Charitable solutions can create a steady stream of payments for a donor or family member. Professional advisors may provide guidance on retirement planning, investments, tax strategies and charitable giving. Clients are often concerned with maintaining their standard of living, minimizing tax recognition and supporting their favorite charitable organizations. Life income gifts are a great solution for clients who desire a steady source of income for the duration of their lives, while also providing a legacy for charity.
Part four of this article series will provide explanations of unitrusts for students, retirement unitrusts and a home sale and unitrust. The information should enable a donor to understand how a charitable remainder trust can fulfill his or her philanthropic goals.
Education Unitrust Funded With An Appreciated Asset
The goal of an education unitrust is to provide for the college education of a child, nephew, niece or grandchild. The education trust may pay a higher unitrust amount for a term of four or five years.
The trust is most advantageously funded with appreciated stock or real estate. The donor receives an income tax deduction equal to the present value of the remainder interest and benefits from bypassing capital gain when the trust sells the stock or land.
Kiddie Tax Applies to Education Unitrusts
The Kiddie Tax rates apply to dependent children up to age 19 (24 for full-time students). The Kiddie Tax generally applies to the unearned income of a child over a basic threshold. This may have an adverse impact on education unitrusts and annuity trusts. With increased tax rates on passive income, a major benefit of education unitrusts has declined significantly. A charitable deduction will be available for a parent or grandparent who funds one of these plans, but the lower student income tax rate no longer exists.
The student will benefit from his or her exemption and pay tax at the lowest bracket on an amount equal to that exemption. However, students under age 24 with over 50% passive income will be taxed on excess amounts at their parent's tax rate. Sec. 1(g)(2)(a)(ii)(II) states that the "Kiddie" tax will apply unless the student has earned income equal to one half of his or her support. This is a standard that college students will find very difficult to meet.
Gift Tax Options
The Sec. 2503 annual exclusion applies if the transfer is a "present interest." This means that the child or grandchild must be able to spend the money. However, with respect to a trust, "an unrestricted right to the . . . income from property is a present interest." See Reg. 25.2503-3(b). This makes it possible for an income stream to qualify for the gift exclusion so long as the income stream right commences immediately after the trust is created.
What impact do these gift tax rules have on education unitrusts? There are two basic choices for the term of years trusts. These are the "Give it Now" option and use this year's annual exclusion or the "Keep a String" option and use future years' annual exclusions.
The "Give it Now" Option
The "Give it Now" option was selected by the donor in PLR 8637084. This donor funded unitrusts with income paid for four years to students S and T. After four years, income was paid to students U, V and W. Since the income to S and T was vested and commenced as soon as the trust was created, these two income interests qualified for the gift exclusion. The exclusion amount would be the lesser of the present value of the income interest or the annual exclusion for each person. If two donors are funding the trusts, then the potential exclusion amount would be four exclusions – two for each donor and the two students.
Since the income to U, V and W is in the future, there is no present gift exclusion for the value transferred to them. This "no annual exclusion" rule also applies if a trustee has the power to allocate income among the various beneficiaries. See Reg. 25.2503-3(c), Example 3.
On April 15 of the year following the creation of this trust, the CPA for the donor will file both an IRS Form 1040 Income Tax Return and an IRS Form 709 Gift Tax Return. The same gift deduction will be reported on both returns. The Gift Tax Return will show the total amount transferred less the charitable gift tax deduction and less the annual gift exclusions, if any. For example, with a $100,000 trust, there could be a $30,000 charitable gift deduction, further reduced by annual exclusions and the remainder would be a taxable transfer. If sufficient applicable gift exclusion amounts were not available, the taxable transfer would merely reduce the remaining available lifetime gift exemption. In rare cases with large estates and donors who have made substantial prior gifts, the donor could pay gift tax on the value of the gift over the available lifetime gift exemption.
The "Keep a String" Option
Method number two is the "Keep a String" or "Use Annual Exclusions" concept. In PLR 8949061, the taxpayer created a term of years trust with income payable to seven students. This donor also retained a testamentary right to revoke income interests.
Under Reg. 25.2511-2(f), the retention of the testamentary right of revocation (permitted under Sec. 664 for remainder unitrusts and annuity trusts) was a "string" that precluded a present gift. In effect, the transfer of funds each year to a student would then be a completed gift for that year, thus enabling the use of annual exclusions in future years.
This conversion to annual exclusions is permitted only for a term of years. In Reg. 1.664-3(a)(5), Treasury notes that, "If an individual receives an amount for life, it must be solely for his life." Since the donor is not an income beneficiary, under this regulation the income could not be payable to a student or students for life, but rather the duration of the trust may be only a term of up to 20 years.
