Do you remember Life, Milton Bradley’s first board game? In the game, players move from college to career, from marriage to kids, from home buying to insurance and investments. The player who accumulates the most wealth before retirement wins. Certain players start raking in money right away. Some are slowed by debt or paying for emergencies—a life-saving operation, or a tornado that hits the house. Others may not hit pay-dirt until a mid-game career change, receiving an inheritance or winning a $10,000 photography contest.

In the game, landing on a space that dictates a sizable contribution to charity elicits groans from players. After all, money given to charity means less money in the player’s hands at the end of the game and a reduced chance of winning. Thankfully, in the real world, this is not the case. Indeed, people are anxious to share their wealth with charities and other institutions. In addition, a wide variety of giving options means that a charitable gift is not a loss when carefully structured.

In this issue of Techniques, we’ll look at the strategies used by three working professionals at various points in their careers and discuss those factors that can bring a gift into the win-win category—the source of funds, the method of giving, the tax issues, and the timing.

Giving Without Depleting the Estate: A Classic “Wealth Replacement” Strategy

In Life, charitable giving is not a choice. If you land on a square that mandates a gift, you make it—then you worry whether giving that money away will keep you from winning. Successful professionals face a different dilemma when contemplating a charitable gift near the end of a career—namely, the concern that a gift may reduce the financial security of other family members. Will today’s gift unintentionally deprive a family member of urgently needed money to meet some future emergency or hardship?

This is a legitimate concern. However, when these worries delay or halt a charitable gift, the donor loses both the personal satisfaction of giving and the income tax and/or estate tax savings available to estate owners who make charitable gifts and bequests.

Wealth replacement is a technique that addresses both a donor’s natural concern for family welfare and the desire to give to charity. The concept is simple: the donor is able to make a substantial gift to charity without compromising the financial security of family members. The execution is a bit more complicated: the donor funds a CRUT with appreciated assets and an ILIT with a life insurance policy, then uses the annual income from the CRUT to make gifts to the ILIT sufficient to pay the insurance premiums. At the owner’s death, the charity receives the remainder amount in the CRUT, while the family beneficiaries receive the policy death benefits as distributed from the ILIT.

Wealth Replacement in Action

Charles and Margaret Stern, both in their late 60s, have worked together in a successful veterinary consulting practice for nearly 40 years. They would like to leave a significant gift to the Infectious Disease and Biodefense Research Center where they met as PhD students. However, they also have concerns for the well-being of their daughter, Sarah, who is divorced and caring for her severely disabled son. Their solution is to use a wealth replacement technique.

They transfer assets to a CRUT…

Charles and Margaret donate appreciated, long-term stock valued at $1,000,000 with a cost basis of $300,000 to a charitable remainder unitrust (CRUT). (This is preferable to a charitable remainder annuity trust or CRAT because it can receive additional contributions). The CRUT will pay them 5% of the annually revalued principal in quarterly installments for their joint lifetimes, with the remainder to be paid to the Research Center. Based on the initial valuation, they will receive a trust payout of $12,500 quarterly, or a total of $50,000 during the first year.

They take a charitable deduction…

Charles and Margaret receive an income tax charitable deduction in the year they establish the CRUT, based, among other things, on the applicable federal interest rate (AFR) at the time of the transfer. The deduction is subject to the 30% of AGI limitation with a five-year carryover for any excess. Assuming an AFR of 2.2%, their deduction will be $380,430, which is the present value of the charity’s remainder interest in the CRUT. In their 39.6% marginal bracket, a $380,430 deduction will save them $150,650 in federal income taxes.

They avoid paying some capital gains tax…

The Sterns will not immediately pay the capital gains tax they would have owed on a current sale of the appreciated stock. However, they must pay tax on the gains realized inside the CRUT as it flows out to them under the four-tier system.^[i]

They establish an ILIT…

The irrevocable life insurance trust holds a $1,000,000 second-to-die life insurance policy on their lives, purchased by the ILIT trustee. Sarah is the beneficiary of this policy. Charles and Margaret carefully choose this amount to match the value of the stock donation. Since they have never held any incidents of ownership in the policy, it will be excluded from their gross estates for federal estate tax purposes. This likely means that more wealth will be available for Sarah than if the stock had passed to her under the Sterns’ wills and been taxed in Sarah’s estate.

