Many owners of family businesses approach retirement with conflicting priorities on thedisposition of their assets. They want to donate as much as possible to charity but worry thatcharitable giving will undercut another vital objective—leaving a comfortable inheritance for theirchildren.
No longer, however, do they have to choose between these two objectives. By setting up two trusts—acharitable remainder trust and a wealth replacement trust—business owners can donate a large amount tocharity while still protecting their family’s inheritance. And there are other benefits: thecharitable remainder trust provides a big tax deduction and is likely to increase retirementincome.
By the time they start thinking about retirement, most business owners hold assets that haveappreciated over the years. They may want to sell these assets and reinvest the proceeds in securitiesthat will provide greater income for their retirement. But selling would trigger a large capital gainstax.
Donating these assets to charity through a charitable remainder trust enables all the money to go towork producing income. When assets are transferred to the trust and then sold, there is no capitalgains tax. The trust reinvests the cash and pays out income for the lifetime of the donor. Only afterthe donor’s death do the assets go to the designated charity.
Meanwhile, the donor receives a charitable deduction equal to the present value of the trust assetsthat will go to charity upon the donor’s death. For example, a $1 million donation to a charitableremainder trust by a 55-year-old business owner would produce a current deduction of just over$349,000. In addition, the trust produces estate tax savings: the assets transferred to the charity atdeath are not included in the donor’s taxable estate for transfer tax purposes.
While a charitable remainder trust looks good for the donor, it leaves potential heirs with amuch-diminished inheritance. That’s why many business owners couple their charitable trust with awealth replacement trust. The name aptly describes what this trust accomplishes—it replaces dollar fordollar the assets donated to charity. It is funded with life insurance that pays its proceeds to theheirs upon the death of the charitable donor.
While any whole life policy could be used, married couples do best with survivorship life, sometimescalled a second-to-die policy. The premiums are relatively low because both lives are insured; thepolicy, which would be owned by the trust, is based on the probability of two people dying and paymentof only one death benefit.
The cost of replacing the value of the assets left to charity is quite favorable in light of the taxsavings realized through the trust. Furthermore, the money received by the beneficiaries will be freefrom federal estate taxes if the life insurance policy initially is purchased by the wealthreplacement trust. In the case of existing insurance policies, they must be held by the trust forthree years prior to death in order for the death benefit to escape taxation.
For example, consider the potential benefits realized from the two trusts for a fictional couple whoare 55 years old and have a $1 million stock portfolio that was purchased for $300,000. Without thetrusts, a sale of the portfolio would bring a capital gains liability of $196,000. The aftertaxproceeds of $804,000 would generate $44,380 of after-tax retirement income per year, assuming an8-percent return and a 31-percent tax rate.
By using the two trusts instead, sale of the portfolio would bring no capital gains liability andwould, in fact, generate a $108,292 benefit for the charitable donation. That would leave the couplewith more than $1.1 million to invest, which would produce an annual aftertax yield of $61,178. Evenafter paying the $14,600 premium to fund the wealth replacement trust, the couple would still enjoy$2,198 more in annual retirement income than they would without the trusts.
For the heirs, the difference is dramatic. Without the trusts, they would be left with $402,000 afterpaying estate taxes; with the trusts, $1,054,146.
The two trusts provide estate tax savings only if they are used to shelter assets above the $1.2million that the federal government allows each married couple to pass on free of estate taxes. Anyassets placed in a charitable remainder trust are forever beyond the donor’s reach, so he or sheshould have enough assets outside the trust to satisfy any future bills.
Reaching your financial goals
Combining a charitable remainder trust with a wealth replacement trust can help family businessowners accomplish a number of financial goals:
- Donate money to charity without hurting heirs.
- Generate tax savings through a charitable contribution.
- Avoid capital gains tax on sale of appreciated assets.
- Generate additional retirement income.
- Use charitable deduction to offset the tax bill on a lump-sum pension plandistribution.
William J. Goldberg is national director of personal financial planning services for KPMGPeat Marwick, in Houston, TX.