Mr. and Mrs. Rich, both 65, have a good income, $5 million in appreciated assets, and have always given generously to charity. They have decided to make a large donation when they die, but not at the expense of their two children. Ideally, they want to give something to everyone.
Using a credit shelter trust (CST), they expect to pass $4 million estate-tax-free to their children (assuming 2006 rates). To eliminate estate tax on the remaining $1 million, the Riches have also created a charitable remainder annuity trust (CRAT) and an irrevocable life insurance trust (ILIT).
A CRAT is an irrevocable trust into which a donor transfers assets. CRATs must have at least one income beneficiary and at least one remainder beneficiary (which must be a charity). An ILIT is an irrevocable trust that owns life insurance. Its assets, including the policy death benefit, pass to the trust beneficiaries (the Riches’ children) estate-tax-free.
The Riches give $1 million in appreciated assets to their CRAT as an irrevocable gift, receiving $50,000 in annual income for life. $50,000 represents 5 percent of their gift, the minimum income they may take. The maximum is 50 percent. The remainder beneficiary, ABC Charity, gets whatever remains when they die.
Additionally, the Riches’ gift must pass two IRS probability tests that help ensure that a charity actually benefits from the gift. First, there must be less than a 5 percent probability that the income beneficiaries will outlive the CRAT income. Second, the projected remainder must be at least 10 percent of the gift’s value. If the CRAT fails either test, the Riches cannot take an income-tax deduction for their gift. If it fails the 10 percent test, the CRAT also loses its tax-exempt status.
The Riches’ CRAT passes both probability tests. They may deduct $308,370 (the present value of the remainder interest to ABC, calculated using IRS tables and interest rates1) from their income to the extent it does not exceed 50 percent of their adjusted gross income. They may carry forward any unused deduction for five years.
After receiving the gift, the CRAT trustee sells it and moves the money into a portfolio that is more efficiently diversified to provide income for the Riches and growth for ABC.
The nature of the CRAT income determines the tax consequences of that income in the Riches’ hands. Since CRATs are tax-exempt entities, they pay no tax on their income. Instead, the income tax consequences flow through to the income beneficiaries, generally in the following order:
- Ordinary income (taxed at rates of up to 35 percent)
- Dividend income (taxed at 15 percent)
- Short-term capital gain (taxed at rates of up to 35 percent)
- Long-term capital gain (taxed at 15 percent)
- Nontaxable income (like municipal bonds, may be tax-free) Principal (not taxed)
To the extent the CRAT cannot generate ordinary or dividend income, CRAT income will be taxed as a capital gain. Although the Riches paid no capital-gains tax when they donated their assets, and the CRAT paid no capital-gains tax when it sold those assets, the trustee keeps track of capital gains. If there is insufficient dividend or ordinary income to make up the Riches’ 5 percent income requirement, the Riches receive the remaining CRAT income as capital gains. The capital-gains tax advantage a CRAT offers therefore is in deferring potential receipt of capital gains on donated assets, not in eliminating them.
If the Riches are in the 35 percent federal income tax bracket and receive only ordinary income from the CRAT, they will get $32,500 per year after federal income taxes, less if their state also imposes an income tax. For the first several years, however, they may be able to reduce federal income taxes with the income tax deduction.
Although the Riches hope their CRAT pays a lifetime income, whether or not it does depends on the CRAT’s investment performance. Good performance will not increase the Riches’ income but may increase ABC’s remainder. Poor performance will not reduce the Riches’ income but could result in that income running out before the Riches die, leaving nothing for ABC.
The Riches’ ILIT will own a second-to-die life insurance policy on both their lives. Premiums for a $1 million death benefit, providing a lifetime guarantee of coverage, are $14,651.2 Each year the Riches give this amount to the ILIT from their after-tax CRAT income.
The $14,651 represents a gift of a future interest to the ILIT beneficiaries (their children) because their children will receive nothing until both parents have died. As such, the Riches may use the annual gift-tax exclusion ($12,000 each year per beneficiary in 2006) only if the ILIT has “Crummey” withdrawal powers. A Crummey power lets the trust beneficiaries withdraw their gifts to the ILIT within a reasonable time after the trustee tells them of the gift. If a trust beneficiary does not exercise this right, the trustee may pay the premiums with the gift. The right to withdraw the gift, even if not exercised, can convert the gift from a future to a present interest, provided the trustee and beneficiaries follow this procedure each time a gift is made.
What happens after the Riches die?
- The ILIT receives the $1 million death benefit federal-income-tax free, and gives it to the Riches’ children.
- There are no estate-tax consequences.
- The Riches’ CST gives $2 million to the children, estate-tax-free.
- The Riches’ estate gives $2 million to the children, estate-tax-free.
- The CRAT remainder goes to ABC Charity.
The Riches have passed their $5 million estate to their children and made a gift to charity. Is it magic? No.
Any growth in the CRAT assets provides income to the Riches and a gift to ABC. Without the CRAT, the Riches’ assets may have experienced the same growth and there may have been more wealth passing to their children at death, possibly with no more estate-tax planning than the CST.
Furthermore, the Riches could have reduced or eliminated estate taxes without a CRAT by using after-tax withdrawals from their assets to make gifts to an ILIT owning a second-to-die life insurance policy on the Riches. The life insurance policy death benefit and premiums could have been reduced to pay a death benefit roughly equal to the expected estate tax due after the Riches had died.
Nevertheless, this idea may work for those who are charitably inclined, have sufficient assets and want to pass money to charity and their heirs at death.
¹ All CRAT calculations derived using NumberCruncher©1987-2005, Brentmark Software Inc., Leimberg and LeClair Inc. Illustration current as of Sept. 19, 2005.
² Using a joint second-to-die life insurance policy with secondary death benefit guarantees, and standard rates, no nicotine use. As long as premiums are paid, and no withdrawals or loans are taken, the death benefit will be paid at the death of the second insured to die, even if the life insurance policy cash value has declined to zero. Rates current as of Sept. 19, 2005.
Stuart L. Dollar, L.L.B., CFP, is an advanced marketing attorney for Genworth Financial specializing in product taxation and estate, business and retirement planning. You may reach him at email@example.com.