WHEN I ASK my clients, "What is your charitable intent?" most of them respond with something like, "Nothing significant." But when asking the same clients, "What is your level of interest if I can show you how to use the tax law to enrich your family, while giving to charity and saving taxes at the same time?" then the reply is something like, "Show me," or "I'm interested."
The case study that follows uses a $10 million target endowment. But don't get hung on the numbers.
Now the facts: Ben and Mary, both age 65, want to create a $10 million endowment at Favorite Charity to honor their deceased son. They don't feel comfortable making this large gift during their lifetime. They fear inflation and don't want to reduce the income level (dividends and interest) of their conservative investment portfolio. Also, they would like to find some way for the gift not to reduce the inheritance of their three surviving children.
Ben and Mary are willing to commit the full $10 million to a charitable plan now, as long as their two goals, maintaining income level and not reducing the inheritance of their kids, are fulfilled. They are in a 35% income tax bracket and 50% estate tax bracket. (Even if the rates change, the strategies used in this study remain the same.)
Following is the four-step plan we implemented for Ben and Mary:
Step 1. They bought a joint and survivor annuity (pays as long as either is alive) for $4 million that yields 6.6% or $264,000 (6.6% x $4 million) per year. The prior annual earnings of the $4 million was $108,000. So, the $264,000 is $156,000 more than the old annual earnings of $108,000 (that was fully subject to income tax). Now, a great bonus: 59.4% of the $ 264,000 ( or $156,816) is income tax free; after considering the income tax savings, Ben and Mary will have an additional $156,000 per year of spendable income (as an inflation hedge).
Step 2. Favorite Charity buys a $10 million single premium life insurance policy on Ben and Mary. Ben and Mary gift the premium of $3 million to fund the endowment when both Ben and Mary have died.
Step 3. Ben and Mary enjoy income tax savings of $1.05 million for the $3 million gift in Step 2. They created an irrevocable life insurance trust to buy a $10 million second-to-die, 15-year pay premium policy. (That means you pay the same amount each year for 15 years and then premiums stop.) The annual premium is $212,800 per year or a total of $ 3.192 million ( 15 years times $212,800). The $1.05 million income tax savings (plus interest earned), together with the additional $156,000 every year in Step 1, should easily cover the annual premium payments.
Step 4. You might call this the "extra-cautious step." We asked Ben and Mary to keep the extra $3 million in a separate interest-earning investment. Remember, Ben and Mary were willing to commit $10 million to the four-step plan. We only used $7 million ($4 million in Step 1 and $3 million in Step 2).
The extra $3 million serves as protection for any small amount that may be needed (doubtful) to pay the premiums in Step 3 and as a hedge against inflation (very likely).
As the years go by, if inflation or some other need requires Ben and Mary to increase their spendable income, a portion of the $3 million in the separate account can be used to purchase a new annuity.
If inflation does indeed rear its ugly head, the annual dollar annuity amount would be larger for two reasons:
- Inflation increases annuity rates, and
- Of course, as Ben and Mary get older, the rate for a commercial annuity rises a bit each year.
Let's summarize the plan created for Ben and Mary:
• Their after-tax annual income for the $4 million is more than doubled (Step 1).
• Favorite Charity will get $10 million (Step 2).
• Their family will get $10 million (Step 3).
• The real economic value of the $10 million committed to the plan ( after 50% estate taxes) is only $5 million. In effect, we turned $5 million into $20 million ($10 million each for Favorite Charity and the family). And, of course, there still is an extra $3 million, as a contingency, in Step 4.
One final point: The $20 million to Favorite Charity and the family was divided 50/50 by Ben and Mary. You can change the ratio to whatever you want to favor Favorite Charity or your family, as you desire. And one final warning: Only work with experienced advisers when you play this type of charity-tax game.
If you want to learn more about this technique, visit my Website www.taxsecretsofthewealthy.com and click on " Personally Designed Philanthropy."
Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL 60606; tel. 312/207-1040, or via e-mail at [email protected].