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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 5 - In Search of ISOs
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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 federal and state taxes. 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.
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.
Contrary to Lynn, Jeff Burrows (Lynn's husband) has had success in the stock market. During the mid-1990s, Jeff exercised a block of incentive stock options (ISOs) provided by his company to top level executives. Despite the ups and downs of the market during the past decade, Jeff held onto the stock because he believed strongly in the financial future of his company. Confirming his belief, Jeff's company stock rose significantly during that time. For example, he exercised the options for $150,000, yet the current market value for his stock is $500,000.
Believing the stock will start to level off, Jeff wants to begin locking in his gains over the next several years. However, he does not like the idea of realizing $350,000 of capital gain income during that time. He also does not like the idea of paying a lot of income tax on Lynn's earnings this year (Lynn and Jeff file joint income tax returns).
Question:
What plan can Lynn and Jeff implement to significantly minimize the tax liability on the $1 million bonus and the sale of Jeff's ISOs? How would it work?
Solution:
Frank Thomas, Lynn and Jeff's tax advisor, suggested that they fund a Grantor Charitable Lead Annuity Trust (CLAT) for a period of 10 years with the $1 million of fallen stocks. The payout rate on the trust would be 5% or $50,000 per year which would be payable to their favorite charities. The creation of such a trust would produce a charitable income tax deduction of approximately $400,000. This tax deduction could be used to directly offset a portion of the $1 million bonus. Therefore, assuming a combined tax rate of 40%, the $400,000 charitable income tax deduction could save Lynn and Jeff $160,000 in taxes this year!
Next, the CLAT could generate capital losses each year to offset the capital gains produced from Jeff's yearly sale of his appreciated stocks. For instance, the trust each year makes a $50,000 payment to charity. In order to generate the $50,000, the trust will need to produce trust income and sell trust assets. Since Lynn's entire portfolio at inception possesses significant declines (i.e., $500,000), each time the trust sells stocks it will realize capital losses. These losses can be used to offset Jeff's capital gains and up to $3,000 of ordinary income. Therefore, this realization of capital losses each year by the CLAT can work in conjunction with the systematic sale of Jeff's appreciated stocks. The ideal strategy would result in no capital gains tax paid on Jeff's sale of appreciated stocks.
In conclusion, Lynn's CLAT would produce a $400,000 income tax deduction which would substantially reduce her income tax liability on the $1 million bonus. Also, Lynn's depreciated stock portfolio may reduce or even eliminate all capital gain income resulting from the sale of Jeff's appreciated stocks. Finally, $500,000 would be distributed to Lynn and Jeff's favorite charities over the ten-year term. Afterwards, the trust principal would revert back to Lynn and Jeff.
Lynn and Jeff are completely happy with Frank's plan. They would cut their current year's tax liability significantly, diversify their investments, lock-in significant gains, and contribute a generous gift to their favorite charities. While always philanthropic, Lynn and Jeff's CLAT would make the Burrows major donors overnight, a title that brings a very warm smile to their faces.
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