directly from the publisher to a charitable fund instead of taking the money as income, paying taxes and giving away the difference.  The charities would have come out ahead, too, collecting 22 percent more than the $840,000 they received. 

“It Takes a President to Overpay the IRS”, New York Times,April 19, 1998

 

For most planners who don’t specialize in charitable planning, their assumption that a CRAT is best for old folks and a CRUT is best for younger donors isn’t necessarily the best way to make a decision about a trust that’s irrevocable.  This is especially true when the timeline of the CRT, something with which a donor must deal for years, is considered.  Disagreements among advisors often pop up over investments inside a CRT since few financial advisors really understand the fiduciary accounting peculiarities of investing for a tax-exempt CRT.  Because a charitable trust invests over a long time horizon, and the trust does not usually pay income tax on its growth or income, chasing returns and reacting day to day is not the style of investing that works best for the CRT.  Add to the long term view the very real concern about avoiding unrelated business income that may be unintentionally created when a broker uses a margin account, acquires partnerships or other working interests that expose the trust to “toxic income” that loses the CRT its tax-exempt status.

 

A well drafted CRUT allows, even encourages, additional contributions; however, it is not an option in the annuity trust.  Trustees need to properly fund the CRAT and be extra cautious to ensure that it is just one straightforward transaction and not in bits and pieces over a period of days.  With a charitable remainder annuity trust (CRAT), the payout is irrevocably set in a fixed dollar amount at the inception of the trust, and this rigidity creates several potential problems for trustees managing the trust and its investments.

 

Which trusts work best?  Sometimes knowing which trust will not work is a good place to start.  For example, if a donor contributes cash or publicly traded stock, that is a workable solution, but if undeveloped land goes into to a CRAT, the downside risks are numerous.

1. Will the asset produce enough income to meet the required income distributions?  A CRAT may not defer required distributions and being illiquid is not an excuse.
2. If the asset is not an income-producing asset, is it readily marketable to make the required distributions?
3. If the CRAT does not have enough liquidity to meet the obligations of the trust, is the asset easily partitioned in order that the income beneficiary can receive an in-kind distribution?  As an added insult, those in-kind distributions typically trigger capital gains tax liabilities, so the beneficiary receives his or her land back and has a tax bill to boot.  That is a recipe for an unhappy client – advisor relationship.
4. Was the contribution of the asset matched with enough additional cash to pay insurance, property taxes, maintenance, marketing, and operating expenses?  Remember, there can only be one contribution in a CRAT, so any cash transfer has to occur simultaneously with the transfer of the real estate deed.
5. Generally speaking, a CRAT is a better tool for a donor unconcerned with eroding purchasing power, and it is typically used for clients with little tolerance for volatility and short term needs, i.e., less than ten years, otherwise inflationary pressures diminish the value of the income distributions.
6. The minimum annuity paid at least annually must be at 5%, but cannot exceed 50% of the initial fair market value of the assets contributed to the trust.  In most cases to prevent trust exhaustion, a CRAT paying out more than 6.5% is a concern.
7. After the Taxpayer Relief Act of 1997 passed, the charity’s calculated remainder interest must be worth at least 10% of the value initially transferred to the trust.  This severely restricts young individuals from having a life income interest in any CRT, and restricts payouts to lower levels for many trusts, especially if there are more than two income beneficiaries.
8. Because there is a very real possibility of a CRAT collapse in a poor investment environment, these trusts must also meet a 5% probability test [Rev Rul 77-374].  If the trust fund has a greater than 5% chance that it will exhaust before the trust terminates and passes to the charity, then the trust will not produce an income tax deduction or qualify as a CRT.

 

