AICPA NOT-FOR-PROFIT
INDUSTRY CONFERENCE
A DISCUSSION
ON
CREATIVE USES
OF
IN
ESTATE AND FINANCIAL PLANNING
Grand
Hyatt
PHILIP T. TEMPLE, ESQ.
McCarthy
Fingar, LLP
H has $5,000,000 estate. His wife W has a $5,000,000 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
2006; his wife then dies later in 2006, leaving her entire estate to their
children. Here is what the estate tax
computations would look like:
H’s Estate
Gross estate $5,000,000
Less: Estimated
expenses -- at 5% $ 250,000
Marital deduction --
balance of estate less
$2,000,000 federal
exemption amount $2,750,000 $3,000,000
Taxable estate $2,000,000
Tentative federal estate tax $ 780,800
Less: Applicable credit amount $ 780,800
Federal estate tax -0-
W’s Estate
Her separate assets $5,000,000
Marital share from H $2,750,000
Gross Estate $7,750,000
Less: Estimated expenses -- at 5% $ 387,500
Taxable estate $7,362,500
Tentative federal estate tax $3,247,550
Less: Applicable credit amount $ 780,800
*No state death tax credit
available as of 2005 _________
Federal estate tax $2,466,750
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 8.2%
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 2006
discount rate of 5.4%:
Gross estate $7,750,000
Less: Estimated
expenses -- at 5% $ 387,500
Gross charitable deduction
computation:
Gross principal into unitrust
of $3,681,250 x 30.228%
factor $1,112,768
into
lead annuity trust of
$3,681,250 x 100% factor $3,681,250
$4,974,018
Less: Estate tax payable* $
262,949
Net charitable deduction $4,531,069
Total deductions: $4,918,569
Taxable estate: $2,831,431
Tentative federal estate tax $1,163,258
Less: Applicable credit amount $ 780,800
Federal estate tax $ 382,458
The estate tax savings is
$2,084,292
*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.
3. Overview of Various Trust Agreements
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.
(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.
(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) Flexible
deferred payment; annuitant can further defer payments.
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?
4. 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) Palmer still lives. [Palmer v. Commissioner, 62 T.C. 684
(1974), aff'd on other grounds, 523 F.2d 1308 (8th Cir. 1975)]; Rev. Rul.
78-197, 1978-1 CB 83; Letter Ruling
8639046.
(2) What about Blake? [Blake v. Commissioner, 42 T.C.M. 1336
(1981), aff'd 697 F.2d 473 (2nd Cir. 1982)].
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:
(1) Ordinary income.
(2) Capital gain income. WIFO basis.
(3) Other income, including tax-exempt
interest.
(4) Return
of principal.
F. Taxation of pooled income fund beneficiary.
5. 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 higher
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; IRC '72(b)(1)); 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 in T.A.M. (LTR 9825001), 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. (LTR 9237020)
(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 IRC '664(b).
(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) More
Current ruling -- LTR 9901023. 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.
6. 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)
B. Installment obligations.
(1) Transfer triggers unreported gain.
(2) Better to use testamentary gifts.
C. (1) S
Corporation stock.
D. The
Accelerated Unitrust and the “Chutzpah
Trust”
of various split-interest gifts
APPENDIX
A PRIMER ON
DEFERRED GIFTS
I. INTRODUCTION
This portion of the outline
is designed to furnish a fuller discussion of the various types of planned (or
deferred) gifts available to institutions and their donors.
II. CHARITABLE REMAINDER UNITRUSTS
A. In Brief. Donor
irrevocably transfers money, securities, real property to trustee (often the
charity) who invests and reinvests assets as separate fund. Donor (or other designated beneficiary)
receives amount each year determined by multiplying fixed percent (minimum of
5%) by the fair market value of trust assets, valued each year. On donor's death (or death of other
designated beneficiary) payments terminate and then assets are absolute
property of designated charitable remainderman.
B. Three Types of Unitrusts Authorized:
1. Plan 1:
Specifies that "recipient" (income beneficiary) receives
annual payments based on fixed percent (cannot be less than 5% nor more than
50%) of net fair market value of trust assets, as determined each year. Percent, determined at time trust created,
remains constant for entire trust term.
Any income not paid out added to principal. If income is insufficient to pay required
amount, capital gains and/or principal make up deficit.
2. Plan 2:
Trustee pays beneficiary only trust income if actual income is less than
stated percent. Deficiencies in
distributions (i.e., where trust income is less than stated percent) made up in
later year(s) if trust income in later year(s) exceeds stated percent.
3. Plan 3.
Trustee pays beneficiary only trust income if actual income is less
than stated percent.
Deficiencies in distributions (i.e., where trust income
is less than stated percent) not made up.
C. The
FLIP Charitable Remainder Unitrust:
A second variation on the unitrust is a hybrid or “flip trust.” There had been some confusion about these trusts which provide for a change in the method of calculating the unitrust amount; first the Service said okay, then it said they didn’t work.
In December 1998, the IRS issued regulations dealing with flip trusts. These spell out the conditions under which the governing instrument may provide for “flip” from a net income charitable remainder unitrust to a standard unitrust during the term of the trust.
The flip trust is especially useful for unmarketable, low-income producing assets that may take some time to sell. The flip unitrust allows the trustee to invest for total return once the trust becomes a standard unitrust.
The regulations will allow the flip trust if (1) the trust instrument requires the flip, so that the trustee does not have discretion to change the type of CRT, (2) the CRT uses a net income method (with or without make-up) until the flip occurs, typically upon the sale of a specified asset or group of assets contributed at the time the trust was created and (3) the trust thereafter is required to convert to a standard charitable remainder unitrust for calculating distributable amounts. Note that any deficit not “made up” by the time of the flip is lost.
