April 1996
Vol 19 No 8
Each of us tends to define asset protection in terms of what would damage us most. At different stages of our financial lives, and as we grow older, we tend to see potential losses from different perspectives. Owners of low income, high density rental units might focus on tenant liability. Investors in mortgage notes or securities markets might worry about inflation’s effects upon adjusted earnings and portfolio values.
Avoiding personal loan liability would reasonably be a major concern of those who speculate in highly leveraged real estate. Environmental issues such as wet lands and kangaroo rats probably pose major threats in the eyes of land owners and developers. Government regulation and intrusion is the bane of businesses and the source of the most of their lost profits.
For everyone, high taxes can do as much damage to bottom line profits as civil litigation. Think of how much time we all spend in trying to find out what we owe, then in seeking ways to protect our hard won income and investments from tax collectors. Many people with accumulated property holdings see loss of financial privacy as a key element in the assault on their assets.
Those who are winding up their careers are probably most interested in the safety and security of their retirement pensions and Social Security. Limited income retirees living on their savings are concerned about attrition caused by increasing costs of living, medical care, and the decline of their purchasing power. Estate and gift taxes pose the greatest financial threat for seniors seeking to pass on property to their heirs and/or to continue the family business.
Suppose you could hold a portion of your business profits and assets, privately without your name being associated with them? In a financial fortress, insulated from most liability and regulatory business risks? Where windfall profits and investment returns could be tax-sheltered by no-cost deductions and thereafter accumulated tax free? From which you could elect to receive either a fixed or variable lifetime income for you and your family? Where there would be no estate or management control over your assets? Where you alone would decide whether to distribute income to yourself or to retain it so it would continue to compound tax free? If I’ve got your attention, let’s see how you (or your parents) can do all this within a single entity at reasonable cost and effort.
As a result of the Tax Reform Act of 1969, IRC Section 664 and various regulations which were finalized in 1972, a new vehicle called a charitable trust sprang into life. It was overlooked for the most part by the investing public, and employed primarily by charitable institutions to raise funds. Typically, a public charity would set up a trust and serve as trustee. The grantor(s) of assets to the trust would take a charitable income tax deduction for the contribution and usually arranged for either a lifetime income in the form of a fixed annuity or for a variable income based upon the value of the trust assets.
With the possible exception of charitable ‘lead’ trusts, the trustee typically sold the assets and invested the proceeds in a bond and stock portfolio which generated the funds for both the grantor(s)’s and charity’s income needs. Upon the death of the grantor(s), the remaining assets reverted to the charity according to the provisions of the trust. Charitable trusts didn’t take the world by storm for two reasons: Many people simply weren’t that charitably inclined and the charities didn’t do much to ‘sell’ the concept to potential donors.
A CHANGING PLAYING FIELD REQUIRES DIFFERENT GAME PLANS . . .
A major reason why charitable trusts didn’t become popular was that people didn’t like the idea of giving up control over their assets. They chose to shelter income through real estate and limited partnerships instead. Then both the tax laws and the world changed. Many tax shelters were wiped out. Litigation became a national blood sport. People began to realize that the perceived financial security they had counted on with Social Security and Medicare wasn’t so certain. They needed a way to fund their retirement by themselves.
Overlooked by most people, charitable trusts began to surface as a viable alternative among financial planners. If free and clear, low basis or appreciated capital assets were to be conveyed to a charitable trust, not only would all profits be tax free, but an income tax deduction could be taken based upon the fair market value of the capital assets donated. If a person held high-risk assets, the risk could be transferred without the loss of income. The trust would own the property. The income recipient could have a much lower public profile. Best of all, in most instances, the donor could retain full control over trust assets and investments. Thus, the donor might conceivably be able to increase the net cash flow yield to himself over and above that produced by the assets prior to the gift. The tricky part is to employ the particular form of charitable trust which best serves a donor’s objectives.
