Presentation on theme: "Charitable Tax Planning and Life Insurance"— Presentation transcript:
1 Charitable Tax Planning and Life Insurance For Producer or Broker/Dealer Use Only. Not For Public Distribution.For Producer or Broker/Dealer Use Only. Not For Public Distribution
2 Agenda Introduction to charitable giving Taxation issues Types of charitable organizationsCharitable gifts of life insuranceCharitable remainder trustsWealth replacement trustsToday’s agenda will focus on the taxation issues of charitable planning that differs upon which type of asset is donated and to what type of charitable organization it is donated to. We will look at charitable remainder trusts and how they work along with wealth replacement trusts, and charitable gifts of life insurance.This document is designed to provide introductory information on the subject matter. MetLife does not provide tax and legal advice. Clients should consult their attorney and /or tax advisor before making financial investment or planning decisionsFor Producer or Broker/Dealer Use Only. Not For Public Distribution.
3 Charitable Gifts: Things to Consider Is the charity a qualified charitable organization?Is it a gift?What is the value of the gift?What is the form or structure of the gift?Are there deduction limitations placed on the gift?Charitable gifts can take many forms, from the simple offering at a church service to sophisticated and complex planning strategies like charitable remainder trusts. Several factors must be taken into consideration to determine if the gift qualifies as a charitable contribution, such as the value of the contribution, and the amount of deduction that can be taken on the tax return. The primary factors are: 1) is the charity a qualified charitable organization?; 2) Is it a gift?; 3) What is the value of the gift?; 4) What is the form or structure of the gift?; and 5) Are there deduction limitations placed on the gift? Each of these issues have an impact on the charitable deduction that can be taken, or whether one can be taken at all.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
4 Public Charity versus Private Foundation Public charities provide higher deductions at the expense of control by the donorPrivate foundations provide control but with substantially reduced deductions, and potential excise taxesQualified charities can be separated into two general categories: public and private. This differentiation is important because the tax benefits provided are determined in part by whether the charity is public or private. Public charities generally include: churches, educational organizations, hospitals, and government organizations. Donations to public charities provide the donor with a higher income tax deduction; however, the donor has limited control regarding what the donation is used for.Private foundations are any charity that does not fall under the public charity classification described in the Internal Revenue Code. Private foundations have three predominant characteristics: 1) there is usually one primary source of funding, 2) the foundation does not provide direct charitable activities, but instead makes grants to other charities, and 3) grants come from endowment income, not from public contributions. Also, a private foundation allows the donor to retain more control over which charities will receive grants. The price of this control is that private charities are subject to complex rules and excise taxes.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
5 Taxation Issues Donative Intent Partial Interest Valuing the Gift Transfer of money or property made without adequate considerationPartial InterestGenerally non-deductible but various exceptions do existValuing the GiftDetermined by type of property giftedGifts that exceed $5,000 must get qualified appraisalIn addition to the requirement that the charitable contribution be made to a qualified charity, it must also be a gift “to” or “for the use” of charity. A general definition of what a contribution or gift would be is that the contribution must be a transfer of money or property made without adequate consideration. In other words, the donor does not receive or expect to receive anything in return for the donation.Gifts of a partial interest in property are generally non-deductible. There are, however, several exceptions to this rule, particularly: certain charitable trusts, a remainder interest in a personal residence or farm, and an undivided portion of a donor’s entire interest in property.Once there has been a gift to a qualified charitable organization the issue then becomes one of valuation. Valuation of a contribution is determined by the type of property donated and the type of gift made. The general rule is that the amount of the charitable deduction is the fair market value of the property gifted. Gifts of property, other than cash and publicly traded securities, that exceed $5,000 must have a qualified appraisal from a qualified appraiser. Once the market value is determined, there are several “reduction rules” that come into play depending on the type of property that is contributed.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
6 Types of Property Ordinary Income Property Assets held less than one year, life insuranceDeduction limited to lesser of cost basis or fair market valueLong Term Capital Gain Intangible PropertyCapital asset held longer than one yearFair market value deduction (exception: certain appreciated property to a private foundation limited to lesser of cost basis or fmv)One of the reduction rules is for ordinary income property. This is property which would not have created long term capital gain had the property been sold for its fair market value rather than gifted to charity. Types of ordinary income property include: short term capital gain property (i.e. capital assets held for less than one year), inventory, life insurance and annuities, and accounts and notes receivables. In the case of ordinary income property, the deduction must be reduced by the value of the ordinary income the donor would have realized upon sale of the assets. Or, in other words, the deduction is limited to the lesser of adjusted cost basis or fair market value.Contributions of long term capital gain property receive favorable tax treatment. Not only does the donor generally get a full fair market value deduction, the donor also does not have to pay tax on the appreciation of the property gifted to charity. However, there is a reduction in the AGI deduction limitations for long term capital gain property.The general limitation on charitable deductions is 50% of the donor’s adjusted gross income or AGI for gifts to public charities or 30% of AGI for gifts to private charities. When making a gift of appreciated property, the deduction limitations are reduced to 30% of AGI for public charities and 20% for private charities. Another important reduction is when gifts of certain appreciated property are made to a private charity. If a gift of LTCG property that is other than qualified appreciated stock is made to a private foundation the income tax deduction is limited to the lesser of FMV or donor’s cost basis. However, these limitations only apply to a charitable income tax deduction during life, bequests at death would receive an estate tax charitable deduction equal to the full fair market value of the property.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
