Steve Drake, Ph.D., CPA, CGMA, CFP ®
By now, everyone has heard there have been recent changes to income and estate taxes. You have also heard that estate tax brackets can still reach 40%. This does not count inheritance and estate taxes assessed by many States.
I am sure that most of you are familiar with traditional estate planning which discusses having certain documents in place. These documents are typically a will, durable power of attorney and durable power of health care (living will). Sometimes, a living trust is suggested. The living trust does not take the place of any of the other documents it is an additional document put into effect to avoid the probate process (this is where a judge rules on the details and validity of the will). The living trust also provides privacy, speeds estate resolution and provides for a successor trustee in case of incapacity. Everyone needs a will and many people also need a living trust. These issues are not discussed in detail in this article but are mentioned as a brief background for the reader. This article discusses other key, tax-planning techniques found in establishing a charitable remainder trust (CRT) and an irrevocable life insurance trust (IUT). The CRT and ILIT are typically used in conjunction with the living trust and the will.
There are many types of trusts. I have mentioned just a few of them. A CRT is a type of irrevocable trust that is typically designed to provide a way in which appreciated property (real estate, stock etc.) can be sold without a capital gains tax. Further, any assets placed into a CRT are removed from your estate and are not subject to any estate taxes.
There are different types of CRTs but all of them are designed to pay the donor (s) a certain amount per year until their death( s) in exchange for the asset( s) contributed. The payment from the CRT to the donor(s) is usually in the 5-7% range of the value of the CRT. The donor(s), say husband and wife, can be the trustee of the CRT but once they are deceased, then any balance remaining in the trust goes to the charity or charities of choice. The CRT must be established before a designated asset is sold or even in negotiation for sale by the donor(s). After the donor(s) contribute the asset to the CRT then the CRT sells the asset. The donor(s) get a charitable deduction based on their age(s) and the CRT payout over the donor(s) remaining years. This charitable deduction can be used to offset the donor( s) other taxable income on Form 1040 as discussed below.
A CRT can also be a great way to avoid some of the multiple tax burdens on such assets as an IRA or other pension plans. In some cases, the total taxes on a pension plan or IRA can be as high as 70% or more.
Most importantly, whatever asset or assets are contributed and then sold by the CRT, the end result should be a greater total inheritance going to the children and/or a fulfilled charitable intent by the donor(s).
Example: Husband and wife (H& W) have appreciated stocks with a cost of $10,000 and a value of $500,000. They want to sell these stocks without a capital gain tax. They initiate a CRT with themselves as the trustee(s) and then the CRT sells the stocks for $500,000. So far so good. No capital gains taxes are paid so the full $500,000 is in the CRT. This balance will then be reinvested by the CRT into other investment(s). Ifthe CRT pays 5% on the $500,000 to the donor(s) then the $25,000 paid is taxable to H&W. Your tax advisor can compute the amount of the charitable deduction that is available to offset this $25,000 and your regular personal income on Form 1040.
Example: H&W have $200,000 of regular income (including the $25,000 payout from the CRT in the above example) and have a calculated, initial charitable deduction for the CRT of $240,000. H&W can offset 30% (limitation provided for in the tax law) of the $200,000 in income for the first year. This is a $60,000 deduction that can be deducted in year 1. The balance of the charitable donation ($180,000) carries over for another 5 years. So, if in year 2 H& W have another $200,000 in regular income then another $60,000 of the deduction carryover can be used on H&W’s Form 1040. By the beginning of year 3, $120,000 of the $240,000 possible charitable deduction has been used. This process continues until all of the $240,000 donation is used. As shown in this example, the carryover is used before the 6 years are up in which case there is no additional deduction from the formation of the CRT. Make sure that you are relatively certain that you will be able to use your entire charitable deduction on or before the expiration of the 6-year period. Any deduction not used within the 6-year period is lost. Your tax advisor should do a projection of your income when the CRT is first contemplated. You must maximize the benefits of setting up the CRT and the charitable deductions resulting from the formation of the CRT.
OK, you think that this sounds good but what is the catch? Let’s review the situation. You have disposed of stocks worth $500,000 and despite the fact you saved income taxes and removed the stocks from your estate, your kids are not happy. The kids think that these stocks are a family asset and that they will no longer inherit them. They are right. They will not inherit them since any balance in the CRT after H& W’ s demise goes to charity. The balance does not go to the kids. Is there any planning that can make this up to the kids?
A great planning technique is to establish an ILlT. This is an irrevocable trust that will hold one or more life insurance polices based on the life(s) of H&W. The policies in the IUT, if properly structured, will provide a tax-free payoff to your kids. This pay-off will come to them income and estate tax free. That’s right, they can inherit the payoff on these polices through the IUT if properly structured, will provide a tax-free payoff to your kids. This pay-off will come to them income and estate tax free. That’s right, they can inherit the payoff on these polices through the IUT without any estate or income tax.
Example: H&W set up a CRT and an IUT. Part of the lifetime payments made to the H&W from the CRT can be used to pay the premiums on a policy(s) held by the IUT. There are strict details to make all of this work (either the CRT or the ILIT) so do not try this without professional guidance. If the face values of the policy in the ILIT are based on the last of the H& W to die (survivor policy) then the kids will inherit after both H&W pass away. Typically, life policies with a last to die feature are the most cost effective. Further, for estate tax purposes, there is usually no estate tax until both H&W have passed on so these policies are used extensively with advanced estate planning.
If the last-to-die policy has a face value of $500,000 then the kids will have the replacement value equivalent of the stocks that H&W put into the CRT some years ago. Since the stocks would have normally been subject to estate tax if no planning had been done, the kids could effectively inherit more through the insurance payoff then they could with the stocks in the estate. With a 50% estate tax bracket that the stocks may have been subject to, the insurance can be a much better planning tool for the family. Roughly speaking, the stocks would have had to grow to $lM in a 50% estate tax bracket to equal a $500,000 policy in a non-taxable IUT.
All of this planning requires the tax advisor to fully understand donor(s) goals, family considerations and objectives, income requirements by the H&W and by doing some analysis to see how it all fits together. Many times, particularly if H&W have any charitable intent, the CRT/ILIT planning is a great way for them to have their proverbial cake and eat it too. There will even be leftovers with plenty of icing on it for the kids or grandkids.