February 4, 2020
Written by Bruce Paulson, Senior Client Advisor, CPA, JD, CFP®
Do you wish to receive an income tax deduction for charitable gifts otherwise “capped” by percentage limitations of adjusted gross income (AGI)? Do you have assets that provide a high cash yield and income taxed at the highest federal and state rates? Would you like to leave these assets to your children at a low (or no) gift-estate tax cost? If so, the story below, a live one, may be of interest.
The Smith Family
Jim and Julie Smith are Minnesota residents. Their self-created wealth far exceeds their and their family’s need. Dynastic trusts are funded; a private foundation exists and will receive their wealth at the later of Jim or Julie’s passing. There is no estate tax exposure. Their taxable income and AGI have fallen dramatically in recent years. However, their desire to make large lifetime contributions to their private foundation is rising and will accelerate as their family foundation is staffed and able to receive and distribute larger amounts of capital.
Their tax problems and concerns include:
- Absent significant realized capital gains, major charitable donations to their private foundation will not be tax deductible, at least not right away.
- Their federal and state tax burden on assets producing ordinary income is over 50%.
- Every income tax dollar paid (over time) means less money will go to their private foundation.
- They fear loading their private foundation with capital and being required to make large distributions before their foundation is ready to do so.
- Their remaining gift-estate tax exemptions are (or soon will be) zero.
A Charitable Lead Trust
We listen and suggest the Smiths create a new taxpayer to hold certain high cash and income producing assets (e.g., commercial real estate, high yield funds). The new taxpayer will be a trust called a charitable lead trust (CLT)[i]. The CLT will make annual payments to the Smith Family Foundation for a fixed term of years or for Jim’s and Julie’s lives (or combination of the two). The obligation to make a series of future charitable payments is called the “lead interest”. The trust can be an annuity trust (a CLAT), where the foundation receives an annual payment based on a fixed percentage of the initial value of the trust assets, or an unitrust (a CLUT), where the annual charitable payment to the foundation is a fixed percentage of the fair market value of trust assets, valued at least annually.
When the trust is funded, a remainder interest exists. It is usually gifted to the family of the donor. Jim asks if he must pay gift tax. In our case, the answer is no. The lead interest in the trust is valued using a monthly prescribed IRS interest rate, currently around 2%. In our case, the lead (charitable) interest will nearly equal the value of the trust assets; hence, when it is subtracted, the gift made to the Smith children or trusts is zero.
We explain to the Smiths that using a 2% discount rate to value the lead interest creates the opportunity to transfer a significant amount of wealth to their children free of tax. If the trust portfolio compounds at a rate that exceeds 2% per annum, the excess return goes to the children or trusts free of any exposure to estate taxes. If the return is 2% or less, the trust remainder beneficiaries will receive nothing.
Income Tax Savings
The Smiths want to see what their income tax savings might be by setting up a $10,000,000 CLAT holding real estate (60% exposure), high yield debt, and cash. We show a 15-year CLAT that pays $778,333 annually to their private foundation. The trust has taxable income but receives an offsetting charitable contribution deduction – one not limited to a percentage of the Smiths’ AGI. Using reasonable asset class assumptions[ii], the income tax savings for Jim and Julie over 15 years are shown below:
As mentioned, the trust is formed gift tax-free: no estate tax is due when it ends. Using a total return of 7.1% for trust assets, the children’s remaining interest in the trust is projected to be just over $8,000,000.
Is 60% Exposure to Real Estate Prudent?
Conventional wisdom and modern portfolio theory might say no – a more diversified, more liquid, higher growth-oriented portfolio should be considered. While Jim sees wisdom in holding assets with different risk and return characteristics, he is comfortable being overweight real estate and high yield debt in this trust. Annual variance in price, to him, means little, especially when his purpose in creating the trust is to save income taxes. As such, pairing high cash flow – high income assets with a stream of offsetting charitable contributions makes great after-all tax sense. Jim’s concern that the trust has the cash to make the required annual charitable contribution requirements is noted and the trustees decide to hold 10% to 15% cash or short-term bonds in the portfolio.
Devil in the Details
This interests the Smith family, but we remind them “the devil is in the details”. Knowing the concept and armed with the numbers, they seek advice from their trusted attorney on these and other matters:
- Where (in what state) should the new trust be created?
- Does putting the trust in a no tax state like South Dakota make sense?
- Can the trust be drafted so that income (as defined in the trust) is as inclusive as possible?
- Who should be trustees of the new trust?
- What if the real estate being contributed to the new trust has debt?
- Should we claim a valuation discount on assets being transferred to the trust?
- Will Jim’s and Julie’s roles as private foundation board members impact the transaction?
[i] Two different income tax results are possible with the CLT, which depend upon who is the taxpayer. If the trust is not the taxpayer, the grantor (or donor) is; when the trust is funded, the donor receives a charitable income tax deduction based on the present value of the charitable annuity. Then, the grantor is taxed on all the trust income during the term of the trust. Conversely, the trust can be the taxpayer. If so, the donor does not receive an income tax deduction for the contribution; instead, the trust is taxed and receives a charitable deduction for the annual payment made to charity. It is possible for a CLT to start as a grantor trust; hence, create a large, upfront charitable deduction, but then change to a tax paying trust, with the trust (now) entitled to deduct (again) annual contributions to charity.
[ii] CLAT Portfolio Inputs