Charitable giving and smart tax planning

Are you hanging on to some low-basis, highly-appreciated assets that you would gladly sell if you could somehow avoid losing much of the value to taxes? One solution might be an estate planning arrangement known as a charitable remainder trust. This type of trust might provide you with income tax deductions and other tax breaks, while enabling you to convert an appreciated asset-such as stocks or bonds, real estate or a work of art-into an income stream for life.

With a charitable remainder trust (CRT), you transfer assets into the trust and may take a charitable income tax deduction, subject to certain limitations. Since the asset will not pass to your favorite charity for several years, the deduction will be less than the assets' current value. The trust, in turn, may sell the assets and invests the proceeds into high income-producing investments. The trustee pays the donor a certain amount each year for a stated period-usually for the donor's lifetime -and then turns over the principal (also known as the "remainder" interest) to the charity named by the donor in the trust agreement. The charity could be your alma mater, a museum, church, or any other qualified charitable institution.

When the CRT sells the asset, it pays no immediate tax on the gain, so all the proceeds can be reinvested to produce income. If you had sold the asset outright instead of giving it to the CRT, you would have paid the IRS capital gains taxes on your profit, in addition to any capital gains tax imposed by your state. In setting up a CRT, you may name yourself as trustee, which enables you to manage the investment of the funds in the trust. You might want to review this with a financial advisor, as there could be reasons why this is not prudent, given your particular financial situation.

Alternatively, by using a professional trustee such as a bank or the charity itself, you could help ensure that the arrangement complies with the complex legal rules, which must be followed to retain the tax benefits.

Suppose a 65-year old doctor owns $100,000 worth of ABC Company stock that he bought some years before for $20,000. He wants to sell the low-yielding shares and invest the proceeds in U.S. Treasury bonds. But by simply selling the stock, he would pay capital gains tax of $12,000 on the $80,000 profit. So he transfers the stock into a CRT instead, and elects to receive $7,000 annual income for the rest of his life, at which time the principal will go to his favorite cause. The trust sells the shares and buys four percent Treasuries, paying no current, capital gains tax on the $80,000 gain. The yearly income stream the trust pays out will generally be considered distributions of ordinary income, on which the doctor will pay tax.

He also has available an income tax deduction in the year the transfer is made. Since the stock won't pass to the charity for several years, however, the deduction will be less than the stock's current market value. The available deduction will be equal to the present value of the remainder interest given to the charity of his choice.

Whether you choose to make a gift of an asset directly to a charity or through a CRT, the value of the asset, together with any future appreciation, will effectively be removed from your taxable estate-which may reduce your estate tax liability at your death. With a CRT, you can shrink your taxable estate by the amount ultimately retained by the charitable organization of your choice. Of course, since the charity will be the ultimate beneficiary of the trust assets, you will want to make sure that you have otherwise adequately provided for your family.

One way to replace assets donated to charities is by purchasing life insurance for the benefit of your heirs. Funds to purchase the insurance policy may be available through increased income resulting from the tax deduction for the donated asset and the cash flow produced by the investment of the trust proceeds. By holding the insurance policy in an irrevocable trust and making it the owner of the policy, the death benefit may be kept out of your estate, thereby reducing your ultimate estate tax bill. Of course, insurance applications are subject to underwriting approval.

There are two kinds of charitable remainder trusts to choose from; both are irrevocable meaning they can't be cancelled once the trust document is executed. The "annuity trust" throws off a steady income flow at a fixed amount each year-$5,000 or some higher amount annually, for instance. These types of CRTs tend to be more popular with people in their seventies or older who want the security of a guaranteed pay out in their old age and who don't want to take the risk that a market dip could erode the trust principle a few years down the road.

The Internal Revenue Code limits the yearly annuity and unitrust payments from a CRT and mandates a minimum percentage value for the charity's remainder interest. Regardless of which type of CRT is used, the annual amounts received by the donor are generally subject to income tax, either as ordinary income or as capital gain.

Erik Gruber is a registered representative and investment advisor representative of Lincoln Financial Advisors. He is located in Traverse City, 231-668-4147, Erik.Gruber@lfg.com.

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