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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 2 - The Tax Me Richer Trust
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Case:
Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly tries class action lawsuits against large, multinational corporations. As a result of the high stakes and high dollar amounts involved, it is not uncommon for a jury to award a judgment of $100+ million. In fact, Lynn is among a select group of attorneys with ten or more successful $100+ million judgments. Accordingly, Lynn is an extremely wealthy woman. In addition to her salary, her firm represents most class action lawsuits on a contingency basis. In other words, the firm receives between 15% and 40% of any favorable judgment (plus costs). As a result, the firm's share of a victory is very substantial.
Recently, Lynn won a major trial against a financial institution. The jury awarded her clients $20 million, and the firm's share was approximately $6 million. As a result of the successful conclusion, Lynn received a $1 million bonus. While extremely pleased with this large bonus, Lynn shudders at the thought that over $400,000 would go to Uncle Sam.
In addition to this year's bonus, Lynn regularly earns about $500,000 a year, which places her in the highest federal and state income tax brackets. Not surprisingly, Lynn desperately wants to minimize her tax liability. She therefore regularly meets with her tax advisor Frank Thomas to discuss her options.
Lynn's primary goals are tax reduction and some basic retirement planning. Lynn is also open to charitable giving if it can help her accomplish her primary goals. Lastly, because Lynn receives a large, annual salary, she does not have any immediate need for the $1 million bonus.
Question:
What plan may accomplish Lynn's goals? What trust investments should be selected? Which trust investments would produce more overall wealth for Lynn: tax-free municipal bonds or a balanced portfolio of stocks and taxable bonds?
Solution:
Frank suggested that Lynn fund a Grantor Charitable Lead Annuity Trust (CLAT) for a period of 10 years with the $1 million bonus. The payout rate on the trust would be 5% or $50,000 per year which would be payable to her favorite charities. The creation of such a trust would produce a charitable income tax deduction of approximately $400,000. With adjusted gross income of $1.5 million this year (bonus plus salary), Lynn may deduct up to $450,000 or 30% of her AGI this year. Therefore, assuming a combined tax rate of 40%, the $400,000 charitable income tax deduction could save Lynn $160,000 in taxes this year!
Lynn knew that if the trust investments were municipal bonds (which are exempt from federal taxes), then all the income from the trust would be tax-exempt income. This tax-free investment decision would allow Lynn to avoid any taxable phantom income problem during the trust's ten-year term. However, Lynn also knew that there would be little, if any, trust growth during the ten-year term with municipal bonds. In fact, it was possible the trust corpus would diminish. Therefore, she wondered if investing in stocks and bonds would prove more fruitful.
Since this was a grantor trust for income tax purposes (i.e., not tax-exempt), Lynn would be taxed on all the trust income. Not surprisingly, Lynn's stock and bond investments would produce taxable phantom income each year. For instance, the trust would pay $50,000 a year to charity. Thus, the trust would need to sell some stock positions and realize some bond income each year to satisfy its financial obligations. These actions would generate capital gain income and ordinary income to the trust which would then flow through to Lynn's Form 1040. Unlike the non-grantor CLT, Lynn's trust is not entitled to a charitable income tax deduction for the $50,000 gift each year, because she already claimed all the gifts to charity in year one, i.e. the $400,000 initial charitable income tax deduction.
Assuming a balanced portfolio producing 2% ordinary income and 6% capital growth, Lynn's tax liability each year on the $50,000 distribution is approximately $8,500 or a federal and state blended tax rate of 17%. Because $1 million cash is contributed to the trust, the basis in the subsequently purchased appreciating stocks is very high. Consequently, there is little capital gain income (15% tax rate) to report each year when the stocks are sold. The bond's ordinary income (35% tax rate) of $20,000 each year will account for most of Lynn's tax liability. Thus, in exchange for the upfront $400,000 charitable income tax deduction, Lynn will pay approximately $8,500 a year in taxes or $85,000 over the ten-year period.
Despite this bad news, there is significant good news to this "taxing plan." Assuming an annual trust return of 8%, the trust will grow to $1,434,597. That is a potential $434,597 increase over the traditional tax-free CLAT. With a more modest annual trust return of 7%, the trust still grows to a healthy $1,276,329. In the event of stronger growth at 9%, the trust may balloon up to $1,607,717. Therefore, Lynn's trust may return 27% to 60% more than the traditional tax-free CLAT.
In this instance, this potentially significant increase in wealth comes at a cost of $85,000 over a ten-year period to Lynn. Therefore, the decision between the traditional tax-free CLAT and the appreciating taxable CLAT is based on market risk and tax strategy. After reviewing the options carefully, Lynn elects the "tax me richer" trust. For Lynn, the payment of $8,500 a year in taxes is not overly burdensome. Yet, the return on this plan greatly exceeds the overall outlay of $85,000. Namely, she will receive a $400,000 charitable income tax deduction and receive between $1.2 to $1.6 million after ten years.
Furthermore, the return of $1,000,000+ would provide Lynn with a wonderful retirement nest egg. The money could be invested for future use or accessed immediately if Lynn so desired. Again, the CLAT provided Lynn with great flexibility. Finally, $500,000 would be distributed to Lynn's favorite charities. She was amazed at this enormous additional benefit.
In the end, Lynn was completely happy with Frank's plan. She would cut her current year's tax liability significantly, retain flexibility, increase her wealth, and contribute a generous gift to her favorite charities. While always philanthropic, Lynn's CLAT would make her a major donor overnight, a title that brings a very warm smile to her face.
Editor's Note: A grantor charitable lead annuity trust produces a charitable income tax deduction equal to the present value of the charity's income interest. When computing the present value, an applicable federal rate must be used pursuant to Section 7520. With CLATs, the lowest AFR produces the largest charitable income tax deduction.
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