THE NEW YORK BOTANICAL
GARDEN
DOING WELL
BY
DOING GOOD
USING
CHARITABLE GIFTS
IN
YOUR
ESTATE
AND FINANCIAL PLANNING
Thursday,
March 24, 2005
10:30
a.m.
PHILIP T. TEMPLE, ESQ.
McCarthy Fingar LLP
White Plains, New York
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
Total
taxes paid $ 296,628
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.
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 says 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).
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) 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:
(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 a
Technical Advice Memorandum, 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 the 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) In a more 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.
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) 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. (1) S
Corporation stock.
D. The
Accelerated Unitrust and the “Chutzpah
Trust”
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 incom