Using your clients’ social capital can help solve their conflicting goals. Rather than having their tax dollars go to the government, we make those dollars go to a favorite charity and, in the process, solve a client problem. For purposes of this article, we’ll focus on two: creating a business exit strategy; and buying out a minority partner.
If the client’s objective is to reduce gift and estate taxes on assets that would pass to heirs, then a charitable lead trust or CLT is one solution. This split-interest trust is the vehicle that provides an income interest to a charity and a remainder interest (in the future) to non-charitable beneficiaries. An alternative solution, the charitable remainder trust or CRT, works in reverse: It pays a percentage of trust principal to named individuals and eventually distributes a remainder interest to charity.
Use of planned giving for an exit strategy or succession plan
Consider a client who owns a corporation and wants to pass the business to a child employed in the firm. In this example, the basis is low and the current book value is substantial, so there would be a large capital gains tax to pay. The client might also have to finance the sale to the child. The client’s child additionally needs to be a shareholder and the cash flow of the business should be good.
Using the CRT
To effectuate the transfer to the child, the business owner creates a charitable remainder trust, donates the stock to a charity with a qualifying stock redemption agreement. The business then repurchases the stock. This technique has several advantages:
(1) Capital gains tax is eliminated on the donated shares;
(2) The company redeems the shares from the charity and keeps the business in the family, since the remaining stockholder is the child;
(3) The charity has the cash to purchase an annuity for the donor;
(4) The child is now the remaining shareholder and owns the business;
(5) The charity has the future benefit of a sizable donation (also called the remainder interest);
(6) The donor has retirement income for the term of the trust, usually 20 years or for the donor’s lifetime; and
(7) With the income tax savings from a charitable deduction and the annual income from the CRT, a life insurance policy can be purchased through an ILIT or wealth replacement trust to effectuate estate equalization among all the children or used to replace the value of the donated asset.
More flexibility can be built into this plan design by incorporating voting and non-voting stock. This structure can accommodate many family situations.
For example, a parent can retain voting stock, give nonvoting stock to grandchildren (to get dollars out of the estate) or to the children who will not participate in the business. Thereafter, the parent can sell or gift remaining voting stock to a child who remains in the business.
This technique can reduce or eliminate control issues for the remaining employee-stockholder child. The terms of the redemption agreement and the choice of which stock is redeemed (and when) creates enough flexibility to solve many transfer issues.
Using the CLT
The charitable lead trust offers a different plan design to accomplish similar goals. The CLT pays the charity an income while the donor is alive, and the remainder interest goes to children at the donor’s death.
This is another method for transferring the corporation to the next generation in a tax-efficient way. Income to the charity can be distributed as dividends on corporate stock. However, because corporate earnings are volatile, clients should consider using a charitable lead unitrust or CLUT, which pays a fixed percentage of the annual fair market value of trust assets (as opposed to a charitable lead annuity trust or CLAT, which pays a fixed amount of dollars).
Use of planned giving for politely removing a minority stockholder from a business
As planners, we can apply these same techniques to cash out a minority partner by changing the roles of different players. If real estate is the donated asset, then we have an alternative to a 1031 exchange, but real estate should be free of debt, since only the equity will qualify for the valuation of the charitable component.
The CRT, for example, allows a minority stockholder to get an immediate tax deduction and the public recognition that comes with assisting a favorite charity. When used in conjunction with an annuity, the vehicle can also create an income stream.
Caution, limitations, and due diligence
Planned giving can provide an attractive solution to several client problems, but an inexperienced attorney or poor coordination with a client’s estate planning attorney could result in a lawsuit.
Common errors include using the wrong asset, making the wrong person the donor and naming the wrong party as the beneficiary. Also to be avoided is making the wrong payout, not gifting enough to the charity, using the wrong type of trust and creating a poor plan design.
If there are inadequate safeguards and if the funds are invested in the equity markets directly or through a variable annuity, market performance might not sustain enough value for the remainder interest or enough income to comply with the required distributions.
The use of an experienced attorney is the best safeguard for the client, the charity, and the planner against government scrutiny. For example, the IRS can challenge the avoidance of capital gains and the income tax deduction if Rev. Rule 78-197 is not strictly followed.
But in the right hands, these planned giving techniques can satisfy a client’s philanthropic goals, improve the client’s cash flow, reduce taxes and transfer property in a socially responsible manner. These techniques can also leave more money for the next generation and achieve the critical goal of keeping peace in the family.