Many owners of family businesses approach retirement with conflicting priorities on the disposition of their assets. They want to donate as much as possible to charity but worry that charitable giving will undercut another vital objective—leaving a comfortable inheritance for their children.
No longer, however, do they have to choose between these two objectives. By setting up two trusts—a charitable remainder trust and a wealth replacement trust—business owners can donate a large amount to charity while still protecting their family’s inheritance. And there are other benefits: the charitable remainder trust provides a big tax deduction and is likely to increase retirement income.
By the time they start thinking about retirement, most business owners hold assets that have appreciated over the years. They may want to sell these assets and reinvest the proceeds in securities that will provide greater income for their retirement. But selling would trigger a large capital gains tax.
Donating these assets to charity through a charitable remainder trust enables all the money to go to work producing income. When assets are transferred to the trust and then sold, there is no capital gains tax. The trust reinvests the cash and pays out income for the lifetime of the donor. Only after the 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 assets that will go to charity upon the donor’s death. For example, a $1 million donation to a charitable remainder 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 at death 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 a much-diminished inheritance. That’s why many business owners couple their charitable trust with a wealth replacement trust. The name aptly describes what this trust accomplishes—it replaces dollar for dollar the assets donated to charity. It is funded with life insurance that pays its proceeds to the heirs upon the death of the charitable donor.
While any whole life policy could be used, married couples do best with survivorship life, sometimes called a second-to-die policy. The premiums are relatively low because both lives are insured; the policy, which would be owned by the trust, is based on the probability of two people dying and payment of only one death benefit.
The cost of replacing the value of the assets left to charity is quite favorable in light of the tax savings realized through the trust. Furthermore, the money received by the beneficiaries will be free from federal estate taxes if the life insurance policy initially is purchased by the wealth replacement trust. In the case of existing insurance policies, they must be held by the trust for three 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 who are 55 years old and have a $1 million stock portfolio that was purchased for $300,000. Without the trusts, a sale of the portfolio would bring a capital gains liability of $196,000. The aftertax proceeds of $804,000 would generate $44,380 of after-tax retirement income per year, assuming an 8-percent return and a 31-percent tax rate.
By using the two trusts instead, sale of the portfolio would bring no capital gains liability and would, in fact, generate a $108,292 benefit for the charitable donation. That would leave the couple with more than $1.1 million to invest, which would produce an annual aftertax yield of $61,178. Even after 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 after paying 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 $1.2 million that the federal government allows each married couple to pass on free of estate taxes. Any assets placed in a charitable remainder trust are forever beyond the donor’s reach, so he or she should have enough assets outside the trust to satisfy any future bills.
Combining a charitable remainder trust with a wealth replacement trust can help family business owners accomplish a number of financial goals:
William J. Goldberg is national director of personal financial planning services for KPMG Peat Marwick, in Houston, TX.