When can a unitrust with a 10 percent remainder value make sense, particularly if the charity is being asked to serve as trustee? The answer: When the funding amount is large enough and the term of years is short. This is particularly true if, as the old adage says, “part of something is better than nothing at all.”
A Little History
As everyone knows by now, the “Taxpayer Relief Act of 1997” created some new parameters for CRTs. Trusts created after July 28, 1997, must have payout rates that cannot exceed 50 percent, and charitable deduction values must exceed 10 percent. It is believed this legislation was enacted largely in response to the accelerated unitrust issue that NCPG brought to the attention of the IRS. In any event, it is the mandatory 10 percent minimum charitable deduction requirement that we want to focus on in this article.
Consider the high-tech executive who has stock (and options) worth several million dollars. He’s felt the effect of the Asian crisis on share value during 1998, worries about the Y2K problem and isn’t sure where the next advancement will come in the high-tech industry that will drive share values as in the 1990s.
Like most high-tech executives, he is a relatively new millionaire. So being a major philanthropist has never been a consideration. After all, he’s been working 60-80 hours a week for years to do his part in building his company’s stock value. There has been little time available to develop interests outside of his work and immediate family.
It’s been a great ride, but as he looks for-ward to his own retirement in five to 10 years, it’s time to think about diversifying his assets. Having the majority of his net worth in one stock is unsettling. In the process of diversifying his holdings, he would like to minimize taxation.
If a plan can be developed to help him diversify his assets, avoid significant taxation and generally preserve his financial interests through a charitable plan, then he’s receptive. Otherwise, he’s not at the stage in life where he’s willing to contemplate a six-figure gift.
|10-Year-Term CRT With 21.24% Payout Rate*|
|Annual after Tax Cash||Compounded by 8.6% Over||Value in Fall of 2008 AD|
|$178,701||(plus tax savings)||9.5||years||$391,300|
|*The key to this illustration is the assumption used in determining how the cash flow from the unitrust will be taxed each year. We’ve assumed that 80 percent of the cash flow would be taxed at long-term capital gains rates (26.7%), and 20 percent would be taxed at ordinary/short-term capital gains rates (45%). In other words, the blended tax rate assumption is 30 percent.|
So, what are his options?
He could sell stock outright, pay the cap-ital gains tax (26.7% blended rate in Oregon) and invest the difference. Let’s assume his cost basis in the stock is only $5,000 and the value today is $1,000,000. That means $265,000 in long-term federal capital gain and state income tax, leaving $735,000 available for reinvestment. Let’s also assume he is 45 years old and wants to retire in 10 years when he is 55 years old. So, over the next 10 years, if the reinvested proceeds grow at a compounded rate of 8.6 percent, he will have $1,677,203 available to spend in 2008.
He certainly has accomplished his diversification goal, but the goal to minimize upfront tax in the process of diversifying just went up in a puff of smoke!
What if, instead, he created a 10-year term, 21.24 percent payout CRT? What would be accomplished in this instance? (Note: With a 6.2 percent AFR, the potential payout rate is 21.24 percent on a 10-year term CRT.) Assuming the same $5,000 cost basis, $1,000,000 value and a 10 percent CRT earning assumption, the following would occur (See TABLE A).
Clearly, the key to make this strategy effective is to pick proven investments to be placed inside the unitrust that will be held long-term, with very little turnover, or dividends, being paid. The objective for most high-income earners is to have their unitrust pay income that will be taxed at the lowest possible rates.
The remainder value in 10 years is projected to be $307,750. On a present value basis, assuming a 3.5 percent rate of inflation, the real value to charity will be $218,170. Most charitable organizations would gladly serve as trustee for 10 years in exchange for $218,170.
High-Tech Executive Wins
The executive is able to diversify his assets, avoid the sizeable initial capital gains tax, and make a six-figure gift to a charitable cause at a small cost to him. The graph in TABLE B illustrates this point in present-value terms.
Note: If long-term interest rates return once again to their historically higher levels, thereby pushing the AFR up, it is reasonable to believe our high-tech executive could make a similar gift at no net cost to himself because the payout rate from the CRT, or the charitable income tax amount, would be greater.
In this particular case, because the cost basis relative to fair market value is so significant, and with the addition of state income tax, the numbers become quite compelling. So compelling, in fact, that our high-tech executive’s charitable receptivity was transformed into a sizeable gift via the 10 percent remainder approach.
What’s more, now that the young executive has made this significant gift, his interest in the charitable recipient begins to develop. With proper recognition and involvement, the charity may well be in line for further gifts from this emerging philanthropist.
K. Gene Christian is regional director for charitable estate and gift planning services within the Providence Health System of Oregon. His article includes input from Larry E. VanLaningham, senior vice president at Solomon Smith Barney, and Kenneth A. Rigert, PC, CPA, both of Portland.
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