FOR
PROFESSIONAL ADVISORS
PART I
Akron, Ohio
PHILIP T. TEMPLE, ESQ.
McCarthy
Fingar LLP
White
Plains, New York
1. Changes in Estate
and Gift Taxes.
A. Estate Tax
Applicable Exclusion Amount -- Really a Credit.
(1) The
Economic Growth and Tax Relief Reconciliation Act of 2001 (“2001 Act”) resulted
in major changes in the estate tax laws.
These changes are effective from January 1, 2002 through December 31,
2010, after which the estate tax law reverts back to existing law without
regard to the 2001 Act.
(2) Under the
2001 Act, the estate tax applicable exclusion amount will increase as follows:
$1,000,000 in 2002
$1,500,000 in 2004
$2,000,000 in 2006
$3,500,000 in 2009
(3) The exemption is really a
credit equal to the tax on the applicable exemption amount.
(4) The estate tax is repealed for
persons dying in 2010 and current estate tax law is reinstated for persons
dying in year 2011 and thereafter.
(5) Under the 2001 Act the top
estate tax rate is 50% and is reduced by 1% each year until 2007 when it will
remain at 45% until 2010.
B. Annual Gift
Tax Exclusion.
(1) Gift tax
annual exclusion is now $11,000 per donee (as of 2002), but only for gifts of
present, not future, interest. Indexed
for inflation; rounded down to nearest $1,000.
With gift-splitting, spouses can transfer total of $22,000 (and more)
per donee per year without gift tax (regardless of which spouse’s property is
used to make gift).
(2) Any amounts
paid on behalf of any individual (a) as tuition to educational organization or
(b) as payment for individual's medical care will not be considered a
gift. Exclusion for medical expenses
and tuition in addition to $11,000 annual gift tax exclusion and is permitted
without regard to relationship between donor and donee.
C. Taxable Gifts.
(1)
2001
Act does NOT repeal the gift tax.
(2) The
gift tax applicable exclusion amount increased to $1,000,000 on January 1, 2002
and is frozen at that level.
(3) Top
gift tax rate decreases with estate tax rate, but in 2010 is reduced to 35%.
(4) Gifts
in trust after 2009 will be treated as completed gifts unless the trust is
treated as wholly owned by the Donor or the Donor's spouse.
H
has $3,000,000 estate. His wife W has a
$3,000,000 estate of her own. H gives an amount equal to the equivalent
exemption to his children and the balance of his estate is set up in such a way
as to obtain the unlimited marital deduction.
H dies in February 2005; his wife then dies later in 2005, leaving her
entire estate to their children. Here
is what the estate tax computations would look like:
H’s
Estate
Gross
estate $3,000,000
Less: Estimated
expenses
-- at 5% $
150,000
Marital
deduction --
balance
of estate less
$1,000,000
NYS
exemption amount* $1,850,000 $2,000,000
Taxable
estate $1,000,000
Tentative
federal estate tax $ 345,800
Less: Applicable credit amount $ 345,800
Federal
estate tax
-0-
W’s
Estate
Her
separate assets $3,000,000
Marital
share from H $1,850,000
Gross
Estate $4,850,000
Less: Estimated expenses -- at 5% $ 242,500
Taxable
estate $4,607,500
Tentative
federal estate tax $2,006,325
Less: Applicable credit amount $
555,800
*No
state death tax credit available as of 2005 _________
Federal
estate tax $1,450,525
NYS
Death tax $ 354,360
Total
Estate Taxes $1,804,885
* limit exemption in this scenario to NYS maximum
exemption amount which is $1,000,000 in
order to
defer
payment of NYS estate tax.
2. Integrating Split-Interest
Charitable Gifts Into the Estate Plan to Save Estate Tax
Assume
that W is charitably inclined. Her Will
divides her estate into two parts. With
the first part, she creates a 6% charitable remainder unitrust (furnishing a
potential hedge against inflation) providing payments to her children in equal
shares for a term of 20 years after her death.
The other half is placed in a charitable lead trust providing for
payment of 7.7% of the initial value of the assets (a guaranteed annuity) to
charity for a term of 20 years with the remainder payable to children (or
grandchildren) at the end of the 20 year term.
