Charitable Remainder Trust: $280,000 Tax Deduction from Appreciated Stock

Charitable Remainder Trust: $280,000 Tax Deduction from Appreciated Stock

Executive Summary

A client holding $2 million in highly appreciated stock faced a significant capital gains tax liability when considering a large charitable donation. Golden Door Asset collaborated with the client and their legal counsel to establish a Charitable Remainder Trust (CRT), allowing them to donate the stock, avoid capital gains taxes, and generate an immediate income tax deduction. The CRT resulted in a $280,000 income tax deduction for the client in the year of the donation, while also providing a lifetime income stream funded by the eventual sale of the donated assets.

The Challenge

Our client, a successful entrepreneur, had accumulated a substantial portfolio, including $2 million in stock of a privately held technology company. The stock, originally purchased for $400,000 several years prior, had appreciated significantly, representing a substantial unrealized capital gain of $1.6 million. The client was strongly committed to supporting a local arts organization with a planned donation of approximately 10% of their portfolio, or $200,000. However, directly donating the stock would trigger a significant capital gains tax liability.

Here's a breakdown of the potential tax implications of a direct donation:

• Capital Gain: $1,600,000 ($2,000,000 market value - $400,000 cost basis)
• Federal Capital Gains Tax (assuming 20% rate): $320,000 (20% of $1,600,000)
• State Capital Gains Tax (assuming 5% rate): $80,000 (5% of $1,600,000)
• Total Capital Gains Tax: $400,000

This meant that donating $200,000 worth of stock would actually require the client to pay an additional $400,000 in taxes, significantly reducing the overall benefit to the charity and the client's philanthropic goals. The client also expressed a desire to diversify their portfolio and generate a predictable income stream during retirement. The challenge was to find a tax-efficient strategy that would allow the client to make a meaningful charitable contribution, minimize capital gains taxes, and provide a reliable income source. They wanted to achieve these goals without substantially diminishing the assets available to his family and future generations.

The Approach

We recommended establishing a Charitable Remainder Trust (CRT). This strategy involved the following steps:

1. Understanding the Client's Goals: We began by thoroughly understanding the client's philanthropic objectives, income needs, and risk tolerance. This involved detailed discussions about the amount they wanted to donate, the type of income stream they desired (fixed or variable), and their comfort level with different investment strategies within the CRT.

2. Collaborating with Legal Counsel: We partnered with a qualified estate planning attorney to draft the CRT documents. This was crucial to ensure that the trust met all IRS requirements and aligned with the client's specific wishes. The attorney handled the legal aspects of establishing the trust, including drafting the trust agreement and ensuring compliance with all applicable laws and regulations.

3. Selecting the CRT Type: Based on the client's needs and preferences, we determined that a Charitable Remainder Annuity Trust (CRAT) was the most suitable option. A CRAT provides a fixed annual payment to the donor (or other designated beneficiaries) for a specified term (usually the donor's lifetime or a term of up to 20 years). This provided the client with the predictability of a fixed income stream.

4. Donating the Appreciated Stock: The client transferred the $2 million worth of appreciated stock to the CRT. This transfer was a tax-free event, avoiding the immediate capital gains tax that would have been incurred if the stock had been sold directly.

5. Selling the Stock within the CRT: The CRT then sold the stock, still avoiding capital gains taxes because the CRT is a tax-exempt entity. The proceeds from the sale were then reinvested into a diversified portfolio of income-generating assets.

6. Calculating the Income Tax Deduction: Based on IRS actuarial tables, the client was eligible for an immediate income tax deduction equal to the present value of the remainder interest that would ultimately pass to the charity. This calculation took into account the client's age, the payout rate of the annuity, and the applicable federal interest rate.

7. Establishing the Annuity Payment: The CRAT agreement stipulated that the client would receive a fixed annual payment of 7% of the initial fair market value of the assets transferred to the trust ($2,000,000 x 7% = $140,000 per year) for the rest of his life.

Technical Implementation

The technical implementation of the CRT involved several key steps and calculations:

1. Trust Document Preparation: The estate planning attorney drafted the trust agreement, outlining the terms of the CRAT, including the annuity payment amount, the duration of the payments (the client's lifetime), and the designated charitable beneficiary (the local arts organization).

