CLIFF A CASE FOR CHARITABLE GIVING AND DEFENSIVE POSITIONING

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1 THE FISCAL CLIFF A CASE FOR CHARITABLE GIVING AND DEFENSIVE POSITIONING The CriTTenTon FoundaTion & LJPr, LLC Leon C. LaBreCque, JD, CPa, CFP, CFa

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3 Preface The Perfect Tax Storm: Prospective Expiration of the Bush Tax Cuts Leon C. LaBrecque, JD, CPA, CFP, CFA April 18, 2012 In December of 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act ), which extended the Bush tax cuts enacted in May 2001 by the Economic Growth and Tax Relief Reconciliation Act of 2001 January 1, Under the 2010 Tax Act, the Bush tax cuts are extended for skipping transfer taxes. The extension ends on December 31, This expiration of the cuts and the corresponding problems and planning institutions. In general, on December 31, 2012, the tax law reverts to the all taxpayers in varying amounts, with some taxpayers experiencing a virtual doubling of income taxes. In addition, a major component of the taxes on Americans with estates over $1M. 1

4 Disclaimer and Caveat Tax law is exceedingly complex, and requires individual analysis to determine the impact on each taxpayer. This paper is intended to help legal and estate planning professionals. Some very important issues should be considered: Service regulations require us to notify the recipient that any U.S. federal tax advice provided in this communication is not intended other taxpayer for the purpose of avoiding tax penalties that may be imposed upon the recipient or any other taxpayer, or in promoting, marketing or recommending to another party, a partnership or other entity, investment plan, arrangement or other transaction addressed herein. Unless Congress and the current President act, the reversion to the and the President may solve or partially solve the problem in many ways, including: 12/31/2014, for example); o Partially extending the provisions of the Act; for example, the President may want to impose the Bush tax cut expiration on millionaires only. Congress and the President may agree to do o Fully revising the Tax Code, which seems exceedingly unlikely in today s political environment. individual s situation. Facts and circumstances unique to each family have certain characteristics which need to be considered carefully to from $5,120,000 with portability to $1,000,000 with no portability. unused portion of his or her $5 million federal estate/gift tax exemption can be carried over to the surviving spouse. 2

5 In General In general, the expiration broadly means: that: o The standard deduction for married couples will be lower, no o The ceiling of the 15% bracket for married couples will be lower, income taxpayers will rise from 15% to ordinary wage tax rates income taxpayers will rise from 15% to 20% levels deduction phase out) provisions will be restored, rescinding million (from the current $5,120,000 for 2012) and rates that top out at 55% $1 million elimination of the student loan interest deductions to the elimination of the temporary repeal of the tax on generation skipping transfers. Rather than create a long list of provisions, this paper is intended to provide Act ( ACA ) also alters the income tax landscape. For example, the ACA 3

6 Income Medicare Contribution (UIMC), a 3.8% tax on interest, dividends and capital gains on higher bracket taxpayers. recognize similar scenarios and consider applicability of the various proposed planning solutions. Hypothetical Case Mike and Cindy are high bracket taxpayers, with both earned and unearned income. They have total income of $350,000, including unearned income of $40,000 per year, primarily dividends, interest and capital gains. They make charitable contributions of $25,000 per year. For purposes of this example, let s assume the following: and bonuses; estate taxes and personal property tax (in Michigan, license plates). Total itemized deductions are about $51, (k) plans of $1.4M; IRAs and 401(k) plans of $1.2M, and life insurance of $1M. No debt. Bush tax cuts expire: Income taxes. The couple will pay about $8,700 They will lose a majority of their exemptions and part of their itemized deductions. Estate taxes. From an estate tax standpoint, if they both died, under the current law, there would be no estate taxes, since the total assets are under $5M ($4.4M). With the expiration, their taxes could be somewhere between $1.3M to $1.8M. The UIMC under the Health Care Bill will add would be about $10,300 higher. 4

