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Monday July 28, 2014

Article of the Month

Reducing the Medicare Tax – Part III

Charitable Lead Trust Planning for NIIT

Individuals with substantial assets may determine that a charitable lead trust will be beneficial in reducing NIIT. For people with current substantial charitable gifts, it will be highly advantageous to transfer assets producing income to a charitable lead trust. The same charitable gifts are then made by that lead trust. Currently, individuals are typically receiving the income and capital gain from the investment portfolio, suffering the adverse consequences of NIIT, the AMT exclusion phase-out, the 3% limitation on itemized deductions and various other phase-outs due to high adjusted gross income levels. By transferring assets to a charitable lead trust and making the gifts through the lead trust, the NIIT may be completely avoided and all of the very adverse results of high AGI may also be minimized.

Charitable Lead Trust Avoids NIIT

John and Mary Green are both age 70 and have a total estate of $8 million. In addition to their home, the majority of the estate is in a portfolio of securities that was inherited from Mary’s parents and has grown substantially over the years. John and Mary have approximately $100,000 per year earned income, $100,000 in IRA distributions and $300,000 in income from their portfolio. They live a moderate lifestyle, have no personal debt and give $200,000 per year to favorite charities.

John and Mary recognize that with the applicable exclusion amounts of over $10 million (plus indexed increases) for a married couple, they can transfer very substantial wealth to family members. However, they also would like to start the inheritance plan at a time where they can better determine the optimum level of inheritance that will help their children to be better persons.

Their goals are to reduce current income tax, reduce the amount of net investment income tax, limit exposure to alternative minimum tax, provide an initial inheritance to children during their lifetime and preserve the flexibility to adjust future inheritance amounts. A charitable lead trust accomplishes all of those objectives.

John and Mary transfer $4 million in appreciated securities with a cost basis of $1 million into a 5% lead trust for a term of 10 years. The $4 million transfer is reduced by a charitable deduction of approximately $1.7 million, producing a taxable gift of $2.3 million. They each report one-half of that amount on IRS Form 709 and use a portion of their applicable exclusion.

The $4 million in the annuity lead trust will require a distribution of $200,000 per year. The trustee will make the required annual payment from the lead trust to qualified charities. Fortunately, under Sec. 642(c)(1), this mandatory distribution qualifies for a charitable deduction. This also will be a qualified distribution that is deductible for purposes of NII. Because the trust will have no net taxable income for either income tax or NII purposes, a properly planned charitable lead trust will pay zero tax.

With the low basis of appreciated assets gifted to the trust, the trustee will not be able to diversify a significant part of the portfolio. Therefore, the transferred assets will hopefully be a reasonably diversified portfolio that may be held for the ten years. Most of the lead trust is funded from the investment portfolio of John and Mary with as much diversification as is possible. Because the portfolio is 80% to 90% blue chip stocks, there is some investment risk, but John and Mary understand that. John says, “If we held the portfolio, we would be experiencing exactly that same investment risk.”

During the 10 years, the annuity of $200,000 will be distributed to the favorite charities of John and Mary. If they wish to permit the family to retain power to influence recipients of all of that distribution, a child may be given a special power to allocate among the favorite charities. Total charitable payments in the term of 10 years will be $2 million.

By transferring the assets to the charitable lead trust and making the charitable distributions from the trust, John and Mary reduce their taxable income by $200,000. With some repositioning of other assets, they are able to reduce their taxable income to $250,000 per year. This places them outside the threshold for NIIT. In addition, John and Mary decide to live on the $250,000. From the remaining $4 million in the estate, they plan to give about 2% or $75,000 in appreciated gifts per year to charity.

The combination of $75,000 in appreciated gifts from the appreciation reduces their estimated appreciation from an anticipated 6% or 7% down to 5% to 6% on the remaining portfolio. They deem this to be a very acceptable appreciation rate. However, the charitable deduction plus cash gifts enables them to reduce their taxable income from $250,000 down to approximately $160,000 per year. They not only have removed themselves from the NIIT, but they also are no longer in the alternative minimum tax and have significantly reduced their current income tax.

