Charitable Planning Charitable Planning with IRAs and Qualified Plans

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1 Charitable Planning Charitable Planning with IRAs and Qualified Plans Charitable Planning With IRAs and Qualified Plans For our Friends at WealthCounsel Advisors Forum Teleconference Seminar March 14, 2007 at 1 p.m. EST Thomas J. Ray, Jr., Esq. Ray Law Offices, P.C Jeffco Boulevard. Ste 110 Arnold, MO Lifetime Charitable Planning 1

2 IRA Charitable Rollover IRA Charitable Rollover Passed as part of the Pension Protection Act of Effective only until December 31, President Bush has proposed making the bill permanent and a bill has been introduced in Congress. IRA Charitable Rollover Effect: 1. A qualified taxpayer makes a taxexempt transfer of IRA assets to charity. 2. Limited to $100,000 per taxpayer. 3. Allows a client to meet his or her RMD for the year of the transfer. IRA Charitable Rollover Six Requirements: 1. Donor Must be 70½. 2. Only distributions from IRAs qualify. 3. Only direct distributions qualify. 2

3 IRA Charitable Rollover Six Requirements (continued): 4. Only Certain Section 170(b)(1)(A) organizations qualify to receive distributions. a. Non-Operating PFs do not qualify. b. Supporting Organizations and DAFs cannot qualify under the new law. IRA Charitable Rollover Six Requirements (continued): 5. Distribution must otherwise qualify for the income tax charitable deduction. 6. Only otherwise taxable distributions from the IRA qualify. NUA-CRT A tax-efficient strategy involving the use of a CRT funded with an lifetime transfer of employer securities from a qualified plan. PLR

4 Charitable Remainder... [A] charitable remainder trust is a trust which provides for a specified distribution, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, charity. Treas. Reg (a)(1)(i). Charitable Remainder Charitable Remainder Trust Property Remainder Trust Charity Tax Deduction. Tax Free Sale/Investment. Trustee Controls Investments. Remainder to Charity. Estate Tax Savings. Charitable Remainder A Charitable Remainder Trust: Is tax-exempt (except to the extent it realizes UBTI in a given year). Not subject to the 2% Net Investment Tax for Private Foundations. 4

5 Charitable Remainder Types of Charitable Remainder 1 type of Charitable Remainder Annuity Trust (CRAT). 4 types of Charitable Remainder Unitrusts (CRUT). - SCRUTs - NICRUTs - NIMCRUTs - FLIP-CRUTs Charitable Remainder Control Uses of NIM-CRUT/FLIP-CRUTs Capital Gains NIM-CRUTs Conrad Tietell s FLEX-CRUT Spigot CRUTs - Funded with Annuities - Funded with Limited Partnership Interests - Funded with Zero-Coupon Bonds Charitable Remainder How the Recipients are Taxed: Step 1: Current Step 2: Step 3: Step 4: Accumulated Current Accumulated Capital Gain Capital Gain Step 5: Current Tax-Exempt Step 6: Accumulated Tax-Exempt Step 7: Return of Principal Ordinary Capital Gain Tax-Exempt Principal Tier 1 Tier 2 Tier 3 Tier 4 5

6 Tax Planning Opportunities for Employer Securities IRC 402(e)(4)(B) Generally, a Participant realizes ordinary income on distributions from his or her qualified plan in the year he or receive receives the benefits. BUT an employee does not pay tax on Net Unrealized Appreciation (NUA) distributed from his or her plan in the form of a LSD. Taking the LSD Rollout Lump Sum Distribution under IRC 402(d)(4)(D) qualifies for NUA if: On account of employee s death After the employee attains age 59½ On account of employee s separation from service After the employee has become disabled (within the meaning of section 72(m)(7) Taxation of the Rollout Ordinary income is recognized by the Participant only on basis in the securities. IRC 402(e)(4)(B). - Participant s Basis is the FMV of the employer s securities when acquired by the plan administrator. Treas. Reg (a)-1(b)(2)(i) (with certain adjustments). Difference between Fair Market Value (FMV) at rollout and basis is NUA. Treas. Reg (a)-1(b)(2)(i). 6

