In recent years, the discussion continues surrounding the topic of inheritance and how much is too much to leave one’s heirs. This issue has taken on renewed significance in light of the much publicized concentration of wealth in recent decades.
On one hand, some holders of significant wealth wish to preserve their holdings and pass them on, largely intact, to their heirs. Another group has gone so far as to pledge to leave the bulk of their wealth to charity after equipping their progeny with the education and other resources to give them a start in life.1 Even those who would like their children and other loved ones to inherit wealth free of tax are often concerned that the timing of the receipt of those assets be appropriate. With a federal estate tax threshold exceeding $10 million for a married couple, few would want an 18-year-old to have unfettered access to this level of wealth.
Others would prefer that their heirs enjoy some income but never have total access to principal. The greater prevalence of blended families in recent years adds additional complexity to the challenge of transferring wealth in a responsible manner.
The desire to control the amount and timing of inheritances combined with philanthropic goals may offer opportunities and solutions that aren’t readily apparent to many wealthy individuals. For example, a number of traditional charitable gift planning tools may be used in non-traditional ways that can result in significant gifts, while effectively addressing wealth transfer issues in a tax-efficient manner.
Giving Heirs a Start
Take the case of Henry and Ellen, both age 65. They have a combined wealth of $25 million. A significant portion of their portfolio is invested in highly appreciated securities that yield relatively little income. They’re in the highest income tax bracket and are interested in ways to reduce their current tax burden. Their three children are in college and graduate school and will soon be embarking on their careers.
Henry and Ellen started with very little and built their wealth over decades and would like for their children to do the same. They would, however, like to give them a limited amount of seed money to help them get started in life and not have to wait until Henry and Ellen pass away to receive an inheritance.
They’ve been asked to make a multi-million dollar commitment to a campaign now underway for one of their charitable interests and are seriously considering it. How can they combine their charitable goals with their desire to assist their children?
Suppose they fund a $5 million charitable remainder annuity trust that will make payments of 6 percent, or $300,000, per year to their children for 10 years. The children would each receive $100,000 per year over the term of the trust. If the trust is funded with securities with a basis of $2 million, Henry and Ellen would bypass capital gains tax on $3 million ($600,000 or more) when the assets were sold and diversified by the trustee at the time of the gift, and the children would receive much of the income at capital gains tax rates under their tier structure of income reporting.
Henry and Ellen would be entitled to an immediate income tax deduction of $2.3 million. This deduction could serve to reduce their income tax by a total of $800,000 or more. If adjusted gross income limits cap the amount they could use in the year of the gift, they would have as many as five additional years to use the deduction, given current carry forward rules.
Their children would each receive $1 million in pre-tax income over a 10-year period. They should net 75 percent or more of that amount after tax. These funds could be used to help start a business, purchase a home or fund their children’s education. Because this gift has been made to the children, Henry and Ellen would report a taxable gift of $2.7 million (the amount of the gift less the charitable deduction) in the year the trust is funded, a practical potential use of part of their unified credit of over $10 million.
Under this plan, they’re providing $3 million in gifts to their children, a gift in the range of $5 million to charity in 10 years and enjoying combined income and capital gains tax savings of nearly $1.5 million.
From the charitable recipient’s standpoint, they’re locking in the receipt of the trust assets in 10 years, instead of receiving a smaller pledge over a shorter time period or being named for a gift in the estate of a couple with a combined life expectancy of some 25 years. If desired, Henry and Ellen could agree to make up any amounts less than $5 million received at the termination of the trust, should the corpus be invaded over time to make the payments to children.
Giving Heirs a Finish
In other cases, wealthy individuals may wish to temporarily disinherit their heirs, preferring for them to make it on their own for the majority of their adult life.
One way to accomplish this goal is through the use of a charitable lead trust. In this case, heirs receive nothing in the near term but receive a lump sum inheritance at the end of a predetermined period of time.
Consider David and Margaret, both of whom are in their early 80s. They have a net worth of $15 million. They have two children in their mid-50s and four grandchildren who are in their 30s. Their children are responsible and have done well financially, and David and Margaret plan to leave the bulk of their assets to them. They’re aware that their total wealth now exceeds their estate tax exemption threshold and would prefer not to pay tax of 40 percent or more on excess amounts.
They would like to leave something to their grandchildren, but they would like their grandchildren to receive their inheritance when they’re at least in their 50s and approaching retirement age.
A charitable lead annuity trust (CLAT) may be the answer. Suppose they funded a CLAT with $5 million and specified a 6.5 percent payout rate that would last for a period of 20 years. Over that time, a total of $6.5 million, $325,000 per year, would be distributed to charities of their choice. They might also provide that a portion of the annual payment be distributed to a donor advised fund that named them, their children and/or grandchildren as advisors.
They’ll report a $5 million gift to their grandchildren, but it will be completely offset by a gift tax charitable deduction of equal amount at the time of the gift. In any event, they’ve retained nearly all of their estate and gift tax exemption amount to shield the bulk of the remainder of the estate they plan to leave to their children from federal estate tax.
If they wish, David and Margaret can tell their grandchildren to expect to receive the remainder of the lead trust in their 50s—or it can come as a welcome surprise. In the meantime, their advisors will continue to invest the funds. The grandchildren’s exact inheritances will depend on the performance of the investments.
These are just two illustrations of many ways thoughtful individual and their advisors can provide for inheritances in the amount and at the time they wish heirs to receive them, while simultaneously making what may be their charitable gift of a lifetime.