7 Exception: Basis Rule for Private Charities Types of PropertyException: Basis Rule for Private CharitiesGifts of qualified appreciated stock valued at FMV rather than basisTraded on exchangeCapital gain propertyStill limited to 20% of AGIThere is an exception to the basis limitation for gifts of appreciated property to a private charity. Gifts to a private charity of qualified stock are valued at fair market value rather than cost basis. Qualified stock is defined as long term capital gain stock for which market quotations are readily available on an established securities market. However, even though the donor may deduct the fair market value of the stock, the income tax deduction will still be limited to 20% of the donor’s AGI.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
8 Types of Property Exception: Unrelated use LTCG Tangible Personal PropertyArt, collectiblesFor public charities, deduction generally equal to fair market valueFor private charities, deduction generally limited to lesser of cost basis or fmvException: Unrelated useLTCG Gifts of tangible personal property such as works of art, collections, and antiques to public charities are normally deducted at the item’s full fair market value. There is an exception to this rule, if a gift is made to charity where the charity’s use of the property is unrelated to its charitable purpose. In that case, the deduction is lesser of cost basis or fmv.For example: if the donor gifts a painting that is LTCG property to a public charitable organization to be displayed in their art museum, the use is related to the charitable purpose and the donor may deduct the fair market value of the property. However, if the painting is given to a cancer research organization and the organization is going to sell the painting to fund research, the use is not related to the organization’s charitable purpose and the donor may only deduct the lesser of property’s cost basis or fmv.With regard to a private foundation, the deduction equal to the lesser of basis or FMV.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
9 Ordinary Income Property 50% - Lesser of FMV or Basis Public - ValuationPrivate - ValuationCash50% - FMV30% - FMVOrdinary Income Property50% - Lesser of FMV or Basis30% - Lesser of FMV or BasisLTCG Intangible Property (e.g. securities)20% - Lesser of FMV or Basis (unless qualified appreciated stockLTCG Tangible Personal PropertyRelated: 30% FMVUnrelated: 50% Lesser of FMV or Basis20% - Lesser of FMV or BasisAs previously mentioned, the maximum charitable deduction allowed in one year is either 50% of AGI for gifts of cash to public charities or 30% of AGI for gifts of cash to private charities. This 50%-30% limitation is a general limitation; deduction limits may be reduced further depending on the type of property donated. The table details the deduction limitation as applied to various types of charitable gifts: (read table).Any deduction that cannot be taken in the current year can be carried over for an additional five years. If the donor is unable to deduct the remaining deduction during the carryover period, the unused deduction is wasted.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
10 Charitable Estate Tax Deduction Estate receives a charitable estate tax deduction for bequests to qualified charities at deathDeduction unlimitedA donor may receive an estate tax charitable deduction for any bequests to a qualified charitable organization upon death. In order to qualify for the estate tax charitable deduction, a bequest must be: 1) made by the decedent, 2) must be certain, and 3) the amount must be ascertainable. This means that the bequest must be made in the decedent’s will or living trust and must sufficiently articulate, directly or by reference to another instrument, the object, purpose and amount of the bequest. Additionally, the estate tax charitable deduction is not limited like the income tax charitable deduction by the AGI percentage limitations. Therefore, the deduction is unlimited.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
11 Gifts of Life Insurance Purpose:Create large endowmentLeverage the charitable donationNow let’s take a look at how life insurance can be used as a charitable giving tool. Life insurance may be used to provide a meaningful gift to charity. For what may be a lesser cost (the premium), a donor can make a large gift to charity via the death benefit proceeds. The tax benefits derived from a gift of life insurance will depend on how the gift is structured. Generally, the gift will be arranged so that either: (1) the donor owns the policy and merely names a charity as beneficiary, or (2) the charity owns the policy and pays premiums via cash gifts made by the donor.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
12 Charitable Gifts of Life Insurance PremiumsAccess to Cash Value *DonorsLife Insurance Policy on Donor(s)If the donor owns the policy and merely names the charity as a primary or contingent beneficiary, no income tax deduction is available for the payment of premiums since this is not a completed gift. Upon the donor’s death, the value of the policy will be included in the donor’s estate, but the portion of death benefits paid to charity will qualify for the estate tax charitable deduction. This technique may have an additional application where a single person w/a death benefit need wishes to own life insurance as a supplemental retirement planning.Death Benefit**Loans and withdrawals will decrease the cash value and death benefit. Tax-favored distributions assume that the life insurance policy is properly structured, is not a modified endowment contract (MEC), and distributions are made up to the cost basis and policy loans thereafter. If the policy has not performed as expected and to avoid a policy lapse, distributions may need to be reduced, stopped and/or premium payments may need to be resumed. Should the policy lapse or be surrendered prior to the death of the insured, there may be tax consequences.CharityFor Producer or Broker/Dealer Use Only. Not For Public Distribution.