7 Income taxes: Investment asset repositioning. One obvious possibility taxable accounts. As an example, suppose you have a stock with a 3.5% is approximately the same. However, in 2013, for an upper bracket free municipal bond yield. Income taxes: Capital Gain Harvesting. Given the capital gains rate will increase on January 1, 2013, another approach is to harvest gains at the lower 15% rate. Securities can be sold at a gain and repurchased. (For example, if you held a stock for more than one year and had a gain tax on the gain at the lower rate.) In addition, some taxpayers may have portfolio and select which assets to sell, donate, or reposition. Example of Gain Harvesting / Repositioning: Suppose our couple had a loss carryover of $25,000, a stock worth $50,000 with a short term gain in an IRA or Roth, or even in the same account. Next, they could donate the capital gain, and deriving a $50,000 charitable contribution. If the charitable contribution is completed in 2012, it avoids the prospective full deduction (only subject to other AGI limits). Another planning opportunity is to have the couple convert a portion of their current IRAs a corresponding charitable deduction. Borrowing from the previous example, the couple might convert $50,000 of an IRA into a Roth, and conversion creates a taxable event, and the charitable donation creates a tax deduction at fair market value. The prospective outcomes of the Roth 5

8 free, both to taxpayer and spouse, and to a subsequent individual o Roth IRAs are not subject to the age 70 ½ Required Minimum Distributions, so the Roth may accumulate until the death of both spouses. o Retaining the Roth (not taking distributions) reduces subsequent income tax liabilities on the formerly taxable distributions from the previous IRA. o Creates a $50,000 income tax deduction (as an itemized deduction). o Eliminates the capital gain taxes on the gift of appreciated property (in the foregoing example, 15 % of the $25,000 gain, or $3,750, plus state taxes). o Reduces the taxable estate by the amount of the charitable contribution. Income and Estate Taxes: Charitable Donation. A simple opportunity in the face of the prospective expiration of the Bush tax cuts is to make charitable contributions in 2012, in anticipation of the Pease itemized level. Charitable donations could take a variety of forms: Direct cash donations to the charity (deductible subject to AGI limits). Reduces income taxes and shrinks the taxable estate. Direct appreciated property donations to the charity (deductible subject to the AGI limits). Reduces income taxes and shrinks the taxable estate. Cash or appreciated property gift to a Donor Advised Fund (DAF, also called a charitable gift fund, charitable gift trust, or a philanthropic fund). DAF donations allow the donor to make a the recipient of the donation. In addition, DAFs allow the donor to invest the DAF assets and all subsequent appreciation can be used for the charitable purposes. This reduces income taxes and shrinks the taxable estate. In addition, DAFs receive a more favorable tax treatment than a private foundation.

9 Charitable gifts of split interests ( Charitable Split Interest Trust ), where the life estate and the remainder interests are split and one portion of the interests is gifted to charity (like the life estate) and the other portion is designated by the donor (the remainder interest for example). The life estate is the value of the assets (usually the income) during the life of the donor(s) and the remainder interest is the value after the death of the donor(s). These include the following: o A Charitable Lead Trust (CLT), where the life estate (or a term of years) of income is gifted to the charity and the remainder can percentage a year (a charitable lead unitrust). The lead trust can then transfer the remainder to the heirs. Any appreciation is not subject to gift or estate taxes (but is subject to capital gains tax). In the above example, suppose the hurdle rate used by the IRS for lead trusts as of April 14, 2012 is 1.4%. This rate is set by the IRS to establish the minimum rate at which the trust must distribute contributions to charity. The Donors above set up a lead trust to make a donation to their college and the Trust pays the college 1.4% a year and leaves the remainder to the children. The Trust would preclude any capital gain income to the donors. Upon their deaths, the children would receive the remainder, which, as long as the value of the bonds and accumulated interest increased by more than 1.4%, would be greater than the original donation. The $100,000 would be out of the Donor s estate. The donors might use higher appreciating property and forego the income tax deduction. This would remove all appreciation and capital gain tax liability from the donor s estate. The Charitable Lead Trust current gift exclusion is $5.12M until year end. o A Charitable Remainder Trust (CRT), where the remainder interest is gifted to the charity and the donor(s) receives income from the life estate. Again there are two forms: one that pays the remainder unitrust). Using the facts from the foregoing example, the couple could donate $100,000 to their charity, arrange a 5% 7

