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Several types of
charitable techniques are available to donors whose
planning goals are twofold: one, to provide benefits to
the donor's favorite charitable organizations, and two,
to financially assist the donor's children and
grandchildren. The most common technique to accomplish
these twofold goals is the nonreversionary charitable
lead trust, in which the income from the trust is paid to
a charitable organization for the term of the trust. At
the termination of the trust, the assets are distributed
to the donor's family.
A second technique to accomplish both goals uses the
combination of a testamentary charitable bequest and an
irrevocable life insurance trust to benefit the donor's
children and grandchildren. Differences exist between the
two techniques in terms of the timing of the
children's/grandchildren's inheritance and in the form of
the charitable organization's interest—one
technique provides income to the charitable organization
and the other provides principal. This article serves to
explain and illustrate each of these two
techniques.
Charitable Lead
Trust
The lead trust provides
income to the charitable organization, and it provides
the means to transfer the donor's wealth to the heirs
upon the termination of the trust. A charitable lead
trust can be designed in one of two ways: a
nonreversionary lead trust or a reversionary lead trust.
The type of charitable lead trust most suited for wealth
transfer to children and grandchildren is the
nonreversionary lead trust—so called because at the
end of the trust term, the assets are distributed to the
donor's chosen beneficiaries (normally the family). A
reversionary lead trust is designed so that the assets
will eventually revert to the donor—hence the term
reversionary lead trust.
In the trust document, the donor determines the amount
of income payable to the charitable organization each
year. The higher the amount of income payable to the
charitable organization or the longer the length of the
trust term, the higher the estate tax charitable
deduction for the donor's estate.
Illustrating the
Charitable Lead Trust Technique
Marlene Smith, age 59,
is a widow with an estate of $5 million. She wants to
provide for her grandchildren more than for her own
children because her two children are both wealthy in
their own rights. She has six grandchildren (ages 2 to
11) and she feels very strongly about establishing a
trust to provide funds for her grandchildren's future.
To accomplish her goals, Marlene decides to establish a
charitable lead unitrust upon her death (testamentary
lead trust). The income payments are set up to be 6
percent of the trust annually for 6 years. With an IRC
Section 7520 rate of 2.4 percent, this charitable lead
trust can be established upon Marlene's death with zero
estate and generation-skipping transfer (GST) tax costs.
In other words, Marlene can establish a nonreversionary
charitable lead unitrust, fund it with $5 million, and at
the end of 6 years, the assets will be distributed to her
grandchildren and her estate will pay no estate or GST
taxes on the transfer. The trust will provide a
charitable estate tax deduction of $1.5 million (the
present value of the charitable income interest) and the
remaining $3.5 million in her taxable estate will be
offset by the unified credit (assuming current rates and
tax laws).
If the trust assets grew during the 6-year period at a
rate of 8 percent, the grandchildren would receive
approximately $5.6 million at the end of the trust term.
The slight increase in trust assets from the initial
contribution of $5 million to $5.6 million is due to
using a growth assumption higher than the income paid (8
percent versus 6 percent).
The nonreversionary lead trust provides Marlene the
ability to meet both her goals. The income from the lead
trust will furnish her favorite charitable organization
with needed revenue for 6 years and at the end of that
time, Marlene's grandchildren will have complete access
to the trust principal.
Charitable Bequest
Coupled with a Life Insurance Trust
The best type of planned
gift for transferring the donor's wealth to his heirs is
the charitable lead trust. Unfortunately, many donors shy
away from this type of gift unless they are
“super-wealthy.” Reasons for this may vary,
but a common reason is the fact that the charitable lead
trust provides no immediate benefit to the donor or the
donor's family. This means the donor's estate must have
plenty of other assets available for heirs in order for
the donor to feel comfortable giving up total control and
access over these donated assets.
Because most other types of charitable gifts do not
readily benefit children or grandchildren, coupling a
charitable bequest with a life insurance trust can
resurrect the needed funds for the
children/grandchildren. A charitable bequest can fulfill
philanthropic wishes with a gift to the charitable
organization, and the life insurance trust can be
established to secure income or principal solely for the
benefit of the donor's children or grandchildren.
The donor can purchase a life insurance policy on his or
her life or a policy on the life of the donor and the
donor's spouse (a second-to-die policy). A policy
covering both spouses is almost always less expensive
than a policy covering just one life. The downside of the
second-to-die policy, however, is the death benefit will
be paid later upon the death of both spouses rather than
potentially sooner at the death of the donor, if the
donor were to die first.
