Two Trusts That Can Help
By: Wasserman, Phillip Sarasota, FL
How would you like to lower your capital gains and estate taxes at the same time? Yes, it can be done through a charitable remainder trust (CRT) or a private annuity trust (PAT). Setting up either of these trusts will allow you to reduce your estate taxes. But hardly anyone knows that depending upon which you choose, you will also be able to defer paying capital gains taxes on highly appreciated assets — such as real estate and stocks — or avoid paying them altogether. With the CRT, you make an irrevocable gift of assets (such as appreciated securities, real estate, or cash) to a trust. For the remainder of your life, you (or a party you designate) receive the investment income from the assets held within the trust. Upon your death, the principal value of the assets is transferred to your designated beneficiary, which must be a recognized non-profit organization.
People typically shy away from the CRT because while the donors receive income for life, the “donated” asset gets left behind to charity, which disinherits heirs. To solve this problem, many people who do set up a CRT “sweep” some of the income off the income stream and use it to pay for a life insurance policy that replaces the amount of the donated asset tax-free upon their death. There are a number of benefits to setting up a CRT, but the three major reasons pertain to reduced taxation. First, you won’t pay any capital gains tax on the appreciated assets in the trust, making CRTs ideal for assets with a low cost basis but high appreciated value, such as real estate. Second of all, contributions to a CRT are considered charitable contributions, so they qualify for an income tax deduction (and any deduction not taken in the year of contribution can be carried forward for the next five years). And third, the value of the assets held in a CRT trust is considered “outside of your estate” by the Internal Revenue Service (IRS), meaning it’s excluded from the calculation of your estate taxes. This could reduce your estate tax rate by as much as 46 cents of every dollar, given current estate tax rates.
To summarize the workings of a CRT, when including life insurance as part of the plan, the donor: 1.) avoids capital gains tax when donating the asset and selling it; 2.) gets income for life from the CRT, which has its own tax breaks given the donation of the asset itself; 3.) removes the asset from the estate, which would lower the estate tax, if there is any; and lastly, 4.) replaces the donated asset tax-free to heirs through the life insurance policy.
It’s really not a bad deal, and it is something that certainly should at least be considered by those who are planning to sell highly appreciated assets and have lots of taxes awaiting them.A PAT is another type of trust that’s similar to a CRT. With a PAT, you transfer the desired assets into the trust, the assets are then sold, and the proceeds are used to purchase an annuity. As with a CRT, the assets held in a PAT are excluded when calculating your estate taxes. But part of each payment you receive from the PAT will contain a portion of the capital gains which were due on sale. So while a CRT eliminates the capital gains tax, the PAT spreads them out over the rest of your life.
This latter point may make the PAT less desirable than the CRT. Yet some people consider the PAT a better option because over time, the investor and the investor’s family receive all proceeds from the sale of the asset. Thus, if you create a PAT, upon your death the asset will be removed from your estate and your heirs will receive whatever portion of the asset remains, free of estate taxes, gift taxes, generation-skipping taxes, and transfer taxes. However, your heirs will have to pay any remaining capital gains tax due.
How much income can you receive from a CRT or PAT? That depends. With a CRT, for example, your income will be based on the amount of income your assets generate while inside the CRT, as well as the “payout percentage,” or the size of the payments you choose to receive. The IRS requires CRTs to distribute a minimum of 5 % of the net fair market value of its assets annually. If you don’t need income from the CRT in one year, you can defer it through a “makeup provision,” but the CRT’s net distributions must eventually equal 5%. This means that you don’t have to start taking income right away. In some cases, if you defer taking the income, you can potentially take more income out later than if you would have taken the distributions in the first place. One caveat here: The higher the payout percentage, the lower your charitable income tax deduction will be, so you’ll want to talk to an advisor about striking the right balance
between the two.
I would strongly urge anyone considering a CRT or PAT to speak with a qualified estate planning attorney. Although the concepts as presented here are somewhat simple, the complexity of the taxation, along with one’s estate and income requirements, all need to be well factored into the decision making process. This is not run of the mill type planning, and it definitely takes an experienced individual to assist you.
That said, don’t be shy. A CRT or a PAT can be an excellent choice in helping you reduce taxes, create lifetime income and of most importance to some — leaving a legacy behind.