They make annual gifts to the ILIT to pay premiums…

With the tax savings from the charitable deduction and the income payout from the CRUT, Charles and Margaret expect to have more than enough to make annual donations of cash or stock to the ILIT to pay the annual premiums on the life insurance policy. They even expect to have income left over to augment their retirement income.

They give Sarah Crummey powers…

Sarah, as the ILIT beneficiary, holds Crummey withdrawal powers. For a period of 30 days, she can withdraw the annual gift that the Sterns make to the ILIT if she chooses. Although she declines the withdrawal, the fact that she was able to do so qualifies the annual gift as a gift of a “present interest”^[ii] for the gift tax annual exclusion ($14,000 in 2014). And, keep in mind that married couples can effectively double the gift tax annual exclusion for each beneficiary through gift-splitting. Thus, Charles and Margaret avoid making taxable gifts as they make premium payments to the ILIT.^[iii]

In the end, they make a gift and provide for family…

Upon the death of the surviving spouse, the income interest in the CRUT terminates and the trust principal is paid to the Research Center. At the same time, the life insurance proceeds will be paid into the ILIT and the trustee will distribute them to Sarah as provided in the trust instrument.

Summary of Advantages

Let’s review what the Sterns accomplished with the wealth replacement technique:

• Made a major gift to the Research Center without reducing Sarah’s inheritance
• Used the untaxed appreciation in their stock to generate a significant charitable deduction (with five years to carry over any excess if they can’t use the whole deduction that year)
• Used the income tax savings and the annual CRUT payouts to pay the premiums on a life insurance policy, with income left over to supplement their retirement income
• Avoided the federal gift tax on the annual transfers to the ILIT through the strategic use of Crummey withdrawal powers
• Removed both the donated assets and the life insurance proceeds from their gross estates for federal estate tax purposes
• Provided creditor protection for Sarah through use of the ILIT

One more important point: The life insurance death proceeds usually will be received federal income tax-free by the ILIT.^[iv]

An Unplanned yet Timely Charitable Solution: CRTs

In the game of Life, everything comes down to the spin of a wheel. There isn’t much strategy when you have very few choices. Luckily, estate owners have more control over their lives. Although they may experience any number of unplanned, unexpected events, instead of just waiting for the next turn, estate owners can plan how best to deal with life’s surprises. Let’s look at another example.

Before accepting the role of trustee, it is wise for the potential trustee to obtain written confirmation identifying the person or persons that will be responsible to provide the trustee support for basis, holding period and classification of the assets that fund the trust. In the case of CRUTs (which permit the contribution of additional assets after initial funding), the responsibility extends to any future contributions. For testamentary CRTs, the trustee may ask the executor to provide basis and valuation information.

Advanced Planning in Action

Dr. Candace Sanders is an executive with a large medical device manufacturer and holds several patents for prosthetic joints that have proven to be lucrative. The company is considering a merger with a small pharmaceutical company in Ireland that would constitute a “corporate inversion.” This means that, in order to reduce taxes, her U.S. corporation would become a wholly owned subsidiary of the Irish pharmaceutical company. The Irish company would purchase either the shares or the assets (or both) while the corporation keeps most of its operations in the United States.

As a major shareholder, IRS rules indicate that Dr. Sanders would face hefty capital gains tax when the deal goes through and her shares are converted. To avoid this tax, her attorney advises Dr. Sanders to consider donating a portion of her holdings to charity. The suggestion appeals to her, even though, at age 39, she had not spent much time thinking about her charitable legacy.

To benefit from this strategy, timing is everything. Once the company takes substantial steps to formalize the merger, the IRS will view any transfers of stock as “anticipatory assignments” which would result in income to the donor. So, Dr. Sanders creates a charitable remainder trust and funds it with stock worth $12 million well in advance of the company’s decision to headquarter in Ireland. Since the appreciated shares of long-term capital gain stock are donated to a CRT, her charitable income tax deduction is available based on the full fair market value of the shares.^[v] Moreover, when the CRT exchanges the contributed shares for shares of the foreign corporation, no tax will be imposed because the CRT is exempt from tax under IRC §664(c).