13 Charitable Gifts of Life Insurance Cash GiftDonorsCharityPremiumsIf the donor wishes to have an immediate income tax deduction for the premium gifts, the charity must be the owner and beneficiary of the policy. The donor will make cash gifts to the charity to pay for the premium and receive an immediate income tax deduction. If the donor gifts the cash for the premium directly to the insurance company, it will also be a deductible gift; however, the deduction may be limited to 30% of the donor’s AGI since it is considered a gift “for the use of charity” rather than the normal 50% for a gift of cash (assuming a public charity). Therefore, the conservative approach and to receive the larger deduction, the donor should make the cash gifts directly to charity. Upon the donor’s death the life insurance death benefit proceeds would then be paid to charity.Death Benefit*Life Insurance Policy on Donor(s)For Producer or Broker/Dealer Use Only. Not For Public Distribution.
14 Gifts of Life Insurance: Existing Policy Valuation based on replacement valuePaid up policy/single premiumPremium paying modeRecently issuedDeduction limited to lesser of FMV or cost basisOrdinary income property reductionPublic Charity - 50% of AGI limitA donor can transfer an existing life insurance policy to charity and receive an income tax deduction. The value of the existing policy for deduction purposes is its replacement cost. The manner in which replacement cost is determined depends on the nature of the policy. If the policy is a single premium or paid up policy, then the value of the policy is the amount the life insurance company would charge for a single premium contract of the same amount on the life of the insured as of the date of the gift. If the policy requires additional premiums, the value is the interpolated terminal reserve. If the policy is a newly issued policy, the value is the premium paid to bring the policy into force.Since life insurance is ordinary income property any deduction will be limited to the lesser of fair market value or the donor’s basis in the policy.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
15 Gifts of Life Insurance: New Policy Charity needs to be owner & beneficiary in order to receive deduction for premium payments gifted to the charityIf premium is paid directly to insurance company, deduction could be reducedImportant to check insurable interest laws for state in questionIf the donor is going to allow his or her charity to purchase a new life insurance policy on his or her life, the charity would need to be the owner and the beneficiary of the policy for the donor to receive the larger deduction. Should the donor pay the premiums directly to the insurance company, the tax deduction would be considered “for the use of charity” and thus limited to 30% of the donor’s adjusted gross income (AGI), rather than the larger 50% of AGI deduction if the premium was gifted directly to the charity. Furthermore, in order for a life insurance policy to be considered valid, it must meet the insurable interest rules in the state in which it is issued. Most state have enacted laws giving a charitable organization an insurable interest in a donor. However, before creating a charitable plan using life insurance, state law should be considered.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
16 Types of Charitable Gifts Outright gifts or bequestsSplit interest gifts:Charitable Remainder Trusts (CRT)Charitable Lead Trust (CLT)Gift AnnuityLife EstateThere are various types of charitable gifts a donor may make. There is the outright gift or bequests to charity that are probably the most common and utilized type of charitable gift. Then there are the more sophisticated charitable giving techniques such as charitable remainder trusts, charitable lead trusts, gift annuities and life estates. Today the focus will by on charitable remainder trusts and we will also discuss charitable gifts of life insurance.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
17 Should a Client Consider a CRT? If clients have:Stock portfoliosLandReal estateAnd want to:Benefit charitySell the propertyReceive an income streamCreate tax deductionsReduce their estateShould a client consider a Charitable Remainder Trust (CRT)? The primary function of the CRT is to provide a present economic benefit to the client or members of a client’s family, or both with a future transfer to charity. Given that the client is charitably inclined and willing to donate assets to fund a CRT, this strategy may provide many benefits including: an immediate income tax deduction for contributing the property to the trust, the ability to sell illiquid assets without paying current tax, a pre-determined income stream for life, and a significant gift to a favorite charity(ies) upon death.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
