Financial and estate planning for high net worth individuals did not traditionally include the use of charitable giving techniques unless the client was a committed philanthropist. Where charitable giving was part of a plan, it usually involved direct gifts by check while alive or a specific or residuary bequest by will. There were infrequent uses of charitable remainder or lead trusts and little planning through more limited forms of philanthropic vehicles. After TRA 86, the arena of tax and financial planning underwent a major revisit.

With the diminishment in planning value of traditional devices (particularly real estate and certain retirement vehicles), techniques identified primarily with charitable giving moved to the front. Accountants, trust and estate lawyers, and financial planners began to consider charitable trusts as a principal planning vehicle. This resulted in a major increase in what are termed planned charitable gifts.

TRANSFERS OF RESIDENCES

Among the assets of high net worth parents are often an appreciated primary or secondary residence, often having no mortgage encumbrance, and a very low basis. The residence has typically been in the family for a number of years, and it is anticipated that the parents will remain there for the balance of their lives. At the death of the survivor, it has been planned that the residence will be passed on to the children, with the probability that it will be sold by the executor and the net proceeds divided as directed in the will. Since the parents are high net worth individuals, the residence does not represent a significant part of their total assets, although it has substantial current value.

The parents face the dilemma of leaving the residence to the children in what may be a bad real estate market and where, after the costs of sale by the executor and the estate tax obligations have been satisfied, the children may be left with a substantial diminution in the net value of their inheritance. It is the planner's goal to find means whereby the real value of the residence, or at least a sizable part of it, will find its way to the children in as efficient and timely a manner as possible.

The parents have a history of philanthropy. They are both age 70 and in good health. It is not intended that either of their two children will make use of the residence at the end of the lives of their parents. The current fair market value of the residence is $700,000. There is a charitable giving vehicle that may solve many of the stated purposes and some yet to be considered. The parents would execute and deliver a deed conveying the property to a public charity (to maximize the usable charitable income tax deduction) while retaining in the conveyance an exclusive and uninterrupted life estate for their joint lifetimes. Upon completion of this gift of a future interest to the charity, the parents have achieved the following tax benefits:

* The avoidance of estate taxes since the value of the property is fully excludible from their federal taxable estates by virtue of the estate tax charitable deduction; and

* A current income tax charitable deduction based upon the actuarial calculations applicable to split-interest gifts of residential real estate (Regs. Sec. 1.170A-12).

The estate tax savings by itself represents a substantial benefit to the parents, whose combined estate tax marginal rates could be as high as 55%. The current income tax charitable deduction, calculated presently to be, say, $250,000, will generate tax savings of $100,000 (assuming combined brackets of 40%), available in the year of the gift or in up to five consecutive years to the extent any unused portion of the deduction is to be carried forward. It is this tax savings that offers the family an opportunity to replace all or a portion of the value of the property (perhaps, irrespective of the reduction by estate taxes that would have otherwise occurred) for the benefit of the children free of estate taxes.

This can be accomplished either through the purchase by the children, as owners and beneficiaries, of a second-to-die insurance policy on the joint lives of the parents or through the establishment of an irrevocable life insurance trust for the benefit of the children as beneficiaries of the trust. Planners might also consider acquiring equities, deferred annuities, zero coupon bonds or other forms of replacement property, especially if both parents are uninsurable. In either instance, the funds can be made available by the parents, if essential to the planning, gift-tax free to leverage the acquisition of a replacement vehicle free of estate taxes as well. If the planning concluded here, the parents would have achieved significant tax savings and made a substantial gift to charity while not depriving their children of the value of the property that they would have inherited had it been left to them outright in the parents' wills.

This plan, however, fails to consider two non-tax issues, but which present strategic problems for the parents. If they desire at a date in the future to move from the residence, they have nothing to sell (the life estate has a calculated value but its marketability is questionable except to a related party). Had they not made the deed to charity, they could have at least sold the property, paid the income taxes on realized capital gain (net of exclusionary amounts), and reinvested the net amount in a replacement residence.

Although the taxes might be substantial, they would have some capital to realize their need for mobility. The planned gift, initiated with the deed/life estate, takes this possibility into consideration by including in the gift agreement the following provisions:

* The life tenants, or survivor, can elect to relinquish the life estate by notifying the charity at any time of this intention. The charity is then obligated to sell the property at its appraised fair market value within a specified period while the life tenants remain in residence pursuant to the retained life estate. When the charity realizes the net proceeds from the sale of the property, this sum is placed in a segregated investment account or trust in order to generate income which will be used to pay the life tenants and the survivor of them a lifetime fixed annuity, the rate of which is established in the initial gift agreement.

For example, if the rate agreed upon initially was 8% and the net proceeds from the sale of the property were $800,000 (assume it was sold five years after the original deed was executed pursuant to the gift agreement), there would be a fixed joint and survivor lifetime annuity of $64,000 a year ($800,000 times 8%). From this annuity, the parents would be able to rent or purchase a new residence, with the annual excess available to supplement their retirement needs (or to be given to their children, gift-tax free, to add to the value of their inheritances).

