By Peter J. Fagan
In 1996, numerous articles appeared in the media regarding an unprecedented phenomenon that will occur in the United States over the next 30 years: the largest potential intergenerational transfer of wealth ever to occur in the history of the world. This transfer will occur between the generation that is currently age 55 and over, and the succeeding generation. It has been estimated that the potential transfer exceeds 10 trillion dollars.
Current federal estate tax figures document the start of this transfer. In 1995, federal estate tax receipts doubled from the preceding year. This occurred without any increase in the tax rates. Age-wave dynamics are certainly at work.
Unless individual taxpayers devote the time and resources necessary to do comprehensive financial and estate planning, federal and state taxing authorities are on line to receive an enormous revenue windfall from the estate and succession taxes that will be generated by this transfer. Charitable organizations, recognizing that they have an enormous opportunity to become recipients of a large portion of these assets, have begun soliciting both current and potential donors for charitable gifts. The primary areas of concentration of these solicitations are gifts of appreciated securities, bequests and various charitable income arrangements. Virtually ignored are the numerous other social capital planning tools, initiated by Congress and contained within the Internal Revenue Code.
Current gifts of appreciated securities usually create an immediate income tax deduction for the donor and, as the charity is a tax-exempt organization, eliminates the capital gain tax due on the sale of the securities. Charitable bequests, on the other hand, occur at the death of the donor and create an estate tax — not an income tax deduction. Charitable income arrangements are usually designed to create both an income and estate tax deduction.
Charitable gift annuities and charitable remainder annuity trusts are the most commonly mentioned deferred giving techniques. In both of the arrangements, the gift annuity aimed at the more modest amounts, a contribution is made directly to the charity or to a trust. A portion of the contribution is deductible for income tax purposes, annual income payments are distributed back to the donor and at the death of the donor the charity receives the remainder of the funds.
Quite often, the impact of such a gift upon the donor’s entire financial and estate planning scenario is not adequately considered. Gifts are treated as isolated transactions and are not integrated into a total financial plan. By its very definition, the charitable gift arrangement is irrevocable. As such, adequate consideration must be given to the impact of the gift, not only on current income, but also, upon the overall financial and estate plan. Upon initiating this process, it is routinely found that a more sophisticated charitable gifting arrangement can provide greater benefits for the involved parties. Locating advisors skilled in these advanced estate and charitable planning areas can prove difficult. Yet devoting the time and effort to seek out such individuals and organizations can prove fruitful to both the donor and the sponsoring charity.
Social capital tools and strategies that can be utilized cover a broad gambit, such as charitable lead trusts, charitable bargain sales, combination split sales and asset rollovers, charitable ESOP plans, charitable IRA deferrals, net income with makeup charitable unitrusts and a variety of private family foundations. The proper utilization of one or a combination of these tools can provide significant added benefits to a financial and estate plan.
The classic version of a charitable remainder trust is a split interest arrangement, where the donor receives a current income tax deduction, a taxable income stream for a number of years or for life and the charity receives the remainder of the trust’s principal at the death of the donor. The majority of charitable remainder trusts operate in this fashion. There are, however, a large variety of applications of this planning tool that can be creatively adapted to individual situations.
The net income with makeup charitable remainder unitrust is one example. It can offer a plethora of planning opportunities for both the donor and the charity. A charitable remainder trust is a tax exempt entity. The ability to combine a charitable remainder trust with the properly structured trust investments can dramatically enhance the financial benefits of the arrangement for both parties. The guidance of a knowledgeable advisor is paramount in order to obtain the desired outcome for all of the trust’s constituencies.
A charitable lead trust is the reverse of the charitable remainder trust. Depending on the donor’s financial situation, there may or may not be a current income tax deduction. The charity receives an income stream during the term of the trust. The donor, or usually a sibling of the donor, receives the principal of the trust at its termination. This type of charitable trust is often used as an estate planning tool. Here is how this worked in the case of one individual:
A portion of “Esther Levitt’s” (age 70) investments consist of $200,000 of stock in a large public company, that was acquired ten years ago for $10,000. She annually contributes $15,000 to two charities. She would like to guarantee that her two great-grandchildren will have the funds available to attend college. One alternative would be to annually gift amounts to her two great-grandchildren to establish a college fund for them. This strategy, as she currently uses the dividend income from the securities, would require her to increase her yield on her other investments.
Her financial advisor suggests combining, in one social capital technique, the funding of her annual charitable gifting and establishing a source that will provide the necessary capital for tuition, while receiving favorable tax treatment on the transaction. This social capital tool would be a charitable lead trust.
Esther establishes a 15-year charitable lead trust with the $200,000 stock. The lead trust will donate 7.5% each year to her two favorite charities. Her two great-grandchildren will receive the principal of the trust at the end of 15 years. The term of the trust was based upon the anticipated entry year into college. Because receipt of the funds by her great-grandchildren is restricted until the expiration of the trust, a discount for purposes of measuring the amount of her gift is applied to the $200,000 value. The discounted amount of the gift at the termination of the trust, based upon the current IRS regulations, will be $66,767. At the end of the lead trust term, the transaction is complete. Esther must then decide how to treat the discounted value of the lead trust for gift tax purposes.
The key to arriving at a successful conclusion, such as Esther’s, is to seek out creative alternatives. Each of the techniques previously mentioned, can be considered and utilized to provide a multi-faceted solution to an individual situation.
Peter J. Fagan (CLU, ChFC, AEP) is president of CorPro Associates, LLC, a New York City financial services organization. He is the author of Charitable Remainder Trusts: A Proven Strategy for Reducing Estate and Income Taxes Through Charitable Giving (Irwin Professional Publishing). His article, “Charitable Tax Planning,” appeared in the Summer 1996 issue of Jewish Action.