Here is what the estate tax calculation in W’s estate would look like
using the January 2005 discount rate of 4.6%:
Gross
estate $4,850,000
Less: Estimated
expenses
-- at 5% $ 242,500
Gross
charitable deduction computation:
Gross
principal into unitrust
of
$2,303,750 x 30.052% factor $ 692,323
into
lead annuity trust of
$2,303,750
x 100% factor $2,303,750
$2,996,073
Less: Estate tax payable* $ 225,359
Net
charitable deduction $2,770,715
Total
deductions: $3,013,215
Taxable
estate: $1,836,785
Tentative
federal estate tax $ 750,350
Less: Applicable credit amount $ 555,800
Federal
estate tax $ 194,550
NYS
death tax $ 102,078
The
estate tax savings is $1,508,257
*Tax
attributable to non-charitable portion of unitrust. Gross principal of each trust is reduced by ˝ of estate tax,
thereby reducing charitable deduction for each trust. Estate tax is determined by interrelated calculation.
4. Overview
of Various Life Income Arrangements
A. Unitrust agreements.
(1) Standard
unitrust -- pays stated percentage (at least 5% and no more than 50%) of net
fair market value of trust assets, revalued at least annually, out of income
and, if income is insufficient, out of principal. Excess income is retained in
trust.
(2) Net income with makeup unitrust (the
NIMCRUT) -- pays lesser of (i) stated percentage of annual net fair market
value and (ii) actual trust income.
Deficiencies in distributions from an earlier year are made up in any
later year in which trust income exceeds stated percentage. Then excess income retained in trust.
(3) Net income without makeup unitrust
-- pays lesser of (i) stated percentage of annual net fair market value and
(ii) actual trust income. Deficiencies in distributions from an earlier year
are not made up. Excess income
is retained in trust.
(4) In net income unitrust, agreement
can provide that realized capital
gain -- but only that portion representing post-gift
appreciation -- can
be treated as income for purposes of
distribution.
(5) Hybrid agreement (the “Flip”
unitrust). Net income unitrust becomes
standard unitrust on sale of, i.e.,
closely held corporate stock. First,
unpublished PLR said O.K. Then, IRS said it doesn’t work. PLRs
9506015 and 9516040. Then proposed §664 Regs again said O.K.
Final Regs confirmed viability
of Flip - - but significantly broadened events that trigger flip.
(6) Why the Flip?
(a) In
NIMCRUT, once non-income producing asset is sold,
there
is expectation that Trustee will invest so as to achieve
ordinary
income at the stated percentage payout rate.
Not easy to do.
(b) Once
crut flips and becomes standard crut, can invest for
total
return. Easier to achieve payout
percentage and some
reasonable
growth in trust assets.
(c) Can
use flip to defer income.
(7) Some
Specific Items Regarding Nimcruts.
(a) Excess
income in earlier year cannot be used to make up
deficiency
in later year.
(b) What
is income? Generally state law
governs. Be careful
of
specific unique situations; i.e., assets such as timber; assets that
have periodic large amounts of income.
Defining income
to
include realized gain attributable to post-gift appreciation.
(c) Net
income provision does not change calculation of
charitable
deduction for income, gift or estate tax purposes.
B. Annuity trusts.
(1) Annuity amount couched in terms of
stated dollars; trustee directed to pay X dollars a year out of income and, if
income is insufficient, out of principal.
Any excess income is retained in trust.
(2) Annuity amount couched in terms of a
percentage of initial fair market value of assets transferred to trust. Once amount determined, stays constant for
trust term.
(3) In either case annuity amount
must be at least 5% (but no more than
50%) of initial value of assets
transferred to trust.
C. Pooled income fund.
Donor irrevocably transfers
money, long-term marketable securities or both to qualified charity's
separately maintained pooled income fund, where it is invested together with
transfers of others who make similar life income gifts. Donor (or other designated beneficiary)
receives his share of pooled income fund earnings each year. On donor's death (or death of other
designated beneficiary) payments terminate and charity removes donor's gift
from pooled fund and uses for charitable purposes.
D. Charitable gift annuities.
(1) Immediate payment. Donor transfers money or property to charity
in exchange for promise to pay fixed amount annually to donor (and survivor, if
desired) for life. Transfer is part
gift and part purchase of annuity.
Annual income (rate of return) paid by charity depends upon
beneficiary's (annuitant's) age at time of gift. Annual rate of return remains constant for life.
(2) Deferred payment. Donor makes gift to charitable institution
in exchange for charity's promise to pay him guaranteed life income starting at
retirement (or any other date specified).
(3) Regulation
in New York by Insurance Department.