10 income stream for themselves (which is ordinary income) for their lifetimes, and get a $20,238 income tax deduction. Their estate would shrink by $100,000, or more, assuming the investment gained in value during the Donors lives. o CRT/ILIT, is where a donor gives property to a Charitable Remainder Trust and uses the income stream to fund an Irrevocable Life Insurance Trust (ILIT, covered later in this paper). The gift to the CRT generates a tax deduction, plus prospectively avoids capital gains taxes on any gift of appreciated property. The ILIT generates an income tax free/estate tax free sum of funds on the death of one or both grantors. The funds from the ILIT can endow. For example, suppose a couple has $10M. They donate $5M to a Charitable Remainder Trust, which pays them a stream die whole life insurance policy (let s presume it is for a $5M face value), which is purchased through an ILIT. Upon the death of both of them, the ILIT receives the life insurance proceeds income tax free and the ILIT is excluded from the taxable estate. The charity receives the remainder interested from the CRT. The net result on the $5M is no tax. o A Charitable Gift Annuity provides an income stream for the life of the donor, removes the asset from the donor s taxable estate, and provides a charitable deduction. Charitable gift annuities can be in one of three forms: an immediate gift annuity (which starts immediately after the gift), a deferred gift annuity (starting at a like retirement). Gift annuities can be for one life, two lives in succession, or a joint and survivor life expectancy. The payments are computed based on the type of annuity and the ages of the capital, and a portion is ordinary income (if appreciated property was donated to a gift annuity, then a portion would also be capital gain). The charity keeps the funds at the expiration of the period. The donor gets a tax deduction for a portion of the gift. In the above fact situation, the payout on a gift annuity for the couple $100,000 from their estate. Alternately, they could use a deferred gift annuity and start the annuity at a later date (like retirement). They would receive a higher annuity payout and a smaller tax deduction. 8

11 Income and Estate Taxes: Low interest loans. The current interest rate mandated by the IRS to avoid a gift (the imputed interest rate) is so low that it provides an interesting opportunity to shift income to children or Low interest loan to children. rate is.22%. This means a donor could loan their child a sum, say $1,000,000, and the child, to avoid a gift, would have to pay 0.22% back to the parent (who would declare it as income). Suppose the parent would not have had that income in their estate) and the child would have paid $2,200 in interest each year. The child could even potentially deduct the $2,200 as investment interest. If the parent dies before the note is paid, the note becomes an asset of the estate or trust. Low interest loan to charity. This is a similar notion in the above scenario, but where a donor wants a charity to have access to funds and is in a high tax bracket for some period of time. Using the example above, the donor would lend a charity funds (say $1,000,000) and the charity would pay back the loan at 0.22%. The charity would invest the money and generate income, tax free. The donor s estate would be reduced by the amount of income earned by the charity. Low interest installment sales to trust. Here, the grantor starts funding an Intentionally Defective Grantor Trust (IDGT) to hold for income tax purposes but is treated as a transfer for estate tax purposes. For example, suppose the donor has a business (like an LLC or Subchapter S corporation) worth $5M. He creates an IDGT and funds it with $500,000 of stock of his company. The trust then buys $4.5M of his stock under an installment note over 13 years. year. Assume the company s value goes up by 5% a year: at the end of the term of 13 years, the trust will own the company, now worth In addition, the owner would have paid income taxes on the distributions, which would result in further estate shrinkage.

