Complex Challenges Require Creative Solutions

Complex Challenges Require Creative Solutions

In my column in the March 2013 issue, I offered an overview of the anticipated impact of changes in federal tax law in the American Taxpayer Relief Act of 2012 on philanthropic planning.

I now turn my attention to other factors coming into play, which may have an even greater impact on the structure of charitable gifts.


Economic Influences

The U.S. economy is entering the sixth year of the economic malaise that began in the fall of 2007. While there’s been steady improvement in many economic indicators, and many investors and homeowners are beginning to see asset values approach pre-recession levels when adjusted for inflation, most Americans have yet to recover their full asset values.  

Historically low interest rates and promises of more of the same for years to come add another layer of challenge for those at or near retirement age. Airwaves and mailboxes are full of advertisements for fixed rate annuities, reverse mortgages and other investments that promise generous income one can never outlive during retirement.  



Against this economic background is the reality of the demographic “glacier” that’s been slowly and quietly shaping our social and economic reality for years.  

As baby boomers retire and reposition their portfolios in a low growth, low yield economy, the world of philanthropy may never be the same. The years between ages 55 and 65 have traditionally been the time in life when individuals make their largest gifts. In 2011, the first of some 80 million baby boomers turned 65, and the numbers of prime years donors has begun to wane.  

Turning to the smaller, heavily indebted Generation X to make up for this shortfall doesn’t appear to be a viable alternative. Few charities have ever found success in acquiring large numbers of donors under the age of 50, regardless of economic conditions, as heavy demands for retirement saving, educational expenses and other priorities dictate smaller regular gifts to a core group of charitable interests, at best.

In the midst of challenging times, educational institutions, health care charities, religion, the arts and social service agencies are all faced with greater demands than ever, while many of their traditional sources of funding are being squeezed by the economic and demographic realities described above. Add to that the continuing calls for federal and state governments to cope with their economic challenges in part by reducing or eliminating charitable tax incentives, and charities may be facing a “perfect storm” on the horizon.


Creative Planning

Fortunately, a number of gift planning tools have been developed over the years that can help those who would like to make meaningful philanthropic gifts, while also coping with fears that would otherwise appear to make those gifts impossible.

During the boom years prior to the recent downturn, billions of dollars were devoted to charitable uses through split-interest gifts that resulted in future gifts while reserving income for a donor or others for life. 

One of the most popular plans was the charitable remainder unitrust (CRUT). CRUTs typically paid an income of 5 percent to 7 percent of the assets as valued annually with total return assumptions in the 8 percent to 10 percent range.  

If all went according to plan in an era of both high interest rates and steady growth in equity values, donors could look forward to a steadily increasing flow of income for the remainder of their lifetimes. In addition, highly appreciated property could be transferred to such trusts without payment of capital gains taxes, which approached 30 percent in the late 1990s.   

For a number of years, charitable and financial communities heralded CRUTs as plans whose time had come. Economic conditions and tax policy in recent years have taken the wind out of the “sales” of this plan, as investment returns, ordinary tax rates, taxes on capital gains and gift and estate taxes all dropped simultaneously.

What then, is the future for split-interest charitable gifts? I believe the future is bright indeed. In fact, we may never see as many charitable remainder trusts (CRTs) created as in coming decades.

There are a number of reasons for this potential boom. For example, the experience of many who have managed the largest numbers of CRTs over decades indicates the average age of beneficiaries of CRTs at the time of creation is in their mid-60s and the most common age is closer to 70. Interestingly, the first baby boomers will reach age 68 next year. Other sources indicate the average age at death of income beneficiaries is early to mid 80s.  

This 15-to-20 year time span closely accords with Internal Revenue Service reports that the average time period from first tax return to last for CRTs is 12-to-15 years. So, it appears that demographic winds are now at the back of CRTs after a 20-year period of fewer individuals in the CRT age “sweet spot,” due to falling birth rates during the Great Depression and World War II. Variations on these trusts can also be the answer to many of the challenges facing wealthier baby boomers as they consider their philanthropic plans.


A Different Kind of CRT

For a number of reasons, I believe the renaissance in CRTs will feature two fundamental structural differences from the prior generation of CRTs created over the past 20 years.

In part, these differences will result from many charities with sophisticated fundraising efforts being increasingly wary of encouraging gifts that won’t result in spendable funds for 25 years or longer, as would be the case with a 60-year-old couple funding a CRUT for life.  

