The Strategist
1st Quarter 1997 - Volume 4 Issue 1
Our goal in working with clients is to
minimize their estate tax liability and maximize what will pass to their
intended beneficiaries. Most times this is future generations. All too often,
charitable interests are ignored in the estate planning process because most
people assume that the only way to benefit charities at death is by reducing
the amount that will pass to our family. This is not necessarily the case. Did
you know that it may be possible to give your estate taxes away to charity!
That's right, your estate taxes, not what your family would inherit.
In estate planning, generally there are only
three planning techniques remaining to achieve this objective. But the three
that remain are exceedingly powerful.
What are these three powerful planning
techniques? Discounts, gifting (both charitable and to family), and life
insurance.
Not surprisingly, most attorneys and
accountants seem to promote discounts as their main estate planning solution.
Most insurance advisors seem to promote using life insurance as their main
estate planning solution. And gift planners seem to promote using charitable giving
tools as the primary estate planning solution. Individually, these tools, while
creating a solution in one area, often end up creating a new problem in another
area.
For example, to completely eliminate a
person's estate tax liability, simply have them give their entire estate away
to charity at death. Great idea, except for the kids. You see, in solving one
problem (estate taxes), the charitable giving technique creates a new problem
(no inheritance for the children).
Another good example is to have your
client/donor buy a multi-million dollar life insurance policy to pay the estate
taxes allowing the entire estate to pass to the children intact. The kids will
cheer this plan but Mom and Dad may not be interested in reducing their current
lifestyle to pay premiums on a life policy simply so the kids can have more
after they are gone. Again, the life insurance technique solves one problem
(estate taxes) only to create a new one (reduced cash flow for parents).
You see, individually, each of these tools
is, at best, only a partial solution. But in combination, they can create
incredibly powerful estate planning solutions. Let me illustrate how two
combinations might work.
Life Insurance with Charitable Giving -- Jim and Mary have a $1,000,000 apartment building
that is now fully depreciated and producing only a 4% net annual income. They
would love to sell it and reinvest the proceeds to increase their retirement
income. The problem is they will lose at least $280,000 in capital gains and
recapture taxes if they sell. At their deaths, the remaining asset value will
face another loss of $396,000 to estate taxes (55%). Ultimately, their children
end up with only $324,000 or 32.4% of the original asset value.
One solution -- create a charitable remainder unitrust (CRUT) and
an irrevocable life insurance trust (ILIT). Jim and Mary transfer the apartment
building into the CRUT and sell the building tax free and reinvest the cash
doubling their annual income. Jim and Mary then use some of the increased cash
flow to make annual gifts to their children's ILIT which in turn buys a
$1,000,000 second-to-die life insurance contract. Jim and Mary now have more
net spendable income. They will pass a full $1,000,000 tax free onto their
children and they make a $1,000,000 gift (affected at the time of the last
death) to the local charitable organization that they are very involved with.
Combining charitable giving with life insurance creates a viable solution.
Discounts with Charitable Giving -- Bill
and his wife, Brenda, own 100% of a limited liability company (LLC) that owns a
motel valued at $6,000,000. Bill and Brenda own 50 units each of the LLC. The
LLC receives an 8% triple net lease returning them $480,000 per year. They have
no need to receive all of this income each year and would like to redirect some
of this to charity. However, they wish to pass the LLC on to their 3 children.
The Solution involves several steps. First, Bill will gift 1 unit
of his 50 units of the LLC in total to his 3 children. Brenda will do the same.
The ownership of the LLC is now the children with 2% total, Bill with 49%, and
Brenda with 49%. Bill and Brenda then obtain a qualified appraisal valuing
their 49% interest each in the LLC. Roughly speaking, the appraiser determines
a discount of 1/3rd for a minority interest. Therefore, their 49% interest each
that was worth just under $3,000,000 is now valued, after the discount, at just
under $2,000,000 each.
Bill then establishes a charitable lead
annuity trust (CLAT) and gives the trust 25 of his remaining 49 units of the
LLC. The appraiser determines that after discounts, the appropriate value of
the gift is $1,000,000. Brenda also establishes a charitable lead annuity trust
under the same terms and gives 25 of her remaining 40 units to the trust.
Again, the appraiser determines that the value of the property going to the
trust is $1,000,000. At this point, the resulting ownership of the LLC is Bill
with 24 units, Brenda with 24 units, children with 2 units, Bill's charitable
lead annuity trust with 25 units, and Brenda's charitable lead annuity trust
with 25 units.
Bill and Brenda set the annuity payout rate
of their trusts at 12% each per year for 10 years. Remember, the LLC was
earning $480,000 per year and each charitable lead annuity trust now owns 25%
of the LLC indicating each trust will have income of $120,000 per year.
$120,000 divided by the value of the property going into the trust ($1,000,000)
equals a 12% annuity payout rate.
A charitable lead annuity trust is the
opposite of a charitable remainder annuity trust. Rather than you
deriving the income for your lifetime or a period of years as you do with a
remainder trust, with a lead annuity trust, the charity derives the income for
a specified term of years.
You have two choices with an annuity trust
as far as the type of deduction you can take. You can take an income tax
deduction and, under this scenario, after the term of years expires on the
annuity trust, the asset comes back to you and is included in your estate. The
second form of deduction you can take is a gift tax deduction. Under this
scenario, after the term of years expires, the assets remaining in the lead
annuity trust can pass to your children. Since we were attempting to move the
assets to the children while benefiting a charity, we select the second option.
Under this scenario, based on a 10 year 12%
lead annuity trust with a value of $1,000,000 per trust and according to the
March 1997 calculation, the gift to the children is going to equal $172,540 per
trust. Therefore, Bill and Brenda would be deemed to have made a $172,540 gift
each and would ordinarily owe gift taxes on this amount. However, Bill and
Brenda have not used their Unified Credits and, therefore, can offset any gift
taxes due with their Unified Credits.
Now let's look at the income stream. Bill
and Brenda will continue to receive 24% each of the LLC income. 24% of $480,000
is $115,200 each or $230,400 between the two of them. The children will receive
$9,600 per year in total. Each respective annuity trust will receive $120,000
or $240,000 combined per year. Bill and Brenda can name different charities but
have chosen to name the same charity, their local hospital, to receive the
income for the next 10 years.
Over the next 10 years, the hospital will
receive a total of $2,400,000 from the two annuity trusts established by Bill
and Brenda. At the end of the 10 year period, the trusts terminate and the
CLATs' ownership in the motel LLC passes to the children.
At this point, the children would have 52%
ownership of the LLC which is comprised a 1% outright gift each from Bill and
Brenda and two 25% lead annuity trusts that terminated after the 10 year
period. Bill and Brenda have effectively transferred over $3,000,000 of value
to the children for zero gift taxes, using only $345,080 of their combined
$1,200,000 Unified Credit amount. Just as important, Bill and Brenda, at their
respective deaths, have a minority interest that should continue to qualify for
a discount for estate tax purposes.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1997 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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