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Thursday, May 2, 2024
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Case Studies |
CRAT vs. CGA – Which is the Better Choice?
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Case:
Frederick Fischer, a widower, purchased 1,000 shares of stock in a new pharmaceutical company in 1990 through an Initial Public Offering (IPO) for $100,000. The company has been very successful, having introduced a number of new drugs that have taken the market place "by storm." The stock in the company has skyrocketed and is now worth over $1,000,000, yet pays very low dividends, currently less than 1%. Mr. Fischer is very concerned that the market is due for a substantial correction and would like to sell the stock and reinvest in a more balanced portfolio. He would like more income as he anticipates cash needs for health care as he grows older. Applying a federal and state capital gains tax rate, he would owe about $180,000 in capital gains taxes on the sale of the stock. This leaves him $820,000 to reinvest for income in the range of 6%, or $49,200 per year.
Mr. Fischer is very philanthropic and would consider using the stock to fund a charitable vehicle that would pay income for the rest of his life. He recently attended a financial seminar in that the speaker discussed using highly appreciated stock to fund a charitable remainder annuity trust (CRAT). The speaker also touched briefly on using such an asset to fund a charitable gift annuity (CGA).
Question:
Mr. Fischer was a bit confused when he left the seminar and had many questions on the differences between the two types of vehicles. He decided to go to the Director of Major Gifts at the local cancer center to assist him in understanding the differences. By understanding these differences, he would be able to make an intelligent decision about which of the two charitable vehicles would be best for him and his situation.
Solution:
The Director stated that the differences between the CRAT and CGA could be classified into four categories: 1) Payor; (2) Security; (3) Type of instrument; and (4) Characterization of income. In the case of a CRAT, the assets of the donor (in this case, stock) are transferred to a trustee who then is responsible for making payments to the beneficiary of the trust. The security for those payments is the assets/investments of the trust. Regarding the type of instrument or documentation, a CRAT requires a trust agreement drafted by an attorney. Finally, the income of a CRAT is classified for tax purposes in accordance with the "four-tier" system of distribution. The beneficiary of a CRAT is required to treat the distributions from the trust in accordance with the following four-tier order of distribution: First, as ordinary income; Second, as capital gain; Third, as other income (e.g., tax-exempt income); and Fourth, as a distribution of trust corpus, or principal. In other words, any ordinary income earned by the trust is distributed first, then capital gain, etc. It is the trustee's responsibility to determine the character of the income each year and send a year-end tax statement to the beneficiary stating how the income is to be reported for tax purposes. Since the investments of the trust change each year, so will the character of the income.
In the case of a CGA, Mr. Fischer would transfer his stock directly to the charity, which would be responsible for making payments to him for his lifetime. The payments are backed by the full faith and creditworthiness of the charitable organization. In regard to the type of instrument or documentation, a gift annuity agreement is a simple one- or two-page document that does not require the services of an attorney. When appreciated property is used to fund a gift annuity, the payments are taxed very favorably. A portion of each payment is taxed as ordinary income, a portion is taxed as capital gain and a portion is taxed as tax-free income throughout the donor's life expectancy. If the donor lives longer than the IRS's defined life expectancy, after that period, the entire payment is ordinary income.
Because of the simplicity of the CGA, Mr. Fischer, 84 years old, decides to fund a gift annuity with his stock. He transfers the stock to the cancer center, which in turn will pay him $76,000 for the rest of his life – a welcome change from the 1% dividend he is receiving currently. Of the $76,000, $13,528 will be taxed as ordinary income, $56,244 will be taxed at the favorable capital gains rate, and the remaining $6,228 will be tax free. He will also receive a nice charitable deduction of $543,802. In light of these benefits, Mr. Fischer is very pleased that the CGA will give him a measure of security for his current finances as well as his future health care needs.
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