18 Charitable Remainder Trust Benefits:Convert non-income producing asset to an income stream without immediate capital gainsGenerate immediate income tax deductionRemove asset and any future appreciation from estateBenefit charityA CRT can offer a donor many advantages besides benefiting their favorite charitable organization. If the donor has non-income producing assets, he or she may donate them to a CRT. The trustee can then sell those assets and invest in income producing assets. Since a CRT is a tax-exempt trust, there would be no recognition of capital gains upon the sale of the assets at the trust level. Furthermore, upon the transfer of the assets to the CRT, the donor will receive an immediate charitable income tax deduction and also remove the assets and any future appreciation of the value of that asset from the estate.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
19 Charitable Remainder Trust DisadvantagesNot all types of property are appropriateComplicated rulesDisinherits the heirsWhile there are many advantages to establishing a CRT, there are also some issues that may arise. First, not all types of property are appropriate for funding a CRT. As we will see later on, the transfer of certain types of property may cause a CRT to lose its tax exempt status, or cause the donor to recognize gain upon the transfer of the asset to the CRT. CRTs are also subject to complicated rules, such as the private foundation rules against self-dealing and jeopardizing investments just to name a few. Another disadvantage to a CRT is that the assets in the trust pass to charity upon termination, so the donor could be effectively disinheriting the heirs.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
20 How a CRT Works An irrevocable trust is created by an attorney Must follow specific rules to qualify as a CRTCRT is a tax exempt trustAn income beneficiary receives an income stream for trust termTerm of 20 or less yearsOne or more livesOnce term ends selected charity receives remainderOnce the client has decided to establish a CRT, an attorney will draft the trust. When establishing the trust the client must decide on the type of CRT to be established, the percentage income payout they wish to receive, who will serve as trustee, and how long the trust will last.The CRT can be created to pay an income stream the donor’s life, for the donor’s life plus the life of other beneficiaries, such as a spouse, or for a fixed term not to exceed 20 years. If the recipient of the specified payment is someone other than the donor or the donor’s spouse, the donor has made a gift of that interest that must be reported for federal gift tax purposes. However, the donor will be entitled to a charitable gift tax deduction for the value of the remainder interest passing to charity.Once the CRT ends, whatever is remaining in the trust passes to the charity or charities named in the trust document.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
21 How a CRT WorksDonor is entitled to an income or estate tax deduction for remainder value of trustNot dollar for dollarDeduction given up front even though actual value passing to charity is not knownDeduction based onTerm of trustPayout rate chosenAssumed rate of return (7520 rate)The donor is entitled to an income tax deduction if the CRT is established inter vivos or an estate tax deduction if it is a testamentary CRT. Due to the fact that the donor or other non-charitable beneficiary retains an income interest, a charitable deduction is allowed only for the present value of the remainder interest that is calculated to go to charity.The factors that are used in determining the present value of the remainder interest are: 1) the annuity or unitrust amount that will be paid to the income beneficiary (the payout rate); 2) the frequency of the payments to the income beneficiary; 3) the length of the income beneficiary’s interest; and 3) the interest rate for determining the remainder interest (IRC Section 7520 rate).For Producer or Broker/Dealer Use Only. Not For Public Distribution.