There are several forms of charitable trusts authorized under IRC Section 664. Some of these are called Charitable Lead Trusts (CLT). In these, assets are donated to a charitable institution for a specified period of years during which time the charity receives the benefits of use or income. CLT assets are under the control of the administrators during the existence of the trust. After the CLT terminates, the remaining assets revert to whomever the donor names. These trusts offer higher upfront deductions than the other forms of charitable trusts. They’re useful where it is desirable to retain control of valuable assets until minors gain the necessary skills and experience to manage them prudently. CLTs enable someone to pass lien-proof wealth, forward in time, to himself.
With Charitable Annuity Trusts (CRAT), the grantor(s) retains control over the assets for a specified period, then they revert to a charity. In the interim, a fixed annuity is paid to the grantor based upon at least 5% of the appraised fair market value of any contributed capital assets. Once established, and after the initial donation, no additional assets may be contributed to the trust. Non-capital assets such as inventory and assets, which wouldn’t receive capital gains treatment if sold, are valued at the lesser of fair market value or the donor’s adjusted cost basis. CRATs work well with older retirees.
A Charitable Unit Trust (CRUT) is similar to the CRAT with a few exceptions. Additional assets can be added to the CRUT at any time, and the value of trust assets are reappraised with each addition, or at least once each year. With a stated fixed percentage payout of the CRUT’s increasing assets, the donor’s annual payment increased with appreciating assets as well as with any additions. This effectively provides a variable income to the beneficiary of the CRUT which can rise with inflation and appreciation. It also enables the donor to make repeated deductible contributions in years when he needs more tax shelter. We’ll delve into this type of trust in more detail a little later on.
In order for donations to CLTs, CRATs and CRUTs to be tax deductible, and for trust assets to be able to compound tax free, the designated charity must be qualified under Section 501 (c) (3) of the Internal Revenue Code. Either a public or private charity may meet the qualification requirements of the Code and be entitled to receive donations. Combining Private Foundation strategies with Charitable Trusts brings considerable luster to charitable giving. We’ll take a brief look at these later. For now, let’s look at how all this might work.
GIFTING YOUR CAKE AND EATING IT TOO . . .
Suppose that you’d optioned a tract of free and clear development land, now re-zoned and ripe for sale. Your basis in the Option is only $5000, but your taxable profits will be $95,000. You want to convert the Option to a more liquid form and to generate an income stream while paying the least possible capital gains taxes. You also want to avoid the inherent liabilities of real estate ownership. If you sold the Option outright, you’d pay $26,000 in capital gains taxes, leaving only $73,400 to invest for income. There’s a better alternative.
You might form a Charitable Remainder Annuity Trust, naming yourself as Trustee. You would assign the Option to the Trust at the $100,000 appraised market value and have the CRAT sell it. Under the CRAT’s terms, you and your spouse could receive a minimum of $5000 each year for life based upon at least 5% of the $100,000. If you wanted to, you could elect a higher percentage payout. Based upon a complex calculation, you could take a tax deduction of up to 30% of your taxable adjusted gross income for that year, but the more annual income you take, the less deduction you’d get. If you didn’t need all the deduction for that year, you could carry the deduction forward and use it up over the next 5 years.
Each year, rather than spending money on property taxes, you’d receive $5000 which would be taxed partially as a return of capital and partially as long term capital gains. It’s hard to live high on $5000, but the $100,000 in liquid assets would be safe from judgment creditors, tax collectors and seizure. Only at the time of the death of the last to die of you or your spouse would your assets pass to charity. The charity might be your own private family foundation.
Let’s look at another situation. You (or your client) own a free and clear apartment complex worth $1,000,000 that produces $60,000 net after all expenses each year. That’s good news. The bad news is that it’s situated right on top of an earthquake fault line (or in tornado alley or the hurricane belt). Moreover, ownership also makes you liable for tenant lawsuits, lead based paint, asbestos, etc. One EPA suit or earthquake could wipe out a lifetime accumulation of wealth. How can you avoid risks, but keep income?