It is also possible that either or both parents might require long- term health care, involving relocation to a care facility, perhaps permanently. Under the gift agreement, there may be an involuntary relinquishment of the life estate under criteria, medical and otherwise, set out therein. In the event of an involuntary relinquishment of the life estate, the same procedure of appraisal, sale, and investment of net proceeds would apply. In such a situation, the disabled person would have a substantial fixed annual sum ($64,000 a year in our example) to aid in the payment of the costs of care. Although high net worth individuals may not need an additional annuity opportunity, it is instructive to report on an initial annuity that may, subject to state law, accompany the deed to charity with retained life estate.

Assume the costs of real estate taxes, upkeep of the residence and other living expenses have risen faster than the income generated on investments. This may be especially applicable in the current fixed interest rate climate, particularly for bank certificates of deposit, and where investors see their returns halved against comparable investment periods a year ago. The gift agreement may provide that the life estate be accompanied by a joint and survivor lifetime annuity, paid simultaneously with occupancy of the residence by the life tenants, and determined by multiplying an agreed upon rate by the charitable portion of the value of the property at the date of gift.

Therefore, as in our example, the property was initially worth $700,000 and the charitable portion was valued at $250,000, the fixed annuity may be, say, 7% of that sum or $17,500 a year. Of course, the value of the charitable deduction available for the parents on their income tax return for the year of the gift will be less than $250,000 because that initial amount must be reduced by the actuarial value of the annuity.

If the parents should subsequently elect to voluntarily relinquish their life estate (or it should occur involuntarily), the net proceeds derived from the sale of the property by the charity would first be reduced by the cumulative total of all annuity payments made to that date before a net sum would be invested to produce this successive lifetime formula annuity.

In this form of comprehensive plan, we have taken an unproductive asset, the family residence, and made it into a financially productive asset while generating income tax and estate tax savings, providing for children in another form, and making a meaningful gift to a favorite charity.

THE CHARITABLE REMAINDER TRUST AND TANGIBLE PERSONAL PROPERTY

Typically, charitable remainder trusts have been funded with appreciated property in the form of stocks and bonds (and marketable real estate on occasion) or with cash. It is the exception to find a plan that includes tangible personal property such as a work of art, gems, or rare musical instruments or jewelry, to fund a charitable remainder annuity trust (CRAT) or charitable remainder unitrust (CRUT).

Considering tangible personal property, however, can present a significant planning opportunity for the high net worth individual. An actual example best explains how this works.

A donor had a rare violin worth in excess of $1 million, which represented, at his age, some major estate tax exposure. Since he could no longer play the violin (he purchased it for a relatively nominal sum many years ago, not principally as an investment, but as a cherished instrument to play), he hoped to find a way to make the asset financially productive, avoid estate taxes and, if possible, make a meaningful gift to his favorite charity. He and his wife were both in their 70s.

A plan was designed to have the donor contribute the violin to a CRAT since it was reasonably concluded, in consultation with a major auction firm that would handle the sale, that the trust would have cash for investment before the end of the year in which it was established and funded.

Under the terms of the CRAT, the donor and his wife would have the assurance of a fixed annuity based upon the fair market value of the contributed property, best determined by its public arm's-length sale within a short time after being placed in the trust and supported by a qualified appraisal on IRS Form 8283. Contribution of this appreciated item of property to a CRAT enabled the donor to avoid income tax on the difference between his basis in the property and its value at date of gift.

Since the trust is a tax-exempt entity, it paid no income tax on the sale of the violin for fair market value. Furthermore, since the trust remainder will be paid over to a named charity at the end of the lives of the income beneficiaries, there will be an estate tax charitable deduction available in the estates of the donor and his wife for the full value of the assets in the trust at the end of the lifetime of the second to die. The real question arises with respect to the value of the income tax charitable deduction.

The rule of deductibility for income tax purposes is that the contributed tangible personal property must be given to a charity that can use it for its exempt purposes, such as art to a museum, musical instruments to a philharmonic orchestra, etc., in order for the donor to deduct the contribution at its full fair market value. Certainly, a CRAT cannot be said to be a related use charity, even if the remainder interest will be paid over to a charity that is. As a consequence, it seems that the deduction available for income tax purposes would be limited at best to the charitable portion of the cost basis in the property in the hands of the donor determined actuarially. Nevertheless, the productivity generated from the fixed annuity paid annually (from what was previously an unproductive investment) for the joint lives of the donor and his wife ($1 million times 8% = $80,000 a year), coupled with the avoidance of both current income taxes on the capital gains and future estate taxes on the full date of death value of the corpus of the trust, make this planning opportunity of significant value for high net worth individuals.

An Adult Child to Consider

Another planning issue may arise in a CRAT that ought to be considered. Suppose the donor in our example had an adult child, age 50, that he wanted to include as a beneficiary of the fixed annuity if she were to survive both of her parents. To include the child in the trust as an income beneficiary would generate a substantial gift tax liability in the donor for the non-charitable portion of the value of the contributed property attributable to the child's income interest.