Lead Trust Distribution to Children

At the end of the 10 year lead trust, John and Mary will be age 80 and the children will be in their early 50s. At that time they would like to start the inheritance for family. John and Mary understand that the inheritance plan for children could be one of two options: Plan A – Give the children a sufficient sum so that they need no other income, or Plan B – Provide children with “added economic security” over and above their current income. Like the vast majority of parents, John and Mary believe Plan B – Provide added economic security – is the appropriate solution. However, because the lead trust is funded during life, the distribution of $4 million plus appreciation will involve potential capital gain to the children.

Recognizing that John and Mary have avoided NIIT, they also desire to minimize both NIIT and income tax for the children. Therefore, the distribution at the end of the 10 year lead trust is into a 5% charitable remainder trust for each child. Each of the two children receives a one-life 5% charitable remainder trust funded with approximately $2.2 million of appreciated securities. The favorable benefit is that the charitable trust is exempt both from income tax and NIIT. The $2.2 million may be immediately diversified for the benefit of the child into an appropriate portfolio.

In addition, the portfolio may grow for the benefit of the child and the additional income is quite possibly going to be within the $200,000 or the $250,000 threshold for a single person or a married couple. Each child will receive approximately $100,000 of added income per year for life.

John and Mary also appreciate the opportunity to determine whether or not this is the appropriate level of enhancement of lifestyle for the child. While they are in their 80s with $4 million plus growth remaining in the estate, they can determine how much of the remaining assets should be added to the 5% charitable trust when they pass away or how much should be transferred directly to favorite charity. If they believe that the children should have additional income each year, then they can easily plan for that addition to each unitrust from the estate of the survivor.

Flexible-FLIP Unitrust

A final enhancement for the 5% trust for the children could be a flexible-FLIP unitrust. When the 5% trusts are created, a nonmarketable asset such as a vacant lot may be included in the trust. That trust could then be defined as a net income plus make up trust with the option to FLIP to a standard payment unitrust upon sale of the lot.

This also is a very powerful tax planning option. With a net income plus make up trust, if the child does not need the income, the trustee may invest in securities primarily for growth. At such time as the child desires or needs income, the lot may be sold to trigger the FLIP to a standard unitrust. Because the child will want to receive capital gain distributions for his or her lifetime, it is important for this trust to define realized capital gain as distributable income for this purpose.

This plan allows great flexibility for the child. While it is difficult to know the exact tax rates in the future, the high probability is that upper-income persons will continue to pay taxes in the mid 40% range in the future. Children who have substantial inheritance are very likely to be in high tax brackets and will welcome the ability to control their recognized income. Given the current structure with ordinary income tax, alternative income tax and net investment income tax, tax-free accumulation of principal in a 5% unitrust is a huge potential benefit.

Traditional Testamentary Trust

A traditional testamentary trust for children may be subject to federal tax of 43.4% plus state taxes on accumulated income in 2014 over $12,150 (with indexed increases in future years). Compared to the colossal tax burden of the traditional trust, a 5% tax exempt unitrust allows tax free diversification of assets and has the potential to allow children to control all three levels of taxation. This is a far superior income tax planning strategy when compared with the traditional testamentary trust for family. With tax free accumulation within the CRT, the total principal available to earn income during retirement years will be far in excess of the tax-devastated value for a traditional trust.


All upper-income taxpayers will soon clearly understand the importance of future income tax planning. Given the Affordable Care Act and the American Taxpayer Relief Act and the obvious targeting of upper-income persons, all professional advisors – the attorney, the CPA, the certified financial planner, the trust officer and other advisors – will want to understand the best ways to reduce all levels of taxation. A combination of cash and appreciated gifts, the IRA charitable rollover, a charitable remainder trust or a charitable lead trust that flows into charitable remainder trusts for children are powerful income tax planning strategies.

Published July 1, 2014

Previous Articles

Reducing the Medicare Tax – Part II

Reducing the Medicare Tax – Part I

Unprearranged Prearranged Sale

CRT Gift and Estate Taxes

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