With the "Use Annual Exclusions" method, a donor with several beneficiaries and sufficient exclusions will not suffer any adverse transfer tax consequences during life. However, under Sec. 2036(a)(2), the donor should know that if he or she dies prior to the expiration of the term of years, there would be an inclusion in his or her estate. Essentially, the present value of the remaining income stream will be a taxable transfer in the estate.
Notwithstanding this rule, if the donor is likely to live most or all of the projected term of years and there are sufficient available annual gift exclusions, it seems probable that the "Use Annual Exclusions" method will be preferable. Since donors may be familiar with the concept of the annual exclusion, this method is likely to be more easily understood by donors.
Which method should be used -- the "Give It Now" option or the "Keep a String" method? If there are sufficient annual exclusions to cover the reported gift now or sufficient available lifetime gift exemption, it may be preferable to file IRS Form 709 and have a completed transaction. However, if the donor is reasonably young, there are several students or the donor has selected an independent trustee and that independent trustee has the ability to allocate among the students, it may be preferable to use the "Keep a String" option.
The retirement/FLIP charitable remainder unitrust (CRUT) includes several options. A person may wish to contribute equal amounts until retirement. Alternatively, an individual may have appreciated stock or land and desire to make contributions over two, three, four, five years or more. Finally, if an individual desires to select a future retirement date, he or she may select a FLIP CRUT with a fixed date for the FLIP or retirement time. The retirement CRUT plan may be structured as either a net income plus makeup CRUT or a FLIP CRUT.
The document in the CresPro One to Eight Lives Unitrust program includes the net income plus makeup and the FLIP options. The FLIP options may use a liquidity threshold or a retirement date for the FLIP "trigger" event. The unitrust will "FLIP" on January 1 following the selected FLIP trigger event.
Retirement Fund for Mary and John With Equal Contributions
Mary and John Jones are both age 55. They plan to retire in ten years and would like to contribute $50,000 each year until retirement. Since a unitrust is valued each year, it is permissible to make additions to the trust. John and Mary initially fund the trust with $50,000 and then make annual $50,000 additions, for a total funding of $500,000 over ten years. Since their desire is to retire after ten years and to maximize income during retirement, the trustee of the net income unitrust invests for growth for the period of ten years. At the end of ten years, the trust has grown to $782,274.
The trustee then changes from a growth mode investment strategy, with approximately 1% earned and paid out and the balance in growth stock, to an income mode. After retirement, the 5% unitrust payouts plus make-up amounts are distributed. During the majority of their retired lives, they will be receiving approximately 6% income. However, there is still some growth of the principal. This projected growth to over $1 million during the balance of their lives also enhances their income and provides inflation protection.
This plan is an excellent means for building tax-free growth for their retirement years. John and Mary receive approximately $60,000 each year for a total retirement income of nearly $1.5 million.
Real Estate Retirement Unitrust
Another option exists if the donors hold real estate. There are many circumstances in which real estate parcels might be contributed and sold over a period of two to six years.
Bill and Kathryn Make Two Real Estate Contributions
Bill and Kathryn Hansen bought development real estate on the outskirts of town ten years ago. Property development has slowly but steadily moved their direction and there now is a commercial center adjacent to their property. Local area developers are knocking on their door, desiring to purchase their property and build new commercial facilities.
Bill is 52 and Kathryn is 50 and plan to retire in about ten years. Since now is the best time to sell, they believe they should sell the property but would like to "rollover" the property gain without payment of tax. By creating a net income plus makeup unitrust and transferring half of the property this year and half of the property next year, they benefit in several ways.
First, the appreciated-property charitable deduction of approximately $60,000 each year may be fully utilized because their income is $200,000 and 30% of that limit would be $60,000. Second, the property would logically be developed in two phases. By selling half this year and half next year, they maximize their total return. Third, their trustee may then transfer the proceeds into growth stocks for the ten years. At that time, they are projected to have over $1.7 million in the trust and the trustee may then begin making retirement income payments of over $86,000 annually to Bill and Kathryn.
During their two lives, the projected income paid out will be over $4.4 million. With their income tax savings and the bypass of capital gain, they are very pleased with the retirement unitrust plan. Finally, after their two lives, a gift of almost $3 million will be made to their favorite charities.
