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 

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.