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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 4 - Stock Losses Vaporize Phantom Income
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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.
Despite her good litigation skills, Lynn is not so fortunate with her stock investments. Specifically, she invested $1.5 million in many technology stocks several years ago. However, when the stock market bubble burst, her $1.5 million portfolio sank to $1 million within one year. Dreading the thought of realizing $500,000 in losses, Lynn continues to hold the stocks.
Now, several years later, Lynn is coming to terms with the fact that her stock portfolio will not leap back to $1.5 million anytime soon. Therefore, it makes sense for her to reevaluate her stock holdings and reposition some of her investments. Lynn's primary goals are tax reduction, investment planning and some basic retirement planning. Lynn is also open to charitable giving if it can help her accomplish her primary goals.
Question:
What plan may accomplish Lynn's goals? How can Lynn take advantage of her stock losses to accomplish her goals in the most tax-favored manner?
Solution:
Frank, her tax advisor, suggested that Lynn fund a Grantor Charitable Lead Annuity Trust (CLAT) for a period of 10 years with the $1 million of stocks. 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 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!
Since this is a grantor trust for income tax purposes (i.e., not tax-exempt), Lynn would be taxed on all the trust income. For instance, any capital gain income and ordinary income to the trust flows through to Lynn's Form 1040. More importantly, any capital losses also flow through to Lynn's 1040. (The carryover basis rules apply, so the trust takes Lynn's basis in the stocks.) Thus, through proper trust management Lynn may utilize her stock losses to offset part of the trust capital gains and income.
In particular, the trust makes a $50,000 payment to charity each year. In order to generate the $50,000, the trust will need to produce trust income and sell trust assets. Since the entire portfolio at inception possesses significant declines, each time the trust sells stocks it will realize capital losses. These losses can be used to offset capital gains and up to $3,000 of ordinary income. This realization of capital losses can easily remove any negative income tax problems normally associated with grantor CLATs (i.e., phantom income).
In addition, the trustee may sell and reinvest trust assets at anytime during the 10-year term. This allows the trust to diversify some of its holdings out of technology. Moreover, the realization of capital losses may be carried forward to offset against future capital gains. Therefore, it would be likely that the trust will diversify and grow without any phantom income tax problems.
In conclusion, Lynn's CLAT would produce a $400,000 deduction and potentially return $1,000,000+ at the end of the 10 years. The money could be invested for future use or accessed immediately if Lynn so desired. Also, the trust would diversify and grow with little to no income tax liability. Finally, $500,000 would be distributed to Lynn's favorite charities. She was amazed at this enormous additional benefit.
Lynn is completely happy with Frank's plan. She would cut her current year's tax liability significantly, retain flexibility, diversify her investments 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 Sec. 7520. With CLATs, the lowest AFR produces the largest charitable income tax deduction. During the past two years, the AFR rates have remained mostly in the 5% and 6% range. Therefore, it is an excellent time to discuss CLATs with clients.
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