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This second installment continues to review the strategies that are used by planners to assist their clients in conserving the wealth they have accumulated in order to transfer it to the next generation(s) at the least tax cost (part one appeared in the June 2006 issue of Investment Advisor). The concepts and techniques discussed in Part I were the equalization of assets, the qualified personal residence trust (QPRT), the grantor retained annuity trust (GRAT), and the intentionally defective grantor trust (DGT). Included in the foregoing discussions was the importance of using the applicable federal rates (AFR), in determining discounts to be applied to the market values of transferred assets. In this column we will explore the use of various special types of charitable trusts and the family limited partnership concepts. Exploration of additional vehicles is available at www. investmentadvisor.com.
Charitable Annuity Trusts
There are two basic types of charitable annuity trusts--the charitable remainder trust and the charitable lead trust.
A charitable remainder trust (CRT) may be established during the grantor's lifetime or pursuant to a will. It requires a fixed annuity percentage to be paid no less frequently than annually to a non-charitable beneficiary for a specified term (maximum 20 years). At the conclusion of the term of the trust, the designated charity will receive the remaining assets in the trust. There are two types of charitable remainder trusts:
A Charitable Remainder Annuity Trust (CRAT) requires a specific sum, calculated on the fair market value at the start of the trust, to be remitted at least annually to a beneficiary other than the named charity.
The Charitable Remainder Unitrust (CRUT) pays a variable amount to the non-charitable beneficiary. This payment varies because it is computed by applying a fixed percentage each year to the value of the trust's assets on a specified date (e.g., 6% of the value of the trust each January 1st).
If properly structured, the CRT can be established so that on the death of the primary non-charitable beneficiary the income payments can be directed to another individual (e.g. surviving spouse) before ultimately getting to the charity. The amount going to the charity is not subject to estate tax because of the estate tax charitable deduction. If the successor beneficiary is the surviving spouse the estate tax marital deduction will apply. If, however, the secondary beneficiary is other than the surviving spouse, the annuity or unitrust payment will be subject to estate tax computed on the actuarial value of the amount to be paid to this individual.
From an income tax perspective, a CRT is a tax-exempt entity. Therefore there is no tax on any capital gains it may incur. If the donor, who can also act as the grantor, has highly appreciated property that does not produce adequate income, it may be the ideal asset to make the basis of the CRT. By having the CRT sell this property it can be converted from a highly valued, low income-producing asset into cash which can then be invested to generate a higher rate of return. Since the CRT is a tax-exempt entity, all of the foregoing is done without the loss of principal due to payment of capital gains tax. The capital gain is reported by the annuitant based upon the annual annuity paid from the trust, reduced by any ordinary trust income the individual would report. This kind of planning can backfire in that the larger periodic payments going back to the grantor may cause an increase in his estate--the opposite of what was intended. However, this negative effect can be offset by having the donor's beneficiaries own insurance policies on the grantor's life which would result in the proceeds coming directly to them without being part of the grantor's estate.
The second basic type of charitable annuity trust is the Charitable Lead Trust (CLAT). With this type of trust the charity receives the annuity on a current basis while the principal is remitted to the donor's family at the end of the trust's term. It is the opposite of the two CRTs previously reviewed and is used when the grantor has adequate income from other sources to forego the income surrendered pursuant to the CLAT. In fact, it is similar to a GRAT, in that the Section 7520 AFR is used to determine the present value of the interest going to the charity and the remainder interest. To the extent that the property's value increases above the discount rate applied to the interest going to the charity, such excess will inure to the remainderman. If one elects to use a CLAT as part of the overall estate plan, be advised that the present value of the piece allocated to the charity, the lead annuity, qualifies for the gift tax charitable deduction [IRC SEC 2522 (c)(2)(B)]. However, the present value portion of the interest determined to belong to the remainderman is subject to gift tax. For this reason it should be attempted to maximize the portion allocated to the lead annuity by having it approach the fair market value of the transferred property and the present value attributed to the remainderman should approach zero.
Family Limited Partnerships
The family limited partnership (FLP) is used in situations where there are large amounts of wealth spread among various investments. The goal is to transfer interests in these assets to younger members of the family through application of discounts for lack of marketability and lack of control (minority discount). While such reductions in values have ranged from 15% to 50%, the IRS has been emboldened by its latest success (Strangi, 96AFTR2d 2005-5230) and is being more aggressive when auditing this entity or the gift tax returns and underlying documents supporting the transfer of interests.
Generally an FLP is established by the parents. Based on current Tax Court decisions they may not be the sole general partners. However, they will own all of the limited partnership interests, portions of which will gradually be transferred by gift to the children. If begun early enough, the parents can use portions of their lifetime exclusions as well as the annual gift exclusion and thereby transfer significant amounts of wealth to the children at less than fair market value due to application of the aforementioned discounts. It is important to remember that to avoid having the assets of the FLP revert to the parents' respective estates on their deaths they should not be the exclusive general partners. If the children are deemed mature enough they can share in the managerial role. If they are too young, trusts can be established for them with an unrelated, independent trustee. It is the responsibility of the general partner(s) to determine how the entity will run, what investments will be made, and whether cash distributions are to be issued. In addition, the FLP agreement will include provisions indicating that the children will not be able to collateralize personal loans with these interests and that if they wish to sell their interests they must only sell them back to the entity and not to outsiders.
This vehicle has been used by some parents to teach fiscal responsibility. What must be remembered, as highlighted in Strangi, is that the FLP cannot be a sham. What is professed to be done in the FLP agreement must be executed in reality. There must be a surrender of interests and responsibilties. The parents may not continue to act and use the assets that have been put into the trust in the same manner they did prior to the establishment of the FLP.
The object of these articles was to give the advisor a primer as to considerations to think about when doing individual estate planning and to develop a basic appreciation for different techniques estate planning professionals use in formulating and evaluating plans for recommendation to their clients. Hopefully you will understand that the area of estate planning is one that has many facets that must be periodically revisited in order to be sure that the current laws have not negatively impacted on your lifetime and post-death plans for the distribution of assets and devolution of your client's estate.
I. Jay Safier, CPA, is a principal in the New York accounting firm Rosen Seymour Shapss Martin & Company LLP, where he advises high net-worth individuals and owners of closely-held businesses .on a broad range of corporate, accounting and auditing, tax, estate and business matters. He can be reached at email@example.com. Cheryl T. Hite, Director of Fiduciary Services at Rosen Seymour Shapss Martin & Company LLP, assisted in developing both parts of this article.