Since the child is relatively young from an actuarial perspective, the size of the taxable gift and the gift tax liability could be considerable. To avoid gift tax, there should be included in the trust instrument a clause permitting the settlor to revoke any and all income interests by will this is described in Regs. Sec. 1.664-2(a)(2)(iii)(4). As a consequence, there is no completed gift; and, if the donor does not revoke the child's interest in his will, there will be estate tax inclusion of the non-charitable portion of the gift at the donor's date of death, subject to estate taxes. The tax is, therefore, deferred to a time when the child will be older, and the value of her income interest (the non-charitable portion of the value of the trust's assets) will be expected to be less than it would have been at the date the trust was established.

Of course, if the child is not in need of the income interest in subsequent years, the donor can revoke her income interest and remove the trust assets from the donor's taxable estate.

A More Aggressive Stance

There are a number of experienced advisors who contend that the issue of income tax deductibility for gifts of tangible personal property to a CRAT or CRUT may not be limited to a percentage of basis. They concede that the related use rule is generally applicable, and that the initial contribution of tangible personal property to the trust cannot generate a deduction based upon the property's fair market value. However, once the tangible personal property is sold in the trust and the assets are either intangible personal property (e.g., stocks, bonds, etc.) or cash, a fair market value deduction (reduced by the actuarial value of the income interests) is available.

The argument is that it is the nature of the property that the charity will receive when the remainder is paid over that is controlling and not the form of the property when it is originally contributed to the trust. Thus, the issue of related use is no longer applicable when the charity will not be receiving an item of tangible personal property. Accordingly, it is argued that when the property is sold in the trust and is no longer tangible, the taxpayer is entitled to calculate a deduction for income tax purposes in the year of the sale based upon the fair market value of the trust's assets.

In a recent private letter ruling, the IRS was asked to consider issues involving the funding of a charitable remainder trust with a collection of foreign coins. One of the issues raised dealth with the amount of available income tax deduction based upon the argument advanced above. The IRS did not reach that issue since, instead, it determined the foreign coins were currency (the first argument raised in the application for the ruling). Therefore, since the coins were not deemed to be tangible personal property, the deduction was determined from their full present value. It is not suggested that an aggressive approach in claiming the deduction will go unchallenged by the IRS in whatever form it may take. Rather, there is a reasonable case to be made in support of the deduction; and, under the appropriate fact situation and with the right taxpayer, it may prove to be an economically beneficial claim and a substantial planning opportunity.

PARTIAL INTERESTS IN REAL ESTATE

A couple owns a second home in the Sunbelt. They make use of it three months each year (January through March). For the remainder of the year, the property is unused--it is not rented. The condominium is currently worth $200,000 and has no mortgage. The donors' basis in the property is less than $50,000. They are regular supporters of a charity in the state in which they principally reside.

It would be tax-wise for the donors to convey an absolute partial interest in the property equal to the unused portion (nine months = 3/4) to the charity so that the donors and the charity own their respective partial interests as tenants in common or the equivalent under applicable state law. This gift of an absolute 3/4 interest in the property to charity will generate for the donors a current income tax charitable deduction equal to 3/4 of the value of the property as determined by a qualified appraiser on IRS Form 8283. This deduction, as much as $150,000 ($200,000 times 3/4), will provide $60,000 in tax savings assuming that the donors have combined tax brackets of 40%. The 3/4 interest, owned by the charity, is no longer an asset of the donors and is not part of their gross estates. The tax savings can be utilized by the donors either to replace the value of the contributed interest for the benefit of their heirs estate tax free or to provide additional current financial benefits for the contributors. The term of use each year by the donors equals their 1/4 retained interest can be subject to negotiation between them and the charity, or it can be specified in the gift agreement when the transfer of the 3/4 interest is made to the charity.

Absent an agreement to the contrary, the charity is obligated to pay those charges allocable to its 3/4 interest in the property. These charges include a portion of the real estate taxes, condominium association common charges and special assessments, hazard insurance, upkeep and other maintenance costs during the year. A generous donor who receives such substantial economic benefits often makes additional annual unrestricted contributions to the charity, above the usual annual gift, and takes an additional income tax charitable deduction. The charity is then in a better position to invest its general (or restricted) assets and revenues in the condominium to pay its proportionate annual costs.

In the future, the donors may decide to convey the remaining 1/4 interest in the condominium to the charity and claim an income tax charitable deduction (or an estate tax charitable deduction, if done by will) for the fair market value of that interest. If the 1/4 interest is not conveyed or devised to the charity, those who inherit that partial interest will invariably cooperate with the charity to sell the property and divide the proceeds in proportion to their interests.

High net worth individuals also profit from charitable planned giving opportunities using charitable lead trusts, closely owned C corporation stock, interests in retirement plans (including IRA, Keogh, and company pensions), charitable remainder unitrusts (funded with unproductive real property), and deferred gift annuities.