22 IRC Section 7520 Rate IRS assumed rate of return 120% of federal midterm rateCan use current month’s or previous two months’Generally, the higher the 7520 rate, the larger the CRT deductionThe IRC section 7520 rate is the assumed rate of return used to calculate the expected trust corpus that will pass to charity when the CRT terminates. This rate is 120% of the applicable federal mid-term rate and is commonly called either the AFR or the 7520 rate. The donor has the option to use either the 7520 rate for the month the transfer to the CRT takes place, or for either of the two months immediately preceding the transfer. For example, if the donor transfers assets to the CRT in May, the donor may use May’s 7520 rate or March or April’s 7520 rate. Generally, the higher the 7520 rate, the larger the income tax deduction will be.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
23 Charitable Remainder Trust Gift Asset to CRTTrust CorpusIncomeCRTDonorWe have talked about how a CRT works, but now let us take a closer look and put all the pieces together. After the CRT is established, the donor will irrevocably gift an asset to the trust. The gift should qualify for the federal gift tax deduction to the extent the gift benefits charity and therefore should not generate any gift tax.The donation of an asset to the CRT creates a charitable income tax deduction. The deduction will be calculated with the help of the donor’s tax and legal advisors. The deduction will be based on the present value of the remainder interest that is calculated to go to charity. Since the charity must wait to receive the trust proceeds until the end of the trust term, the deduction is not going to be a dollar for dollar deduction. The most that the donor will be able to deduct in one year is an amount not to exceed 50% of their adjusted gross income. Any deduction that the donor is unable to use in that first year can be carried forward for five additional years.Once the CRT is established and the donor has irrevocably gifted an asset to the trust, the donor, or other income beneficiary, will receive an income stream from the CRT.Once the CRT terminates, the entire remaining value of the trust passes to the charity. If the donor did not decide on a charity to name in the trust when it was established, the donor may retain the right to name the charity in his or her will, or give the trustee or a third person the right to name the charity. However, it is important to state in the trust document that the ultimate beneficiary will be a qualified charitable organization for the trust to qualify as a CRT.DeductionCharityGovernmentFor Producer or Broker/Dealer Use Only. Not For Public Distribution.
24 CRT: Irrevocable Trusts What Cannot Be Changed:Income beneficiariesTerm of the trustPayout ratePayout frequencyType of trustTrust must not be a grantor trustIt is important to remember that a CRT is an irrevocable trust and most of the terms of the trust cannot be changed. Specifically the donor will not be able to change the income beneficiaries, the term of the trust, and the payout rate and frequency of the income stream. In addition, a CRT must not be a grantor trust.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
25 CRT: Irrevocable Trusts What Can Be Changed:Charitable remaindermanInvestments in trustThe donor will, however, be able to change certain terms in the trust. Specifically, the donor will be able to retain the right to change the ultimate charitable remainderman and the trustee. However, once the CRT is established and assets have been transferred into the trust, the donor can never recover title to those assets.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
26 CRT: Four-Tier Taxation Four-tier income taxation to the extent each exists in trust:Ordinary incomeCapital gainsTax-free incomeCorpus (return of basis)If income recipient is not donor, gift tax may be levied on present value of income streamWhile the CRT is a tax exempt trust, payments from the trust to the donor are taxable. Whether a distribution to the donor is taxable is determined under a unique system, normally called the “four tier system”. This system treats payments to the donor as being paid in the following manner: 1)First, as ordinary income, to the extent that the CRT has ordinary income for the current year, or undistributed ordinary income from the prior years. 2) Second, as capital gain, to the extent the CRT has capital gain for the current year, or undistributed capital gain from prior years. 3)Third, as tax exempt (or other income), to the extent the CRT has other income for the current year, or undistributed from prior years. 4)Fourth, as a distribution of trust corpus.The end result of this system is that the income beneficiary recognizes taxable income on distribution before any nontaxable distributions are made. Also, as previously mentioned, if the income recipient is someone other than the donor or donor’s spouse, the donor may have gift tax consequences (and GST tax consequences depending on who the recipient is).For Producer or Broker/Dealer Use Only. Not For Public Distribution.