CRAT vs. CRUT invested in a growth mutual fund 1/1/1990–1/1/2002

Too many trustees take an ultra- conservative and shortsighted investment approach to preserve principal.  However, prudent investment management is important if the income distributions are going to be tax efficient and the remainder value is to appreciate for the benefit of the charitable beneficiary.  As an example of a well balanced equity approach, an annuity trust (CRAT) established on January 1, 1990 and funded with $250,000 that purchased diversified GFAA shares (after fees) would produce significant gains, even with the fixed dollar annual income distributions of $12,500 (5% of the initial value) made through the end of the trust period.  While this specific trust is historically accurate in depicting annual returns even through several real market corrections, there is no guarantee of similar performance in the future; however, this particular fund has produced a trust remainder value of $928,488 as of12/31/2001   Using exactly the same investment vehicle and historical time horizon as the CRAT above, a 5% charitable remainder unitrust (CRUT) that pays a fixed percentage of the trust (annually revalued, so the payouts vary with the trust’s investment performance), yet it still produces a significant return of $765,884 for the remainder beneficiary and the income interest is enhanced to offset the effects of inflation.  A variable payout CRUT takes a percentage of a well-invested and diversified trust and increases in value. The CRUT in the example produced $273,444 of aggregated income over the twelve year period.  Compared to the CRAT’s income payments of just $150,000, it should be obvious that the variable payout unitrust offers more opportunity for growth if the investment performs properly.  Besides having a greater opportunity for an improved income stream, an equity based trust investment tends to produce more tier two (realized capital gains) income.  Remember, realized gain taxed at the more efficient 20% rate leaving the income beneficiary with more spendable income, rather than being penalized at the highest marginal ordinary federal rate of up to 38.6%.

 

 

 

CONTACT US FOR A FREE PRELIMINARY CASE STUDY FOR YOUR OWN CRT SCENARIO or try your own at Donor Direct. Please note — there’s much more to estate and charitable planning than simply running software calculations, but it does give you a chance to see how the calculations affect some of the design considerations. This is not “do it yourself brain surgery”. Knowing when a CRUT is superior to a CRAT or which type of CRT is best used with which assets and what investments “poison the trust” is critical. Although it may be counter-intuitive, sometimes a lower payout CRUT makes more sense and pays more total income to beneficiaries. Why? When should you use a CLUT vs. CLAT and what are the traps found 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.

Choices, it’s all about choices.

This is a case study about a curmudgeon client best known for the attention he lavishes on the bottom line of his businesses.  He is known to be opinionated, completely wrapped up in his business activities, unwilling to give up control and notoriously difficult to work with, previously going through six or eight estate and financial planning teams.  His tax and legal advisors were frustrated since they’d been unable to put a plan in place, having failed to move him off center into a decision making mode, but his pressing health concerns prompted them to take another crack at solving the problems.

Jeff Anderson arranged for a wealth counseling session after being exposed to a seminar program on zero estate tax planning.  Considering how a little creative, nontraditional thinking might solve some of his estate tax problems, he decided to pursue some options.  Jeff, in his mid 60’s, is a self made entrepreneur who made his money in the hardscrabble oil and gas industry, making and losing several fortunes along the way.  Sitting down with the client and his advisors, we reviewed his past estate plans and goals.  He started off by saying, “I don’t like insurance, I don’t want to buy any of it and every planner who sees me tries to sell me something.  What have you got to offer so I don’t have to pay any tax?”  A good response might be, “I don’t know, tell me about your goals and concerns first.”  A lot of his prior planning had been short sighted, but by rearranging pieces on his financial chessboard, it appeared that there were several new options available to the family.  So after doing a quick snapshot review of the balance sheet, income and estate tax liabilities on that day, it was agreed that with his current plan, his family would receive 46.7% of his estate and various government taxing authorities would receive 53.3%.   Asked how he felt about that inequity, and he said he was very upset about that distribution fact pattern. 

Jeff and his wife Ellyn have children from prior marriages, and each has divergent interests and planning goals.  Jeff, who has the bulk of the estate assets in his name is in remission from a past bout with cancer and is somewhat concerned that if he doesn’t get proactive with his planning, a significant portion of his estate will default to the IRS.  What was unsaid, but was an issue is what would happen if he predeceased his wife and his wealth passed to one of her ne’er do well children instead of his family. 

The traditional estate planning approaches weren’t motivating, as he didn’t feel like he had unneeded wealth to give away.  He was unwilling to sacrifice significantly in his lifestyle in order to pass wealth to heirs.   Jeff wanted to provide a comfortable income stream for his surviving spouse, but she was inexperienced dealing with investments and he didn’t want to enrich her at the expense of his children or lose control of his family’s wealth.  For a client like that, it’s easiest to separate the issues of control from ownership, since it’s what’s owned is what’s taxed.

We discussed his priorities in life and tried to foresee how his family’s concerns would develop over the next ten or twenty years.  Asked how he would redistribute his estate if given a choice, he opined that if he could avoid paying any tax at all, he’d split his estate 80/20 between his kids and charity, especially if he knew the charity was going to be sensible with his money.  Jeff said, “I’m not all that charitable, although I give something to charity every year.  I don’t think they respect the amount of work it took me to be able to make that gift and they fritter my money away on silly projects or poorly supervised programs.  If I could direct those funds, I could do it better.” 