7 Taxation of the Rollout If the distribution does not qualify as LSD, then the whole distribution is taxed as ordinary income. Treas. Reg (a)-1(b)(1)(i). Even if the distribution qualifies as LSD, if Participant is under age 55, a 10% excise tax penalty is imposed on the basis of the securities. Taxation of the Rollout Taxation of the Net Unrealized Appreciation Fair Market Value (FMV) of stock $ 750,000 Employer basis $ 150,000 Net Unrealized Appreciation (NUA) $ 600,000 Amount taxable if stock is rolled out $ 150,000 The $600,000 of NUA is Deferred Until the Stock is Sold! 7

8 Taxation of the Stock Sale Post-Distributions Taxation: The Participant pays taxes on the NUA as long-term capital gain only when he or she sells the securities, and regardless of how long the securities were held before sale. Treas. Reg (a)-1(b)(1)(i). IRS Notice 98-24, C.B At sale, the Participant may also pay tax as LTCG or STCG on that part of the gain not attributable to NUA. Treas. Reg (a)-1(b)(1)(i). - The characterization depends on the Participants holding period. Taxation of the Stock Sale Holding Periods: 1 year or less -- Short-term Capital Gain taxed as ordinary income. IRC 1221(a)(3). Greater than 1 year -- Long-term Capital Gain Taxed with Favorable Rates. IRC 1222(3). NUA Treatment at Participant s Death NUA is IRD. Rev. Rul , C.B In our example, the $600,000 of rollout gain does not receive a step-up in basis at the Participant s death. But post-distributions gain (above $600,000) should receive a step-up in basis. 8

9 The NUA-CRT If the participant chooses to take employer securities from his plan as a lump-sum distribution, he may find a CRT useful. This option allows the participant to diversify his securities in a tax-exempt environment. The NUA-CRT Example: Chester, 65, 401(k) with $600,000 in employer securities. Securities have a cost basis of $100,000 to the plan. 401(k) stock $600,000 The NUA CRT Chester, Age 65 Tax Deduction of $218,256 (4.6 AFR) (Offsets Tax on Basis) Avoid Tax on LTCGs. 7% Unitrust $600,000 One Life Trust of 5% paid first year = $42,000. Estimated Total = $882,000 Charity At death: No Probate No Estate Taxes 9

10 Testamentary Charitable Planning Testamentary Charitable Planning From a tax standpoint, retirement plan assets may be the ideal asset to fund testamentary charitable gifts: 1. The gift qualifies for the estate tax unlimited charitable deduction. 2. Because the charity is a tax-exempt entity, it pays no income tax on receipt of the distribution. Testamentary Planning - Example 10

11 Testamentary Planning- Example Problems with Charitable Planning Problems arise if the client wants charities and non-charitable beneficiaries to share retirement assets at the client s death: 1. If the client names a charity in the beneficiary designation, he may spoil DB status for the noncharitable beneficiaries. 2. If the client names a trust with individuals and charities as beneficiary of the plan, the client may spoil DB status for the trust. Solving the Dilemma Solutions: Split IRA into separate IRAs during participant s lifetime with one IRA having only charitable beneficiaries and one IRA with only DBs. Cash out the charity by September 30 of the year following the participant s death, thus leaving only individuals as beneficiaries on the determination date. Create separate accounts by December 31 of the year following the participant s death. If the spouse is named as a primary beneficiary with a charity, the spouse can do a roll-over of his or her share into his or her own IRA. 11

12 Testamentary Remainder Transfer Uses Because of the IRD Element for IRAs and Qualified Plans, Testamentary CRTs make great recipients for these assets! Both charity and noncharitable beneficiaries share in the benefits. Under current law, it is poor planning to make an inter vivos transfer to a CRT - No rollover treated as a withdrawal from the plan. - If under participant under 59½, transfer subject to 10% penalty. - BUT inter vivos transfer of employer securities from qualified plan may be viable. (More about that later.) Testamentary CRTs Requirements - Obligation to pay begins with the date of death. - Trustee may defer payment until the testamentary distribution is received. A CRT to hold retirement assets typically take one of three forms: - CRT for IRA participant s spouse. - Term of Years CRT for participant s children. (the Give-It-Twice trust.) - S t r e t c h CRT for children. 12