12 Estate taxes: Credit Bypass. The current 2011 law provides a $5.12M exclusion per person for gift and estate taxes purposes. A couple can using a family trust and a marital share or trust. This arrangement will typically place the credit exclusion amount in a family trust (the bypass or B trust) and distribute the rest to the spouse to exploit the maximum marital deduction (the marital trust or share, or A Trust). Many individuals have either created trusts based on the current $5.12M exclusion or do not have an estate plan at all. With the expiration of the Bush Tax cuts, the exclusion goes from $5.12M to $1M. Obviously a couple would want two trusts rather than one, to double the exclusion. In our example above, with a $1M exclusion and 55% rate, the couple would save $550,000 in estate taxes on the second death by using two credit bypass trusts. Estate taxes: Equalization. Frequently, estates are unbalanced in favor IRAs. Returning once again to the hypothetical couple described above, Spouse A has life insurance of $800,000 and spouse B $200,000. All other assets (real estate and non IRA/401(k) assets) are jointly held. As long as the exclusion is $5.12M, our couple is safe. If the exclusion reverts to $1M and the couples use the credit bypass trust method, then if spouse A dies there is a (new) concept called portability that allows one spouse to use the other s unused estate exemptions, but this expires on 12/31/2012. To solve this problem, the concept of equalization will require either funding equalization, meaning each spouse will actually fund their trusts as close to equally as possible, or formula equalization, which will require a change in the formula for the respective trusts. Estate taxes: Excluded gifts of annual exclusion. With the possibility of reversion to the $1M exclusion upon expiration of the Bush tax cuts, a very simple method is to make lifetime gifts that are excluded from the calculation of gift tax. For 2012, this is $13,000 per donee. A married couple may make a joint gift of double the exclusion, so a couple can their spouse, and $13,000 to each grandchild. This would shrink her estate by $130,000 a year and could prospectively save the family up 10

13 to 55%, depending on the size of grandmother s estate. Note this is an annual exclusion, and over ten years grandmother could shrink her estate by $1,300,000, and save up to $715,000. Direct payments of tuition and medical expenses are further excluded, so if grandmother gave the grandchildren $13,000, she could also pay their tuition directly (note this exclusion is only for tuition paid directly to the institution and does not include room, board, books, travel, etc.). Estate taxes: Excluded gifts to 529 plans. There is a special exclusion the distributions are used for qualifying higher education expenses. The the Department of Education, including tuition, room, board, books, etc. contribution as if it was made over 5 years. For the couple we were plans for each grandchild. Such gifts are out of the estate and do eliminate subsequent $13,000 gifts. Estate taxes: Using the $5.12M exclusion. One very obvious and profound way to reduce the potential burden of future estate taxes in view of any future change (aside from total repeal of the estate tax) is to make 35%. The prospect of a 55% tax and $1M exclusion provide a myriad of planning opportunities, including the following: Outright gifts. Certainly the easiest technique for individuals with estates larger than $5.12M is to make outright gifts to recipients. estate by the amount of the gift. A gift over $5.12M will result in a 35% gift tax and will shrink the estate by the gift and the gift tax. Example: Mother is 84 and has one son. Her total estate is $20M. She makes a gift to him of $10M. $5.12M is excluded from tax, and $4.88M is subject to taxes at 35%. She would shrink her estate by $11.708M (the $10M gift and the $1.708M in gift tax). If the Bush Tax 11

14 so the son may be subject to future capital gains. Within the gift, she might include a legacy asset like a family vacation home which may not be sold any time in the near future. Gifts in trust. An obvious problem with a present interest gift is that it is a gift. The donor has relinquished control of the property. To provide control, there are variety of trusts that can be used as a receptacle to receive some or all of the gift: o Irrevocable Trust. One technique is to make a completed gift to an irrevocable trust. The trust will have terms of governance, control and management. In the previous example, the mother might make a $5M outright gift to her son, and then make a $5M gift to an irrevocable trust for her son and his children. o Dynasty Trust. A dynasty trust is a trust created for the maximum period of time allowed by law, possibly 100 years or more (Michigan, for example, has repealed the Rule Against Perpetuities in 2008) and a trust can therefore virtually last into perpetuity. These are trusts that cross multiple generations. o Domestic Asset Protection Trust (DAPT). A Domestic Asset Protection Trust (DAPT) is a trust set up in a jurisdiction that shelters trust property from creditors and hence does not include to freeze the assets and still enjoy the use of those assets. For example, suppose an individual transfers $5.12M to a Delaware DAPT (note that DAPTs must be established in a DAPT state, like AK, DE, MO, NV, NH, WY, UT, TN or HW, with DE the normal of the DAPT. He uses the full exclusion, and the assets are not subject to his creditors, so the $5.12M is out of his estate. Suppose he dies in 2020 and the trust assets are worth $10M. If he has been escapes estate tax. Partial trust gifts. Another technique to use up some of the $5.12M exclusion is to make a partial gift to a trust, where the donor gets o Grantor Retained Annuity Trust (GRAT). A Grantor Retained Annuity Trust, or GRAT, is an irrevocable trust where the grantor term of years. The amount paid can be increased by up to 20% 12

