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University of Massachusetts Amherst

Family Business Center

A Planning Tool For The 21st Century Economic Citizen

by Charles Epstein, CLU, ChFC, FBS (Family Business Specialist)

MassMutual Life Insurance Company, Epstein Financial Services

As our politicians wrestle over reducing our country's federal deficit, one conclusion becomes silently clear: responsibility for providing the funding for our nation's non-profitable charitable organizations which provide food for the homeless and funding for the arts will fall increasingly upon each of us as individuals and less upon the nation state. We can all take solace in the fact that last year's charitable donations jumped almost eleven% to $144 billion. This increased giving was perhaps fueled by the growth of assets tied to the stock market.

Charitable giving is not necessarily for just the extremely wealthy who establish personal family foundations. A tool available to any family business owner is the Charitable Remainder Trust (CRT). It is often characterized as one of the last great transfer tax planning tools. The CRT offers individuals the ability to enjoy a number of income, gift, and estate tax benefits--and at the same time--provide a benefit to charity.

Charitable Remainder Trust Defined

A CRT is a tax-exempt Irrevocable Trust established for the benefit of charity (public, private, or both). Because the CRT is a tax-exempt entity, it can liquidate highly appreciated assets without incurring capital gains tax. By transferring highly appreciated assets to a CRT, an individual receives the following benefits:

  1. The avoidance of huge capital gains on the sale of taxable assets
  2. An immediate income tax deduction
  3. An increase in the yield on sold assets thus generating higher income for retirement
  4. Reduction in one's taxable estate
  5. Creation of substantial benefit to charity
  6. A greater creation of a larger estate for one's heirs

Mechanics of the CRT

Consider the following example: A sixty-seven year old couple has $500,000 in a stock investment with a cost basis of $60,000 and a 2% return. If they were to sell the $500,000 asset, $440,000 is subject to capital gains tax. If they were in the 28% capital gains tax rate, $123,200 would go to the IRS.

If the couple were to invest the balance of $375,800 at 8%, five years later the $376,800 will have grown to $553,643. If both spouses passed away and because of other assets in their estate, they would be in the 50% federal estate tax bracket. Thus $276,821 will be lost to the IRS. Their heirs would receive $276,821; in total the IRS has received $400,021.

Consider the results the couple would have if they gifted their stock in a CRT with a 6% pay-out. Initially, the client would receive an income tax deduction for their gift of $165,000. They would also receive a first-year income of $30,000 (6% of the full $500,000 invested in the CRT). On the death of the income beneficiaries, the remaining Trust assets are distributed to named charities.

This procedure eliminates any capital gains tax if or when the CRT sells the stock. There will also be a much lower tax value included in the estate for estate purposes of this couple since the amount going to charity qualifies for the unlimited charitable deduction.

A major drawback is that the heirs are disinherited from receiving any of the gifted stock or Trust assets after the death of both parents.

The Solution: The Wealth Replacement Irrevocable Trust

To solve this problem, we establish a Wealth Replacement Trust (WRT). This is a Trust separate from the CRT and receives money for the primary purpose of buying life insurance on the couple's life. In this case, the Trust purchases a $500,000 Survivorship Life nsurance Policy on the lives of the couple with a premium of $18,197 payable for approximately twelve years.

The $500,000 death benefit is payable to the Trust income and free of estate tax. The couple has gifted $500,000 in assets to a charity. The $500,000 life insurance policy replaces the charitable gift back to their heirs. The good news--the money needed to pay the life insurance premium comes from the CRT's income tax deduction and/or the higher income earned on the assets contributed to the CRT. In effect, the IRS pays the premium.

The CRT and Closely Held Business Stock

There are very few simple ways to transfer a family business to children without incurring substantial transfer taxes. When a buy-sell approach is used, the estate of the deceased business owner will pay estate taxes on the date of death value of the stock. Where a lifetime sale to children is considered, the business owner usually faces a substantial capital gain and the children are faced with the problem of raising the money to purchase the stock.

If a long-term stock gifting program is contemplated, it takes a long time to transfer stock in a business using your $10,000 annual exclusion gifting. It may ultimately be necessary to use up your full $600,000 one-time gift or pay gift taxes to accelerate this process. Even where a family limited partnership is used to transfer the stock and substantial discounts are applied, it still may take a long time to gift away a family business. In the event a business owner dies during the time of the gifting, any stock he owns at the time of death will be included in the taxable estate.

How then can you, the owner of a family business, design a cost-effective exit strategy? Using the CRT to affect the transfer of your closely held company stock appears to enable you to transfer the business free from income, gift, and estate tax.

How can this be accomplished? In a typical scenario, the children must own some shares in the business before the transfer. The business owner then transfers his stock to a CRT. As in any CRT transfer, the business owner receives an immediate income tax deduction equal to the value of the remainder interest. You will also retain an income stream which can provide a valuable source for supplemental retirement income on your life.

All capital gains taxes are avoided, and the business owner's taxable estate is reduced by the value of the asset. Following the transfer of the stock to the CRT, the business can redeem the shares held by the CRT with cash, or in some states, with a note.

So What Has Been Accomplished?

Following the redemption, the children are now the sole shareholders of the family business--no one in the family has incurred any gift, income, or estate taxes. In fact, the transaction likely has placed the business owner in an overall better tax position. You have transferred the family business without using up your unified credit or exclusions. No sale was required; therefore, no capital gains tax was paid. Furthermore, you have reduced your taxable estate by the value of the business, generated a substantial income tax deduction, secured a stream of retirement income, and provided a substantial benefit to charity. The one downside to such an approach is that the children receive no step-up in basis to your stock. For this reason, the CRT/Redemption Technique may not be the best approach in future sales contemplated by the children. In conclusion, the CRT enables you to enjoy a number of substantial tax benefits and provides a substantial benefit to charity. By transferring closely held business stock to a CRT followed by a non-binding redemption, you--the business owner--may be able to avoid paying capital gains tax; secure a stream of supplemental income tax deduction; provide a substantial benefit to charity; and transfer the family business to your children's income, estate, and gift tax free.

For those wishing to explore the concept further, never implement a plan without the close supervision and approval of your legal and tax advisors. This article is only meant as an introduction to the CRT concept and legal advice is neither implied or given.

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