FLIP Unitrust Options
A FLIP unitrust is a net income (NICRUT) or net income with makeup (NIMCRUT) unitrust that may be converted to a standard unitrust. The FLIP trust operates with a "trigger" event. This may be the sale of a nonmarketable asset such as land, a future date or an event such as marriage, divorce or other occurrence not within control of the trustee. The FLIP may be used for retirement purposes, but also is quite convenient for handling the contribution and sale of real estate. Many donors would eventually like to receive the steady payout of a Type I or standard unitrust. The FLIP is an excellent means for enabling the conversion of real estate into a Type I trust.
If an individual desires to select the FLIP date, it may be appropriate to hold a moderate cost city lot in the trust. This version of the unitrust is described as the "Flex-FLIP" method. The trigger in this trust for the FLIP is the sale of the lot. When the donor desires to change from a net plus makeup to a standard unitrust, the trustee sells the lot. This method is acceptable because the sale of a nonmarketable asset is a permissible FLIP trigger event. The Flex-FLIP is qualified even if the lot is a small fraction of the value of the trust.
Mary Jones Funds a FLIP Unitrust With Development Land
Mary Jones owns real estate that she inherited twenty years ago from her parents. Her cost basis is only $10,000, but the development land has now appreciated dramatically and has a current fair market value of $500,000. She would like to create a trust that will pay her 6% each year.
Mary transfers the $500,000 property to a FLIP unitrust. The FLIP unitrust document specifies that the trigger event will be the sale of 50% or more of the property. Until the trust has sold that property, the unitrust remains a net income with makeup trust. Since there is no current income from the property, the trust does not pay income to her.
The property does not sell until the middle of 2024. Under the net income rules, the proceeds are then invested and Mary will receive the 6%, plus makeup if they earn more than 6%, until the end of 2024. On January 1, 2025 the trust "FLIPs" and becomes a standard unitrust. Any deficit from the first years is forfeited, but Mary believes that it is more important for her to have the assurance that the trust will now pay 6%, regardless of fluctuations in the stock market.
Over Mary's lifetime, the trust pays out over $740,000. When she passes away, the $500,000 trust will have grown to $700,000. Mary receives steady income, with about one-half of the payouts taxed at favorable capital gain rates. Finally, she will make a generous gift to her favorite charities.
The "Great Home Buy-Down"
Many couples or single persons of retirement age are living in large single-family dwellings. Like many Americans, they purchased a large home in their mid-forties, when there were still children at home. Now, the children are out of the nest, the home has no mortgage and our homeowners have more home and responsibility than they desire. But given the appreciation in their home, many owners with valuable homes are unwilling to sell and pay a large tax.
Is there a solution? Can they find true happiness, minimize taxes and a smaller home that fits their needs? The "Great Home Buy-Down" could be just the answer to fulfill their goals.
John and Mary Want to Move to a Condo
Over the years, John and Mary Jones have enjoyed a good life. They bought an initial starter home, but as their children grew older they sold that residence, rolled over the gain and acquired a second home. Their current residence is the third home they have purchased. It is now worth approximately $1,800,000 with a cost basis of $200,000. John and Mary no longer need the big home and would be quite happy with a smaller retirement condominium. However, they do not want to sell the big home and pay a large capital gains tax. Is there a solution for our friends John and Mary?
There is indeed a plan that would enable them to have cash in the bank, acquire the new condominium, receive a very significant increase in income and accomplish all of this with no taxation. The plan involves transferring half the value of the home into a charitable remainder unitrust and then a joint sale by the trustee of the trust and John and Mary.
First, John and Mary move out of the home. Second, they deed one half of the home to a charitable remainder unitrust. Third, they and the unitrust list the home for sale and sell the property. Fourth, at closing, the proceeds are divided between the unitrust and John and Mary Jones.
How are John and Mary able to do this with zero taxes? First, the one half of the property that is transferred to a remainder trust will bypass capital gain under Sec. 664, so long as there is no prearranged sale. The basics of avoiding prearranged sale are that the trustee must have lawful capability to select the purchaser and the price. One half of the basis is allocated to the one half of the value in the trust, leaving the other half of the home with value of $900,000 and prorated basis of $100,000.
When the property is sold, it is possible to protect $500,000 of the sale price with the principal residence gain exclusion ($250,000 for single individuals and $500,000 for married couples) and, with the $100,000 of allocated basis, the gain is now $300,000. The $500,000 exclusion is available if John or Mary Jones have lived in their principal residence for two of the last five years.