15 long as the annuity term. A GRAT can be zeroed out so there is not an actual gift, but the appreciation on the assets is transferred o Residence Trust, or QPRT, is where a donor transfers a personal residence to a trust for a term of years. At the end of the term, the children, etc.). If the donor dies during the period, the property is included in their estate (which it would have been anyway). If the donor outlives the term, the appreciation is out of the estate. For worth $1.2 M, which he intended to leave to his children anyway. He establishes a QPRT for a term of 10 years. Assume the IRS rate is 1.4% (which it is for 04/12). The value of his gift (the remainder) is about $801,000, so he would use $801,000 of his $5.12M exclusion to get a $1.2 vacation home out of his estate. If he dies within the next 10 years, the home is included in his estate. If the home appreciates (don t laugh, it might), then the $1.2 million appreciation is out of his estate if he outlives the 10 years. Irrevocable Life Insurance Trust (ILIT). Life insurance is an interesting asset in that its value is much greater at death than during life. In fact, it can be argued that a term life insurance policy has virtually no value while the donor is alive. Life insurance death an insurance policy is correctly transferred to an Irrevocable Life Insurance Trust (ILIT), the proceeds from the life insurance are not subject to estate taxes. It is usually best to have the ILIT buy the policy directly. If a policy is transferred to an ILIT, the insured needs to survive the transfer by not less than three years to have the policy proceeds not be included in the estate. In our example from the beginning of this paper, the couple had $1,000,000 of life insurance, which is irrelevant under a $5.12M exemption, but subject to estate taxes if the Bush tax cuts expire. It would be in their family s best interest to either transfer the policies to an ILIT or issue new policies to an ILIT. Generation Skipping Transfer (GST) Tax. The Generation Skipping Transfer Tax, or GST is a tax originally intended to prevent taxpayers from skipping generations. For example, under previous law, if I tax proceeds, and left it to his daughter, and his estate paid tax, and 13

16 an additional GST tax on the skipping transfers. For 2012, the GST exemption is $5,120,000. This means a married couple could grandchildren, great grandchildren and subsequent heirs with $10,240,000 and use their entire gift/gst exclusion but pay no tax. Coupled with Michigan s repeal of the Rule Against Perpetuities, this trust is now valid. Dynasty trusts can be coupled with life insurance. individuals, particularly those with charitable intent. The current historically low interest rates provide an unprecedented opportunity for Charitable Lead Trusts, excluded gifts, or low interest rate loans. The possible expiration of the Bush tax cuts make it imperative for taxpayers with estates larger than $1M to sit down with advisors and make a determined plan of action. If the cuts expire, individuals now have a very narrow window of opportunity to utilize the $5.12M exclusions, the GST tax is repealed and the income tax rates are permanently lowered to the tax cut rates (in which case we will have a whole new set of problems), the overall family and charity situation has been reviewed and carefully considered. 14

17 is the CEO and Chief Strategist over $450M of assets under management. Part of LJPR services is to best to serve their goals and objectives. We d also like to thank Sanford for his valuable input on this complex topic. To have Leon provide a presentation to your group, or to have an hour consultation with our team of professionals, please contact LJPR at josephine.dries@ljpr.com (cc to 4555 Investment Drive Suite

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