First, form a CRUT, then contribute the apartments to it to be sold shortly thereafter. As Trustee, you aren’t comfortable with the stock or bond markets, so you opt to invest in a Real Estate Investment Trust (REIT) such as any of those that are traded on the New York Stock Exchange (NYSE). Let’s say that it yields almost 10% and pays out at least 95% of its earnings tax free to your CRUT. Your CRUT specifies that 8% of CRUT assets are to be paid out to you each year, so you receive $80,000 in the form of passive income. With less tenant liability and management effort your net income has been increased by 25% and your assets spread out throughout a wide geographic area over many different properties. Furthermore, your real estate will thus have been converted into liquid securities. Depending upon your age and that of your spouse, your deduction to offset taxable income could easily be as much as $50,000.
A NIMCRUT is a special kind of CRUT. The extra initials stand for Net Income with Make-up Provisions. Suppose, in the above example, you didn’t want any income distributions because of your high tax bracket, and chose to defer payments until retirement. Your CRUT could include a provision that would allow the trustee to invest in non-income producing assets. These might include zero coupon bonds or a timber forest, or non-dividend-paying stocks such as Berkshire-Hathaway, or Microsoft. With no income earnings, the NIMCRUT wouldn’t make a distribution. Instead, each year, a credit would be entered in the Trustee’s accounts reflecting that the CRUT ‘owed’ you $80,000. This sum would continue to accrue and compound tax free inside the CRUT. It could be drawn on simply by selling something and paying out the proceeds when you chose to. In the meantime, the NIMCRUT could become a repository of highly liquid and accessible investments.
NOW, THE PLOT THICKENS . . .
You can see that charitable trusts offer interesting possibilities, but your heirs would lose the assets that go to a charity at the end of yours or your spouse’s life. All assets must go to a qualified Section 501(c)(3) charity, but that charity could be your own family’s private non-operating foundation. This isn’t a totally cynical plan. Provided that you think it worthwhile to support a charitable enterprise, isn’t it true that you’d be able to leave more after using your own expertise and ability to help the CRUT’s assets grow? What better role in life for your heirs than to distribute needed funds to the charity they feel most worthy on an annual basis. Besides, you could use the tax savings to buy a ‘wealth replacement’ insurance policy naming your heirs as beneficiaries.
The regulations require that a private family Foundation qualifying under IRC Section 501(c)(3) distribute a sum at least equal to 5% of the value of all Foundation assets except those used in furthering the purpose for which the Foundation was granted its tax exemption. Administrative expenses of running the foundation may be included in the 5% that must be distributed annually. In addition, a 1% excise tax must be paid on Foundation assets each year.
One private Foundation I know of is situated on a high bluff overlooking the Hudson River in a 20,000 square foot house which features private dining and recreational facilities. The property is appointed with fine furnishings, the latest in computer equipment, and the necessary infrastructure to publish economic and political essays. It also operates a summer school three weeks each year and has facilities for about 40 students to board. It even maintains a staff to serve them together with several vehicles. Each year, staff members scour the world doing research for Foundation publications and course subject matter.
The house, grounds, and equipment are subtracted from the assets used to calculate the 5% charitable distribution. The expenses are deducted from funds that are eventually distributed to public charities. This arrangement is the rule rather than the exception for most Foundations. As a practical matter, only about 3% of most foundation’s assets are distributed annually. Imagine how fast assets pile up when they can earn 10% and pay out only 5% each year. It’s like being in the 6% maximum tax bracket no matter what your foundation earns!
Now picture your heirs as paid Trustees and Administrators for such a Foundation living in that big house with all expenses paid by it. The Foundation could be the recipient of a CLT founded by you which will revert to your heirs personally in a few years. Or, it could be the remainderman recipient of assets through a CRUT, which you’ll use for your lifetime to generate tax free growth. With all your estate and profitable projects sheltered from taxes, away from creditor/predators and tenants, you’ll enjoy an automatic income stream now, and see your estate safely disposed of to your selected heirs in the future.
Charitable Trusts and Foundations aren’t just for the elderly and the rich. With some care, you can use them to shelter windfall profits, or to sell off stale inventory, to form LLCs, to invest in discounted Notes, to hold copyrights, Options and Land Trusts. They can be beneficiaries of your IRAs and Pension Plans. Or avoid double taxation when liquidating your corporation.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