Avoiding the “Anticipatory Assignment of Income” Doctrine

The IRS and the courts have often dealt with the issue of whether charitable donations in transactions involving mergers, liquidations, or redemptions constitute anticipatory assignments of income. In the case of a corporate inversion, donors must be careful not to wait too long before donating stock. Otherwise, they will be taxed on the gain, defeating the purpose of the charitable gift.

A leading case in this area is Palmer v. Com’r.^[vi], which involved a controlling shareholder who donated his corporate stock to a private foundation, which he also controlled. Pursuant to a prearranged plan, the donor had the corporation redeem the transferred shares from the foundation the next day. The Tax Court ruled that there had been no taxable redemption and that the gift of stock had in fact been made to the foundation since the foundation was not legally obligated to redeem the stock when it received title to the shares. In Rev. Rul. 78-197,^[vii] the IRS stated that it will treat the proceeds of stock redemptions under facts similar to Palmer as income to the donor only if the charity is “legally bound” or can be compelled by the corporation to surrender the shares for redemption.^[viii]

Given this background, stock should only be donated well before a charity is under a legal obligation to surrender the stock pursuant to the inversion transaction. If it is not, the transaction will be taxed to the donor under the anticipatory assignment of income doctrine. Once shareholders vote to approve an inversion, it is likely too late to avoid the negative tax consequences unless there are regulatory approvals required or other substantial events that must occur before the inversion is completed.

For Dr. Sanders, the keys to a successful transaction were:

• Early recognition of a charitable solution through trusted, competent advice
• Donation of stock prior to shareholder vote and regulatory approval
• Thorough documentation of the timing of the transaction to avoid the issue of anticipatory assignment of income

A Comprehensive Estate Plan: Charitable Gift Annuities

When you reach the end of a game of Life, you pay off your debts, total your assets, and pack everything away in the box. The “kids” riding in the back of your car get packed away as well. There is no need to plan what happens to your assets. In real life, if we don’t plan, we miss out on the very important opportunity to take care of family, find a proper home for important assets, and support meaningful charities. Let’s look at an example of someone making a comprehensive estate plan that accomplishes all three of these goals.

Estate Planning in Action

As a noted photojournalist, Bryce Tannehill, age 70, has devoted his career to covering major news events throughout the world. His employment with top media organizations has allowed him to amass substantial savings in various qualified retirement arrangements. In addition, his archive of photographs is estimated to be worth several million dollars. His only other asset of significance is a mid-town apartment that has also greatly appreciated in value.

Given his lifestyle, Bryce never married. He knows he has neglected his estate planning, and is now considering revisions to his outdated will, which names his 50-year-old stepbrother, Alan (a hunger-relief missionary) as sole beneficiary.

While Bryce would like to provide for Alan, burdening him with settlement of his estate is not an option. Also, he would like to donate the bulk of his estate to an appropriate assortment of art museums and historical societies. With the help of his attorney he adopts a three-step charitable solution that will:

• Provide income for Alan and himself
• House his life’s work within charitable institutions
• Donate any retirement assets remaining at his death

Providing Income

Alan lives simply and has few needs. Bryce chooses a straightforward method of providing him with income—a charitable gift annuity. After discussing their future plans, they agreed that Bryce would purchase a gift annuity for their joint lifetimes with the remainder benefiting Alan’s religious order. Alan was grateful to be able to leave funds to further the efforts of an institution that would continue the work to which he had dedicated his ministry. Since Bryce intends to travel extensively during his retirement, he will transfer his valuable New York apartment to the charity to fund the gift annuity.

Charitable Gift Annuity Basics

A charitable gift annuity is a relatively simple contractual agreement between a donor and the charity issuing the gift annuity. The donor makes an irrevocable gift of cash or property to a qualified charity, and in exchange, the charity pays a fixed amount periodically (monthly, quarterly, semiannually or annually) for the lifetime of one or two annuitants. All states currently permit a charity to issue a gift annuity in exchange for real estate.

