If I can say anything positive about tax code it is this: It sure makes charity rewarding. Charitable giving reduces not only your income tax burden, but also escapes the mother of all taxes, the estate tax.

Most wise people I’ve met or read about, whether or not they are faith-based, believe in some principle of charity. So, presuming that the desire to give is an attribute you share with other wise souls, let’s look at a couple of special situations.

Give Those Municipal Bonds Away!

Say what? I know what you’re thinking: what is this guy smoking?

I encourage you to read on and perhaps a ray of sunshine will strike you and you’ll find yourself with one great big deduction that you can use over the next 5 years. Oh, by the way, you get to keep all the municipal income for the rest of your life.

Let’s suppose that you’ve accumulated a nice portfolio of stocks and bonds and some of these bonds are muni’s. For the heck of it, let’s also assume that you are likely to face estate taxes when your estate passes to your children and those awful people they married (more later on this subject).

You’ve received through the years solicitations from your alma mater to give them money either outright or at death by including them in your will. They may have even suggested a gift annuity or sending a gift to their donor advised fund. Most of my clients have given a little money outright and a few have included them in their will to some degree, but those gift annuities and donor advised funds seem interesting yet murky at best. I believe people don’t get rich by accident and I think trusting your gut on matters like this is prudent.

Undoubtedly you’ve heard a pitch or two of Charitable Remainder Trusts. Here’s how the typical pitch goes: take your appreciated asset (land, stocks, art, etc.), give it to a trust with you and your spouse as lifetime income beneficiaries. Since this is a charitable entity, the gain is forgiven, so you can invest 100% the proceeds by converting the asset in the trust and buying a portfolio that spins off the desired income for your combined lifetimes. After the second spouse dies, the money goes to the named charity or charities.

By doing this, you get two significant tax benefits. First, the money is out of your estate and reduces your estate tax liability. Second, you get a calculated income tax deduction (a future value calculation based on your combined mortality as the charity doesn’t get the money until then). This income tax deduction can be material depending on your age and the size of the gift.

It would look something like this:

Say you have targeted a gift of $1 million. This portfolio has a basis of $300K.

You and your spouse are each 75. You select a 5% payout for your joint lifetimes paid quarterly.

Tax Benefits:

• $1 million and its growth are out of your estate saving the estate over $350K in estate taxes.
• You get an ordinary income tax deduction for a shade over $500K that you use this year and carrying forward for up to 5 years.
• If you want to replace the asset to your heirs, you can use the tax benefit of the deduction to fund a joint life policy that your kids can own, or you can put it into an Irrevocable Life Insurance Trust, and the proceeds will go income and estate tax free to heirs.

Yes, it all sounds good and more than one eager life insurance agent has nearly convinced you before.

Still, you haven’t bit.

Here’s a strategy I doubt anyone has ever suggested.

First, use full basis assets to fund the CRT. Second, forget about the life insurance.

The second part is easy because you hate life insurance and when you think about it, your kids don’t need all that money any way.

The first part, though, is counterintuitive, admittedly, but in a lot of cases it’s a rich idea. Here’s why.

No one ever takes time to explain how the income distributions from a CRT are taxed to you. When you read the code you’ll cross your eyes and pass out in stupor before you can slog through it. So, let me make it simple.

There are tiers of income. The fundamental rule is no real surprise: the IRS wants the income to be taxed as least favorably to you as possible. So, if the trust produces any ordinary income, you get that first. Then, if there is any capital gain, that comes out second. Then if there’s any non-taxable income, that comes out last.

Perfect, say you, I’ll put in the CRT that appreciated asset, sell it, and then buy municipals and live forever after happy in my counting house, thumbing my nose at the IRS. Sorry, what no one told you is that all that capital gain you thought you escaped, you have to recapture fully before you get the benefit of the tax-free income.

But what if you take that aforementioned municipal bond portfolio which has no capital gain in it and donate it to your CRT? The only income the CRT produces is the same municipal income you’re currently enjoying. Face it, you are never going to convert that muni bond portfolio to anything else. Why not get a great big fat deduction and reduce your estate at the same time?

Result, you put the $1 Million portfolio into that CRT, save at least $370K in estate taxes and get a half million charitable income deduction. And, all the while you collect the same municipal income you were going to in the first place.

Dollar for dollar, I know of no more powerful strategy for giving. After all the savings derived from the strategy, the gift costs you pennies (well, dimes) on the dollar.

By the way, what if you formed your own charity (family foundation) and made it the charitable beneficiary of the CRT? More later. . .

Posted in BIG Blog, Guidance