27 Example: $1,000,000 CRT CRT has 8% payout Has income of 6% $80,000Has income of 6%$60,000CRT has $500,000 of built in capital gain$60,000 taxable as ordinary income$20,000 taxable as capital gainLet us take a look at an example of how the four-tier taxation system works. Donor contributes stock with a fair market value of $1,000,000 and a cost basis of $500,000 to a CRT with an 8% payout rate. The trustee of the CRT sells the stock and invests the proceeds in a bond fund earning 6%. The first year payout of $80,000 (8% of $1,000,000) would be taxed to donor $60,000 as ordinary income (which is all the ordinary income earned by the trust) and capital gains of $20,000 (leaving $480,000 of undistributed capital gains remaining in the trust).If there are two or more income beneficiaries, each is treated as receiving a pro rata portion of a distribution and would incur taxes evenly.This hypothetical example is for illustration purposes only and actual results may vary.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
28 CRT: Selecting the Proper Asset Publicly traded stockLow basisStock pays low dividendsDonor seeking to defer capital gains taxNeeds a source of premium dollarsA CRT is usually structured as a tax-exempt trust, therefore any earnings in the trust are not taxed. If a donor has appreciated assets such as stocks or real estate one advantage of the CRT is the ability to transfer those assets to the trust, have the trustee sell the property, and not to have to pay capital gains tax on the sale. By not paying the capital gains tax on the sale, the CRT has more money to invest than if the donor had sold the property and incurred the capital gains tax. In addition, if the donor has publicly traded stock that is only yielding a small dividend, the client can diversify their portfolio inside the CRT.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
29 CRT: Selecting the Proper Asset Appreciated Real EstateLow basisDebt freeContribute 100% of donor’s interest in the propertyIdeally 100% interest = whole property.100% interest in a fraction is less marketable.Appreciated real estate is another asset that should be considered when funding a CRT. Ideally, the donor will own the property free of any debt or mortgage and will transfer his or her entire interest in the property. Transferring property subject to debt may have adverse tax consequences to the donor and the CRT. The donor can transfer a fraction interest of the property, however, a fraction interest in real estate is generally less marketable and therefore hard to sell.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
30 CRT: Problem Assets Debt encumbered property Partnership/S corporation More than 20% of business interestInter vivos transfer of IRA, qualified plans, or annuityWe have discussed selecting a proper asset to fund a CRT, what about problem assets a donor may want to avoid transferring into a CRT. Assets that a donor may not want to transfer to a CRT include: debt encumbered property, partnership interests, more than a 20% interest of a business, and S corporation stock. If a donor transfers S corporation stock into a CRT the S corporation would lose its S status since a CRT is not a permissible holder of S corporation stock.Additionally, inter vivos transfers of IRA, qualified plans or annuities to a CRT would cause adverse tax consequences to the donor. The transfer would be treated as a distribution and the donor would have to recognize income tax on that distribution.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
31 Unrelated Business Taxable Income (UBTI) If CRT has UBTI, the trust will pay an excise tax of 100% of the UBTIEncumbered propertyCertain partnership interestsMore than 20% of the voting stock of a businessS corporation stockAs mentioned before, a CRT is normally structured as a tax-exempt trust. However, when the CRT has unrelated business income (UBI), the trust will pay an excise tax of 100 percent of the UBTI. UBTI is defined as the gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it.. Assets that we just discussed, encumbered property, more than 50% interest in a business, partnership interests, and S corporation stock may create UBTI inside of the CRT. Because of the potential for UBTI, careful planning is needed in determining what type of assets are appropriate for funding a CRT.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
32 Problem: Encumbered Property Bargain sale treatmentPart sale, part giftPotential disqualification as CRTDebt financed incomeALL trust income becomes taxable for that yearException: If (1) the donor owned the property for more than five years before the gift and (2) the mortgage was placed on the property more than five years before the gift, the indebtedness is not acquisition indebtedness for ten years after the gift.Besides UBTI, transferring encumbered property to a CRT may cause bargain sale treatment. A bargain sale is a sale of appreciated property to a charity for less than fair market value. A bargain sale is treated, for income tax purposes, as part sale of the property to charity and part charitable gift. If there is a bargain sale, the donor will be required to pay capital gains tax. In addition, a transfer of encumbered property may disqualify the CRT if the trustee pays any part of the debt as well as violate the self-dealing rules that apply to CRTs.However, there is an exception to the UBTI problem, if the debt is non-recourse and the property is owned by the donor for more than five years and the debt is more than five years old, the CRT may not have UBTI. However, the donor will still be subject to the bargain sale treatment. Thus, encumbered property is normally not a suitable asset for funding a CRT.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
33 Encumbered Property Solution: Transfer debt to another property Partition property so debt is only on part not transferredPay off debtIf the donor wants to transfer property subject to debt to a CRT there are several ways to remove the debt from property. The donor may transfer the debt to another piece of property. The donor may partition the property so that the debt is on the part of the property not transferred to the CRT. Or the donor may pay off the debt before transferring it to the CRT.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
34 Trust Designs CRAT Charitable Remainder Annuity Trust CRUT Charitable Remainder UnitrustNIMCRUT Net Income with Makeup UnitrustFLIP Net Income Unitrust Switching to Straight CRUTNow that we have looked at the taxation of CRTs and what assets should be used to fund a CRT, let’s switch gears and talk about the different CRT designs. Today we will look at four different trust designs, a charitable remainder annuity trust or CRAT, a charitable remainder unitrust or CRUT, a net income with makeup unitrust or NIMCRUT and finally a net income unitrust that switches to a straight CRUT or a FLIP.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
35 CRAT CRUT Pays a fixed percentage of the trust corpus Pays a fixed annuity based upon initial fair market value of trust* Fixed percentage or dollar amountCRUTA CRAT pays a fixed annuity payment based upon the initial fair market value of the trust. The payment can be stated as an absolute dollar amount or as a percentage of the initial fair market value.A CRUT must pay a fixed percentage of trust corpus. Since the payout is a percentage of the trust corpus the income payments may fluctuate as the corpus may increase of decrease each year.The perceived advantage of the CRAT over the CRUT is that the annuity payment from a CRAT is certain whereas a payment from a CRUT fluctuates with the value of the trust. However, one of the cited advantages of a CRUT over a CRAT is the ability to have a continually increasing stream of income, thus providing a measure of inflation protection.Pays a fixed percentage of the trust corpusIncome payments may fluctuateFor Producer or Broker/Dealer Use Only. Not For Public Distribution.