Benefits of charitable gift annuities include:

• An income tax charitable deduction in the year of the gift for the gift portion of the annuity (i.e., the value of the property less the present value of the annuity payments)^[ix]
• Annual payments over the lifetime(s) of one or two designated individuals, part of which is federal income tax-free return of principal
• Immediate or deferred income payout

If the donor transfers long-term appreciated property for the annuity, the income tax deduction limitation is generally 30% of AGI (50% of AGI for cash transfers). The donor may take any deduction in excess of this amount in up to five following tax years.

Income Taxation of the Annuity

The taxation of an annuity payment is not always simple. A portion of each annuity payment received by the donor or other annuitant will be a tax-free return of principal until the assumed cost of the annuity (as determined under IRS tables) has been fully recovered upon the annuitant’s attainment of life expectancy.^[x]

If the donor has transferred long-term appreciated property in exchange for the gift annuity, a portion of each payment will be taxed as long-term capital gain until life expectancy is reached (and as ordinary income thereafter). Any long-term capital gain portion of the gift annuity payments will be taxed according to the annuitant’s tax bracket.^[xii]

Individuals must be careful when purchasing a charitable gift annuity for a third party with appreciated property. When capital gain is realized from a gift annuity, the gain is recognized ratably over the period of years in which the annuity payments are expected to be received only if both the following requirements are met:

• The transferor is the only annuitant, or the transferor and a designated survivor annuitant are the only annuitants
• The annuity is non-assignable, or the annuity is assignable but only to the charitable organization issuing the contract^[xii]

In our example, unless Bryce meets both of these requirements, the capital gain on the apartment will be recognized all at once in the year of the transaction. Since Bryce named both Alan and himself as beneficiaries, the capital gains would be recognized over their lifetimes.

Estate Taxation of an Annuity

The federal estate tax consequences of a gift annuity generally depend on whether the donor names himself/herself or another as annuitant, and whether the annuity is for one or two lives. The present value of any individual survivor annuity is generally included in the deceased donor’s gross estate. If there is no remaining annuity payable at the donor’s death, then nothing is includible in the gross estate. The value of a third-party annuitant’s interest (in this case, Alan’s interest) will come back into the donor’s estate tax base as an “adjusted taxable gift.”

Placing the Photography Collection

Bryce feels his collection of photographs has historical significance and he is not particularly concerned with realizing monetary gain from their transfer. Of more concern is that they are properly archived and preserved. He works with his attorney to establish an irrevocable trust to house his collection, naming a national history museum in Washington D.C. as beneficiary. The museum will act as trustee and fulfill the terms of the trust. Fortunately for Bryce, the terms of the trust were worked out during his life with the museum’s legal team to ensure in detail how the photographs will be cared for, displayed and utilized for research purposes.

A donor like Bryce (with very specific ideas about creating a philanthropic legacy with personal property) and the charity (interested in accepting such a gift) should insist on a carefully reviewed gift agreement. This legally binding contract between the donor and the charity must cover the donor’s intentions and outline the terms of implementing the gift. Such an agreement may help prevent future problems through the collaborative effort of the donor and the charity.

Here is a non-exclusive list of precepts often included in a gift agreement:

• A clear statement of the donor’s intentions
• Specific restrictions on the use of the contribution (as long as the chance that the “transfer will not become effective is so remote as to be negligible”)^[xiii]
• Realistic benchmarks for measuring the success of the restricted gift
• Flexibility for use of the contributed funds over time in order to preserve the donor’s intentions
• Provisions for dispute resolution between the charity and the donor (and/or representatives of the donor)
• If advisable, a reverter clause or other exit strategy that allows both the donor and charity to end the relationship in the best manner possible^[xiv]

Donating Retirement Assets

Bryce has straightforward options for donating his retirement assets and chooses a combination approach. With respect to his three IRAs, he was able to simply name a qualified charity as beneficiary with the assistance of each of the account custodians.^[xv] To avoid losing or misplacing them, he stored the beneficiary forms in a safe deposit box (he could also have left them in the possession of an attorney or an institution). Without proper documentation of a designated beneficiary, the IRA’s default beneficiary provisions would apply, denying the intended donation to the designated charity.