While his heirs possessed varied talents, Jeff felt that being exposed to a family foundation might help his grandchildren develop a better value system, improve their business skills and independence.  Although his estate was significant, the charitable component of this plan made more sense with a donor advised fund (DAF) inside a community foundation instead of a private foundation.  These organizations are 501(c)3 public charities with sub-accounts through which families can make recommended grants to community organizations of interest to them.  While the family DAF still has the ability to help research and fund charitable interests, it offers professional assistance, infrastructure and should prevent the heirs from abusing the authority to make grants to inappropriate causes.

Planned giving is situational; few clients come into a planner’s office to ask about doing a FLIP NIMCRUT any more than a patient is likely to walk into a surgeon’s office and ask for a cholecystectomy.  Professional advisors and development officers need to help their clients meet personal goals by passing down a value system.  Good interviewing techniques and an empathetic approach to coaching clients about their opportunities will elicit those values driven responses that point to specific tools that will help build successful plans.

Will every client become a philanthropist, albeit a reluctant one?  No, but if a client fully understands the available options, most opt to do something that benefits a community project if it’s properly presented.  While there’s no philanthropy gene, there is a desire amongst many people to create some sense of significance, and leaving something to charity is one way of making a mark that will last.

Learning Experiences in CRT Design – Henry & Associates

Learning Experiences in CRT Design with Families

What to do when a couple isn’t insurable and a wealth replacement trust using life insurance isn’t economically affordable?  A typical solution is to name children as successor income beneficiaries to the CRT.  Factor in the §1089 TRA-97 10% charitable remainder requirement and naming younger income beneficiaries becomes much more difficult.  Many advisors have also forgotten another area in the Code that might cause them further difficulty in beneficiary planning.   Although there’s a natural desire of a client to include children in a CRT, advisors must explain that when a non-spouse is included as an income beneficiary, there’s a taxable gift involved.  If the trust names the spouse and children, then not only are the children receiving taxable gifts, so is the spouse, as the unlimited marital deduction* is lost.  There are solutions in a family situation when using a multi-generational CRT that might be worth considering:

1. To avoid making a taxable gift to a child when creating an inter-vivos CRT, retain the right to revoke the income interest by Will.  Since the gift is incomplete, the value of the CRT’s income interest becomes an estate tax liability if the right to receive income hasn’t been revoked.  In the meantime, the income beneficiary ages and the charitable remainder increases, and that may reduce the transfer cost.  Unless the trust value appreciates significantly, the estate tax value to the heir will be less than the original gift tax value.

* Because of ERTA (1981), a person can gift during lifetime or leave a surviving spouse his/her entire estate free of the federal estate tax, no matter the amount, except for certain terminable interests in property.  Now, only non-terminable or “qualified” terminable interests are eligible as unlimited marital deductions under I.R.C. §2056(b).  What’s terminable?  A terminable interest means the interest will end at the spouse’s death; for example, a life income interest in a trust.  The purpose of the terminable interest rule has been to deny any marital deduction at the first spouse’s death if the property will escape taxation at the second spouse’s death.  There are two “qualified” terminable interests under Code §2056(b) that qualify for gift and estate tax marital deductions.  One is for a “qualifying income interest for life” that passes to the surviving (donee) spouse from the deceased (donor) spouse with the following three conditions:

(1) a surviving spouse must be entitled to all the income from the property, payable annually or at more frequent intervals;

(2) no person can have a power to appoint any part of the property to any person other than the surviving spouse;

(3) the executor must elect to deduct the property on the federal estate tax return. This election is irrevocable. Note that a trust that paid the spouse an income for a term of years (rather than life) could not qualify, nor could a trust that terminated on the occurrence of a contingency (such as the spouse’s remarriage) PLR 8347090 (8-26-83).

The other qualifying terminable interest happens when the surviving spouse is the only income beneficiary of a charitable remainder trust.  The surviving spouse need not have a life income interest, as an income interest limited to just a period of years could still qualify I.R.C. §2056(b)(8).  The IRS, in Technical Advice Memorandum 8730004, noted that a CRT with two successive non-charitable beneficiaries lost the use of the marital deduction. The ruling related to a testamentary charitable remainder trust in which the decedent had named a surviving spouse followed by another non-charitable beneficiary. The Service ruled that since the Code specifies a surviving spouse to be the only non-charitable beneficiary, the interest, therefore, did not qualify for the marital deduction §2056(b)(8).  — ACCESS AUS 1997

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