CHARITABLE REMAINDER TRUSTS

By Nathaniel E. Clement, J.D.

As an estate planning attorney, I have often referred to revocable living trusts with tax-planning features as the single best - and easiest - way to pass an estate, provide for standby disability protection, and save $1,000,000 in death taxes (in 2007). When properly structured, living trusts accomplish tax-planning to protect up to $4 million in married couple assets in 2007, while still allowing all of that amount to be available to support both husband and wife for life and thereafter to control their estate even after death, without probate. But what about protecting from death taxes estates larger than $2 million for the single person or greater than $4 million for the married couple? And what if we need more income and the only way to achieve that is to sell something that we own and pay the dreaded capital gains tax just for the privilege of reinvesting the money in something more productive? In this case, all to often we are told "I'm sorry, there's nothing you can do without taking assets away from the two of you to live on." Well, happily, there is something that often can be done in these cases to reduce death taxes and capital gains taxes without conflicting with your goal of having enough assets to support you for life.

John and Joan Hobbs, both age 65, are a retired couple (or would like to retire). During their earlier years they sacrificed, worked hard, and achieved a sizeable net worth. They bought common stock over the years for $50,000 basis, which now is worth $500,000. The yield on this common stock is 2.5%, or $12,500 of dividend income per year. John and Joan's objectives have now changed. The acquisition stage of their life is over and now they want to enjoy the fruits of their thrift. Specifically, they need more income. They know that if they sell their stock, they'll pay capital gains taxes of about 23% (federal and state) - $115,000. This will mean they will have $385,000 left to invest. They know from their financial adviser that they can obtain a yield of 6% on their money without much trouble, or an annual return on this money of about $23,000. This is certainly better than $12,500 - but at a price! The Hobbs have living trust plans in place with tax planning features, so their estate is probate proof and is protected from death taxes up to $2 million. But their estate is more than that. This $385,000 - assuming no further growth - will be taxed at a combined federal and State death tax rate of about 50%, leaving only $192,500 to pass to their children. This is only 38.5% of the original amount! John and Joan consult with their CPA and explain their dilemma. He recommends a "Charitable Remainder Trust" ("CRT")combined with a "survivorship" life insurance policy.

The CRT works this way: John and Joan set up a special trust and name themselves as Trustees. They donate their stock to this trust (now the trust owns the stock). The trustee of the trust now sells the stock. This trust, under Internal Revenue Code Section 664, is tax-exempt and, thus, pays no capital gains taxes. The trust invests the $500,000 - completely undiminished by capital gains taxes - in mutual funds or bonds. This trust is designed to pay a certain amount to John and Joan for their lives. The actual amount paid is determined up front by John and Joan in the design of the trust. The trust pays no income taxes each year (remember, it's tax exempt). But John and Joan will pay income tax when they receive distributions from the trust.

Let's assume John and Joan pick a 6% payout rate. At that annual rate, the trust will pay John and Joan $30,000 in the first year. (This amount will is taxable to them). Now they are receiving 40% more than they would have received under the "pay capital gains taxes" scenario. And, this trust will last for as long as John and Joan are alive. This trust will keeps making payments to them until they both die. If the Hobbs desire, they can structure this trust to continue to make payments after both of them die to their children (sometimes, for tax reasons, this is not advisable). And, when the trust ends, none of the assets in the trust are subject to death taxes! This means the government is denied estate tax revenue of about $250,000 in death taxes, assuming the value of the trust at the end is still $500,000.

What about the Hobbs' three children? The IRS says that in return for the above tax benefits, the Hobbs' children get nothing from the CRT. This is, of course, most disappointing to John and Joan Hobbs. In fact, all of the remaining funds in the CRT must pass to a nonprofit or to a charitable organization, chosen by John and Joan. It might be their alma maters, their church or synagogue, or various local organizations. Or, it might be the "Hobbs Family Foundation," which the Hobbs' children can be in charge of. The children's inheritance has been reduced by $250,000, but with the foundation they can make gifts to charities of their choice with proceeds from the Hobbs Family Foundation. If the foundation is worth $500,000, a 5% return would mean they could give away $25,000 to local charities every year. The Hobbs' children will be very popular in their communities.

Benefits of the CRT

The Hobbs' CRT strategy has produced the following benefits to the Hobbs' family:

The Hobbs have increased their current income. This is because they were able to convert capital gains taxes to principal at work for them. Instead of paying 23% of their gains to the government, they paid the "tax" to themselves. Invested at 6%, this returns $9,500 more income to John and Joan each year.

The Hobbs avoided death taxes on the property contributed to the trust.

The Hobbs have made a substantial gift to a charitable organization of their choice. This is a charity that will send them and the family a thank you note and memorialize the Hobbs family in many other ways. This is a way to teach the Hobbs children financial responsibility and about giving. Had this money gone to the government, no recognition would have been received except a demand notice for more and a threat of interest and penalties. Because the Hobbs' estate was in "taxable territory," only about one-half of this money could have gone to the children anyway. By directing all of this money to charity, at least the Hobbs get to choose the social use for which this capital will be put to work.

By setting up a family foundation after death, and letting their children run the foundation the Hobbs have involved their children and bestow indirect benefits on their children. The foundation can pay reasonable expenses of the children getting together each year to decide what projects the foundation will benefit. The children can take credit in their communities for the local charities which benefit from the foundation.

Is There Anything Else the Hobbs Can Do For The Children?

Yes! Remember, the Hobbs' children were only going to get 50% on the dollar of the $500,000 anyway (this is optimistic and assumes there was a way to get around the capital gains tax problem). So, let's assume it will take $250,000 to make the children whole. This is where the government comes to the rescue. John and Joan Hobbs will get a charitable deduction on their income tax return when they establish and fund the CRT. The actual deduction will depend on the Hobbs' ages and an IRS-published interest rate during the month of the gift to the trust. Let's assume the IRS says the deduction will be about $125,000. (The deduction will not be $500,000, because the money does not actually go to charities until John and Joan die - which may be many years from now). A charitable deduction of $125,000 will reduce John and Joan's income taxes by about $43,000. At John's and Joan's ages, $43,000 should easily buy $250,000 of life insurance, which can be made payable to the children. Now the children are whole. Please refer to our article entitled "The ILIT-An Ideal Way to Own Life Insurance."

Can the Children Be Made Income Beneficiaries of the CRT?

Yes. John and Joan can direct that the trust continue to make distributions to the children after both John and Joan die. However, this is equivalent to leaving something of value to the children, which means the CRT will be subject to death taxes when John and Joan die. Life insurance is a far better way to take care of the children's interest.

Doesn't the Government Lose Out?

No. It, too, benefits. Studies that show that private charity is more efficient in bestowing benefits on society than governmental charity.

How do IRAs Fit With CRTs?

They fit in nicely! IRAs can be used to fund CRTs when the IRA account holder dies. John Hobbs, in the above example, plans to leave his IRA to his wife, Joan, if he (John) dies first. Joan will then continue to use John's IRA to support her for the balance of her life. However, when Joan dies, what's left in John's IRA will be subject to both death taxes and income taxes. John can accomplish his goal of providing for Joan just as well by having his IRA payable at his death to the Section 664 trust and have the CRT make payments to Joan for her life. Then, when Joan dies, there will be no taxes on the IRA. Because of the double taxes on IRAs, Section 664 trusts are an ideal beneficiary for IRAs.

Our firm stands ready to help our clients understand CRTs. We have the software to run the calculations to help you and your other advisers determine which payout rate is best for you.

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