13 IRA Retirement Plans to CRT for Spouse, 56 Marital Deduction and Charitable Deduction result in zero taxes. 5 % Unitrust One Life Trust of 5% paid first year = $40,000. Estimated Total = $1,148,000 Charity At spouse s death, trust assets to charity. IRA Give It Twice Trust Retirement Plans to CRT for Children Charitable Deduction = $299,237 (4.2% AFR). 5 % Unitrust Term of 20 Years Trust of 5% paid first year = $40,000. Estimated Total = Charity At end of term, trust assets to charity. IRA S t r e t c h Unitrust Retirement Plans to CRT for Lives of Children, Ages 47, 45, 43 Charitable Deduction = $100,392 (4.2% AFR). 5 % Unitrust Three Lives Trust of 5% paid first year = $40,000. Estimated Total = $1,932,000 Charity Death of last child, trust assets to charity. 13

14 Mechanics 1. Prepare and Submit a Beneficiary Designation Naming CRT as Beneficiary. 2. Name a Preexisting CRUT (Cannot Name a Pre-existing CRAT). Testamentary CRT. 3. Upon death, IRA transferred to CRT. Criticisms of IRAs to CRTs: There is little or no tax advantage to transferring...retirement plans to [CRTs] versus outright to children - Bianculli Criticisms of IRAs to CRTs Our Response: The Stretch IRA is fully subject to estate tax; the CRT is not. Many Stretch IRAs fail to achieve the parent s objectives. - Stretch not available. - No income control. Hard to accomplish charitable planning with a Stretch IRA. It is possible to outlive a Stretch IRA; it is impossible to outlive a Stretch CRT. Potiental for better investment performance. 14

15 Criticisms of IRAs to CRTs: The beneficiaries will never realize the benefit of the deduction for estate taxes paid. Bianculli The deduction for practical purposes disappears nobody gets to use it. - Choate Criticisms of IRAs to CRTs: What are they talking about? Section 691(c) allows the IRD recipient to take an income tax deduction for federal estate taxes paid on IRD. PLR the 691(c) deduction does not flow through a CRT to the trust recipients; it does offset Tier One Ordinary. Criticisms of IRAs to CRTs: Our Response: With estate tax reform, many taxpayers can t use the 691(c) deduction anyway. PLR permits the trustee to push ordinary income out of the trust more rapidly. Through proper investment, the beneficiaries may receive capital gains income/dividend income taxed at 15% rather than ordinary income. Illustrated Thusly: 15

16 Partly IRA Tax Free Payments Stretch Out For Life of Child Full Ordinary Tax 0 At Life Expectancy Payouts Terminate Payouts Age 50 Tax Free 691(c) Period Partial Deduction Ordinary Full Ordinary Tax Life Expectancy Payouts End Age 86 UT Ordinary + Tax Savings Long Term Capital Gain Charity Payments for Life 16

17 Payouts Age 50 Ordinary 691(c) Period Ordinary Capital Gain Most or All Capital Gain Life Expectancy Payouts To Age 110+ CST-CRT A CRT as a CST for Retirement Plans The Idea: Use a CRT in lieu of a traditional credit shelter trust to hold IRAs and Qualified Plan benefits. Estate Profile: Estate $1,000,000 to $8,000,000. IRA/Qualified Plan is 60% to 80% of the estate. Non-IRA Assets < Exemption. Particularly Important as Exemption grows: $1,500,000, $2,000,000, $3,500,000. CST-CRT Case profile: Dr. Benjamin Rush - $4,000,000 Estate - $200,000 in cash equivalents. - $3,800,000 in IRA. Mrs. Rush - $1,500,000 Estate - personal residence. - $500,000 in IRA. - $200,000 in cash equivalents. 17

18 CST-CRT 2005 Ben s Estate $4M IRA QTIP $2.3M 5%UT $1.7M Charity $6M Three Lives Mary and Children $7.8M (No Tax Paid by Charity) CST-CRT Drafting/Planning Ideas: Create the CST/CRT as a Spigot Trust. Create the CST/CRT as a Capital Gains Unitrust. Create the CST/CRT as a FLIP-CRUT - With death of Spouse as Trigger. Create the CST/CRT as a FLEX-CRUT. 18

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