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Sunday, May 5, 2024
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Case Studies |
A FLIP for the Spouse
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Case:
Michael Williams just turned 72 and has begun the mandatory withdrawals from his individual retirement account. The assets of the IRA have been invested primarily in equities over the past ten years and Michael has been astounded by the growth of the account over that period. What was once a very moderate account has grown to over $3 million in value and, therefore, he will be required to withdraw over $100,000 per year based on his life expectancy. Michael has planned to leave the balance of the account to charity upon his death, but he has become concerned about providing for Michelle. They do have $3 million in other assets, but the majority of the $3 million is in income-producing real estate which he manages. The real estate throws off a very nice income stream (over $200,000 net per year), but this is primarily because of Michael's management expertise. Michael is very concerned that should he predecease his spouse, the real estate will not produce near this kind of income because he will not be available to provide the savvy management skills.
Michael and Michelle have been married for only three years. They both lost their spouses to cancer and were fortunate to meet at a fund-raising dinner sponsored by a charity where they both volunteer. Michael is a retired vice president of a small manufacturing company and Michelle, now age 60, is a retired engineer. Michael's estate consists primarily of the real estate holdings and the IRA account. Michelle's estate is valued at about $150,000.
Michael and Michelle, feel they do not need the income from the IRA due to the $200,000 per year produced by the real estate holdings. They have more than enough for their basic living expenses and actually only spend approximately $75,000 of that amount per year. The balance of the funds (less taxes, of course) are primarily being reinvested in long-term bonds or are being used to keep the properties owned and managed by Michael in excellent condition.
Michael and Michelle are philanthropic and have supported a number of charities over the years. Because they are now receiving the additional $100,000 in income annually from the IRA, they have made the decision to give at least $50,000 of this amount to their favorite charities. Also, since they have no children, their desire is to see their entire estate eventually pass to charity. Should Michael predecease Michelle, the estate plan is structured so that all of the real estate holdings will pass to a QTIP trust for the benefit of Michelle. Then, upon Michelle's death, the assets of the QTIP will pass on to charity.
Question:
In a recent meeting with the Major Gifts Officer of one of the charities they support, Stephen Atkins, Michael voiced his concern regarding his provision for Michelle. He explained the current structure of the estate plan and concerns regarding the real estate holdings and the charitable distribution of the IRA. Michael's desire is to make a substantial gift to charity when he is gone utilizing the IRA. Michael also wants to make sure that Michelle has ample income especially if the real estate holdings should suffer a market decline or mismanagement. Is there a way for Michael to provide financial security for Michelle which addresses the concerns of the real estate holdings and make a substantial bequest to charity?
Solution:
After reviewing Michael's objectives, Stephen came up with a very creative idea using a FLIP unitrust. Since Michael and Michelle do not need the $100,000 in income from the IRA and they are giving $50,000 to charity each year, Stephen suggested that Michael create a two-life charitable remainder trust (CRT). The CRT would be funded each year with the other $50,000 not required for their current financial needs. The trust would be drafted with the FLIP provisions which would mean that the trust would be a net income with makeup trust until a 'triggering event' occurs in the future. At that point in time, the trust would convert to a standard pay unitrust. The 'triggering event' in this case would be Michael's death.
To explain further, Michael would be the primary beneficiary of the trust and distributions would be made to him under the net income provisions. However, since additional income is not needed from the trust, the trustee would invest the $50,000 contributions each year in growth types of investments. Therefore, since the trust provisions dictate that the income distributions would be the lesser of net income or the trust percentage, little or no income would be distributed to Michael during his lifetime. Meanwhile, the annual $50,000 contributions would compound and continue to grow. Assuming that Michael lived another fifteen years, the total contributions of $750,000 would result in trust principal of approximate $1.4 million assuming an 8% total trust return during those years.
Now, regarding the IRA, Stephen suggests designating the beneficiary on the IRA account as a 50/50 split, with 50% to the charitable remainder trust and 50% to charity. The result when Michael passes away, approximately $1.5 million would be added to the principal of the unitrust and $1.5 million would be distributed directly to charity thus fulfilling Michael's bequest objective. Therefore, the principal of the unitrust would be approximately $2.9 million (using the mortality and investment assumptions outlined above). If the unitrust percentage payout is 5%, Michelle could expect to receive distributions beginning at $145,000 per year from the now converted standard pay trust.
In summary, Michelle's financial security is now protected from any mismanagement or market downturns in the real estate market because of the lifetime income from the unitrust.
Michael is very pleased with Stephen's creativity and was impressed with his knowledge of the current tax laws regarding the FLIP unitrust. It is an excellent vehicle to use in Michael's situation, especially with the ability to trigger the standard pay trust payout at his death. Finally, Stephen pointed out one additional side benefit of the trust. Because Michael was contributing $50,000 to the trust each year, a charitable income tax deduction would be available with each contribution, thus offsetting a portion of the reportable income from the IRA.
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