Over the past decade, there’s been a steady reduction in the impact of federal estate and gift tax considerations on estate and financial planning in general and philanthropic planning in particular.
As tax rates have decreased and exemption levels raised, planning for the transfer of wealth to family members without heavy emphasis on transfer taxes has become possible for many individuals in middle and upper-middle wealth ranges (that is, those with a net worth of $1 million to $10 million, depending on marital status). Does this development mean that philanthropic planning strategies are no longer relevant? Not at all.
From the perspective of philanthropically inclined individuals, the reduction of the estate and gift taxes, including the elimination of these taxes for many individuals, opens up new opportunities for creative charitable planning. As a result, through careful planning, individuals may now make significant charitable gifts using funds that might have otherwise been absorbed by taxes, while also meeting a number of other estate and financial goals.
In my September 2013 article in this magazine, I offered examples of how charitable remainder trusts (CRTs) and other planning tools could be used in nontraditional ways and alluded to the fact that lower estate taxes made many of these planning opportunities more attractive than in the past.
In this article, I’ll touch on a few of the ways that reductions in federal gift and estate taxes create new opportunities.
Let’s begin with the common situation in which an individual would like to make testamentary dispositions for charitable purposes, but would also like to provide an inheritance for family members. Recent studies1 have revealed that high-net-worth (HNW) individuals wouldn’t reduce their charitable gifts at death based on the reduction or elimination of the estate and gift tax at the federal and/or state level. Not only that, the majority of HNW individuals indicate they would actually expand the charitable component of their estate plans.
Here’s why. Suppose a couple with a combined estate of $10 million planned, under prior law, to leave $1 million to fulfill a charitable gift commitment made during their lifetimes, leaving the remainder of their estate to their two children, in equal shares, after the payment of tax due on their inheritance. Assume that under prior law, the charity would receive $1 million and the children would enjoy whatever amount was left after paying federal estate tax on their $9 million gross inheritance.
Fast forward to 2013. Under current law, the couple could leave up to $10.5 million to anyone they wished, free of federal estate tax. Under this fact pattern, it’s now possible for the couple to leave $1 million to charity with their children splitting the entire remainder of the estate, potentially inheriting an additional $1 million or more each than they would have under the federal tax laws in effect as recently as 2009.
Why would anyone reasonably expect this couple to eliminate their previously planned estate gift because it will no longer result in any estate tax savings? Under these facts, the charity will still receive $1 million, while the family will actually receive a larger inheritance than they would have under prior law. In fact, the donors in this case could significantly increase their charitable commitments by the amount of the taxes that would have been paid on their children’s inheritances, with the children receiving the same amount as before. While that might not be the course some would choose, keep in mind that many wealthy individuals first decide how much they would like their heirs to receive, provide for payment of tax on that sum and leave the rest to charity or others.
This example illustrates why HNW individuals have reported in more than one study that reduction or elimination of the estate tax would lead them to expand the charitable component of their estate.
Splitting the Difference
For those who’d like to provide for charitable interests after first taking care of the financial needs of one or more survivors, the lack of estate tax for most individuals makes it possible to create CRTs or other split-interest gift plans that no longer need to be qualified to yield an estate tax deduction under federal law.
This freedom opens up the possibility of creating “non-qualified” CRTs, free of the restrictions of Internal Revenue Code Section 664, that make payments to one or more beneficiaries for whatever time period they choose in amounts in the total discretion of the testator or trustee, whether fixed, variable or some combination of both. In cases in which all of the income from the trust is paid to a survivor, there would be no income tax due at the trust level.
If donors would, instead, like to limit the amount of income available to a survivor, with any growth in trust assets accruing on a tax-free basis, a testamentary CRT under IRC Section 664 might still be a good choice. The irrevocable qualified trust option could remain particularly attractive when an individual would like to provide a source of income for a loved one, perhaps a spouse, with no possibility of encroachment of trust corpus other than to make predetermined payments under the Section 664 framework. This option also assures that any growth in the trust, beyond amounts necessary to fulfill payments, would take place in a tax-free asset management environment.
In the case of tax-qualified CRTs, it’s also important to note that attractive inter vivos planning opportunities still remain for those who wish to provide an income for themselves for life, followed by an income to a survivor. Recently, if one spouse created a CRT for his benefit with either a joint income or an income paid to a surviving spouse, there were no adverse gift tax or estate tax consequences because of the unlimited marital deduction.
In the past, many individuals who would have otherwise created CRTs with an income to themselves for life, with the remainder to a survivor at their death, refrained from doing so. That was because when there was a taxable estate, the corpus of the trust would, under the IRC and regulations, be included in the estate, with only a partial charitable deduction, and it was possible that federal estate tax would be due on the value of a survivor income trust. These circumstances would give rise to estate tax while the assets were outside the estate and not available to contribute toward the payment of that tax.
As an unexpected result of recent tax law changes, it’s now possible to create joint and/or survivor CRT interests with non-spouses, with the knowledge that the income interest for the survivor won’t give rise to the tax during life or at death that would have previously applied.
Take the case of an individual who’d like to provide an income for life for himself, with the income continuing for the life of another individual who doesn’t qualify as a spouse for purposes of the unlimited estate and gift tax marital deduction. Assume this client contemplates having a total estate of less than $5 million that won’t be subject to federal estate tax.
