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Philip T. Temple, White Plains lawyer, A Smorgasbord of Charitable Planned Giving Strategies

UJA-FEDERATION OF NEW YORK

DEPARTMENT OF PLANNED GIVING

AND ENDOWMENTS

ESTATE, TAX AND FINANCIAL PLANNING CONFERENCE

A SMORGASBORD OF CHARITABLE

PLANNING STRATEGIES

Thursday, May 23, 2002

PHILIP T. TEMPLE, ESQ.

McCarthy, Fingar, Donovan, Drazen & Smith, L.L.P.

White Plains, New York

1.A. Case Study. An extremely simplified example of the horrific estate tax on the death of a surviving spouse (or, for that matter, a single person).

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 2002; his wife then dies later in 2002, 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 equivalent

exemption $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 $4,607,550

Tentative federal estate tax $2,079,550

Less: Applicable credit amount $ 345,800

Less: NYS Tax Credit $ 260,730

Federal estate tax $1,473,020

NYS Death tax $ 347,640

Total Estate Taxes $1,820,660

1.B. 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 8.5% 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 February 2002 discount rate of 5.6%:

Gross estate $4,850,000

Less: Estimated

expenses -- at 5% $ 242,500

Charitable deduction:

Gross principal into unitrust

of $2,303,750 x 30.272% factor $ 697,391

into lead annuity trust of

$2,303,750 x 100% factor $2,303,750

$3,001,141

Less: Estate tax payable* $ 262,303

Net charitable deduction $2,738,838

Total deductions: $2,981,338 

Taxable estate: $1,868,662

Tentative federal estate tax $ 721,698

Less: Applicable credit amount $ 345,800

Less: NYS death tax credit $ 67,608

Federal estate tax $ 308,290

NYS death tax $ 90,144

Total taxes paid $ 398,434

The estate tax savings is $1,422,226

* Tax attributable to non-charitable portion of unitrust. Gross principal of each trust is reduced by ½ of estate tax, thereby reducing charitable deduction for each trust. Estate tax is determined by interrelated calculation.

2.A. Example where H dies in 2001 and W dies in 2005.

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 2001; 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

$675,000 equivalent

exemption $2,175,000 $2,325,000

Taxable estate $ 675,000

Tentative federal estate tax $ 220,550

Less: Applicable credit amount $ 220,550

Federal estate tax -0-

W’s Estate

Her separate assets $3,000,000

Marital share from H $2,175,000

Gross Estate $5,175,000

Less: Estimated expenses—at 5% $ 258,750

Less: NY State Estate Tax* $ 382,220

Taxable estate $4,534,030

Tentative federal estate tax $1,971,794

Less: Applicable credit amount $ 555,800

Federal estate tax $1,415,994

NY State estate tax $ 382,220

Total Tax $1,798,214

*As of 2005 the state death tax credit is repealed after which there will be a deduction for death

taxes actually paid to the state.

2.B. 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 8.7% 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 July 2001 discount rate of 6.2%:

Gross estate $5,175,000

Less: Estimated expenses—at 5% $ 258,750

Charitable deduction:

Gross principal into unitrust

of $2,458,125 x 30.403% factor $ 747,343

into lead annuity trust of

$2,458,125 x 100% factor $2,458,125

$3,205,468

Less: Federal estate tax payable* $ 132,616

Net Charitable deduction $3,072,852

NYS estate tax deduction** $ 88,325

Total deductions: $3,419,927

Taxable estate: $1,755,074

Tentative federal estate tax $ 670,583

Less: Applicable credit amount $ 555,800

Federal estate tax $ 114,783

NY State estate tax $ 88,325

Total Tax $ 203,108

The estate tax savings is $1,595,106

*Tax attributable to non-charitable portion of unitrust. Gross principal of each trust is reduced by ½ of estate tax, thereby reducing charitable deduction for each trust. Estate tax is determined by interrelated calculation.

**As of 2005 the state death tax credit is repealed after which there will be a deduction for death taxes actually paid to the state.

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) 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) 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) 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”

7. Ethical Considerations.

1. Acting as fund-raiser and not attorney.

2. Potential conflict of interest.

Contact Me

If you think you may require the assistance of Phil Temple in any matter, email (ptemple@mccarthyfingar.com) or phone him (914-385-1028) with any question you may have.