36 Payout made only if trust has net accounting income NIMCRUTPayout made only if trust has net accounting incomeDonor does not need funds immediatelyInvest in growth assetsCan makeup prior missed payments if net income is sufficientA NIMCRUT payouts out the lesser of the trust net income or the full unitrust percentage. The trust may also contain a provision that allows any previously unpaid unitrusts amounts to be “made up” where there is net income in excess of the standard untirust payment.The NIMCRUT is advantageous in situations where the donor does not immediately need the income payment and would like to accumulate funds, on a tax-deferred basis, in the unitrust for payment at a later date such as retirement. Through a careful selection of growth and income assets, the trustee could invest in growth assets during the accumulation period and then switch to income producing assets once the donor has decided that he or she needs the income.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
37 FLIP Trust Starts as a net income trust Upon triggering event, changes to standard CRTSale of assetDeathDivorceForfeit any makeup upon “flip”Ideal for unmarketable assetsA FLIP untirust is a CRUT, which is initially structured as a net income trust, but converts or “flips” to a standard unitrust upon the occurrence of certain events. The flip must be outside the control of the trustee or any other person. Examples of non-discretionary triggering events include: sale of an unmarketable asset, marriage, death, divorce or birth.The FLIP trust can be advantageous in situations where the transferred property does not generate income or may not be immediately sold. In these situations, if a standard unitrust is used, it would require a payment to the income beneficiary even though no income had been generated. If a FLIP unitrust is implemented instead, no distributions are required until income is generated once the property is sold. Once the property is sold, the trust flips to a standard unitrust and payments may begin. However, unlike a NIMCRUT, once the FLIP trust switches to a standard unitrust, any make up amounts must be forfeited.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
38 Case Study: Mike and Carol Brady Ages 72 and 68 establish a CRUT$1,000,000 of stock, $200,000 cost basis5 % and 7% payouts7% return7520 rate of 2.6%Federal income tax rate of 28%Federal capital gains tax rate of 15%Now let us look at some case studies to see how a CRT works. First let’s look at Mike and Carol Brady who will establish a CRUT. (Read Slide).For Producer or Broker/Dealer Use Only. Not For Public Distribution.
39 Case Study: Mike and Carol Brady 5% PayoutDeduction $410,070Total Income $1,345,287Remainder $1,502,8011st year income $50k7% PayoutDeduction $293,070Total Income $1,510,648Remainder $960,3451st year income $70kThe results of establishing a 5% versus a 7% CRUT. (Read Slide).This hypothetical example is for illustration purposes only and actual results may vary.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
40 Case Study: Sale or CRT? Sale: Invested: $880,000 Initial After Tax Income: $38,106Heirs: $1,541,697Charity: $05% CRT:Invested: $1,000,000Income Tax Deduction: $ 410,070Initial After Tax Income: $36,000Heirs: $509,947Charity: $ 1,502,801Using the same assumptions for Mike and Carol Brady, let’s look at a case study comparing selling the asset and investing the after-tax proceeds versus establishing a 5% CRUT. (Read Slide).This hypothetical example is for illustration purposes only and actual results may vary.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
41 Tax Diversification Plan Contribute stock to CRTCreates income tax deductionsSell enough stock so that taxable gain is offset by CRT tax deductionProvides both income stream and cashThe tax diversification plan may help an individual to make a charitable gift and sell appreciated property. The donor will contribute stock to a CRT which will create a charitable income tax deduction. The donor will also retain some of that stock outside the CRT. The donor will then sell enough of the stock that is outside of the CRT so that any taxable gain from the sale will by offset by the income tax deduction received. This tax plan will create for the donor an income stream from the CRT and cash from the sale of the stock.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
42 “Implementing a CRT Disinherits Our Heirs!” Client Objection“Implementing a CRT Disinherits Our Heirs!”A potential drawback of implementing a CRT is that whatever is left in the CRT when the trust terminates will pass to charity. This effectively disinherits the heirs who would have normally been the recipients of such property. A common planning strategy, the wealth replacement trust, used in conjunction with a CRT attempts to address this problem.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