At age 78, this client could create a $1 million charitable remainder unitrust (CRUT), paying 5 percent for his lifetime and the lifetime of a 75-year-old survivor. Assume the trust is funded with low-yielding securities worth $1 million with a cost basis of $250,000. The creator of the trust would be entitled to an immediate federal income tax deduction of $515,000. The trustee of the CRT can then sell and diversify the assets without payment of the combined federal capital gains and Medicare contribution tax of as much as $178,000 that would be due if the donor sold the securities. These immediate tax benefits result from accelerating what might have otherwise been a bequest from a non-taxable estate.
The settlor of the trust retains the right to revoke the secondary life interest by will or during lifetime. Suppose the creator of the trust passes away two years later at age 80, with $1 million remaining in the trust and without revoking the survivor’s income interest. In that case, the entire amount of the trust would be included in the decedent’s gross estate, with an offsetting charitable deduction of approximately $670,000 and the remaining amount of $330,000 subject to tax.
When the estate tax exemption unified credit was in the $1 million range, this particular gift could have given rise to estate taxes of over $100,000—a significant disincentive. That’s no longer the case under the new broader exemption scheme, opening up new opportunities for those who wish to create CRTs during lifetime, benefit from immediate income tax deductions, avoid or delay capital gains and receive tax-free asset management for life, without the fear of incurring gift or estate tax.
The same principles apply for individuals who wish to create CRTs, charitable gift annuities or other split-interest gifts during their lifetimes that benefit only a parent, child, sibling or individual other than a spouse. If the donor in that case doesn’t retain income, the entire amount net of the gift tax deduction would ordinarily give rise to an immediate gift tax.
Imagine the 78-year-old would like to make a significant charitable gift, after first providing income from a $1 million, 5 percent CRUT for the lifetime of a 70-year-old sibling. In that case, the charitable income tax deduction would be $522,000, with an immediate taxable gift of $482,000. Payment of gift tax on that amount may have dampened interest in this alternative in the past. The new higher exemption equivalent amount for federal gift tax, however, renders this gift a non-taxable transaction.
From a testamentary planning standpoint, individuals who wish to make charitable gifts and are no longer subject to federal estate tax may still want to plan for charitable dispositions from qualified retirement plan assets or other assets that could give rise to income in respect of a decedent (IRD) if inherited by non-charitable heirs. This planning has, in the past, been applicable when individuals were subject to estate tax on those amounts and when there was a possibility of a “double tax” on retirement assets. Keep in mind, though, that the practical elimination of estate and gift taxes only removes one of the tax issues from the table. The IRD issue remains, still making it a wise alternative to first turn to these sources to fund charitable dispositions at death.
Another option for a high-income retiree faced with mandatory withdrawals that aren’t needed for current income is to use the withdrawal to effect a “partial rollover” from a qualified retirement account to another tax-favored charitable retirement planning option that can result in an additional source of income in later years, if needed.
Take the case of a 70-year-old recently retired couple with total assets of $8 million. They’ve recently been told that they must begin taking $100,000 from their individual retirement accounts. They hold over $2 million of their other assets in the form of highly appreciated, low-yielding securities.
Testamentary charitable dispositions are currently included as part of their estate plans. Recent estate tax law changes will, however, result in no tax owed on their estates; thus, they receive no tax benefits from the charitable gifts they have planned.
Suppose this couple creates a 5 percent CRUT that will provide income for the remainder of their joint lifetimes. If they were to take a $100,000 withdrawal in a
33 percent combined federal and state income tax bracket, they would owe tax of $33,000. If they were to place $80,000 of the withdrawal in their CRUT, this would result in a tax deduction of 52 percent of that amount, or $41,600, leaving $58,400 taxable. The tax on that amount would be $19,200. This plan would reduce the tax on the withdrawal by some 42 percent, nearly $14,000. The $80,000 in the CRUT can then grow tax-free and provide a source of additional income in later years, if needed.
Instead of funding the CRUT with the $80,000 in remaining cash, they could use $80,000 worth of their appreciated securities with “locked in” gain, bypass the capital gains tax on those assets when funding the trust and use the $80,000 in cash remaining from their withdrawal to diversify their investments or make tax-free cash gifts to their children or others using their gift tax annual exclusion amounts.
Note that this planning strategy doesn’t depend on the existence of the past constraints of an estate tax planning issue and, in effect, accelerates the testamentary gifts they were planning in ways that result in immediate income and capital gains tax savings.
These are just a few examples of how the reduction in federal estate and gift tax may open new planning opportunities that allow clients to meet multiple needs while making charitable gifts, without incurring tax on the non-charitable portion of the split-interest gift.
In effect, the glass was half empty in the past due to tax considerations, and now it’s full because many taxpayers no longer must use a portion of their assets to pay taxes. As a result, those assets are now in play and available to devote to charitable or non-charitable purposes, as the case may be.
Many may assume that the primary motivator for charitable dispositions at death in the past was to avoid taxes. It’s important to recall, however, that even when a 55 percent estate tax was due, a charitable gift at death would still deprive natural heirs of $450,000 for every million dollars devoted to charitable use.
When the amounts left to family members and other non-charity heirs will no longer be subject to tax, it results in more discretionary assets in the estates and shouldn’t cause individuals who planned for charitable gifts in the past to remove them now that the gifts will cost their families less than under prior law. In fact, through thoughtful planning and using the charitable “toolbox,” it’s possible to make these charitable gifts in ways that produce immediate tangible benefits for the donor, while still meeting charitable objectives.
1. The 2012 Bank of America Study of High Net Worth Philanthropy (November 2012).