The regulations give examples of valid and invalid triggering events for the flip.
Valid triggering events include: an individual’s marriage, divorce, death or birth of a child; the sale of an unmarketable asset (more properly thought of as a hard-to-market asset); and a fixed date.
Invalid triggering events include: the sale of marketable assets; a request from the income beneficiary or his or her financial advisor that the trust flip.
With many trustees moving to a total return concept, without regard to whether the return is categorized as income or capital appreciation, the flip trust may be increasingly popular.
D. Income Tax Charitable Deduction:
1. To qualify, value of charitable remainder interest must be
at least 10%.
2. Donor gets sizable income tax charitable deduction in year
he creates unitrust. Deduction is for
value of charitable institution's right to receive unitrust principal (the
remainder) after donor's life.
Determined by official Treasury tables.
3. Amount of charitable deduction depends on:
(a) Donor's age (and age of any other beneficiary).
(b) Percent to be paid.
(c) Amount of money or fair market value of long-term securities
or real property contributed.
(d) Discount rate of month.
Can make election to use rate for either
of two months preceding month of gift.
4. Donor's gift deductible up to 50% of adjusted gross income
when unitrust is funded with money and remainderman is a school, church,
hospital or other publicly supported charity.
Any "excess" deductible, until exhausted, over five following
years -- up to 50% of each year's adjusted gross income.
5. For unitrusts funded with long-term appreciated securities
or real property, contribution deductible up to 30% of adjusted gross income --
with five year - 30 % carryover for any "excess." In some cases, ceiling can be increased to
50% with five year carryover by electing to reduce amount of charitable
deduction by 100% of appreciation allocable to remainder interest. Generally not good idea.
E. Providing Income for Another: Donor's unitrust can provide income for
another -- his wife, parent, child, etc.
He can also have income paid to him for life and then to a family
member. Contribution deduction lower for
two life unitrust since payments are for longer time than in one life plan.
F. How Unitrust Payments Taxed:
1. Amount paid to income beneficiary retains character it had
in trust. Each payment treated as
follows:
First, as ordinary income to
extent of trust's ordinary income for year (and any undistributed ordinary
income from prior years).
Second, as capital gains to
extent of trust's capital gains for year (and any undistributed capital gains
from prior years). On WIFO
(Worst In, First Out) basis;
first short-term, then long-term.
Third, as other (usually
tax-exempt) income to extent of trust's other income for year (and any
undistributed other income from prior years).
Fourth, as tax-free
distribution of principal.
2. Potential Favorable Tax Treatment for Trust Payments. Part of income received by donor each year
can often consist of capital gains (which can be offset by beneficiary's
capital losses or is taxed at somewhat more favorable capital gains tax rates)
or even be tax-free return of principal.
This achieved by growth rather than income oriented investment
policy. In Plan 1 unitrust (described
above), income beneficiary receives stated percent each year even though
unitrust income less than stated percent.
Capital gains or principal are distributed to make up any deficit.
G. Capital
Gains Benefits When Unitrust Funded With Appreciated Property:
1. No capital gains tax on transfer of appreciated securities
or real property to fund unitrust.
Furthermore, contribution deduction for gift of long-term appreciated
securities or real property determined by multiplying
appropriate actuarial factor
from Treasury tables by property's full fair market value -- not lower cost-basis. Note:
Appreciation element is tax preference item for alternative minimum tax
purposes.
2. Gains on sales of appreciated securities by unitrust not
taxed to trust; nor is ordinary income. Exception: Unitrust not exempt from tax in any year it
has income which would be taxable unrelated business income if trust were
exempt organization. Unrelated business
taxable income includes debt-financed income.
Payments made to income beneficiary taxed as described above.
H. Estate Taxes Reduced.
Substantial estate tax savings also achieved. When Donor is only beneficiary (or, in two
life unitrust, is not survived by second beneficiary), unitrust not taxed to
estate. If there is survivor
beneficiary, only value of
survivor's right to life
payments (computed on donor's death) subject to tax in donor's estate. If survivor beneficiary is spouse, qualifies
for marital deduction. Charitable gift
-- charitable institution's right to unitrust principal on death of
survivor -- completely free from estate
tax.
I. Gift Tax Implications:
1. One life unitrust.
No gift tax implications if donor beneficiary. If donor names another as beneficiary, gift
made to that person for value of life interest (reciprocal of remainder
interest). If spouse, qualifies for
marital deduction.
2. Two-life unitrusts.
Donor who funds unitrust with own property and provides for income first
to himself and then survivor, makes gift to survivor. However, proper drafting of trust agreement
-- donor retains right, by his Will, to revoke survivor's interest -- makes
gift to survivor free of gift tax. If
spouse is survivor beneficiary, qualifies for marital deduction.
J. Generation-Skipping Transfers
1. If charitable remainder unitrust deemed to create a
"generation-skipping transfer," no income, gift or estate tax
charitable deductions will be allowable.
Reason: Tax on
generation-skipping transfer is payable out of trust assets. Charitable remainder trust disqualified if
possibility exists that payments will be made from trust assets -- other than
those required to be made to trust beneficiaries or for good and valuable
consideration.
2. Most charitable remainder trusts will not run afoul of
generation-skipping rules because they provide payments to only donor or to
donor and spouse.
3. Generation-skipping trust generally one in which there are
two or more generations of trust beneficiaries younger than the donor's
generation.
4. Generation-skipping implications should always be considered
before creating charitable remainder trust.
K. Applicability
of spousal election rule. Under New
York law, a surviving spouse has the choice of receiving that part of the
estate passing to him or her by will and other testamentary provision or
renouncing this interest and claiming his or her elective share. Prior to