43 Possible Solution: Wealth Replacement Trust Value of asset transferred to CRT may be replaced for heirs with the purchase of life insurancePremiums may be paid from CRT income streamLife insurance purchased inside wealth replacement trust may avoid estate inclusionThe concept behind the wealth replacement trust is to “replace” for the heirs what is lost to them because of the CRT. This involves establishing a wealth replacement trust for the benefit of your heirs. Life insurance can be purchased insuring the donor’s life or the life of the donor and the donor’s spouse inside the wealth replacement trust which will allow the death benefit proceeds to pass to the heirs generally income and estate tax-free. A portion of the payout from the CRT can be gifted to the wealth replacement trust and used for premiums. Therefore, upon the termination of the CRT, the charity receives a significant donation through the CRT and the heirs will not be disinherited because they are beneficiaries of the wealth replacement trust.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
44 Why Use a Wealth Replacement Trust Trust document controls destiny of policyprotects policy from surrender by childrendetermines when proceeds will be paid to childrenOutside donor’s estateMay provide protection from child’s creditors ** Creditor protection laws vary dependant upon governing federal and state law. The applicability of such laws also depend on the terms of the trust. One should be sure to confer with their independent tax and legal advisors prior to establishing a trust for this purpose.Some of the benefits of using a wealth replacement trust are that the trust document can control the destiny of the policy. Therefore, it will protect the policy from surrender or lapsing should the children not pay the premium amounts. The trust can also instruct when the proceeds will be paid out the beneficiaries. Additionally, if the trust is properly structured the life insurance death benefit proceeds can pass to the trust beneficiaries both income and estate tax free.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
45 Designing the Wealth Replacement Trust Trust is owner and beneficiary of policyInsured(s) cannot be trusteeInsured(s) cannot have any incidents of ownershipTo ensure that the life insurance death benefit proceeds are excluded from the donor’s estate, the wealth replacement trust should be the owner and beneficiary of the life insurance policy. In addition, the donor/insured should not be trustee of the trust or have any incidents of ownership over the life insurance policy that would cause inclusion in the donor/insured’s estate.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
46 How Much Coverage to Purchase Full replacementAmount equal to CRT remainder valueEqual replacementAmount equal to contributions to CRTNet replacementAmount equal to remainder net of estate taxRealistic replacementAmount donor(s) can afford to giftOnce it has been decided that a wealth replacement trust will be used, the question becomes what the level of replacement should be. The replacement amount can be any amount the donor desires but is generally either: (1) an amount equal to the full remainder value that actually passes to charity (full replacement); (2) an amount equal to the initial value of the asset placed in the CRT (equal replacement); or (3) an amount equal to only what the heirs would have received net of estate taxes (net replacement).For Producer or Broker/Dealer Use Only. Not For Public Distribution.
47 Example Replacement value: Equal value: Net value: Realistic value: $1,184,304Equal value:$1,000,000Net value:$592,152Realistic value:Whatever the net payout of $40,200 will buyDonor, age 70, gifts $1,000,000 to CRTAt life expectancy, CRT remainder value is $1,184,304Payout is 6% & tax rate is 33%Estate tax bracket is 50%Let’s take a look at an example: Mr. Donor, age 70, gifts $1,000,000 to a CRT in 2013 with a payout of 6%, which subsequently grows to a remainder value of $1,184,304 at his death. Mr. Donor income tax rate is 33% and his estate tax rate is 50%. If Mr. Donor wanted to use the full replacement method the death benefit would be $1,184,304. If Mr. Donor used the equal replacement value the death benefit would be $1,000,000. If the net value method was used the death benefit would be $592,152.This hypothetical example is for illustration purposes only and actual results may vary.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
48 Questions?If the donor is gifting a new policy to charity, the charity needs to be the owner and the beneficiary of the policy for the donor to receive an immediate charitable income tax deduction. Also, for the donor to receive the larger deduction it is best to make the cash gift directly to the charity and not to the life insurance company. Furthermore, in order for a life insurance policy to be considered valid, it must meet the insurable interest rules in the state in which it is issued. Most state have enacted laws giving a charitable organization an insurable interest in a donor. However, before creating a charitable plan using life insurance, state law should be considered.For Producer or Broker/Dealer Use Only. Not For Public Distribution.
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