Fortunately, there is a charitable income tax deduction of approximately $300,000 that offsets the long-term capital gain on the cash portion. This gain will be recognized in the current year and the charitable deduction will be subject to the 30% of adjusted gross income limit. In some cases, the result is a payment of a modest amount of tax in year one and tax refunds in future years due to charitable deduction carryforwards. However, the net result is still zero taxes when viewed from a multi-year perspective.
There are two cautions that must be emphasized with respect to the "Great Home Buy-Down." First, the self-dealing rules of Sec. 4941 are designed to prevent a donor from receiving benefits from the trust other than the stated trust income amount. This self-dealing rule states that one cannot "buy, sell, lease or otherwise transact business with the trust," meaning that a homeowner may not live in his or her unitrust. Does that mean that the Jones cannot live there even if they pay rent? Yes, that would violate the self-dealing rules. Because John and Mary are giving half of a four-bedroom house to the trust, may they live in two bedrooms and permit the trustee to use the other two? No, that still is not acceptable -- the owners must move out prior to deeding the partial interest to the trust.
This rule is especially important after PLR 9114025. In this Private Letter Ruling, an attorney initially approached the IRS and asked for a favorable Private Letter Ruling on the transfer of a partial interest in real property to a unitrust. The IRS initially refused to give a favorable ruling and later gave a favorable ruling only after the property was transferred to a limited partnership.
In this ruling, the Service viewed the joint ownership between the donors (considered prohibited parties from a self-dealing standpoint by the IRS) and the trustee as potentially facilitating manipulation of value. Possibly, donors could receive greater than proportionate value and the trust would receive less than its fair share of value. Two very important issues are raised in this ruling. First, the favorable ruling emphasized that there was no use by the donors of the jointly held property. Second, there was an independent trustee.
Thus, it appears that it is possible to complete the home buy-down if one is very careful to avoid any use of the property by the donor and there is an independent trustee for the unitrust. Indeed, it is very desirable to create both a revocable trust and a unitrust with the same independent trustee managing both. The donors transfer half of the home into the unitrust and the other half into the revocable trust. The trustee handles the sale and then allocates pro rata proceeds into the two trusts. At that time, donors can recover the $900,000 in proceeds from the revocable trust.
The Great Home Buy-Down is a wonderful plan. John and Mary Jones were receiving no income before from their primary residence and were forced to expend considerable sums to pay taxes and maintenance on their large home. They are much happier now in their new retirement condominium and have significant income from the remainder trust plus extra cash in the bank. Their life has improved dramatically. Best of all, this improvement was accomplished with no net payment of taxes.
Carl and Sue Combine a Sale of Home and Unitrust
Carl and Sue Johnson have lived in their home for many years. It has a cost basis of $100,000 and is valued at approximately $1,000,000. They are interested in obtaining cash to move to a retirement condo. They no longer need the large four-bedroom home, and the cost and effort to maintain the property are incompatible with the freedom that they would hope to enjoy during their retirement years.
Carl and Sue qualify for the $500,000 exclusion of capital gain. They could not sell the million-dollar property, however, without payment of some capital gains tax. It would be better in their view if there were a "capital gains tax-free" sale option and a way to benefit their children.
Carl and Sue estimate that it will cost approximately 7% or $70,000 to sell their home. They moved into temporary housing and transferred 40% or $400,000 into a 5% charitable remainder trust for two lives plus 20 years. The trustee and the Johnsons then jointly sold the property and divided the $70,000 of costs pro rata between the unitrust and the Johnsons. The unitrust netted $372,000 and the Johnsons received $558,000.
Since they can use their $500,000 exclusion to offset the gain on the sale portion, there is no tax on the sale portion. They bypass $332,000 of gain on the unitrust and save $49,800. In addition, they receive an income tax deduction of $49,000 with the charitable remainder unitrust. This saves additional taxes on their other income.
For two lives plus a term of twenty years, the unitrust will make payments of 5%. Assuming that it earns 6% and pays 5%, there will be 1% growth. This is quite important because the trust could last 30 or 40 years. In the anticipated 43.1 years, the trust is projected to pay $1.5 million to the Johnsons and to their children.
The Johnsons are able to use part of the cash portion to purchase their retirement condominium. They use the balance of the cash for liquidity and investment purposes. In addition, they have the unitrust income for their lives. This "Great Home Buy-Down" using the unitrust and the home-sale exclusion is an excellent plan that greatly enhances their retirement security.
Charitable giving can be crafted to meet the goals of the particular client, whether those goals are financial, familial, philanthropic or a combination of all three. By creating a charitable remainder unitrust, donors will be satisfied that they have created income for life and will enjoy knowing they have made a positive impact through their charitable gifts.