2. Appraisal of the Stock: A qualified appraiser valued the stock to establish its fair market value at the time of the donation. This valuation was essential for determining the amount of the income tax deduction. We ensured the appraisal met IRS standards for qualified appraisals.

3. IRS Actuarial Calculation: To determine the income tax deduction, we used IRS Publication 1457, Actuarial Values, to calculate the present value of the remainder interest passing to the charity. This involved considering the following factors:

   • Applicable Federal Rate (AFR): The AFR is published monthly by the IRS and reflects the prevailing interest rates. The AFR for the month of the donation was used in the calculation. For example, if the AFR was 3%, then that rate was used in the present value calculation.
   • Client's Age: The client's age at the time of the donation was used to determine the actuarial life expectancy factor.
   • Annuity Payment Rate: The annuity payment rate was set at 7% of the initial fair market value of the assets.

   The calculation uses a complex formula found in IRS Publication 1457 to determine the present value of the charitable remainder. In this case, the present value of the remainder interest was determined to be $280,000.

4. Portfolio Management within the CRT: We managed the assets within the CRT to generate sufficient income to cover the annual annuity payments. The portfolio was diversified across various asset classes, including stocks, bonds, and real estate, to balance income generation with capital preservation. The asset allocation was tailored to the client's risk tolerance and income needs. We use a Total Return investment strategy within the CRT to maximize both income and capital appreciation.

5. Tax Reporting: We prepared all necessary tax documentation for the client and the CRT, including Form 5227 (Split-Interest Trust Information Return) and Schedule K-1 (Beneficiary's Share of Income, Deductions, Credits, etc.). This ensured compliance with all IRS regulations and facilitated accurate tax reporting.

Results & ROI

The implementation of the CRT resulted in significant financial benefits for the client:

• Income Tax Deduction: The client received a $280,000 income tax deduction in the year of the donation. This deduction significantly reduced their overall tax liability. Assuming a combined federal and state income tax rate of 35%, this deduction resulted in tax savings of $98,000 ($280,000 x 35%).
• Capital Gains Tax Avoidance: By donating the appreciated stock to the CRT, the client avoided paying $400,000 in capital gains taxes. This represents a substantial tax savings and allows the client to donate the full value of the stock to charity without incurring significant tax liabilities.
• Lifetime Income Stream: The CRT provides the client with a fixed annual income stream of $140,000 for the rest of their life. This income stream provides financial security and helps the client meet their retirement income needs.
• Charitable Giving: The client was able to make a significant contribution to the local arts organization, supporting their mission and benefiting the community.
• Diversification: The sale of the highly appreciated stock within the CRT and the subsequent reinvestment into a diversified portfolio reduced the client's concentration risk and improved the overall risk-adjusted return of their portfolio.

Here's a summary of the ROI:

• Initial Investment (Stock): $2,000,000
• Capital Gains Tax Avoided: $400,000
• Income Tax Deduction: $280,000
• Tax Savings from Deduction (35%): $98,000
• Annual Income Stream: $140,000
• Total First Year Benefit (Tax Savings + Income): $238,000
• Long-Term Benefit: Lifetime income stream and charitable impact.

Key Takeaways

Here are some actionable insights for other advisors considering CRTs for their clients:

1. Identify Clients with Appreciated Assets: Look for clients who hold significant amounts of highly appreciated assets, such as stocks, real estate, or other investments. These clients are prime candidates for CRTs.
2. Assess Charitable Intent: Determine your client's philanthropic goals and their desire to make a significant charitable contribution. A CRT is most effective when the client has a genuine interest in supporting a charitable organization.
3. Collaborate with Legal and Tax Professionals: Partner with qualified estate planning attorneys and tax advisors to ensure that the CRT is properly structured and meets all IRS requirements. This collaboration is essential for maximizing the tax benefits and ensuring compliance.
4. Tailor the CRT to the Client's Needs: Customize the CRT to meet the client's specific income needs, risk tolerance, and philanthropic objectives. This may involve selecting the appropriate type of CRT (CRAT or CRUT), determining the annuity payment rate, and designing an investment strategy that aligns with the client's goals.
5. Educate Clients on the Benefits: Clearly communicate the benefits of a CRT to your clients, including the tax savings, income stream, and charitable giving opportunities. Provide them with a clear understanding of how the CRT works and the potential impact on their financial situation.

About Golden Door Asset

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