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Wednesday, May 8, 2024
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Case Studies |
The Charitable Financing Plan
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Case:
Louise Collins, age 50, has been Vice President of Finance for a major Internet provider for the past five years. As part of her compensation, she has been granted nonqualified stock options over that period that are now worth over $1,000,000. This year, due to the escalating value of the stock price, she chose to exercise $500,000 worth of these options, purchasing 5,000 shares of stock. The stock was trading at $100 per share at the time of exercise and her option price was $20 per share. Therefore, as a result of exercising these options, she is required to report $400,000 in ordinary income on her income tax return. She immediately sold the stock and now has $500,000 invested in a money market fund.
Over 10 years ago Louise purchased a 20-acre parcel of property on the outskirts of town for $50,000. A number of housing developments have since been built around this parcel and now the property is valued at $500,000. An interesting twist to the history of this property is that her church acquired a seven-acre parcel of property next to hers about five years ago. Since then the church has relocated and built a new sanctuary on the property. Over the past two years, the church has grown rapidly in number and is looking to purchase additional property to accommodate the growth. Louise, who now serves on the church board, has been approached regarding the sale of her property to the church. However, at this time, it would be difficult financially for the church to afford the purchase price of $500,000.
Question:
Louise would like to consider making some type of gift to her church in regard to her property. She feels that she cannot 'afford' to give the entire parcel to the church and ideally would like to receive at least 50% of the value from the property. In other words, if she could receive $250,000, she would be satisfied. However, the church would still be hard pressed to come up with this amount up front or over time due to budgetary constraints. Louise posed this scenario to her attorney, Blake Collins, and asked if he had any solutions to these challenges.
Solution:
As Louise's financial advisor, Blake was well acquainted with the fact that she had exercised the options this year and would need tax deductions to help offset her income. Being an expert in charitable planning, Blake suggested a very creative solution that would require the following three steps:
1) Louise would transfer her 20-acre parcel to a charitable remainder annuity trust that would last for a term of 10 years. The trust would pay to Louise, during that 10-year period, 5% of the value of the property, or $25,000 per year. Therefore, she would receive $250,000 in total income from the trust over the term. At the end of the term, the trust assets would be distributed to the church. As a result of creating the charitable trust, she would receive a charitable income tax deduction of $308,559 (based on an Applicable Federal Rate of 5.6%).
2) The property would then be sold to the church from the charitable trust on a 5% interest-only note. As with the term of the trust, the note would last for a period of 10 years. Since the church is the remainderman of the charitable trust, the note would be 'self-forgiving' at the end of the 10-year period.
3) Louise would then use the cash received from the sale of the stock to create a grantor charitable lead annuity trust for a term of 10 years. The payout rate on the trust would be 5% and therefore, $25,000 would be paid annually to charity, which in this case, is the church. Since this would be a grantor lead trust, Louise would be taxed on the income of the trust. Therefore, the trustee would invest the cash in tax-exempt or municipal bonds. At the end of the 10-year term (projected to be Louise's retirement date), she would receive the assets of the trust, i.e., the bonds. Since this would be a grantor lead trust, a charitable income tax deduction of $191,441 would be available to Louise.
As Blake explained, this plan has a number of favorable results. First, Louise would receive two charitable income tax deductions - one for the charitable remainder trust and one for the lead trust. The deductions would total $500,000, equaling an outright gift of the original value of the property. Secondly, Louise would bypass the capital gains taxes that she would owe if she sold the property. Third, the church would receive $25,000 per year for 10 years from the lead trust, which it then would use to purchase the property from the charitable remainder trust. Therefore, the church could purchase the property with no net cash outlay and would not need to utilize budget moneys to make the purchase. Lastly, Louise would receive $25,000 per year for the same 10-year period from the remainder trust. At the end of the 10 years, the bonds in the lead trust would be transferred back to Louise and would then be available for her retirement.
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