Planning for large estates after TRA '97.

• Author: Milonas, Taso M.

A New Look at Some Old (Charitable) Friends

In the estate planning area, the Taxpayer Relief Act of 1997 (TRA '97)[1] has been heralded as among the most taxpayer friendly pieces of legislation during the last 15 or so years.[2] Unfortunately, the "relief" will not be felt by many high net worth individuals. For example, while the unified credit currently exempts the equivalent of $625,000 in assets from estate tax,[3] the benefit of the credit is phased out (as under prior law) for estates that exceed $10 million.[4] The phaseout is equal to five percent of the value of the estate in excess of $10 million until the "average tax rate" equals 55 percent.[5] As such, under both current and prior law, the intent to tax larger estates at essentially a 55 percent tax rate remains basically the same.

For planners dealing with larger estate situations, the impact of TRA '97, therefore, is somewhat neutral--not much better, not much worse than before. As such, traditional large estate planning techniques such as irrevocable life insurance trusts, family limited partnerships, and charitable trusts continue to be important weapons in the planner's arsenal. In addition to the typically older client for whom these strategies have been employed in the past, our current economy has spawned a whole new generation of younger (typically entrepreneurial) individuals who can benefit greatly from this kind of planning.

The focus of this article is on employing several traditional charitable and estate planning techniques in nontraditional ways. Before getting into specific applications, however, an overview of the benefits available through sophisticated charitable planning in large estate situations and how these plans are structured is in order.[6]

While there are variations on the theme, most of the planning discussed in this article keys off the use of some form of a charitable trust. Generally, there are two types of charitable trust: 1) the charitable remainder trust (CRT); and 2) the charitable lead trust (CLT).[7] Each type of trust has both a charitable and a noncharitable beneficiary. The main difference between them is the order in which the beneficiaries receive their interests, as discussed in more detail below.

Overview of CRT

A CRT distributes income to one or more individuals (usually the individual who established the trust) during the term of the trust, with the remaining assets passing to charity upon termination. The principal tax and nontax advantages of establishing a CRT include:

* Maintain or enhance current standard of living.

* Increase cashflow from low-income-producing or non-income-producing assets.

* Defer or eliminate capital gains tax on highly appreciated assets.[8]

* Reduce income tax.

* Eliminate estate tax on value of assets transferred to trust (and future appreciation thereon).

* Potential to eliminate Florida intangible tax on stocks transferred to trust.[9]

* Maintain control over investments.

* Asset protection.

* Perpetuate charitable giving.

In order to achieve these benefits, the trust must be drafted to meet very specific requirements provided under federal tax law, including:

Payout Rate. The trust must have a minimum annual payout of five percent, but the payout rate can be higher. As a result of TRA '97, the maximum payout rate will be equal to the lesser of: 1) 50 percent of the value of the trust property;[10] or 2) that amount that will result in a remainder interest equal to 10 percent or more of the initial fair market value of the property placed in trust.[11]

The payout can be calculated in either one of two ways, as an "annuity" or as a "unitrust" amount. A charitable remainder annuity trust (CRAT) pays the beneficiary an annual income equal to a fixed percentage of the initial value of the property transferred to the trust during the term of the trust. For example, a CRAT funded with $1 million that provides for a five percent payout rate will produce $50,000 per year during the entire term of the trust ($1 million times five percent), regardless of changes in asset value (increase or decrease) from year to year.

A charitable remainder unitrust (CRUT), on the other hand, pays a fixed percentage of the trust assets determined annually. For example, assume a five percent CRUT is funded with $1 million worth of property that appreciates during the first year to $1.5 million, then further appreciates in value to $2 million in the second year. The trust would pay $50,000 during the first year ($1 million times five percent); $75,000 during the second year ($1.5 million times five percent); and $100,000 during the third year ($2 million times five percent). Because the equity markets generally have outperformed the inflation rate, most planners (and clients) tend to prefer the CRUT over the CRAT because of the potential "upside." However, if the value of the trust assets decreases, a CRAT may prove the better choice.

From a planning perspective, an individual oftentimes is able to enjoy a higher income using a lower payout rate with a CRUT because of the fact that the percentage is calculated on an ever-increasing amount of principal. Sometimes setting the initial payout rate too high can frustrate the trustee's ability to increase the value of the trust assets. Of course, if the assets decrease in value, the payout rate will decrease proportionately.

Term of Trust. Generally, the trust may last for the lifetime of one or more individuals or a fixed number of years, not to exceed 20 years. The selection must be made at the time the trust is established and cannot be changed later. The reason for this is the charitable income tax deduction is based on the use of special actuarial tables put out by the IRS.[12]

Qualified Charity. Upon termination of the noncharitable beneficiary's interest, the remaining trust assets must pass to one or more "qualified" charities as defined for tax purposes. The charity may, but does not need to, be designated initially. For example, many individuals leave the trustee the discretion to select one or more qualifying charities, rather than designating a specific charity at the time the trust is established. Other individuals establish a private foundation (during lifetime or at death) to receive the trust assets. The selection of charitable beneficiary can and will have a significant impact on the charitable income tax deduction otherwise available to the donor. The deduction generally is higher when the assets are being left...