Bryce makes sure to name contingent charitable beneficiaries on the forms to further ensure that the gifts are realized if the primary charitable beneficiaries are for any reason unable to accept the donation at the time of his death. He also informs the intended charitable beneficiaries of the coming donation in writing.

With respect to his 401(k) and qualified profit sharing accounts that had appreciated in value to nearly $4 million, Bryce decides to take a slightly different approach to enable him to better control the disposition of assets. He makes his estate the beneficiary of his accounts, leaving detailed instructions in his will directing the executor to make charitable income distributions to the museum housing his photographic collection. These distributions will help the museum maintain the collection in accordance with the terms of the trust and gift agreement. This arrangement allows the executor to effectively claim the unlimited income tax charitable deduction for the retirement assets that would otherwise be taxed as “income in respect of a decedent.”^[xvi]

Life is much more complex than the game. However, that complexity comes from the sheer number of choices available. There are many ways working professionals can share their financial success with charitable causes at any point in their careers—the circumstances of every gift will be unique. Those who seek out advice in a timely manner can tailor their approach to suit the situation at hand.

Two of the most critical choices are: How to give, and when? These questions have been asked throughout the ages…

To give away money is an easy matter and in any man’s power. But to decide to whom to give it and how large and when, and for what purpose and how, is neither in every man’s power nor an easy matter. Aristotle, 384 – 322 B.C.

Endnotes

[i]IRC §664(b)[↵]

[ii]IRC §2503(b); Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 C.B. 321[↵]

[iii]Crummey powers are sometimes limited to $5,000 per donee per year. It may be necessary to take additional steps to use the entire gift tax annual exclusion amount. See, IRC §2014(e).[↵]

[iv]IRC §101(a)[↵]

[v]This is also true for donations to private foundations, as long as the stock constitutes “qualified appreciated stock” under IRC §170(e)(5). [↵]

[vi]Palmer v. Com’r, 62 TC 684 (1974), aff’d on other grounds, 523 F2d 1308, 36 AFTR2d 75-5942 (8th Cir. 1975), acq. 1978-1 CB 2[↵]

[vii]Rev. Rul. 78-197, 1978-1 CB 83[↵]

[viii]In Gerald A. Rauenhorst, 119 TC 157 (2002) the Tax Court characterized the “legally bound” standard in Rev. Rul. 78-197 as the “bright line” test to determine whether a contribution of stock to a charity should be recharacterized as a redemption of the stock followed by a contribution of the proceeds by the donor to the charity.[↵]

[ix]A charitable gift annuity is part-gift and part-sale (i.e., a bargain sale) since the donor contributes the property in exchange for annuity payments from the charity.[↵]

[x]The adjusted expected return multiple must be calculated in accordance with IRC §72.[↵]

[xii]The annuitant may also be subject to the net investment income Medicare surtax of 3.8%.[↵]

[xii]Treas. Reg. §§1.1011-2(a)(4)(ii), 1.1011-2(c), Ex. (8)[↵]

[xiii]Treas. Reg. §1.170A-1(e)[↵]

[xiv]But keeping in mind Treas. Reg. §20.2055-2(b)(1) which provides that the “possibility of occurrence” of the condition or power burdening the transfer must “be so remote as to be negligible” at the time of the decedent’s death for a deduction to be allowed.[↵]

[xv]Under final regulations issued in 2002, the naming of a charitable beneficiary does not negatively affect the required minimum distribution. Since a charity has no life expectancy, a donor was essentially penalized under prior RMD rules for naming a charitable beneficiary by being forced to take larger distributions than would have been required with an individual beneficiary. Current regulations eliminate this treatment of charitable beneficiaries. The lifetime RMDs for account owners are now determined under the Uniform Lifetime Table regardless of the life expectancy of the designated beneficiary.[↵]

[xvi]Treas. Reg. §1.691(a)-1(b)[↵]