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Do you ever find a client with a highly appreciated asset such as stock or real estate? Don’t they always want to sell to diversify but they can’t because of capital gains taxes? Do you have clients that would like to leave a Charitable Legacy but won’t because they don’t want to disinherit their heirs? What if you could be the advisor to show them how to accomplish all of those goals? Well it is possible through the use of a Charitable Remainder Trust and a Wealth Replacement Trust utilizing life insurance. You can show them how they can sell the asset, avoid capital gains, increase their income, gain diversification, more than double what their heirs will receive and, as an added incentive, get a current income tax deduction.
Sound too good to be true? Let’s look at a particular case. John and Mary Smith purchased an asset a number of years ago for $50,000. The asset is now worth one million dollars. The asset is paying only 2% income or $20,000 per year, but if they sell the asset, in this case stock, they will lose over $200,000 due to capital gains taxes. What should they do?
First, transfer the asset to a specially designed trust before it is sold. The trust will help to convert this low yielding, highly appreciated non-diversified asset into a high quality diversified investment without paying the capital gains.
Once again we are talking about a Charitable Remainder Trust. It allows you to do all this and still retain an income from the trust for life. There are two basic types of charitable remainder trust that are normally used: the charitable remainder annuity trust and the charitable remainder uni-trust. The charitable remainder annuity trust pays a fixed dollar amount each year. The increase or decrease in the value of the trust does not affect the amount of the payment. The charitable remainder uni-trust pays a fixed percentage of the value of the trust recalculated each year. An increase or decrease in the value of the trust affects the amount of the payment accordingly.
After the asset is placed in the trust, the trustees direct that the asset be sold. (In this case the trustees are Mr. and Mrs. Smith; this isn’t advisable in all cases, but it is permitted.) By definition, a charitable remainder trust permits the sale of an asset without payment of any capital gains. Mr. and Mrs. Smith, now called donors, receive the income for life. However, at their death the trust is paid to the charity or charities of their choice.
Now! Who is real upset with us? The heirs, because they get nothing. To compensate for this, we set up what we call a “wealth replacement trust” with some of the income. The purpose of this trust is to purchase and own a life insurance policy on the life of the donors, Mr. and Mrs. Smith. The Smiths have no incidents of ownership in the life insurance policy; therefore, the proceeds of the policy, which by the way are normally equal to the value of the asset transferred but can be more or less depending on the clients desires, are paid to the heirs income tax-free, estate tax-free and probate cost-free.
As you have already seen, Mr. and Mrs. Smith were good “investors” because they increased the value of a $50,000 investment to $1 million, but now they are also “donors,” because they have set up a charitable remainder trust. The IRS will allow them an immediate income tax deduction for the future gift. The charity will not actually receive the gift until their death. The amount of the deduction will be based primarily on the donors’ age and amount of income being received from the trust. The older the donors are, the greater the deduction because the charity will not have to wait as long to receive the trust assets. Assuming the property transferred to the trust is appreciated assets, then the amount of each deduction is limited to 30% of the donor’s adjusted gross income each year with a five-year carry-forward. The deduction can be used for a total of six years.
Let’s look at how the numbers actually work, using a 7% annuity trust
Current Program
| $ | 1,000,000 | Asset |
| $ | 20,000 | Income |
| $ | 510,000 | Net to heirs @ 49% (inheritance and probate) |
| $ | 0 | Tax deduction |
Proposed Program
| $ | 1,000,000 | Charitable Remainder Trust |
| $ | 70,000 | Income @ 7% |
| $ | 12,500 | Wealth Replacement Trust |
| $ | 57,500 | Income |
| $ | 1,000,000 | Net to heirs |
| $ | 323,883 | Deduction |
With the current program Mr. Smith, age 64, and Mrs. Smith, age 62, would receive an annual income of $20,000; then at their death, the $1,000,000 asset would be included in their taxable estate. Based on a 55% inheritance tax and probate cost, the heirs would net $450,000. Of course, there is no tax deduction; the Smith’s estate is paying taxes.
With the proposed program, the asset is transferred into the charitable remainder trust and then sold. Based on a 7% return, the trust would generate an annual income of $70,000. The Smith’s could use $12,500 annually to fund the life insurance in the wealth replacement trust, leaving an income of $57,500. At their death, the heirs would receive $1,000,000 tax-free and the charity would receive the value of the charitable remainder trust. Also, the Smith’s would receive an income tax deduction of $323,883 that could be used over six years.
A true WIN-WIN-WIN situation.
William R. Davis is the CEO and President of Asset Management, Inc., an advanced marketing firm in estate planning and wealth management. Representing a number of quality insurance companies as a regional marketing firm and assisting other producers with their insurance product needs. He can be reached at 864-675-1571 or info@assetm.com
Please be advised that neither Asset Management Inc. nor any of its agents give legal or tax advice. This information has been derived from sources which we believe to be reliable but has not been independently verified by us. The opinions expressed herein reflect our current judgment and are subject to change without notice. We recommend that you consult with your tax advisor and attorney for complete details before making any final decisions.
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Asset Management, Inc. is not affiliated with Mutual Service Corporation.
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