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Wednesday, May 1, 2024
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Case Studies |
Extreme Makeovers for the Grantor Charitable Lead Trust, Part 6 - Bear Market Exercises
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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 current year's tax liability.
A similar financial success follows Jeff Burrows (Lynn's husband). A top-level business executive, Jeff owns a large number of nonqualified stock options (NSOs) which he receives as part of his executive compensation package. In addition to his NSOs, Jeff's yearly salary is $100,000. Despite the bear market of the past several years, Jeff's company stock continues to grow steadily. For example, Jeff may exercise his options this year for $150,000; however, the current market value for his stock is $650,000.
Believing the stock is going to skyrocket in the near future, Jeff wants to minimize his tax liability prior to such a jolt in the stock's value. However, Jeff does not like the idea of realizing $500,000 of ordinary income at the time he exercises the options. Jeff also does not like the idea of paying a lot of income tax on Lynn's bonus 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 exercise of Jeff's nonqualified stock options? 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 13 years with Lynn's $1 million bonus. 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 $500,000. This tax deduction could be used to directly offset a portion of the $1 million bonus and $500,000 of ordinary income from the NSOs.
Therefore, assuming a combined tax rate of 40%, the $500,000 charitable income tax deduction could save Lynn and Jeff $200,000 in taxes this year! It is important to remember that the $500,000 tax deduction will be subject to the 30% AGI limitation (even though cash is used). However, the Burrows' AGI is approximately $2.1 million this year ($1 million bonus + $500,000 NSOs + $500,000 salary +$100,000 salary). Thus, the 30% AGI limitation on $2.1 million is $630,000. Fortunately, the Burrows can fully deduct the $500,000 tax deduction this year, since it falls well below the $630,000 limitation.
In conclusion, the Burrows CLAT would produce a $500,000 income tax deduction which would substantially reduce their income tax liability. Also, $650,000 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. Since Lynn and Jeff do not currently need the $1 million bonus, the option of "stashing it away" temporarily in a CLAT has great appeal to them.
Lynn and Jeff are completely happy with Frank's plan. They could cut their current year's tax liability significantly, exercise options at the right time 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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