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Wednesday, May 1, 2024
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Case Studies |
The Super Retirement Unitrust
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Case:
Dale and Darlene Sullivan, both age 55, are executives who have been employed over the years by a number of high tech and internet based companies. They are known throughout the industry as marketing gurus who have been involved in taking a number of companies public. Instead of taking a salary at these various companies, they have opted to take their compensation in the form of nonqualified or nonstatutory options. These are the kinds of options that when exercised create reportable ordinary income for the difference between the exercise price and the fair market value of the stock at the time of exercise. For example, if Dale and Darlene are holders of a nonqualified option in which they can purchase a share of stock currently valued at $50 for an exercise price of $10, then they are required to report ordinary income of $40 on their tax return.
As a result of working with a number of companies over the years, Dale and Darlene have very little in the way of pension plans as they usually leave a company prior to their account being vested. The longest that they have worked for a given company has been about five years. They are concerned about their retirement, and would like to begin to build a nest egg for the future. Three years ago, they received nonqualified options in one of those "dot com" companies and decided to exercise those options soon after they were granted. At that time they were given the opportunity to purchase $500,000 in stock for an exercise price of $50,000. They did not sell any of stock and now the value has ballooned to $2,100,000. However, they fear that due to the turnover in the management of this company, the "bubble may soon burst" and the stock could decline substantially. They have considered unloading the stock, but are very concerned about the capital gains taxes.
Dale and Darlene have no children, but they have a special place in their hearts for children of single parents. As a result they have both served as a Big Brother and Big Sister. They have made annual contributions of $10,000 the past five years to the charity, but they feel that they would eventually like to make a far bigger impact with their giving. Eventually they would like to provide a scholarship fund for those children who have participated in the Big Brother/Big Sister program.
Question:
Dale and Darlene would like to use the $2 million block of stock to provide for retirement and would also like to make a substantial contribution to Big Brothers/Big Sisters to fund a scholarship program. Their desire is to begin the fund today with a gift of $100,000 and then to add to the fund over the next few years. Then, upon their passing, they will transfer at least $1,000,000 to the scholarship fund probably in the form of an outright bequest at death. What is the best way to accomplish these objectives?
Solution:
These questions were posed to the Director of Major Gifts at Big Brothers/Big Sisters, Carolyn Morgan. Carolyn explained that the best strategy for Dale and Darlene would most likely be to create a "super retirement unitrust" funded with $2,000,000 of the stock. The other $100,000 could be given as an outright gift to begin the scholarship fund. The unitrust would be for their lifetimes and would be drafted as a net income with makeup trust. In order to payout gain when they retire, the assets will be placed in a partnership. While the partnership will invest and recognize income and gains, only when the partnership distributes income or gains to the unitrust will they be paid out to Dale and Darlene.
Carolyn suggested that the payout rate on the trust be 5% in order to maximize the charitable income tax deduction. Based upon their ages, the charitable tax deduction would be $495,660 (assuming an Applicable Federal Rate of 5.6%). Should Dale and Darlene choose to exercise more of their stock options this year, now would be an excellent time due to the offsetting income tax deduction.
Carolyn then went on to explain that the partnership investment method is important in order to allow diversification and investment in a portfolio of growth stock, but also to enable the distribution of capital gain after retirement. During the next ten years prior to their retirement at age 65, the trustee retains all gains in the partnership. After retirement, the trustee then distributes gains from the partnership to the unitrust. They then may be paid as income.
Dale and Darlene have the best of both worlds. They receive the benefit of equities growth prior to retirement and then much more favorable capital gains rates on distributions after retirement. Also, they are able to bypass the capital gains taxes on the sale of stock inside the trust and diversify their holdings thus alleviating their primary concern of the long term health of this particular company and the value of its stock.
Carolyn presented a computer illustration to Dale and Darlene projecting how the numbers would look on the unitrust in the case wherein the trust would be invested in a portfolio of growth stock. Assuming an 8% average trust return over the next ten years, the investments inside the trust would grow to $4.3 million. At that time the accumulated deficit would have grown to over $1.4 million dollars. This deficit could be paid out over a number of years or paid as needed or desired by Dale and Darlene. This assumes, of course, that the trust would divest itself of some of the stock portfolio and realize capital gains. If the deficit were paid out over a number of years and the trust would realize capital gains of 7% per year, Dale and Darlene would receive in excess of $300,000 per year from the trust for their retirement. And, based upon the computer projections, over $6.2 million would be available to Big Brothers/Big Sisters when they passed away.
Other advantages of this trust arrangement are also available. First of all, Dale and Darlene could add to the trust at any time. Any additional transfers would generate a current tax deduction which may be used in part to offset the reportable income should they choose to exercise additional options. Secondly, if they desire to make a contribution to Big Brothers/Big Sisters from the trust at any time during their lives, this could be done. In other words, they don't have to wait until they pass away to assign the principal of the trust to charity.
Dale and Darlene never realized that retirement planning could be so super! They were so pleased with Carolyn's fine presentation of the "super retirement unitrust" that they decided to establish the unitrust posthaste.
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