Charitable remainder and wealth replacement trusts: too good to be true?

Clients with charitable inclinations often are concerned about the contributions' effects on their well-being and on the amount of property ultimately passing to their heirs. This month, Ted Kurlowicz, JD, LLM, CLU, ChFC, associate professor of taxation, The American College, Bryn Mawr, Pennsylvania, and Barton Francis, CPA, CFP, a partner of Shellenhamer and Company, Palmyra, Pennsylvania, describe a technique - a charitable remainder trust (CTR) coupled with a wealth replacement trust - that enables clients to take maximum advantage of charitable contributionn's benefits while funding a trust to offset the donated asset's loss.

Qualifying gifts of property to charity generate federal income, gift and estate tax deductions. While charitable deductions are limited for income tax purposes, qualifying gifts of property are fully deductible against either the donor's federal gift or estate tax base.

Contributions are deductible only if made to a qualified charitable organization - one operated exclusively for religious, charitable, scientific, literary or education purpose. A list of qualified charities is published by the Internal Revenue Service and should be consulted before making contributions.

CHARITABLE REMAINDER

TRUST

A CRT can reduce significantly a donor's income and estate tax liability without completely divesting the donor, or his or her heirs, of the donated property's current benefits. A CRT provides the donor with

* An immediate income tax deduction equal to the present value of the remainder interest.

* A chance to avoid the built-in capital gain on appreciated property contributed to the trust.

* Annual income in the form of a fixed or variable annuity.

* A lower estate tax liability since the appreciated property is deducted from his or her gross estate.

As noted above, the donor avoids the realized capital gain on appreciated property placed in the trust. However, the unrecognized gain is a preference item for alternative minimum tax (AMT) purposes if the income tax deduction the donor takes is bases on the property's full fair market value. For this reason, CRTs often are established in December, when it's easier to forecast any potential AMT liability.

A CRT can be created during the donor's lifetime or at death with appropriated provisions in the donor's will. A CRT allows the donor to take advantage of the tax benefits of charitable contributions while retaining the property's current benefits. This is an advantage over the typical alternatively of making an outright gift during the donor's lifetime.

A CRT's current benefits must be provided only to noncharitable beneficiaries. These benefits are reserved for such beneficiaries for a specified time (usually the donor's life or the lives of selected family members) with the charity entitled to receive the remainder interest. If a fixed term is chosen, it is limited to 20 years.

Current income, estate and gift tax deductions are measured by the present value of the remainder interest given to the charity, as calculated according to Internal Revenue Code section 7520. This present value is affected by mortality assumptions of noncharitable beneficiaries (if the CRT terms is measured by their lives) and the applicable federal midterm interest rate that is published monthly by the IRS.

Valuation rules permit the deduction to be based on the taxpayer's choice of the current monthly rate and the rates applicable to the two months before the donation. Since these rates are published in advance, the donor can choose a valuation rate from any of four months and time the donation appropriately. CPAs can make calculations to help the client select the valuation rate that maximizes the donation's tax savings. IRS notices 89-24 and 89-60 provide additional valuation guidance.

BENEFITS FOR

NONCHARITABLE

BENEFICIARIES

IRC sections 170, 2055 and 2522 clearly limit the income, estate and gift tax deductions for CRT's to specific payout arrangements. The rights the donor retains for noncharitable beneficiaries must provide for an annual annuity or unitrust payment, as defined by IRC section 664(d). The charitable remainder annuity trust (CRAT) provides noncharitable beneficiaries with a fixed annual annuity payment, determined at the time the trust is created. After the CRAT is funded, no additions are permitted.

The charitable remainder unitrust provides the noncharitable beneficiary with a fixed percentage, selected at the time the trust is created and not less than 5% of the trust's annual value (a variable annuity). Since a unitrust permits additions and payouts varying with the trust's value, it generally is considered more flexible than a CRAT.

One potential problem with CRTs is the required annual payout; trust assets may have to be sold if trust income is not sufficient to make the required annuity or unitrust payment. If a unitrust approach is adopted, the payout can be limited to the trust's actual accounting income, if that income is less than the unitrust amount in a given year. Deficiencies can be made up in future years when income exceeds the required payment.