E. Charitable lead trusts.
(1) Donor can avoid tax on income paid
to charity, but the trust must not provide reversion for donor or spouse. Trust should be lead unitrust or lead
annuity trust. Otherwise, value of
charity's income interest will be subject to Federal gift tax. And, if donor dies before property reverts
to him, there will be no estate tax charitable deduction.
(2) Main drawback of law is that donor cannot get income tax charitable deduction unless trust so drawn that he is taxed on income paid to charity -- a grantor trust. Thus, except for very wealthy individuals, charitable lead trust created during lifetime is generally not advantageous. Some create trust with tax-exempt bonds so that income is not taxable.
(3) Lead trusts paying income to charity
are advantageous when created by donor's will.
Estate tax charitable deduction allowed for value of income stream paid
to charity under lead trust created by donor's will. To get estate tax
deduction, income interest must be guaranteed annuity (annuity trust) or fixed
percent of net fair market value of trust assets, determined yearly
(unitrust).
(4) The Jackie O Lead Trust: Illusionary? But, still wonderful story.
5. Basic Tax Implications
A. Income tax charitable contribution
deduction allowed for charitable remainder interest or other gift element. In order to qualify, value of
remainder must be at least 10%.
B. Capital gain avoidance; the problem
of prearranged sales.
(1) The Palmer case still
lives.
(2) What about Blake?
C. Gift tax charitable deduction
(unlimited) allowed for remainder interest.
D. Estate tax charitable deduction
(unlimited) allowed for charitable remainder interest.
E. Taxation of remainder trust
beneficiary -- four-tier system - - WIFO basis.
(1) Ordinary income.
(2) Capital gain income; first
short-term, then long-term.
(3) Other income, including tax-exempt
interest.
(4) Return
of principal.
6. The Lifetime Uses of a NIMCRUT
A. Use of securities.
(1) Highly appreciated, but low-income
stock to fund "net income with makeup" unitrust.
(a) Provide low percentage payout --
but, at least 5% -- to increase charitable deduction.
(b) By retaining securities with high
appreciation potential but low income, reduce income paid to donor when in
higher income bracket and less need for income.
(c) Trust sells later when securities
appreciated and invests proceeds in high yield securities paying stated
percentage of increased value plus make-up of deficiencies from earlier years;
donor now possibly in lower tax bracket (say, at retirement) or needs greater
income.
(2) Transfer of closely held corporate
stock (charitable stock bailout) to charity.
(a) Donor transfers stock of close
corporation to charity generating deduction for fair market value with no tax
on appreciation.
(b) Corporation, although not legally obligated to do,
redeems stock from charity. Palmer;
Rev. Rul. 78-197; but see Blake.
(c) Transfer to charitable remainder
trust.
(i) Generally not good idea unless trust
can sell without violating self-dealing prohibitions.
(ii) A way out: Offer to redeem all stock is made.
(iii) Query: Is close
corporation stock a "prudent" trust investment?
B. Use of zero coupon bonds.
(1) Basic rules.
(2) Watch state law on questions of
whether trust can make interest income on redemption or sale principal.
(3) Flexibility of timing.
C. "The Spigot Trust." Use of commercial tax deferred annuity
contract.
(1) Donors funded a net income with
makeup unitrust with appreciated common
stock; the trustee plans to reinvest the trust assets in a commercial
deferred annuity contract.
(2) Regular annuity payment tax rules don't apply (payments partially excludable); because contract not held by natural person, it's all ordinary income -- but, that's good. Trustee will be able to use entire later payments to make up deficits. Also, Donors can “control” when they will begin to receive income.
(3) IRS made noise that “retirement unitrusts” are
suspect. Then IRS ruled in technical
advice that purchase of deferred annuity contracts doesn’t adversely affect
qualification of unitrust and would not be considered an act of self-dealing.
D. Funding Charitable Remainder Trust With Individual
Retirement Account (IRA).
(1) The general rules on "income in respect of a decedent."
(2) Other tax problems on IRAs and like plans.
(3) IRS Private Letter Ruling.
(a) D has Individual Retirement Account. She plans to create testamentary CRUT for
son's benefit. To fund trust, D will
name CRUT as beneficiary of her IRA.
(b) IRS rules. Trust
will qualify and entitle D's estate to estate tax charitable deduction for
value of remainder interest. Any IRD received by CRUT will have same character
in its hands as it would have had in D's hands, had she lived and received it.
(c) IRS also said that trust won't be taxable on its income
unless it has unrelated business income.