At the same time, those donors may not be interested in a 5 percent payout that could result in attrition of the trust corpus over their lifetime if the earnings aren’t met or, on the other hand, “lock them in” to a low payout should higher inflation and interest rates coincide in the way they did in the late 1980s and early 1990s.

In many cases, the solution will be trusts that are the opposite of the type that were popular in the past. For example, charitable remainder annuity trusts (CRATs) that pay a relatively high fixed amount for a particular period of time may prove the answer, instead of a CRUT that pays a small percentage of the trust as valued annually for the remainder of one or more younger beneficiaries’ lifetime.  


Case in Point

Take the case of 63-year-old George, who’s been asked to make a $500,000 gift to his alma mater as part of an endowment funding campaign. The campaign guidelines grant full credit for all amounts paid by the end of the 7-year campaign period. George recently sold his business for $15 million. The bulk of the consideration he received was in the form of stock in the acquiring company, which he now holds with a very low cost basis carried over from the stock he transferred.  

In addition to proceeds from his business sale, he has a substantial amount of assets in his qualified retirement plans, from which he’ll be required to take large withdrawals beginning at age 70½. In the meantime, he’s not receiving a salary, and he would like to generate an additional $100,000 per year to supplement his other income until he begins these withdrawals. He doesn’t, however, want to pay federal and state capital gains and Medicare contribution taxes of 25 percent or more as the cost of diversifying the stock he received in exchange for his company.

How can George solve his dilemma and make the $500,000 gift he would like to make? He’s advised to create a $1 million CRAT that will pay 10 percent, or $100,000, per year for seven years. His advisors will provide trust services and manage the funds after liquidating the stock free of capital gains tax at the time of the sale. If the trust earns a net return of 5 percent, much of the income George receives from the trust will be reported at capital gains rates under the terms of the “tier structure” of income reporting from CRTs. He, thus, “hates” capital gains taxes when contemplating a sale, but “loves” them when he reports income at rates lower than many other sources.

George is entitled to an immediate charitable income tax deduction of $334,000, which, if desired, he can use to offset capital gains tax on additional liquidation and reinvestment of other portions of the stock he received for his business. Or, he could use the income tax savings to purchase life insurance on his life and perhaps on that of his wife. This could provide a source of funds to pay estate tax that may be due at the death of the survivor, as George and his wife anticipate that their estate will be in excess of the $10.5 million that can currently be transferred by a married couple free of federal estate tax.

If the trust earns a net of 5 percent and makes fixed payments of $100,000 per year, the remainder interest at the end of seven years would be $593,000, an amount in excess of George’s desired gift. At the time he funds the gift, George enters into a binding pledge that commits him, his wife or his estate to make up any amount less than $500,000 that’s received at the termination of the trust.  

The trust remainder recipient is pleased to acknowledge George with credit toward the campaign goal of $500,000. If the trust should earn a net of 8 percent, on the other hand, the remainder will be $822,000 and George will be credited with that amount, rather than the originally anticipated $500,000.


A Bridge to Retirement

From George’s perspective, he’s created a “bridge to retirement,” as the trust will terminate when he’s age 70, the same time he’ll begin taking withdrawals from his retirement plans that will serve to replace the income he’ll no longer receive from the trust.

For the charity, this plan is somewhat similar to a charitable gift annuity for the life of a 90-year-old. The current recommended gift annuity rate is 9 percent for a person that age. Some institutions are reluctant to take on such an open-ended obligation at a time when centenarians are one of the fastest growing groups in our society. No one knows when a 90-year-old will pass away or how long these payments must be made. A 7-year term trust paying 10 percent will, on the other hand, “die” in precisely seven years, and a charity may literally “take that to the bank.”  

George’s financial advisors will continue to manage the $1 million George has placed in the trust without any immediate diminution due to capital gains tax, and much of the annual payment amount may find its way back to other investment management accounts over time. The financial advisors are also free of the pressure to generate the higher total returns necessary to make traditional CRUTs work. Their role is to manage an anticipated “control burn” of the trust assets over a limited period of time.

This is just one example of how the inherent flexibility of CRTs can be used to meet multiple goals for charitably inclined individuals and the interests they wish to benefit in ways that cope with the realities of today’s environment.