WEALTH REPLACEMENT

TRUST

A CRT works particularly well in conjunction with an irrevocable life insurance trust (a so-called wealth replacement trust). Life insurance in the trust is paid for by a combination of the income and estate tax benefits of the CRT and, if necessary, by trust income. Exhibit 1, page 90, illustrates the general principles behind a wealth replacement trust.

Example: Dan Smith, 62 and his wife Dorothy, 60, expect to be in the 55% federal estate tax bracket. Their current estate plan includes an optimal marital deduction formula. However, they still are concerned about estate settlement costs and wish to pass the maximum amount possible to their children. They also feel strongly about making a contribution to their church but don't think they have sufficient resources to make a current contribution and are concerned about depriving their children of their inheritance.

To solve their problem, the Smiths can make a donation to charity and use the resulting tax savings to fund a wealth replacement trust. Exhibit 2, page 90, summarizes the results of creating this arrangement.

What to give ? The Smiths have a large parcel of undeveloped land, the value of which has fluctuated considerably in recent years. The property was purchased 20 years ago for $100,000 and has a current market value of $1 million. Taxes on the $900,000 capital gain, if the Smiths decide to sell the property themselves and reinvest the proceeds, also are a concern.

How it works. The Smiths can contribute the land to a CRT and retain a 7% unitrust interest for their joint lives, with the remainder passing to the church. The trustee can sell the property and reinvest the proceeds. At the same time, the Smiths can create an irrevocable life insurance trust to purchase a $1 million survivorship life policy that will pay a death benefit at the death of the second of the two insureds. Their 7% income interest in the trust will generate $70,000 annually, which is more than sufficient to pay the $15,805 annual premium on the life insurance coverage.

Benefits for the Smiths. The combination of a CRT with a wealth replacement trust meets a number of important goals. The Smiths reduce their current income tax liability and future estate tax liability while avoiding capital gains tax on the property's appreciation. Current income (and future retirement income) has been increased, an uproductive asset has been eliminated and family members still will receive the same inhertance.

POTENTIAL PROBLEMS

CRTs are not without their disadvantages.

Contributions of encumbered property. Property subject to a mortgage will create problems if placed in a CRT. The IRS ruled privately that in doing so the donor creates a grant or trust ineligible for CRT status under section 664. This means the income tax deduction and capital gain avoidance could be lost.

Limit on donor's income tax deduction. In the absence of a taxpayer election, the charitable deduction is based on the appreciated property's full fair market value. However, for AMT purposes, the deduction is limited to the donor's adjusted cost basis. Thus, the unrecognized capital gain on the donated property is an AMT prefrence item and must be added to the donor's other preference items in determining AMT.

Since the deduction for contributions to a CRT is limited to 30% of the donor's contribution base - adjusted gross income with some adjustments - for the year, the current deduction could be limited, subject to a five year carryforward. The AMT preference item is limited to the deduction actually available to the donor in a given year. Because the CRT's tax benefit depends on other income tax factors, the donation may have to be delayed until a time when a clear picture of the client's tax situation for the year is available.

ESTATE PRESERVATION

Resent federal transfer tax rule changes, such as limits on estate freeze techniques and the generation-skipping transfer tax, have placed an enormous burden on taxpayers trying to plan the disposition of their estates. Two planning techniques have survived: the charitable remainder trust and the irrevocable life insurance trust. For many taxpayers, use of either or both of these techniques can provide a means of estate preservation unmatched by other planning alternatives. CPAs familiar with how these techniques work can assist clients by "running the numbers" to determine when and how such arrangements should be implemented.

EXECUTIVE SUMMARY

* A CHARITABLE remainder trust (CRT) combined with a wealth replacement trust enables clients to take maximum advantage of the income tax benefits of charitable contributions while also funding a trust to offset assets lost to heirs.

* THE BENEFITS OF a CRT include an immediate income tax deduction, a chance to avoid the capital gain on appreciated property, a steady source of income and lower estate taxes.

* ASSETS GIVEN TO charity are replaced by an equal amount of life insurance paid for with the income and estate tax savings of making charitable gifts.

* CRTs DO HAVE some disadvantages. Property subject to recourse indebtedness cannot be placed in trust, and income tax deductions for charitable donations are limited, subject to a five-year carryforward of unused deductions.

* CPAs CAN ASSIST clients in deciding when and how to set up a charitable remainder or wealth replacement trust arrangement to yield maximum tax benefits.