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Using Charity to Keep Your Client's Estate Intact
Roger Silk | 05-02-02
"I want to throw a tough one at you," Bill, a reader of this column, wrote to me. His e-mail continued with the salient facts of the case, "Widow, age 92. Net worth about $3.5 million, but has done no estate planning of any significance. No children, but three nephews/nieces. I don't think she'll live three more years."
The two goals were to get the maximum amount to the heirs with the minimum amount of estate taxes and to provide for charity. The nieces and nephews didn't really need the money themselves, but they wanted to keep it from going to taxes. The advisor also wanted to keep as much of it intact as possible because it was a nice piece of money-management business.
I suggested that Bill consider a charitable lead trust (CLT). A CLT is a split-interest trust with a charitable beneficiary and a non-charitable beneficiary. The charitable beneficiary gets a series of periodic payments for the term of the trust, and the non-charitable beneficiary gets the remainder--whatever is left--at the end of the trust term. Depending on the specifics, I wrote, there might be virtually no tax on a $3.5 million estate.
That comment generated a phone call.
"Here's where we are now," Bill said. "If Agnes dies tonight, she's got a $1 million exemption, and half the remaining $2.5 million will go to estate taxes. That's a $1.25 million tax bill. Not good. Can a CLT help?"
"What do you figure you'll earn on the assets long term?" I asked.
"Probably about 12%, I hope," Bill said.
"And the heirs don't insist on the money right away?" I asked.
"Well, they might wait if it means they'll get more. Give me some ideas."
I did some figuring based on the information Bill had provided. The key terms of the CLT--which will be decided by Agnes and Bill--are the number of years that the CLT lasts and the size of the annual payments to charity. By playing around with these terms (and depending on the government interest-rate tables in effect at the time the CLT is set up), I determined that Agnes can leave roughly half of her estate to her new foundation, half to her heirs, and virtually none to estate taxes.
"If Agnes sets up a CLT with a six-year term, puts the entire $3.5 million into it, and you set the payout rate at 14% per year, there'll be no estate tax," I told Bill. "About $500,000 a year will go into the private foundation. At the end of year six, the heirs will get about $2.75 million free of estate tax. If the heirs took the money right now, they'd get about $2.25 million."
You may be asking how the heirs can wind up with more money if the trust pays out 14% per year but only earns 12% per year. The answer is that before estate taxes, you have $3.5 million with no planning. Take that same $3.5 million and put it into a CLT. If you can earn 12% while giving away 14%, and you're left with $2.75 million at the end of six years. Because of the way the CLT rules work, the $1 million estate-tax exemption covers the entire $2.75 million in six years. The $2.75 million is more than the $2.25 million the heirs would inherit without planning, but they have to wait six years to get it.
If you want to model these scenarios yourself, you can do it by building an annuity model in Microsoft Excel. An easier way is to use a set of add-ins called Zcalc. Like Bill, I think you'll find that in many cases, it's well worth your time to run the numbers.
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