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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 3 - Throw Out the Trust But Not the Gift
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Case:
Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly represents 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.
In Case Study "Extreme Makeovers for the Grantor Charitable Lead Trust" Parts 1 and 2, a Grantor Charitable Lead Annuity Trust (CLAT) for a period of 10 years with the $1 million bonus was created. Based upon a payout rate of 5% or $50,000 per year, the charitable income tax deduction was approximately $400,000 in each case. Depending on the trust investments, the estimated growth of the trust after ten years ranged from $1 million to $1.6 million (return rates ranging from 5% to 9%). In both cases, Lynn was very pleased with the achievement of her financial objectives and with her substantial philanthropic contributions.
Question:
Lynn wonders if she could achieve the same or similar results without the use of the CLAT. Specifically, what are the tax benefits and drawbacks to Lynn when she removes the CLAT step but not the overall plan goals?
Solution:
As an alternative, Frank offers the "give it now and invest the rest" plan. The first part of the plan requires Lynn to give $400,000 outright to charity this year, which is the present value of the proposed CLAT's income stream. Accordingly, this cash gift equals the proposed CLAT's charitable income tax deduction. However, the outright cash gift is subject to the 50% of AGI limitation whereas the CLAT cash gift is subject to the 30% of AGI limitation, which is due to a "quirk" in the tax code. Therefore, the higher AGI limitation is an obvious benefit in favor of the outright cash gift.
Another excellent benefit about this plan is that charity receives the $400,000 gift in year one as opposed to yearly installment type gifts. While the CLAT would distribute $500,000 over ten years, many charities would likely prefer a lump sum gift of $400,000 in year one.
The second part of the plan requires Lynn to invest the difference or $600,000 ($1,000,000 - 400,000). Based upon a balanced portfolio investment and an average yearly return of 8%, Lynn's $600,000 would grow in ten years to approximately $1.3 million. With a 6% and 9% return, the $600,000 would grow to approximately $1.075 million and $1.420 million, respectively. These potential growth figures are very comparable to the grantor CLAT growth figures, which produced $1 million to $1.6 million using similar rates of return.
Therefore, it appears Lynn can accomplish many of her stated objectives without the implementation of the CLAT. She can receive the same income tax deduction, but with higher AGI limitations. She can make a substantial, immediate gift to charity. Lastly, after ten years, Lynn will have $1,000,000+ for her retirement assuming her investments grow consistently.
In the end, Lynn is very happy with Frank's alternate plan. She could cut her current year's tax liability significantly, retain flexibility, increase her wealth, and contribute a generous gift to her favorite charities.
Editor's Note: One of the main differences between the CLAT strategies and the "give it now and invest the rest" plan revolves around income tax liability issues. For example, with the CLAT invested with municipal bonds, you have little trust growth but you also have no ongoing yearly income tax liability. With the CLAT invested in a balanced portfolio, you have substantial trust growth potential but you also have an ongoing yearly income tax liability. Finally, with the no CLAT plan, you have good asset growth potential and you have only a minor yearly income tax liability (some dividend and interest income may spin off from the balanced portfolio). With respect to the latter two plans, there will be a significant capital gains tax upon disposition of the appreciated property. However, Lynn has a great deal of control over that capital gains tax liability. For instance, she can continue to hold the appreciated property, she can sell the appreciated property piecemeal over time, or she can transfer the appreciated property into a CRUT. In the end, all three plans can accomplish Lynn's objectives. Therefore, the best fit for Lynn (and your clients) will depend on a clear understanding of Lynn's tolerance of investment risk, tax situation and charitable giving goals.
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