Giving to charity has always been a prudent way to reduce income taxes. But suddenly the value of charitable giving has increased dramatically, especially for people in higher tax brackets who own their own businesses.
Thanks to the Omnibus Budget Reconciliation Act of 1993, the maximum marginal income tax rate has increased from 31 percent to 40 percent. If you are in the top bracketÑif your annual taxable income exceeds $250,000Ñthis means that the value of charitable deductions has increased by almost 30 percent. Even if your rate has increased from 31 percent to 36 percent, you will realize a significant 16 percent increase in the value of income tax savings resulting from charitable gifts. Furthermore, the Act did away with the alternative minimum tax, which added extra burdens on wealthy individuals who gave appreciated property to charity.
These changes are important for family business owners who plan to give a portion of their company stock to a charity, whether the gift be outright or in exchange for an annuity.
Under the new laws, however, family business owners can maximize the tax benefits of charitable gifts by using a charitable remainder trust. This is a legal document by which owners transfer property to a named trustee. The owner retains a lifetime interest in the property, and the balance is distributed to the charity at a designated time. During the interim, the trust pays the the owner an annuity.
The net effect is that an owner can transfer otherwise nonliquid assets such as stock to a charitable remainder trust on an income-tax-free basis, and receive annuity payments in return. And if the trust is set up properly in conjunction with an estate plan, ownership of the business can be passed on to heirs in the process.
Apart from diversifying the ownerÕs investment portfolio, and eliminating income taxes associated with the capital gains realized on the sale of property, the trust can provide the owner with an annuity that is greater than the underlying earnings of the trust. Although the trust investments may only yield, say, 5 percent, the trust can be required to pay an annuity of, say, 8 percent, for the lifetime of the owner. Though this dilutes the principle of the assets that remain in trust, the charity will still receive a substantial sum.
The benefits of a charitable remainder trust, and the way it works, are easier to understand by considering an example.
John is 65 and is subject to the maximum income and estate tax rates. He and his son each own 50 percent of XYZ Co., which has a fair market value of $2 million. John gives all his stock to a charitable remainder trust. He names State Bank trustee. The bank receives the stock, sells it back to the company, and invests the cash. The bank will pay John an $80,000 annual annuity for life. When John dies the remaining trust assets will be given to a charity.
As a result of the stock buyback, JohnÕs son now owns 100 percent of the company. For this to work, however, XYZ Co. must have $1 million in cash, or be willing to borrow it, to buy back the stock. Second, the annuity can be adjusted to any level; $80,000 represents an 8 percent return on the $1 million the bank will invest. Third, the charity can be named, or can remain nameless until later.
Before considering a charitable remainder trust, John had planned to sell his stock to the company and supplement his retirement income with earnings from investments he would have made using the sale proceeds. John would have paid approximately $300,000 in combined federal and state income taxes, leaving him with $700,000 to invest. At 5 percent, a typical rate these days, his investment would have yielded $35,000 a year. When John died, his son would have inherited $315,000 after paying estate taxes (at a 55 percent rate on the $700,000).
Under the new plan, JohnÕs trust will contain $1 million, because no income taxes are paid with respect to the redemption of stock owned by the trust. At the same 5 percent investment payoff, John will receive $50,000 a year on the $1 million. However, he chose to set the rate higher, giving him $80,000 a year. In addition, John will realize a deduction of approximately $240,000 from the actuarial value of the charitable gift that will be made from the trust at his death. This will result in a $90,000 income tax savings. John plans to give a portion of that money, or small annual gifts from the extra annuity income, to his son so he can purchase a life insurance policy on John in the amount of $315,000, which will replace the lost inheritance.
By structuring his charitable giving using a remainder trust, John ends up with much more income during his retirement years. JohnÕs son will receive the same net inheritance. And one or more charities will receive a substantial giftÑwell into the six figuresÑfollowing JohnÕs death.
Clearly, charitable remainder trusts make sense only for owners who want to give to charity. But the net cost of making gifts is small, and the net benefits to owners is large.
Joe M. Goodman is a partner in the law firm Boult, Cummings, Conners & Berry in Nashville, TN, and leads the firmÕs estate planning and family business workgroups.