The life insurance trust can be designed with as much
flexibility or control in distributing income or
principal to the beneficiaries as the donor chooses to
include. Unlike a charitable remainder trust, in which
the donor may commonly name himself or herself as the
trustee, the donor should never be the trustee of the
irrevocable life insurance trust. If the donor has
control over the trust by serving as trustee during his
or her lifetime, the trust assets would be includable in
the donor's estate for federal estate tax purposes.
Hence, with all life insurance trusts, the donor should
nominate someone other than himself or herself as the
trustee.
Upon the donor's death (or the second death if both
spouses are insured under one insurance policy), the life
insurance death benefit is paid to the trustee of the
life insurance trust. The trustee then uses the insurance
proceeds according to the trust's terms. The donor can
choose the type of distribution method he or she prefers
for the children. The trust distributions are usually
spread out over a number of years, especially when the
beneficiaries are quite young, thus discouraging quick
liquidation of assets due to financially immature
beneficiaries.
The most valuable benefit of using life insurance, which
is almost always income tax–free to the
beneficiary, is that it is received free of estate taxes,
provided the life insurance is properly owned outside the
insured's estate. The children will receive their
inheritance free of both estate and income taxes and the
estate will receive a charitable estate tax deduction for
the gift to the charitable organization. The donor will
have met two goals: providing financially for children or
grandchildren and making a contribution to a favorite
charitable organization—in the most tax-efficient
manner possible.
Illustrating a
Charitable Bequest Coupled with Life
Insurance
Dan, aged 65, decides to
make a direct bequest of $900,000 from his 401(k) account
to his favorite charitable organization. He always
thought, however, that his three children should also
benefit from his 35 years of hard work at the town plant.
After meeting with his attorney to plan his estate, Dan
was advised about the tremendous amount of taxation
applied against pension, 401(k) and IRA accounts. In
fact, he was disappointed to learn that as much as 65
percent of his 401(k) account could be confiscated by
federal estate and income taxes (depending on the
particular tax brackets), leaving his three children with
only $321,750 of the original $900,000 (assuming a 45
percent estate tax bracket and 35 percent income tax
bracket).
To combat the excessive taxation, the estate attorney
suggested that Dan purchase a $900,000 life insurance
policy on himself. The life insurance policy will be
owned not by Dan, but by an irrevocable life insurance
trust. The trust document will provide that each child
receive one-fourth of the trust principal amount
immediately following Dan's death. After that, at every
five-year interval the trust will distribute funds to
each of the children. One-third of the trust will be
distributed five years following Dan's death, and
one-half of the remaining trust will be distributed 10
years following Dan's death. The balance will be
distributed 15 years following Dan's death. This
technique of staggered trust distributions will help
prevent Dan's children from quickly depleting their
inheritance, as many beneficiaries with lump-sum
inheritances have been known to do.
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Dan will need to convert a
portion of his financial portfolio each year into enough
cash necessary to pay the life insurance premiums. To the
extent Dan has annual exclusion gifts available to use, he
can use up to $13,000 per year per trust beneficiary. So,
for example, if Dan's premiums equal $45,000 per year and
Dan has three children as trust beneficiaries, Dan could
use $39,000 ($13,000 x 3) of gift-tax-free exclusions. The
remaining $6,000 of premiums would require use of his $1
million gift tax exemption. If Dan is married and his
spouse hasn't used any of her annual gift tax exclusions,
the amount they could use is doubled to $78,000 per year.
(Note: Under current pension laws, if Dan is married, his
spouse would need to consent in writing before he could
name someone other than his spouse as the beneficiary of
his 401(k) account.)
This technique will provide $900,000 of 401(k) money to
Dan's favorite charitable organization, and because of its
tax-exempt status, the organization will receive it income
tax–free. Dan's estate will receive an estate tax
charitable deduction of $900,000. The life insurance trust
will provide $900,000 of income tax–free life
insurance to his children and grandchildren. The life
insurance will also be estate tax–free if properly
owned outside Dan's estate in an irrevocable life insurance
trust. Thus, Dan's dual goals will have been achieved with
the most tax-efficient strategies possible.
Summary
Donors can still transfer
wealth to their families without feeling they have to give
up their philanthropic goals. Several charitable techniques
can provide benefits to both family and favorite charitable
organizations, fulfilling all of the donor's good
intentions. Charitable lead trusts are the primary gift
designed for this type of donor. An alternative, but
equally effective, technique combines a testamentary
bequest to a charitable organization with an irrevocable
life insurance trust structured to solely benefit the
donor's heirs. With modifications, these planned giving
techniques can also be used during the donor's lifetime. As
always, the donor must weigh individual charitable and
familial considerations before deciding on the type of
gift.
For more information,
please contact Jeff W. Anderson, J.D. at 423-439-5352 or
andersjw@etsu.edu.
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