This, CRUT won't be taxable on IRD; instead, that income will be taxed
to son piecemeal as it's paid to him in satisfaction of annual unitrust amounts
under four-tier provisions of Code.
(d) Generous individuals often disappointed to learn that
IRAs and other pension plans can't be "rolled over" tax-free into
charitable remainder trusts during lifetime.
Resulting income is taxed to donor in year of transfer, reducing funds
available for trust. However, by
funding testamentary unitrust with her IRA, D has avoided up-front income
tax. And unitrust payments based on a
percentage of assets in CRUT, as revalued each year. Thus, the more (untaxed) assets pass to trust, higher payments
will be - and more pre-tax funds will be available for reinvestment.
(4) Current ruling. IRS confirmed its holding in above ruling,
but made it clear that income tax deduction for estate tax attributable to IRD
belongs to CRT not its beneficiaries.
Extent of adverse impact?
E. Wealth
Replacement
(1) Create CRT
(2) Use tax savings and/or increased income stream to purchase
life insurance to replace amount transferred to CRT. Perhaps use life insurance trust to hold insurance.
7. Some Potential Pitfalls
A. Transfer of mortgaged property to
remainder trust.
(1) Don't do it.
(2) Some possible outs.
(a) Pay off mortgage or get lien
released.
(b) Sale to charity of undivided
interest. Donor uses proceeds to pay
debt and transfers balance of his interest to CRT. Caveat: The
undivided interest problem and self-dealing.
B. Installment obligations.
(1) Transfer triggers unreported gain.
(2) Better to use testamentary gifts.
C. S Corporation stock.
D. The Accelerated Unitrust and its
progeny
JEWISH
COMMUNITY BOARD
OF
AKRON
PART
II
CHARITABLE GIFTS
OF
UNIQUE ASSETS
I. Gifts of Closely Held Corporate Stock
1. Background on Corporate Income Taxation.
A. Generally, corporate income is subject to double taxation. First, the corporation pays corporate income tax on its net income. Then, the corporate shareholders pay income tax on receipt of dividends or on distributions of corporate assets when the corporation terminates. There is some relief from double taxation for S corporations, as discussed below.
B. Example: Jane Donor created a corporation some years ago and made a capital contribution of $10,000.00. The closely held corporation has assets worth $200,000 with a tax basis of only $40,000. Jane believes that her stock is worth $200,000 - - the value of the corporate assets. However, if the corporation sold those assets and liquidated, the IRS would collect approximately $81,520 of income tax and Jane would be left approximately $108,500.
Corporation: Sells assets worth $200,000
Tax basis 40,000
Taxable gain $160,000
Corporate tax (assuming 34%
tax bracket) 54,400
Proceeds left for shareholder
(Sales proceeds of $200,000 less
$54,400 tax) = $145,600
Shareholder: Liquidating distribution of net
proceeds $145,600
Less: Jane’s cost basis 10,000
Long-term capital gain $135,600
Capital gains tax (20%) 27,120
Net proceeds to Jane $108,480
C. The result would be the same if the corporation merely distributed its assets to the shareholder because the law requires the corporation to pay income tax as if it had sold its assets and the shareholder is treated as if she had sold her stock.
The tax burden would be even worse if the distribution of assets were treated as a dividend to the shareholder because then the corporation still pays income tax as if it had sold the assets but the shareholder pays ordinary income tax on the value of the assets received rather than the more beneficial long-term capital gain rate.
D. Clear Conclusion: Keep appreciated assets, such as real estate, out of a C corporation. The problem is that the gift planner must deal with that fact because the shareholder/donor has already placed assets inside the corporation.
E. The corporation itself can contribute assets to a charity or a charitable remainder trust and avoid the tax on the assets’ growth if sold by the charity or the trust but, if a trust is established, the income stream would be paid to the corporation, taxed to the corporation at its rates and then, when distributed to the shareholders, would generate regular income tax as a dividend.
2. Gifts of Closely Held Stock.
A. Gift of appreciated publicly traded stock to charity - - whether a public charity or a private foundation - - will still generate a double tax benefit: A charitable contribution deduction based on the fair market value of the stock with no realization of capital gain income.
B. However, the benefits obtained on a gift of closely held corporate stock will depend upon the charitable donee:
(1) If the gift is to a public charity, the deduction is still at fair market value with no realization of capital gain income;
(2) If the gift is to a private foundation, the dedu